During our last Falls Angel Fund meeting, we heard investment pitches from three high-growth startup companies that are based in the Dakota’s. One company was a software and services business that we had invested in an earlier round. One was a new software company seeking capital for the first time. The third was an early-stage medical device startup coming out of a local university. Normally Falls Angel Fund says yes to about one out of three pitches that we hear, but our fund members liked all three deals and invested just over $525,000 between these three companies. Given that we had planned on investing about $500,000 per year, we did a year’s worth of angel investing in one meeting.
This was a fantastic development because it means there is more deal flow happening in the greater Sioux Falls area, but it also presents some issues. After these three checks are written, Falls Angel Fund II only has about $225,000 left to invest in additional companies (or about 15% of our fund’s capitalization). Falls Angel Fund II launched just eighteen months ago, but given where we are at, it is probably already time to start thinking about Falls Angel Fund III. We could do a third fund using the same structure as we have before and that would not be a bad option, but there is a lot of innovation that has happened in the angel capital space over the last five years when it comes to fund structure and deal structure that we might be able to learn from.
Now is the perfect time to rethink what seed-stage capital looks like in Eastern South Dakota. Here are a few possibilities that the startup ecosystem could pursue.
- Establish a True Pre-Seed Capital Fund.
Outside of state proof-of-concept funding which does not apply to many businesses, there is no venture capital group willing to write the first check for $10,000 or $25,000 in risk capital. Businesses at this stage tend to be pre-revenue and pre-product-market-fit, which makes them difficult to evaluate. One solution would be to simply not try to evaluate them at all. Instead, a fund could be developed that would write a $10,000 check or $25,000 check to any high-growth company that plans on raising growth capital in the future. To do some basic filtering, the fund would only write checks to companies that have completed an accelerator program such as Falls Fintech or Co-Starters.
The fund would use a Simple Agreement for Future Equity (SAFE) mechanism, where the fund would only gain ownership in the company once they raise a priced equity round (such as a Series A). The SAFE documents would have to have a low valuation cap (probably $1-$2 million), a discount rate and pro-rata rights for the deals to make sense. This would be an incredibly high risk, incredibly high reward investment opportunity. There would also be standardized terms/pricing offered to every participating company. Using a SAFE as an investment vehicle would keep a fund from owning a small piece of failing companies that are not worth anything, while protecting ownership interests in companies that are doing well and plan on raising future funds.
I am interested in this idea and would probably fund at least part of it but would need a venture capital firm or the Enterprise Institute to do the administration of a pre-seed fund. I have not talked to anyone about this idea before writing this blog post, so this idea is still in the earliest of stages. In addition to finding an organization administer the fund, it would probably be a hard sell to many investors due to its extremely high-risk, extremely high-reward nature. This means it would probably have to be funded by a handful of investors who believe in the concept. Fortunately, a $1 million fund would probably cover 3-5 years’ worth of these types of investments.
There could also be a pre-seed element of a future iteration of Falls Angel Fund, where the fund authorizes an executive committee to invest 10-20% of a fund’s capitalization into pre-seed stage investments. The current fund requires a majority vote of the members to make an investment, which works fine for $100,000 to $200,000 investments but is a little bit too clunky for $10,000 to $25,000 investments because of the limited number of pitch slots our fund has.
- Establish a State-Wide Angel Fund that Meets on Zoom
South Dakota’s community-based angel funds already invest in state-wide deals, so why not allow a group of investors state-wide to be part of the same fund? By planning to hold fund meetings on Zoom, you could have investors from across the state (even across the region) invest in the fund. You could also hear a broader array of startup pitches because startups would no longer have to drive to Sioux Falls, Rapid City, Aberdeen, or Brookings to pitch one of the South Dakota angel funds.
There was a state-wide fund tried in the past through our network, but that was before my time and I am not sure how well that went. With virtual meetings being the new normal, the probability that a state-wide fund would work in 2021 is much higher than in years past. It would be an opportunity to re-engage investors in previous funds that may no longer be actively investing in any of the current angel funds. It would also create an opportunity for angel investors to get additional exposure beyond their existing community-based fund, such as Falls Angel Fund and Black Hills Regional Angel Fund.
- Establishing a Rolling Fund
The hardest part of setting up an angel investment fund is the initial fund raising, but once the fund is setup you are good to go for three years and do not have to think about it again for a while.
Another challenge that angel investments fund have is that they tend to be closed-end funds. This means all the capital commitments are made up front and the fund cannot accept new investors after the first deal is made. Interested new investors simply have to wait for the next fund to start up, which could be a couple of years in the future depending on where a fund is at in its lifecycle.
One solution to these issues is the idea of rolling funds. A rolling fund allows angel fund managers to setup a new fund and start investing quickly, without raising all their capital up-front. Instead, investors commit to investing a certain dollar amount each quarter (say, $5,000) and the fund manager makes investment decisions as capital comes in. Rolling funds also allow angel funds to accept new investors at any time, and investors that want to stop investing can stop contributing to the rolling fund. Rolling funds may allow for public fundraising if they are conducted under Rule 506(c), which provides greater awareness of funds and makes them more accessible to new accredited angel investors. Fees tend to similar to what you might see elsewhere.
The big question with a rolling fund is whether or not accredited investors that invest in startups in the Dakota’s are ready for a more modern and Silicon Valley-esque deal structure. Most local angel investors are used to a general partner model where every investor gets a vote on every deal according to their ownership percentage. They are also used to working with the Enterprise Institute, a state-wide organization that sets up angel funds. A rolling fund would almost certainly have to be ran through AngelList, which would be a new experience for many local investors. I do not know if this is the right solution for South Dakota, but it’s definitely worth exploring.
I am bullish on the future of seed-stage capital in South Dakota. Falls Angel Fund 1 has a solid winner in its portfolio (Bushel) that will likely generate 10X+ returns when it exits. I think there is a deal just as good in Falls Angel Fund II. The South Dakota Equity Fund is actively making later-stage venture deals. I also have a large personal deal that I am currently working on. I do not know which of the ideas mentioned in this article are the right next step for the South Dakota network of angel investors, but I hope this blog post will help start that discussion.