Daniel Einhorn isn't big on PowerPoint presentations. He used to give them, but found he never quite got all the way through his slides.
When an early stage company pitches him seeking an investment from his Mequon-based venture capital firm, Capital Midwest Fund, he likes to hear the initial presentation in about 10 minutes.
What Einhorn is most interested in at the first meeting is how the entrepreneur plans to get the product into the market. He asks a series of questions to which he expects thoughtful responses.
“What I'm trying to learn in that first meeting is critical thinking,” Einhorn said. “What I have learned in the last 10 years is it is almost exclusively about management. You have your product, you have your technology. You wouldn't have gotten to see me without having something there.”
He doesn't care whether the company does direct sales or distribution. What he cares about is why you chose one over the other and the thought process behind the decision.
Einhorn and his team at Capital Midwest are among a small group offering venture capital investments in Wisconsin.
Wisconsin companies completed 10 venture capital deals worth a total of $18.5 million in the first quarter of 2015, while California saw 420 deals totaling $8 billion, according to a MoneyTree Report by PwC and the National Venture Capital Association, which was based on data from Thomson Reuters.
It's safe to say Wisconsin doesn't hold a candle to Silicon Valley when it comes to venture capital investment. However, that figure is an improvement over the first quarter of 2012, when just two venture capital deals were completed in Wisconsin, totaling about $4.5 million.
Raising the funds
Capital Midwest Fund I was just $4.2 million when it was raised in 2008. Capital Midwest used the funds, raised from family and friends, to make 11 investments of about $400,000 each. Eight of those are still active. Capital Midwest sold out of its position in one of them for a loss, and two others went bankrupt.
“The first fund didn’t take that long because it was just friends and family,” Einhorn said.
That family is a driven, successful group. His brother, David, 46, is the founder and president of titan New York hedge fund Greenlight Capital who in 2011 considered a $200 million minority ownership stake in the New York Mets. David, famous for short selling Lehman Brothers’ stock before its 2008 collapse, started Greenlight in 1996 with financial assistance from the family. He invested in Capital Midwest’s first fund, and was the largest investor in its second fund. Daniel and David’s cousin is Facebook chief operating officer Sheryl Sandberg.
Capital Midwest Fund II was raised in 2009 and 2010, from 70 high net worth investors and a couple of foundations. Capital Midwest’s partners were talking to private wealth managers who just lost 25 percent of their equity and then had to rebalance, so they weren’t going to invest in alternatives, making it one of the most challenging times to raise money, Daniel said.
The partners, who also include Daniel’s father and firm founder Stephen Einhorn and Alvin Vitangcol, rely on their networks to identify potential investors.
“I think that all of the principals – Alvin, Dan and myself – all have extensive contacts at the top of a number of companies,” Stephen said. “You do that over a number of years of being active in business, active in the community. If you work long enough and hard enough, you meet a lot of people.”
The first close for Fund II was in April 2010, and the second was in April 2011. From Fund II, Capital Midwest was able to make 10 investments of between $1 million and $8 million, and has some capital left over to make follow-on investments.
Venture capital funds have a five-year investment period and a 10-year life. Fund II just completed its five-year investment period.
Fund III is currently being raised, and the firm expects it to be completed by the end of the year. The third fund will be the largest, at between $100 million and $150 million, but Daniel expects it will also be easier to raise. The investments from that fund will likely be between $1 million and $10 million.
“Based on the track record that we’ve developed and the people that we’re talking to, I feel pretty comfortable that we’ll hit the mark,” he said.
Coming off two years of phenomenal stock market performance, few people want to invest in bonds, and a venture capital fund makes an attractive investment, Daniel said. On the other side, the valuations for companies that Capital Midwest invests in have declined.
Capital Midwest Fund I portfolio companies
Centron Energy Corp., Grafton
EpiCare Ltd., New York, N.Y.
Great Lakes Pharmaceuticals, Broomfield, Colo.
HarQen Inc., Milwaukee
Immune Cell Therapy, Chicago
Ocularis Pharma, Chicago
PreEmptive Meds, Whitehouse Station, N.J.
VasoGenix, Overland Park, Kansas
Capital Midwest Fund II portfolio companies
Always in Touch (OnKol), Milwaukee
CytoPherx, Ann Arbor, Mich.
Intellihot, Galesburb, Ill.
LiquidCool Solutions, Rochester, Minn.
NanoStatics, Columbus, Ohio
OPS Solutions LLC, Novi, Mich.
Physician Software Systems, Lisle, Ill.
ProNAi Therapeutics, Vancouver, Canada
Rapid Diagnostek, Plymouth, Minn.
Therapeutic Proteins International LLC, Chicago
Since there are so many venture capital firms on the coasts, and few in the Midwest, it made sense to focus on a less competitive area with greater need, the Einhorns said. The firm wanted to be located close to the companies it is investing in, which is why it has remained in the Midwest, Stephen said.
“Wisconsin is strong in manufacturing, and the Midwest is strong in manufacturing,” Stephen said. “We’re investing in Wisconsin and Midwestern manufacturing, but high-tech manufacturing.”
Capital Midwest uses comparable transactions to value early stage companies, since they are often not generating cash flow.
“Wisconsin right now, it’s not a very robust community for someone to give you $5 million,” Daniel said. “So if someone wants to give your $5 million in Milwaukee or Appleton, you don’t have a lot of choices.”
The firm doesn’t talk with early stage companies about terms or valuation for the first several months, in favor of developing a relationship and completing due diligence, Daniel said. Once Capital Midwest is willing to make an investment, then the negotiations can begin.
At the moment, since there aren’t many competitors in the early stage investment space, Capital Midwest has some leverage in the negotiations, he said.
“Now, I hope this changes,” Daniel said. “This is not something that is good for the Wisconsin community in any way, shape or form. Drive Capital just came into the (Midwest) market and made seven investments in five months,” because the seasoned California venture capitalists who started Drive are so used to Silicon Valley and how competitive it is.
More successes will drive more interest, more competition, and thus higher valuations in the region, he said.
“The future of America is early stage companies that develop, and it always has been,” Stephen said. “And I thought that it would be better to do something from a company and personal perspective that I thought was more important, which is helping to build the next generation of high-tech companies in the Midwest.”
[caption id="V2-150609731.jpg" align="alignnone" width="440" class="align"] Daniel Einhorn[/caption]
Venturing into investments
Daniel, 43, is the son of Stephen and Nancy Einhorn.
Stephen Einhorn, 71, sold the family paint business and moved from New Jersey to Milwaukee in 1976 to be closer to Nancy’s family.
“I had met a number of people in the chemical business who wanted to buy a company, but not ours,” Stephen said. “I had met a lot of people who might be good buyers for companies, and so I decided that I would try to find buyers for chemical companies.”
He founded Einhorn Associates and did that for 32 years, completing about 200 M&A transactions.
In 2000, Stephen, an alumnus of Cornell University, was asked to serve as chairman of the entrepreneurial committee of Cornell’s Technology Transfer Committee.
“Universities have new ideas that lead toward early stage companies so I became very interested in this,” he said. “That is what led toward ultimately starting a fund. I’ve had 40 years of experience in dealmaking. That’s what this is. You’re making deals. The difference basically is in mergers and acquisitions. You’re in the middle. Every transaction is voluntary, and so you have to get two parties that might not see things quite the same way together.”
In venture capital, you’re not in the middle, and you have more control over what happens in the deal, he said. All the parties must still have their interests aligned, though.
“Our responsibility as a venture fund is to help the companies we invest in grow and succeed and to do what’s in the best interest of our investors,” Stephen said. “What I believe and what we try to do, it’s not only to get the best results, but also every step of the way should be done properly. The process is just as important as the result, and maybe the process is more important than the result.”
At Einhorn Associates, Daniel raised equity in private market transactions and negotiated with prospective acquiring companies on behalf of his clients.
“Raising money in Wisconsin with no relationships for early stage companies is very challenging. It just got to the point where even though we were incredibly successful, because we had one deal that ended up selling for $1 billion, it wasn’t fun,” Daniel said. “I didn’t like talking to the Silicon Valley venture capitalists, and I just said, ‘Let’s just get on the other side.’ There’s so much opportunity here. Let’s raise a small fund, let’s start making investments, learning how this works and go from there.”
So in 2008, the firm shifted to venture capital and Capital Midwest was born. Now, the team makes the investments themselves. Daniel vets prospective investments and conducts market research and due diligence on the technology firms the company targets.
Capital Midwest has seven total employees, some of whom are analysts who help with narrowing down the pool and conducting due diligence. Vitangcol, joined the firm as an analyst in 1999, a year after he had graduated from Andrews University in Michigan. He’s the firm’s Michigan expert, since that’s where he’s from, and has led three investments there.
[caption id="V3-150609731.jpg" align="alignnone" width="440" class="align"] Stephen Einhorn[/caption]
A technology niche
Capital Midwest focuses on investing in technologies and life sciences in Wisconsin, Illinois, Minnesota and Michigan.
“I’m very agnostic,” Daniel said. “The more interested I am in something personally, the less interested I am in investing in it.”
For example, he passed on a fantasy baseball investment in 2007 because he loves fantasy baseball and didn’t want to be blinded to everything else in the deal.
About 75 percent of Capital Midwest’s deals come from the partners’ network. The rest come from venture capital conferences they attend, he said.
One of the keys to Capital Midwest’s process is building a give-and-take relationship with companies it is considering, versus the adversarial relationship some firms create by simply asking for more and more information, Daniel said.
“I think it’s very key to open up and start working with that company really from day one,” he said. “If that company needs help, they need a customer, they need a strategic partner, they need help getting a contract manufacturer, they need banking relationships or accounting relationships, whatever it is, it doesn’t matter. We start doing that day one because what you’re really trying to do is build relationships.”
If at the end of five or six months an investment doesn’t make sense, Capital Midwest is willing to walk away, Daniel said.
“If I’ve helped a Wisconsin company build their business over this period of time and we can’t come to an agreement, that’s great,” he said.
Capital Midwest doesn’t have a lot of competition in the region and prefers to co-invest. Many of its deals are syndicated with other investment groups.
“I’d rather syndicate a deal from one of the other investors here in Wisconsin than steal a deal from them,” he said. “That’s just not going to be a fruitful relationship.”
There’s a soft spot for investments in the $1 million to $10 million category, Daniel said. Many of the larger venture capital investors focus on deals larger than $10 million.
“We’re not going head-to-head with Sand Hill Road on investment opportunities,” Daniel said. “There’s firms in California that want to invest closer to home.”
Tom Shannon, who has invested in several startups across the state both individually and through the venture philanthropy nonprofit he heads, BrightStar Wisconsin Foundation, said Capital Midwest fills a void between angel investments and venture capital investments in Wisconsin.
“I’ve always considered them kind of a tweener,” Shannon said. “Most of the real private equity people here…none of those guys want to touch something without profits and certainly not something without revenues, and Capital Midwest will certainly do that. They’ll take the early due diligence and the very early stage stuff, but then they’ll also invest in later rounds where true series A starts. That’s unusual.”
[caption id="V4-150609731.jpg" align="alignnone" width="440" class="align"] Alvin Vitangcol[/caption]
Problem solvers wanted
Capital Midwest aims to see a company when it’s in the prototype stage, while the founders are still developing a product and they’re looking at how to bring it to market.
“I like to see things at a very early stage. In the 14 months that I monitor this product, what kind of progress do they make?” Daniel said. “That’s the kind of thing that I’m looking for in order to get really excited about an investment.”
He’s careful because the financial risk is high. About 64 percent of these early stage companies fail because they run out of money, Daniel said.
Entrepreneurs who can build the business and invest in long-term growth are ideal.
“Cash flow is completely different than revenue. I’m perfectly OK burning money as we grow the business,” Daniel said. “All that matters to me is: what value and how much money did I give you to start with and what do I sell it for? Anything in between, it doesn’t matter how quickly it gets to cash flow positive.”
The firm spends at least six months evaluating a company before deciding whether to make an investment.
For example, Capital Midwest first met the creators of Milwaukee-based OnKol in November 2011 and didn’t make an investment until January 2013.
OnKol makes a remote monitoring system used to help people keep track of their elderly parents’ health.
While evaluating the young company, Daniel flew to San Francisco and met with a leader of Kleiner Perkins Caufield Byers, one of the earliest investors in the Nest smart thermostat, about why the investment firm had gone forward with the Nest deal.
During this relationship-building phase, Capital Midwest helped OnKol connect with the right contract manufacturer and introduced its founders to two other chief technology officers, eventually helping to change the leadership team.
“In order to be successful, you need the right guy at the top,” Daniel said. “You’re going to go through several different challenges as an entrepreneur and a lot of them are pretty similar. Unless you can identify a problem, it’s going to be hard to get to a solution.”
Daniel describes his ideal leader as a “block and tackle, sales driven, no excuses CEO.”
Capital Midwest invested $1.2 million initially, and then additional funds as milestones were achieved, said Marc Cayle, chief operating officer and founder of OnKol. The firm is now in the process of raising a $5 million round as it enters production and ramps up employment and marketing.
“(Capital Midwest has) been supportive and easy to work with and have put more money than they initially even indicated because we’ve met our milestones,” Cayle said. “That, I think, helps everybody. When you do what you say you’re going to do, it helps things along.”
Generating a return
Capital Midwest would like to have an overall return for its entire portfolio of about four times what it invested.
So far, Capital Midwest has had just one exit, on Therapeutic Proteins, which was sold in 2012 for more than double the firm’s investment.
In Fund III, Daniel will take the lead on raising and investing the capital. He anticipates having the flexibility in this third fund to make smaller bets on some riskier plays.
The key is to diversify the portfolio for each fund by aiming to make at least 10 deals, he said.
“We’re in so many sectors that any kind of macroeconomic event would probably help one company and hurt another one,” Daniel said.
Capital Midwest has learned some lessons along the way, particularly about the alignment of interests for all parties to a deal.
And being half health care and half technology, Capital Midwest has learned it’s important to be flexible and opportunistic, he said.
A cancer therapeutic company that Daniel was unsure of investing in is now in the process of going public and raised $128 million in commitment for its crossover round. It will probably end up being the best company in the portfolio, he said.
In the time Capital Midwest has been investing in the Midwest, Wisconsin’s startup companies are becoming more impressive, particularly some of the companies that have spun off from firms such as Epic, Johnson Controls Inc. and Harley-Davidson Inc., he said.
The talent is also better today than just five years ago, which he attributes to the growth of the incubator and accelerator community in the state.
“They understand the issues. They’re problem solvers. And they’re real business people,” Daniel said.