Club benefits: you don't have to be a member to benefit from a new source of financing: venture capital clubs

Entrepreneur, May, 1996 by David R. Evanson

You don't have to be a member to benefit from a new source of financing: venture capital clubs.

When Robert Vito looks at the average home, he sees a gold mine. Vito's Malvern, Pennsylvania, company, Elcom Technologies Corp., has perfected technology that allows the simultaneous distribution of voice, audio, video and data over a home's existing electrical wiring systems. Suddenly, using Vito's EZ Phone, every outlet in the home becomes a phone jack. With EZ Audio, a CD player on the first floor can send tunes up to speakers on the third floor. Or, using EZ Comm, the computer on the second floor can drive the printer on the first floor. All this without laying a stitch of new wire.

Though the Elcom line, which also includes an EZ TV product, is just now being launched, Vito is optimistic about its prospects. "We anticipate doing $380 million in sales by the year 1999," he says.

Perhaps it's this unwavering commitment to the end result that has earned Vito a mark of distinction not only in the world of electronics but in the world of finance as well. To date, he has raised several million dollars to transform a concept into a company. What makes this sum even more remarkable is that Vito did it without a single dime of traditional venture capital funding. Instead, he raised almost all his money from an emerging source of funding increasingly important to small-business owners: venture capital groups or clubs, which consist of wealthy accredited entrepreneur investors.

Vito eschewed traditional venture capitalists because, he says, they didn't really fit the kind of egalitarian deal he had in mind--and found, with his current investors. "Venture capitalists want special deals," he says. "They want separate classes of stock, they want to be on the board of directors, they want to put their money in in stages. That's not the route we took."

That Vito could even be this choosy demonstrates that the times, they are a-changin'. Venture capital, at least the early-stage kind, is coming from new and vibrant sources. It's not so much that the balance of power has shifted away from traditional venture capital funds. More accurately, the new breed of early-stage venture investors has filled a vitally important void.

Tectonic Shifts

According to Jeffrey E. Sohl, director of the Center for Venture Research at the University of New Hampshire's Whittemore School of Business in Durham, the venture capital clubs that are beginning to dot the landscape owe their genesis to the early venture capital funds that invested heavily in technology companies during the late 1970s as well as the booming initial public offering (IPO) market that began in 1984. Like a powerful two-stroke engine, the two factors pumped out a new generation of wealthy, and in some cases just plain filthy rich, entrepreneurs.

"Today," says Sohl, "many of these entrepreneurs are banding together in groups and forums and recycling their capital into the next generation of emerging companies."

Their arrival came none too soon, says Sohl. The maturation of traditional venture capital funds resulted in larger and larger pools of capital . . . and less appetite for smaller deals. "Suddenly," he says, "with a $100 million venture capital fund, it's impossible [for the fund] to make any money by putting up, say, $200,000 a shot."

The problems venture capital firms were facing became similar to those banks encounter when trying to make small-business loans. That is, the costs to locate, analyze, disburse and monitor deals must get spread over a fair-sized investment to generate any profits. Just as bankers say, "Why should I make a $500,000 loan when I can make a $5 million loan for the same costs?" venture capitalists began saying, "I'd rather invest my $100 million in fifty $2 million deals than five hundred $200,000 deals."

That left a deep void on the landscape--a void that wealthy entrepreneurs, cashed out of their businesses and looking to invest, stepped in to fill. There was one hitch, however: It's hard to get into the loop of venture capital deals operating on your own. So rather than travel solo, many of these entrepreneurial investors banded together. "Operating in a group context," Sohl explains, "investors can magnify their deal flow by a factor of 10"--a vitally important aspect of successful early-stage investing.

Finding venture capital clubs is simply a matter of keeping your eyes peeled and asking everyone you know if he or she knows whom to contact. There is no official tally of these groups, and they range in character from mobilized to downright shadowy. For instance, the Pennsylvania Private Investors Group, where Vito found two investors, maintains a rather high profile as an arm of the Eastern Technology Council in Wayne, Pennsylvania, and even advertises from time to time. But another nearby group--known as LORE, for "loosely organized retired executives"--won't be found in any phone book.

Brass Tacks

As Vito will attest, the real work is not finding venture capital clubs but getting them to commit capital to your company. Vito has been raising money since 1993, and during that time has raised equity from 12 venture capital clubs or groups, making him perhaps one of the most successful graduates of this school of capital formation. Among the lessons he's learned along the way: