Second quarter venture capital: Money flows in from outside Minnesota

Susan Feyder and John J. Oslund / Star Tribune

The old printing plant on the south end of Chicago's Loop might look like nothing more than an empty building, but to the founders and financial backers of fledgling Dantis Inc., it's the birthplace of a worldwide Internet communications network.

Dantis, which has dual headquarters in Minnetonka and Chicago, has raised more than $100 million in debt and equity in recent months, including $31.6 million in venture capital in the second quarter. The funds will be used, in part, to turn the 170,000-square-foot building into the company's first operations center that will provide Web hosting, Internet access, management, security and other value-added services to corporate clients doing business on the Internet.

"It's built like a bunker," CEO and founder Tim Devine said of the old printing plant. High ceilings and reinforced floors will be able to accommodate not only the communications equipment, but security systems, backup power generators and 40 air conditioning units that weigh 20 tons each.

Turning the Old Economy into the New Economy is expensive, which partially explains the dramatic surge in venture capital funding that has occurred in Minnesota and around the nation. In the past 18 months, more than $945 million in venture capital has flowed into Minnesota companies -- most of it from venture capital firms based outside of Minnesota.

That's nearly twice as much as was invested here in the previous 36 months. In the first six months of this year, venture capital funding of Minnesota companies already has surpassed the amount placed in all of 1999.

The physical build-out of young, capital intensive technology companies like Dantis has fueled a spurt in big-ticket investments.

Data compiled by PricewaterhouseCoopers shows the growth in total venture capital dollars outstripping the growth in deals.

In Minnesota, all but one of the dozen $20 million-plus deals recorded by PricewaterhouseCoopers have been struck in the past 18 months. Six of those were closed in the first two quarters of this year, PricewaterhouseCoopers said.

Yet despite the unprecedented level of investment, the state's share of the nation's venture capital pie continues to shrink. For the most recent quarter, the figure was 1.3 percent, down from 1.6 percent in 1998.

The paradox of Minnesota's shrinking national share of what nonetheless constitutes a flood of venture capital dollars has sparked much debate in recent months.

Indeed, the issue will be aired at next month's Technology Summit convened by University of Minnesota President Mark Yudof. Venture capital is considered a vital indicator of a region's economic health because it's used to finance the start-up companies that can become the blue-chip employers of the future.

Dantis' $31.6 million venture capital investment, which easily would have topped the list a year ago, wasn't even the biggest in Minnesota for the second quarter. Optical Solutions Inc., a Plymouth-based maker of equipment to deliver voice, video and high-speed fiber-optic lines into homes, raised $73.7 million in venture-backed funds, the largest venture capital investment ever in the state, according to PricewaterhouseCoopers.

"Three years ago, that would have been a good-sized IPO in this state," said Jay Hare, a partner in PricewaterhouseCoopers' technology industry group. "The landscape [for venture capital investing] has definitely changed."

Hare said he doesn't know of any other venture deals the size of Optical Solutions on the immediate horizon. But he said there will be at least one in the $30 million range reported in the third quarter.

Not a 'candy store'

Dantis' Devine said outfitting the Chicago building will consume about $30 million. And that's just the beginning. Dantis' expansion plans, which include adding operations centers in 16 other markets in the next couple of years, will require about $1 billion in capital.

The company last week closed on $70 million in debt financing from the CIT Group, which also is providing $4 million in equity capital. An eventual public stock offering will provide additional financing, but before that, Devine said, Dantis probably will return to the venture capital market.

"We're not playing around," Devine said. "This isn't a candy store."

Dantis has about 55 employees, but expects to have about 200 by year's end and as many as 1,000 worldwide at the end of 2001, Devine said. In addition to corporate offices, the company eventually will establish one of its Internet operations centers in Minnesota, he said.

Norwest Equity Partners of Minneapolis and Chicago-based Madison Dearborn Partners Inc. provided most of Dantis' venture-backed funds in the second quarter. Devine said he and cofounder Scott Rediger specifically sought venture partners in the company's two headquarters towns.

"We also knew we wanted to be with [venture firms] that had deep pockets, who could potentially be with us for a second round of financing," Devine said. "And we wanted partners that were well established with the investment community. When we do go public we can tell people who we're partners with, and they'll know who we're talking about."

Norwest Equity was drawn to Dantis mostly because of its experienced management team and the huge potential market for its Web hosting and other services, said Art Monaghan, a principal at the venture capital firm.

Devine and Rediger cofounded Minneapolis-based Ovation Communications, a local exchange carrier, in 1997 and sold it last year to Cedar Rapids, Iowa-based McLeodUSA for more than $400 million. Devine and Rediger remained with McLeod for a while but eventually left to pursue their plans for Dantis.

Norwest Equity also was attracted to Dantis because of a long-standing investment focus in the communications industry, Monaghan said. "We were communications investors a long time before it was cool," he said. Its $12 million investment in Dantis is on the small side; most of the fund's investments typically run from $10 million to $40 million, Monaghan said. "But we're planning on investing more as [Dantis] grows," he said.

Bigger not always better

Minnesota-based venture capital funds traditionally have invested between 15 and 30 percent of their money in Minnesota, Hare said. Given the increased interest in high-tech companies on the coasts, he estimates the current percentage is probably toward the lower end of that range.

For some, bigger investments might be better. But for others -- especially for small start-ups that don't need tens of millions of dollars -- the swelling average size of venture capital deals has become a financial barrier.

"There are a lot of [potential] deals that are not raising that amount of money," said Brian Johnson, a veteran Twin Cities investor. "And they aren't getting what they need."

Johnson is among a half-dozen or more Twin Cities investors aiming to plug that gap by starting small venture capital funds ($15 million to $70 million) that plan to invest primarily in start-ups in the Midwest.

Johnson's firm, Touchstone Venture Partners, is planning to raise $15 million in private funds, which could grow to $45 million by leveraging funds under the Small Business Administration's Small Business Investment Company (SBIC) program. Johnson's Touchstone also is working with Stockwalk.com Group Inc. founder David Johnson (no relation).

Hare calls the entry of local venture funds into the Twin Cities market encouraging, but notes that they are relatively small.

"Does it help? Absolutely," Hare said. "But it's not going to have a sea-change effect on where we're at. It's good news; I'm not trying to dampen that. But it's not like a billion-dollar fund is moving to town."

Still, smaller funds investing in early stage companies -- perhaps the most underserved market in Minnesota today -- can make a difference. "You bring two or three new funds to focus on those and that's a substantial improvement," Hare said.

Mark Gaalswyk, founder, president and CEO of Easy Systems Inc., agrees. He recently received $1.5 million in venture capital from several firms, including Sherpa Partners, one of Minnesota's new venture funds.

"Many of today's deals are Internet related, which consume a lot of cash," Gaalswyk said. "I think that works against some of the Midwest firms" who might not need so much money.

At $1.5 million, Easy Systems' capital infusion was relatively small. The average deal size for Minnesota companies in the second quarter was $8.8 million, a figure that's driven higher by large placements in companies like Dantis, Optical Solutions, Onvoy and Eschelon (formerly Advanced Telecommunication Inc.).

But just because Easy Solutions is small doesn't mean it doesn't have big aspirations: "Our goal is be be the hottest dot-com on the prairie," Gaalswyk said.

The company's core business has been providing software and information systems to the feed industry. That is, to farmers and feed mill operators who need to keep the cows, chickens and pigs properly fed.

The company, which Gaalswyk started in the 1980s as a hobby, has grown to sales of more than $7 million last year and 75 employees who serve thousands of customers around the world from its headquarters in Welcome, Minn., near Fairmont.

Gaalswyk has journeyed to Silicon Valley in search of venture capital, so far without success.

"I can't say it's been a negative experience, but it has been time consuming," he said. A business relationship with Sherpa partner Mac Lewis helped Easy Solutions land its recent investment.

Gaalswyk is pragmatic about the large vs. small debate and even offers a solution: "If some of the Midwest VCs don't have the huge funds, and the current business models require large sums of money to be invested, to me it becomes a no-brainer -- you need the local funds partnering with the larger coastal funds. That's the model that I see will work for the problem that's being discussed."

Gaalswyk also argues that the difference between the go-go California culture and the more conservative Midwestern style can be a competitive advantage in seeking venture capital money.

"If you don't blow it," he said, "you only need half as much."

-- This article and chart information and other recent stories on venture capital investments in Minnesota are available online at http://www.startribune.com/venturecapital.

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