Virent Energy Systems (part of Chapter 7: I'm An Angel?)

(Note: This post is my first entry to another ‘book’ of sorts (different than The Rise and Fall of Kohl’s Department Stores) that I will be periodically 'releasing’ on this blog, the result of years of writing about all kinds of things that I have experienced. This entry, on Virent Energy Systems, is part of a chapter titled 'I’m An Angel?’, about my years as an angel investor in early-stage, start-up companies.)

Based in Madison, Wisconsin, Virent Energy Systems started not unlike many technology transfer start-ups coming out of academia. In this case, Dr. Randy Cortright, a researcher with significant catalytic chemistry experience at the University of Wisconsin, spun out research through the Wisconsin Alumni Research Foundation(WARF) in creating this new venture, which began in 2003.

Virent ‘s secret sauce involves the economical and energy-efficient conversion of plant-based sugars found in biomass into the fuels and chemicals that drive the world’s economy. The company, with the results from years of research and subsequent implementation, created an unconventional chemical pathway to renewably generate proven liquid fuels such as gasoline and diesel.

There were two global forces very much in Virent’s favor during the company’s early years. For starters, at a time when the post -9/11 United States was increasingly uncomfortable with it’s dependence on foreign oil, start-ups that potentially reduced that reliance were in the catbird’s seat; there was a lot of grant money out there, and Virent got millions of it from the Department of Energy, the Office of Naval Research, among others. In addition, with irrefutable evidence regarding the worsening problems associated with global warming, again Virent was in a sweet spot, in that demand was increasing for ‘green’ energy that is renewable, like versions of hydrocarbon chemicals but especially hydrogen and propylene glycol.

Virent’s process was not only green, but also cost-effective and produced more net energy than existing methods, and played in a huge marketplace.

What’s interesting about this company from the perspective of an angel investor like myself is how quickly and relatively easy the company ramped up and took institutional money to fund their growth. In mid-2006, the private equity investment arms of energy and energy-related players Cargill and Honda made major multi-million dollar investments, as did local Wisconsin VC’s. In early 2007, only three years after the company’s true launch as a start-up, a major financing round was pitched nationally to institutional players, resulting in a $21 million Series-B equity financing round in August, 2007. In addition, in May, 2007, Virent announced a major collaboration with Shell Hydrogen. Virent now has 55 employees, in a 26,000 square foot facility.

As someone who came in one of the early ‘seed’ rounds, you’d think I’d be doing cartwheels with all this momentum, no?

Pleased, yes. But doing cartwheels? No, or at least not yet.  I invested my money in 2003, as an early angel.  Three years later, with some of the best tailwinds a start-up could every get in this world, the mid-2006 $7.5 million VC round was priced in two traunches – the first $3.75 million was invested at a pre-money valuation of $10 million, and the next $3.75 million to be invested would be at a pre-money valuation of $20 million. The most recent round in August, 2007, has a pre-money of $70 million. Whew, sounds terrific, right?

Not so fast. Here’s the possible rub. Actually there are two.

Translating the above into actual share prices, while I’m hesitant to publish exact numbers at this point in time, I am concerned that the per share price has not truly risen 'appropriately’ in relation to all of the traction that the company has experienced.  To add, when you take into consideration all of the VC bells and whistles (the convenants, add-ons and crap that dilute the existing investors), new employee stock options, etc., the most recent actual share price is in a range that, in my view, should be considerably higher.

Despite all this incredible traction over the four years leading up to this major VC funding, my investment on paper suggests that the early angels of this deal will not get the ten-bagger that one should expect for an exit that in all likelihood will be 'large.’   To me, that is a disappointment. Your reaction may be that I’m a greedy SOB. But you need to understand the numbers associated with angel investing. Because so many investments in startups go down the drain, or are treading water with no real exit in sight, it becomes critical that when a startup is truly successful, the early angels hit a huge, out of the park, run around the bases a few times homerun, to make up for all of the other losers.  Otherwise, if you don’t score big with your occasional winner, your internal rate of return (IRR) for this part of your overall portfolio(i.e., angel investing) will be less than 20%.  So why take all of that risk, and have to deal with all of the angst associated with all of the unavoidable losers that are part of the package?  Why not just put the money somewhere else?

I am concerned that the events at Virent set the stage for the unthinkable: that a start-up that had genuine success from the beginning and no real cashflow problems might have a huge exit in the form of an IPO or acquisition, but the angel investors who wrote their checks early when there was lots of risk and no company revenues, don’t get the necessary 10-bagger to offset all of the dogs that one gets when you play in this early-stage venture game.

The other rub (and it’s only a slight one) involves the very bright CEO of Virent, Eric Apfelbach, and the approach he has taken toward raising capital. Eric had extensive experience raising funding for growing companies; when he was at Alfalight, a private high power laser company, he raised $49 million in three venture rounds. On the one hand, Eric has the skill sets to go out there and get institutional money; the company has been extremely fortunate to have him in this role. My gosh, he has gone out and gotten over $30 million in VC funding for Virent. That’s very impressive.

I could turn out to be wrong, but I think Eric was too quick to shut down the angel channel of funding, and jumped too quickly to the VC rounds. As a result, I’m not sure he really strongly embraced the idea that the early supporters of the company –the angels—were deserving of appropriate rewards if Virent succeeded in the early years. This is really key when you are thinking about making an investment in a start-up: does the CEO really appreciate the value of angel money? Do they really understand the metrics of playing in this space and the returns that are necessary for the small percentage of startups that succeed?

That’s really the rub, not that Eric isn’t running the company great, or setting things up nicely for some sort of successful ‘exit.’ I’ve just always had this hunch that Eric viewed himself as a VC-friendly CEO, and not necessarily an angel-friendly CEO. They are two very different kinds of managers.

That’s why it’s so darn important that pre-money valuations in the early ‘seed’ rounds be low enough to insure that angels get appropriately rewarded. It’s also very important to understand where your CEO is on ‘protecting’ and rewarding the angels. Some CEO’s get it, and understand just how big the upside needs to be with a start-up that’s really successful. Others don’t. In those cases, you’re setting yourself up for VC cramdown or ‘takeover’ rounds, and a corporate atmosphere where angels soon get blown off.

Eric, if you are ever reading this before Virent’s exit:

If it turns out that Virent’s exit is Big (like an IPO or an acquisition from a multi-billion dollar company) and doesn’t provide the early angels at least a ten-bagger, well, that sucks. And it’s not right.

If it turns out that Virent’s exit is Big and does provide the kind of big return to the early guys that they deserve, then I apologize, and I owe you an incredible dinner in Madison at the restaurant of your choice!