Is 'Venture Equity' the Next Capital Gap Solution?

Startup failure is the rule, not the exception. However, much startup ”failure” includes businesses that made a workable product and grew — just not fast enough to attract venture capital. A hybrid venture capital-private equity approach is trying to identify these slower-growing businesses as part of an investment model that may provide an exit strategy for spurned startups throughout the country.

As reported recently in the Wall Street Journal, at least three firms are taking this hybrid approach to venture capital: San Francisco-based Turn/River, Las Vegas-based Xenon Ventures and San Antonia-based Scaleworks. The strategy is to identify startups that looked promising through the seed stage of the funding cycle but were unable to realize the growth needed to attract venture capital, despite posting millions of dollars in revenue. Ed Byrne, General Partner of Scaleworks, calls the investment strategy, “venture equity.”

The venture equity model is to buy businesses cheap (although sometimes by acquiring tremendous debt), provide some level of management and process changes (each fund is currently focusing on specific business types), and prepare the growing business for sale. While such turnaround strategies have long generated negative impressions (see 2012 coverage of Bain Capital or Pretty Woman), startup founders may prefer this approach to being acquired by Yahoo!, selling their IP for $10, or being unemployed.

The potential market for this strategy appears sizable. Dow Jones VentureSource identifies 1,479 startups with at least $1 million in funding from 2010-2013 and none from 2014-2016. The most recent Tracking Angel Returns report found funds holding onto investments for a full year longer than in 2007, with 70 percent of investments yielding a less than 1x return. Meanwhile, the most recent data shows that venture capital investments are coming later, larger and to fewer companies. These are the ingredients for the type of funding gap that could swallow a revenue-producing, but not explosive, startup.

The self-identified venture equity firms report success in their early efforts. Turn/River reports no losing deals from their $110 million fund to date and has sold one company for a 150x return. Xenon Ventures claims a 40 percent internal rate of return on their first $5 million fund and has raised another $10 million for investment. Scaleworks is recently launched and does not appear to have any exits in its portfolio at this point.

This model for capital is still very early. Arguably, there are only two real players in the space at this time: Scaleworks General Partner Ed Byrne was a General Partner for Xenon Ventures (after his company was acquired by the firm), and Scaleworks three investments were purchased from Xenon Ventures.

The venture equity approach is worth watching for signs of scaling and the long-term health of portfolio startups. Funds specifically interested in scaling companies at a slower rate of growth would seem to be ideal partners for funds and startups in regions that struggle to attract traditional venture capital.