Back to the Future? Venture Investing in Flyover Country

The term “Venture Capital” covers a lot of ground, even when confined to the traditional institutional funds at the heart of the industry. Funds come in many flavors based on factors including stage of investment, industry focus, geography, and propensity to lead or follow in deals.

I’d like to suggest another basis for classifying venture investors, one that I think is absolutely critical when considering the unique opportunities – and challenges – of investing in places outside of the major established centers of venture capital investing. Places like where I grew up, and after twenty years in Silicon Valley and North Carolina, returned to some years back: Wisconsin.

My classification is based on two alternative paradigms for investing capital and managing investments: Nurturing and Managing.

The Manager Venture Investing Paradigm

The Manager paradigm dominates the venture business today (certainly in terms of capital deployed and public mindshare). It is characterized by large funds, many in the billions of dollars (see Softbank’s $100 Billion fund for the current outer limits of the industry) with multiple levels of investment professionals, many of which do not have early stage operating experience or even STEM educational credentials. The “value add” Manager investors provide is largely in terms of the later stages of expansion and exit planning and execution.

The Manager paradigm is ideally-suited to the contemporary Silicon Valley venture capital scene and in terms of number of deals and capital deployed the large majority of Manager paradigm investing occurs in Silicon Valley and a handful of other major venture capital hubs. Today’s large funds simply can’t efficiently make and manage smaller deals. Even those that operate affiliated “seed” funds typically make larger initial investments than their traditional seed fund peers, and limit those investments to deals that they perceive as having mega deal potential (and capital needs) going forward. As a result, the Manager paradigm funds are much less likely to invest in raw entrepreneurs who need a lot of hand-holding on basic operational blocking and tackling. Their deep pockets also make them more likely to focus on capital intensive growth/brand-driven exit metrics than profitability.

Now, the Manager paradigm may get all the headlines, and skew the statistics such that Silicon Valley round deal sizes and valuations or as much as an order of magnitude or even more than the comparable figures in flyover country markets, but it is not the only venture investing paradigm. In fact, it was preceded by a very different and still important, if no longer as publicly prominent, paradigm.

The Nurture Venture Investing Paradigm

The modern venture capital era began in the late 1940s and hit its stride in the 1970s.  Throughout that period, and into the 1980s, even the largest venture capital funds seldom exceeded $100 million and most were only a fraction of that. The prototypical Nurture VC was someone with industry operating experience as well as a STEM education. Further, these smaller funds had minimal junior staff compared to the layers of analysts, directors, junior partners, etc. that make up the bulk of the investment professionals at today’s larger venture funds.

The early decades of the venture business were characterized by something else, besides smaller funds: less experienced entrepreneurial teams. With the industry’s small size, and even with fairly rapid growth in the 1970s, it took awhile for the “serial” entrepreneur to emerge as a regular part of the deal flow. It was probably not until well into the 1990s that most venture-backed Silicon Valley startups included founders and senior managers well-versed in the art of building a high impact company from experience at prior venture backed emerging companies.

When you put all of these factors into a pot and stirred them up, you came up with the Nurture venture investing paradigm. An investment model based on VCs focusing on startups where they could add a lot of value to the deal in terms of the basic nuts and bolts of defining and building the business. Indeed it was a time where the venture investor was often involved – as for example Brook Byers and Genentech – in the actual conception of the business, recruitment of the founding team and formulation of the business plan. Sometimes well before it was even clear there would be any resulting investable deal.

The industry’s structure during the ascendancy of the Nurture paradigm had other implications, among the most prominent of which was the emphasis on profitability as an exit metric. This was not because Nurture investors were any smarter than today’s Manager investors, who by comparison are far less concerned with early profitability. Profitability was part of the Nurture paradigm simply because the typical Nurture fund – even when factoring in syndication of investments – simply did not have sufficient capital to support a portfolio company burning tens or hundreds of millions (or as per Uber recently billions) of dollars of capital a quarter.

The Nurture paradigm led to venture capital’s first golden age in the 1980s. It also sowed the seeds of the Manager paradigm which arrived on the scene in the later half of that decade. The Manager paradigm was launched, ironically enough, when some of the great Nurture firms started raising the first wave of mega funds with hundreds of millions of dollars and, before long, even billions of dollars to deploy.

Implications for Flyover Country Venture Investing

If there is still a meaningful role for Nurture funds in Silicon Valley, there is very little room – today – for Manager-modeled funds outside of Silicon Valley and a handful of other of the larger venture investing centers. And that is something that too many folks in flyover country just don’t understand. And something that is making it even more challenging than it needs to be to foster the emergence of a meaningful high impact entrepreneurship and investing sector in still nascent and emerging flyover markets.

I saw the problem in North Carolina circa 1990, and I see the problem in Wisconsin, today. Regional folks who want to foster a vibrant high impact entrepreneurship and investing community look to Silicon Valley and, seeing how the Manager venture investing model dominates the headlines, conclude that we should be doing the same thing here. That we should invest as if our entrepreneurs had the same kind of “been there, done that” startup experience and networks that their Silicon Valley counterparts enjoy.

Well, they don’t. The opportunities and challenges of venture investing in Wisconsin in 2017 are indeed comparable to the opportunities and challenges of venture investing in Silicon Valley. But Silicon Valley circa 1975, not 2017.

What places like Wisconsin need, in terms of venture investors, is Nurture VCs, not Manager VCs. We need small funds, run by hands-on partners who bring their own “been there, done that” high impact startup operating and investing experience to the game. People who are willing to get down in the trenches with entrepreneurs to help shape raw talent and ideas into fundable deals; and who are willing and able to start doing that even before making an investment. Venture investors who can proactively help their portfolio entrepreneurs achieve profitable operations supporting attractive exit opportunities with lifetime risk capital needs that don’t exceed even the average A round in today’s Silicon Valley.

Unfortunately, instead of Nurture funds led by experienced startup entrepreneurs and hands-on investing professionals helping raw entrepreneurs with good ideas build modest companies that offer solid investment returns with limited capital, what I’ve seen here in Wisconsin is mostly investors with little or no venture backed startup operational or seed/early stage risk capital investing experience casting about for the kind of startup teams and capital-ready deals that fit the Manager venture investing paradigm.  Teams and deals that we just don’t yet have enough of in Wisconsin to support a sustainable high impact venture-driven startup community.

Don’t get me wrong. I think – know – that Wisconsin and places like it have the raw entrepreneurial talent and capital to become small but important and sustainable centers of high impact entrepreneurship and investing. But getting there is not going to happen unless and until the folks who want that to happen understand that right now we need Nurture venture investors, the kind that built Silicon Valley, not Manager venture investors in the mold of those who get the headlines in Silicon Valley today.

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Consumer Product or Medical Device? (Or Maybe Toy?)

By Paul A. Jones and Joel E. Henry, Ph.D. (Managing Partner, Michael Best’s Missoula Office)

So when is a consumer product – say a little matchbook-sized box you wear on your wrist that keeps track of your pulse over the course of the day –a medical device?

“What difference does it make?” you might ask. Well, if you are developing that little box for market, quite possibly tens of millions of dollars of added development and testing expenses, a couple of years more development and testing time, and millions of dollars of legal fees, regulatory expenses, insurance premiums, and misc. other costs both before market introduction and after. Not to mention likely a different distribution model, a higher price point, and lower volumes.

Alas, having perused FDA Guidance on distinguishing consumer products from medical devices (including some recent draft Guidance), and talking about the matter with some of my colleagues who spend substantial time practicing in the medical device regulation space, my take is that there is a lot of gray area around this question. Which is to say, there are a lot of current and soon-to-appear products out there for which good arguments could be made that they are consumer products – and good arguments could be made that they are medical devices. And that in some cases, the answer might even hinge on whether the manufacturer labels the product a toy. And that’s a problem.

While it takes pages and pages of regulation and guidance to get there, basically the distinction between a consumer product and a medical device – according to the FDA, which is to say the people that matter here – is pretty simple: the application of the distinction, less so.

First, the distinction. If the purpose of a product is to process inputs which are collected by the product from a person (a substance, for example sweat or blood, or data, for example a pulse) and use that to diagnose or suggest treatment for a medical condition, you have a medical device. Thus, for example, a personal ECG consumers can purchase without a prescription for the purpose of determining if they should see a doctor about an arrhythmia is a medical device, and is regulated as such. And that is true regardless of the intended use (well, I think so: more later).

Now, on the above logic, you would think that a product you wear on your wrist that keeps track of your pulse would be a medical device. I mean, the only real reason to have such a device – beyond a gee whiz sort of curiosity – is to monitor your physical activity for purposes of improving (or at least monitoring) your health. Clearly a medical device, right?

Well, no. The FDA has said, in its guidance on medical devices, that it will not deem a product a medical device if it’s only intended use is to encourage or maintain a general state of health or healthy activity, and the use of the product does not entail any significant risk to the user or third parties. Thus, your smartphone app for keeping track of your pulse isn’t in fact a medical device according to the FDA. This class of products would include (among many others) things that monitor calories burned or suggest healthy menus to control weight.

On the other hand, if your exercise monitor claims it can help you manage your Type II Diabetes, you’ve got something that is a medical device and that the FDA will consider to be a medical device. (You can see, I think, how this could get confusing.)

It gets more confusing. Our exercise monitor that is marketed as a tool for helping manage Type II Diabetes is in fact a medical device according to the FDA, and thus subject to regulation as such by the FDA. But the FDA, as a matter of policy, has indicated that it will not enforce those regulations with respect to such a medical device. That’s not a regulation but a policy. Which means it can be changed pretty much any time for pretty much any reason, without going through any rule making process or seeking industry or consumer input.

The thinking, here, is not to enforce the medical device regulations in the case of medical devices that present a low risk and are aimed at helping the consumer better manage a particular medical condition where the use of the device conforms to a generally accepted medical consensus. In this case, getting more exercise is a generally accepted mechanism for managing Type II diabetes. Another example of this kind of medical device would be a device that “coaches breathing techniques and relaxation skills, which, as part of a healthy lifestyle, may help living well with migraine headaches.” But, then again, FDA guidance says that it would regulate a medical device that listened to someone’s breathing to diagnose bronchitis (and yes, there is technology that does just that).

You can see, I think, how all of this can get pretty confusing. And we have not even talked about what “low risk” means (basically, if a product is invasive – that is it involves puncturing the skin or otherwise inserting something in the body as opposed to on it, or if it involves applying something (a laser, for example) to the body that could harm the user or a third party if not used correctly, you have a product that is not low risk).

If you think you can figure all this out on your own, here is a final twist; admittedly a pretty strange twist, but I think a valid one for purposes of illustrating how much uncertainty there is as the FDA struggles to adapt to a rapidly changing technological environment.

If you’ve ever had kids, you know that you can buy toy stethoscopes. These products, at least some of which are as functional as low end “real” stethoscopes, are not regulated as medical devices. They are marketed and intended to be used as toys, and include labels that they are not to be used for medical purposes.

On the other hand, traditional stethoscopes intended for medical use are medical devices (albeit regulated with a light touch). And “smart” stethoscopes – devices that enhance, manipulate, or interpret information generated by the stethoscope – are in fact regulated as medical devices (which, given the initial example of the personal ECG product, isn’t surprising).

So, what about a “toy” smart stethoscope? Before you say that labeling it a toy doesn’t work because it is clearly capable of performing a medical function, remember that so can a dumb toy stethoscope.

The answer? I am not sure. But there is, in fact, a “business card toy ECG” on the market. At least there is as this blog goes to press. You figure it out. And if you are smart, talk to your lawyer about your thinking before you run too far with it.

Supreme Court Changes Where Patent Lawsuits Can Be Filed

On May 22, 2017, the United States Supreme Court overturned nearly 30 years of venue practice under Federal Circuit precedent. Prior to the Supreme Court’s decision, patent litigants could be dragged into court essentially anywhere an alleged infringing act occurred. In TC Heartland LLC v. Kraft Foods Group Brands LLC, No. 16-341, slip op. (U.S. May 22, 2017), the Supreme Court reversed the Federal Circuit and held that “a domestic corporation ‘resides’ only in its State of incorporation for purposes of the patent venue statute.” Id. at 2. Thus, a domestic corporation can only be sued for patent infringement in the state where it is incorporated, or where there has been an act of patent infringement and where the corporation has a regular and established place of business.

The patent venue statute provides that “[a]ny civil action for patent infringement may be brought in the judicial district where the defendant resides, or where the defendant has committed acts of infringement and has a regular and established place of business.” 28 U.S.C. § 1400(b). The general venue statute, however, provides that “[f]or all venue purposes,” certain entities, “whether or not incorporated, shall be deemed to reside, if a defendant, in any judicial district in which such defendant is subject to the court’s personal jurisdiction with respect to the civil action in question.” 28 U.S.C. § 1391(c)(2). The Federal Circuit in TC Heartland held that this language defines the meaning of the term “resides” in § 1400(b), relying on its prior decision in VE Holding Corp. v. Johnson Gas Appliance Co., 917 F.2d 1574 (Fed. Cir. 1990), which had interpreted the version of the general venue statute enacted in 1988 to reach a similar conclusion. In re TC Heartland LLC, 821 F.3d 1338, 1342-43 (Fed. Cir. 2016).

The Supreme Court disagreed with the Federal Circuit. It found no material difference in the language of § 1391(c)(2) and the language of the general venue statute in effect when the Supreme Court issued its decision in Fourco Glass Co. v. Transmirra Products Corp., 353 U.S. 222 (1957), where it held that the patent venue statute was “not to be supplemented by” the then-codified version § 1391(c). TC Heartland, slip op. at 5, 9. In fact, the Supreme Court in TC Heartland found the argument for incorporation of the current general venue statute’s definition of “resides” to be even weaker, noting that the statute now includes “a saving clause expressly stating that it does not apply when ‘otherwise provided by law.’” Id. at 9 (citing 28 U.S.C. § 1391(a)(1)). The Supreme Court also found that there was “no indication that Congress in 2011 ratified the Federal Circuit’s decision in VE Holding” when it enacted the current version of the general venue statute. Id. “If anything,” the Supreme Court observed, “the 2011 amendments undermine that decision’s rationale,” which relied heavily on Congress’ decision in 1988 to replace the language “for venue purposes” present in the statute at the time of the Supreme Court’s decision in Fourco with “[f]or purposes of venue under this chapter.” Id. at 9-10 (emphasis in original).

Though the Supreme Court limited its holding to domestic corporations, the decision is a dramatic change to the patent litigation landscape. The Court’s decision abruptly ends the practice of a domestic corporation being brought into a court which has little connection to the corporation. Frequently, these cases were brought in the Eastern District of Texas, as it was perceived to be “plaintiff friendly” to patent owners. Now, domestic corporations can only be sued for patent infringement in their state of incorporation or where they have a “regular and established place of business” and have committed acts of patent infringement. Oddly, this means that a patentee seeking to enforce its patent can be forced to sue in the defendant’s state, rather than its own home district court. While the Supreme Court’s decision significantly limits the practice of “forum shopping” in patent cases, it is possible that Congress will enact new venue legislation. In the meantime, however, plaintiffs must comport with the venue restrictions as interpreted by the Supreme Court, and defendants in pending cases will want to investigate moving the cases back to their home court.

This blog post was written by Kenneth M. Albridge, III and John C. Scheller of Michael Best.

A Term Sheet is Not a Deal

First the good news. If you get a signed term sheet with a reputable angel or venture investor, there is a very good chance you will get a deal done. Unless, of course, you don’t.

Probably the most common element of every term sheet is the provision that states unequivocally that by signing the term sheet neither party is obligating itself to enter into an investment transaction, whether on the terms reflected in the term sheet or otherwise. Still, if the parties do reach agreement on a term sheet, there usually is a deal made, and usually on terms mostly consistent with the term sheet. That said, herewith a look at the most common reasons a “done term sheet” does not lead to a “done deal.”

  1. The investor can’t build a syndicate sufficient to close the deal out. As they teach you in entrepreneurship boot camp, getting a deal done is first about finding a lead investor. Someone credible who can put a stake in the ground and then help the entrepreneur close a syndicate around that stake. If your lead investor is a top tier fund, or even a second tier fund committed to invest 75% or more of the minimum closing amount, chances are somewhere between no-brainer (top tier fund) and highly likely (second tier fund) that you will get the deal done. On the other hand, if your lead investor is an anonymous angel committed to take only 35% of the minimum-closing amount, don’t hold your breath. The take home point here: your chances of turning a term sheet into a deal are pretty closely tied to the market credibility and relative capital commitment of the investor that signed the term sheet.
  2. Deal due diligence uncovers a major issue that either can’t be suitably resolved, or reflects badly on the entrepreneur’s competence. All-too-common issues that come up in due diligence include IP ownership issues (e.g. important IP was developed without appropriate work-for-hire or assignment documentation) and capitalization table issues (e.g. equity distribution is not well-documented; potential claims for significant equity outside of the cap table turn up; previous investors were unaccredited, or paid too high a price). The take home point here is get your due diligence ducks lined up (and shot, if they need shooting) before you sign the term sheet. Investors – good ones, at least – don’t like surprises, particularly when they suggest a careless, clueless or deceptive entrepreneur.
  3. In the rush to get the term sheet done, one of the parties punted on an important issue, figuring that she could take care of it in the fine print of the closing documents. For example, I once saw an investor leave the question of subjecting some of the founder’s stock to vesting for the closing documents. The very fact that the investor thought avoiding the issue at the term sheet stage was a good idea shows what a bad idea it was. A simple lesson: if an issue is material to either party, deal with it in the term sheet. It may kill the deal, but it will save a lot of time, distraction, energy and expense.
  4. The entrepreneur and the investor discover, under the pressure of getting the deal done, that they do not work very well together; or one or both of them loses confidence in the integrity of the other. Closing an early stage deal can put a lot of pressure on an entrepreneur (less so an experienced investor, who does a lot more deals). Pressure can bring out the best in a good entrepreneur. And the worst in a bad entrepreneur. Just as bad investors turn off good entrepreneurs, so bad entrepreneurs turn off good investors. Not that you can’t be an aggressive, take no prisoners entrepreneur and succeed, if that’s your style. But whatever your style, wear it well.
  5. Internal events at the investor’s shop derail the process. Say, for example, the partner leading your deal moves to another firm, or gets hit by a bus. Stuff happens, and when it does, deals often die. Being good is not enough in the high impact entrepreneurship world. You’ve got to be lucky too. Or at least not unlucky.
  6. A major external event shocks the market generally or the particular segment of the market the deal is in. Remember 9/11? I do. And so do several entrepreneurs I know who were trying to close deals at the time. More failed than succeeded. I’ve also seen deals blow up based on a shock to a particular market segment, as for example diagnostic deals in the aftermath of a major patent ruling that basically gutted the IP protection upon which the bulk of diagnostics companies were built. The take home lesson here: after you get the term sheet signed, close your deal with all deliberate speed. And stay lucky.

When an entrepreneur tells me they have a lead investor on board, my first reaction is to ask some questions. Who is it? Have they signed a term sheet? How much are they committing? How confident are you that all of your due diligence ducks are lined up? If the answers to these questions are satisfying, I’ll mentally note that the deal in question will most likely happen. Unless it doesn’t.

Jones: Alas, here is still not there

Paul Jones, co-chair of Venture Best, the venture capital practice group at Michael Best, has been selected as a regular contributor of OnRamp Labs, a Milwaukee Journal Sentinel blog covering start-ups and other Wisconsin technology news. Paul’s most recently contributed piece, “Jones: Alas, here is still not there” can be found under their Business Tab in the Business Blog section: Click here to view his latest blog.

A short excerpt can be found below:

“‘Over the course of the past two years, the median pre-money valuation for seed-stage financings was $6 million and the median deal size was approximately $2 million.’

So reports Mark Suster, partner at Upfront Ventures, in a fourth quarter 2016 venture capital market report by Cooley, LLP, one of Silicon Valley’s leading law firms. (They also reported serving as counsel for 187 venture capital financing involving $2.7 billion in the fourth quarter: yes, Virginia, the rich really are different.)

Clearly, the seed deal market in Wisconsin – where my sense is that the median pre-money seed round valuation is something more like $1 million, and the median seed deal size more like $300k – is a bit of an outlier. As are most flyover country markets. That said, here are some things these numbers got me thinking about.”

Click here to read more.

Those Who Do it All… Shouldn’t

Paul Jones, co-chair of Venture Best, the venture capital practice group at Michael Best, has been selected as a regular contributor of OnRamp Labs, a Milwaukee Journal Sentinel blog covering start-ups and other Wisconsin technology news. Paul’s most recently contributed piece, “Those Who Do it All…Shouldn’t” can be found under their Business Tab in the Business Blog section: Click here to view his latest blog.

A short excerpt can be found below:

“In more than thirty years in and around the high impact entrepreneur and investing space, I’ve come to the conclusion that every entrepreneur, even and in fact particularly the most successful, has at least one serious personality flaw.

One of the more common flaws is the “I can do it all” personality: the entrepreneur who insists that they are not only good at, but the best at everything involved with making their business a success.

What really makes the “I can do it all” entrepreneur so frustrating is not so much that they are almost always wrong about their capabilities. Rather it is that even if an entrepreneur really is the best at everything actually doing everything is still a bad idea.”

Click here to read more.

The Silver Linings in the Fundraising Cloud

Paul Jones, co-chair of Venture Best, the venture capital practice group at Michael Best, has been selected as a regular contributor of OnRamp Labs, a Milwaukee Journal Sentinel blog covering start-ups and other Wisconsin technology news. Paul’s most recently contributed piece, “The Silver Linings in the Fundraising Cloud” can be found under their Business Tab in the Business Blog section: Click here to view his latest blog.

A short excerpt can be found below:

“Entrepreneurs generally think of fund raising as a real drag. For all but the sainted few, it is a time-consuming distraction from growing the business. A bothersome exercise courting folks who think they are smarter than you are (and sometimes are). And all too often at a time the cash clock is rapidly ticking down to zero.

But it’s not all bad. Really. As dark as the fund raising cloud is, there are several silver linings (besides closing on the capital) that make the process useful, if not pleasant. Herewith a couple of those silver linings.

Click here to read more.