The Boston Globe Business Intelligence Column

By Robert Weisman, The Boston Globe

Nov. 7–Readying his 17-month-old Boston software company Xplana Inc. for a new phase he describes as “aggressive growth,” Hakan Satiroglu recently began foraging for venture capital, long the financial fuel for technology start-ups. He quickly discovered that it won’t be easy.

Venture investors told Satiroglu they had little experience with his business — making educational software and turning lesson plans into digital formats — and would find it hard to value. And the $2 million to $5 million he is seeking to bulk up research and sales, and expand into Europe and the Middle East, is smaller than the typical amount venture funds now want to invest in early-stage companies.

“Some people are warning me to stay away from venture capital,” said Satiroglu, who started Xplana with his own funds and remains open to financing from individual “angels” or other investors.

Satiroglu is stepping into a dramatically changing venture capital environment. Even as the overall volume of venture investing is rebounding from its post-bubble doldrums, early-stage companies are finding it tougher to get venture financing. And the tumble in early-stage funding threatens to stymie the innovation and cutting-edge technology that have long powered the US economy, and especially high-tech hubs such as Boston and Silicon Valley.

“Funding companies in their infancy is important at a time when the New England economy can use all the help it can get,” said Nicholas S. Perna, a Connecticut economist. “Historically, these small firms have generated most of our employment growth. If it’s harder to get companies started, that makes it harder to get employment growth.”

The shift toward later-stage funding, a trend that has been accelerating over the past year, is also causing unease in a industry that prides itself on being in the vanguard of economic change.

“It’s a real problem for the industry if we’re not doing early-stage deals,” said Mark G. Heesen, president of the National Venture Capital Association in Arlington, Va. “That’s what venture capital is about, and our best returns historically have been from the early-stage deals.”

Data from the MoneyTree survey, released last month, tell the story: Third-quarter venture outlays climbed 13.2 percent nationally, and 16.5 percent in New England, from the corresponding period a year earlier. But investments in early-stage firms — those recently formed and starting to grow — dropped 5.1 percent nationally and 11.1 percent in the region for the same period.

At the same time, later-stage investments — in more mature companies preparing for mergers or initial public offerings — vaulted 71.4 percent nationally and 68 percent in New England in the three months ended Sept. 30, compared to a year earlier, according to the MoneyTree survey. The quarterly survey is sponsored by the venture capital trade group, along with PricewaterhouseCoopers and Thomson Venture Economics.

One reason venture capitalists are thinking twice about funding early-stage firms is they typically require more due diligence than companies that have revenue and profits. In the past, the extra effort was worthwhile because an early stock offering could generate a tremendous windfall for venture backers. But the window for early IPOs has been shut in recent years, meaning firms funding early-stage companies with no track record and unproven technology take on greater risk without the prospect for greater returns.

And as funds grow larger, with more pension funds, endowments, and other institutional investors clamoring to participate, venture firms are inclined to do fewer but larger deals. “VCs want more validation of the technology today,” said Matthew Littlewood, a partner at PricewaterhouseCoopers in Boston. “They’re chasing fewer deals. And in that environment, early stage is going to get less money.”

Jeffrey Sohl, director of the Center for Venture Research at the University of New Hampshire, said “seed money” continues to be available to take entrepreneurs out of a garage and into an office. But getting a few million dollars for the next stage of development, he said, is proving hard.

“As the VCs move to later and later stages, they’re no longer playing in that $2 million to $5 million range,” Sohl said. “So even if companies are successful getting started, they can run into a funding gap and fall off the abyss before they get to the later stages.”

To be sure, many venture funds, including a growing number that have turned away money from investors, continue to bankroll start-ups. “Venture capitalists should be focused on one thing: finding entrepreneurs with good ideas,” said Robert E. Davoli, managing director at Sigma Partners.

Still, the chillier reception by many venture firms has prompted early-stage entrepreneurs to reassess their fund-raising strategies. Some, especially in life sciences, are seeking larger rounds right out of the box — often $7 million to $10 million or more.

Other entrepreneurs tell venture capitalists their companies specialize in niches, have alternative business models, or focus on underserved sectors. Satiroglu believes he’ll succeed by convincing investors his educational software company is a leader in a technology niche with potential double-digit revenue growth.

One of the region’s largest early-stage funding rounds went to Alinea Pharmaceuticals Inc. of Cambridge, which raised $25 million for research on treating diabetes. While other biotechnology firms farm out their research, Alinea formed a partnership with an independent research house, the Institute for Diabetes Discovery in Branford, Conn.

In certain sectors, especially software, the early-stage void is being filled by angel investors, who often provide initial funding of less than $1 million. Such angels are increasingly gravitating to small technology companies that put themselves up for sale even before they have customers.

Robert Weisman can be reached at weisman@globe.com.

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