Public venture, public gain?
A follow-on to the July fedgazette cover story that looks at governments' role in promoting entrepreneurship and venture capital.
Published September 1, 2001 | September 2001 issue
If entrepreneurship is contagious, local and state governments are doing everything they can to catch and spread it.
Take Bruce Davis. As head of the Northwest Regional Planning Commission (NWRPC), a public planning agency in Spooner, Wis., Davis is charged with trying to spark economic development in a 10-county region at the top of Wisconsin. Like many rural regions throughout the Ninth District, sometimes it takes more than a simple spark for a new business to be successful.
So Davis has tapped his own entrepreneurial instincts to develop financial and other tools that can help young entrepreneurs get on their feet and make a contribution to the local economy. One such tool is a first-of-its-kind venture capital fund in the area, the Wisconsin Enterprise Fund. As of May, the fund had financed one company and was considering two others. Efforts have evolved to the point where Davis has recommended that a stand-alone, for-profit organization be spun off to better leverage and ultimately multiply existing capital and other resources for the benefit of local entrepreneurs.
These measures are needed, Davis argued, because most of the attention at the state level is focused on Madison, Milwaukee and the Interstate 94 corridor between them"places that clearly don't need any more help," Davis said. "Get an hour away and there is nothing going on there." Davis is not alone in his earnest pursuit of local economic development. As profiled in earlier issues of the fedgazette, state and local governments have become intimately involved with economic development (see April and July 2000 issues). But the growing emphasis on entrepreneurship and venture or equity capital has created a new sense of urgency regarding economic development strategy. A recent National Governors Association (NGA) report stated, "Venture capital is critical to growing the new businesses that will drive the 'new economy.' Finding ways to nurture the culture of entrepreneurs, and the capital that feeds them, must be a top priority of states."
Roughly two dozen sourcesincluding entrepreneurs, venture capitalists and public officialsdiffered in their opinion about government's exact role, but most said there was a useful and necessary role for government to play when it came to entrepreneurship and venture capital. Davis, for one, said government's role in economic development and entrepreneurship "is to start new things, give it a jump start ... and then disengage."
Governments, particularly at the state level, have responded with a raft of initiatives designed to nurture young entrepreneurs and encourage the formation and distribution of venture capital, all in hopes of getting a piece of the new-economy pie. But despite the best intentions, there is little in the way of hard evidence to show such programs are able to shiftoutside the marginsthe geographic flow of investment capital or entrepreneurial activity in a given area, or kick-start entrepreneurial activity to critical mass in a state where it was previously absent.
As discussed in the July 2001 fedgazette, the prevailing assumption that cities and regions in the district suffer from a lack of venture capital is misleading. Investment capital exists in virtually all regions but might not be properly organized, or investors see better investment opportunities elsewhere. Capital is also just one element necessary for entrepreneurs to succeed in a given location. Most of the attention and government programming at the state level is nonetheless designed (directly or indirectly) to increase the supply of venture capital.
Government venturing into new programs
The NGA report identified almost 100 state-based programs to increase entrepreneurs' access to capital, including a combined nine programs in the six states wholly or partially located in the Ninth District. One-third of these programs consisted of direct state funding and included programs in Minnesota, Montana and North Dakota. Some are very modest. North Dakota's Development Fund has made equity investments for about a decade, but spends well less than $1 million annually.
Other efforts are more aggressive. In 1999, for example, Wisconsin set aside $50 million in tax credits for insurance company investments in certified capital companies (referred to as CAPCOs) that provide venture capital to in-state businesses. Spread over 10 years, the tax credits allow participating insurance companies to recover 100 percent of the original investment regardless of financial performance, according to a program description by the state Department of Commerce. At least 17 other states offer such investment tax incentives, the NGA report found.
A second initiative authorizes the State of Wisconsin Investment Board (SWIB, which manages the state's public pensions) to invest $50 million in venture capital firms that, in turn, are required to allocate at least three-fourths of that capital to biotech and other high-tech start-ups in the state. According to the NGA, 18 other states have a similar effort in place.
No state tax dollars are involved, but it is Wisconsin's first purposive effort to invest state pension money directly in state-based entrepreneurs. Joseph Gorman, the chief investment officer for the SWIB, said the program was in line with their traditional investment strategy, as the board already has $250 million in venture capital investments and "we were interested in biotech way before this [initiative] started."
Gorman pointed to cutting-edge biotech research coming out of the University of Wisconsin-Madison and the Medical College of Wisconsin. "There ought to be the ability to put money in these ideas," Gorman said. "There are hotbeds of venture capital, and it's conceivable that one of them could be here because of the work done in this area."
Like other pension investments, Gorman said that state pensioners ultimately shoulder both the program's risk and reward. But it appears that venture capitalists aren't falling over each other to manage the funds. Requests-for-proposal were sent to 50 venture capital firms nationwide, but only 14 responded because of the in-state investment requirements, Gorman said. After interviewing six firms, the board committed $40 million to two Wisconsin-based firms.
Other district states have made much smaller commitments to encourage more venture capital investments. Montana has almost $4 million in tax credits available for investment in capital companies financing in-state businesses, according to the state Department of Commerce. In his inaugural address, North Dakota Gov. John Hoeven proposed $2.5 million in investment tax credits. The Minnesota Legislature considered, but ultimately dismissed, similar proposals in its latest session.
In at least five casestwo in Minnesota and one each in Wisconsin, North Dakota and Montanapublic resources have also been used to capitalize for-profit venture capital funds. One example is the Wisconsin Enterprise Fund, which is majority-owned by Wisconsin Business Innovation Corp., itself a nonprofit spin-off of NWRPC.
With $2 million in capital, the fund helps fill a local void in risk capital, Davis said, as banks and other critical pieces of the rural business sector "are not very entrepreneurial ... and are risk-averse." Such a conservative predisposition is reinforced by financial regulators, including the Federal Reserve System, and stockholders looking for stable profits, he said. Venture capital firms are nowhere to be found, and given significantly lower average wealth in rural Wisconsin, "there's not any elaborate angel [investor] network" to tap into.
The schmooze connection
Many also see a role for government in connecting entrepreneurs with the resourcesparticularly capitalnecessary for them to be successful.
Dick Leazer, president of the Wisconsin Technology Council, believed government had a "network stimulation role ... to provide forums and connectivity and reasons [for entrepreneurs and venture capitalists] to get together and talk." Hot markets like Silicon Valley need no such push, he said. Entrepreneur forums at Stanford University, where students and professors discuss current research projects, are packed with venture capitalists. "If you want a seat, you have to get there an hour early," Leazer said. In contrast, at a similar event at the University of Wisconsin-Madison, "they're lucky if two or three people are around."
The state of Wisconsin is trying to change that. In cooperation with two development-oriented nonprofits, the state sponsors annual "venture fairs" in Madison and Milwaukee to "allow start-up and expanding [Wisconsin] firms an opportunity to make presentations to and network with venture capitalists and investment professionals from across the nation," according to the event's Web site.
More recently, the state Department of Commerce began taking promising companies to venture capitalists on both coasts. After a trip to California in August 2000, department Secretary Brenda Blanchard led a delegation of start-up companies to Boston this past April. Company representatives were responsible for their own travel and lodging costs. But the department and Forward Wisconsin (a state marketing and development agency) helped pick up the tab on organizing the event, which included an evening reception, presentations to an audience of East Coast venture capitalists, a networking lunch and one-on-one meetings with venture capitalists. Through a spokesperson, the Department of Commerce declined to comment on the trips.
In other district states, however, private efforts are under way to accomplish the same goals. Minnesota has two wholly private organizations (Netsuds and The Collaborative) and one nonprofit (Minnesota Seed Capital Network) that provide entrepreneurs and venture capitalists alike with networking opportunities. Even Montana has two private efforts (Montana Private Capital Network and LocalFund.com) designed to connect various entrepreneurial pieces with each other.
What role government?
Opinions regarding government's value-added role run the gamut. For-profit venture capitalists appear to favor limited government roles. "As far as government goes, in most cases, they tend to muck it up more than they help," said Daryl Erdman, senior director of Aavin Venture Capital Partners of Minneapolis. Government tends to throw money at business concepts, he added, "before they are proven."
"I really don't think government plays that much of a role [in entrepreneurship]. It really boils down to individuals" and their willingness to take risks, said Matt Noah, head of Netsuds, a three-year old company that hosts "mixer" events and provides other opportunities for entrepreneurs to network with venture capitalists and other professionals. Noah said "some government inducements" like tax incentives might help grease private investment activity, but pointed out that California and Massachusetts dominate the venture capital industry despite being high-tax states.
Partners at St. Paul Venture Capital (informally polled by a spokesperson for one of its satellite funds) said the best role for government is to put in place the right securities and regulatory incentiveslike low capital gains taxesthat encourage risk taking by individuals. In fact, two instances about 20 years agoa big capital gains cut and a federal clarification regarding venture capital investments by pensionsare credited by many for planting the growth seeds of the venture capital industry.
Similarly, many entrepreneurs favor a hands-off approach in principle. "The idea of expecting a government organization to foster entrepreneurialism is like hiring a staff of only men to start a women's magazine," said one Montana entrepreneur. "Every entrepreneur I know desires less government involvement. They desire less confinement with minimal roadblocks to getting their venture up and running," said Nancy Meyer, CEO of WeMentor, a Minneapolis-based consultant for entrepreneurs. "Entrepreneurs break rules that don't make sense. It is innate."
Nonetheless, a half-dozen entrepreneurs contacted for this story also voiced support for government's involvement, mostly in making venture capital more locally accessible. The most common model suggested was a guaranteelike program similar to Small Business Administration loans, where government mitigates some of the financial risk associated with equity investment. (In fact, this sort of program already exists. See "The granddaddy of VC".)
Most other sources also believed that government had a financial role in entrepreneurship. Public venture capital programs can help change the local entrepreneurial culture and attract more investment talent to a region, according to Robert Heard, president of the National Association of Seed and Venture Funds, which represents public and private interests involved in venture capital. Heard co-authored the NGA report on state venture capital programs and is also president of Edge Development Capital Inc. of Oklahoma City, Okla.
"Entrepreneurs are much more likely to find a receptive venture investor if that investor is local, rather than across the country," Heard said. "[And] local investing talent is much more likely to emerge if resources are made available for them to manage locally."
Tinkering on the margins?
What's not clear is whether these public initiatives have more than a marginal impact when it comes to risk capital and entrepreneurship. Davis acknowledged that the $2 million Wisconsin Enterprise Fund did not have a big influence on the northern regional economy, saying it would take $15 million to $25 million in venture capital "to make a visible difference in per capita income and tax base." Hoping to average six deals a year, "we're just replacing what we lost," Davis said, adding that one silver lining is the fact that the new companies are "better companies," more high-tech and aligned with the new economy.
Very little formal research exists on the ability of public programs to induce entrepreneurship, make venture capital more available or systematically seize investment opportunities that the market has passed on. The private venture capital industry itself is still young and immature, and, as such, related government initiatives and research on their efficacy are also in their infancy.
Anecdotes are readily available to support either side of the issue regarding public venture capital programs. For example, the Oklahoma Capital Investment Board operates a venture capital program that raises capital from institutional investors, guarantees a return and holds $50 million in contingent tax credits to make good on the promise. The board has invested $26 million in Oklahoma firms, produced an internal rate of return of 28 percent and has yet to issue any tax credits, according to Heard. "The profits from the program accrue to the benefit of the state. So this model is actually revenue positive."
On the other hand, Louisiana was the first to pursue the CAPCO strategy of investment tax incentives in 1983, and its performance has been less than stellar. From inception through 1999, the state had doled out about $550 million in tax credits for investments in 112 companies in the state, according to a 2001 report by the state's legislative auditor. Only 64 were confirmed to still be in business, and they employed just 2,725 people. Heard acknowledged that "this model is widely regarded as extremely expensive relative to the benefits received."
A lack of thorough research has meant that the performance and impact of most programs are usually taken at face valuethat any positive results are assumed to stem directly from the program and would not have been realized otherwise. While this might be true in some instances, it's not clear such a cause-effect relationship usually exists.
One of the most rigorous evaluations to date on a public venture capital initiative was done by Harvard professor Josh Lerner. He investigated the Small Business Innovation Research program (SBIR, run by the Small Business Administration), which provides grants to small businesses for feasibility and development research in high-tech areas and was designed to correct a perceived market gap in the equity financing of young, technology-based companies.
Lerner looked at two groups of similar small businesses, one that received SBIR awards and one that did not. At first glance, SBIR awardees appeared to have higher employment and revenue growth rates. But Lerner found that "the presence of an SBIR award alone had little impact on employment and sales." Rather, he discovered "a strongly positive impact" on SBIR recipients that were coincidentally located in areas with significant venture capital.
The SBIR, Lerner wrote, acted as "a complement to venture capital organizations and other private institutions that assist new firms, and the impact of the awards in regions without these private sector mechanisms was minimal." These findings, Lerner concluded, "underscore doubts about federal efforts to encourage the formation of venture funds investing in economically distressed areas."
"In theory, [government involvement in venture capital] makes a lot of sense," Lerner said in a phone interview. "In practice, there are a lot of practical barriers." Along with the tendency to "glom onto" those areas already receiving venture capital, Lerner said that "political distortions" influence where funding goes. Companies also become adept at jumping through the tedious application process and receive multiple grantsLerner called them "SBIR mills"but these companies "tend to provide less innovation than single-time winners," he said.
A better strategy for public programs would focus on the demand side of venture capitalnamely, greater development of ideas and new firms. "Supply (of venture capital) will adjust accordingly," Lerner said. Available evidence suggests that regions seeing growth in venture capital (Raleigh, N.C.; Austin, Texas) have done so largely through university-based initiatives to increase high-tech research and the transfer of ideas and technology out of university labs. Similar initiatives have been proposed for the flagship universities of Minnesota and Wisconsin.
Have mouth, need money
If, indeed, states are worried about entrepreneurial activity and venture capital, what might be more surprising is what state and local governments are not doing.
For instance, significant local and state resources are funneled every year through a vast network of public and quasi-public development organizations. Yet few of these organizations are set up to help entrepreneurs or the kinds of businesses most often targeted by venture capitalists and various public initiatives. A 1999 state survey of more than 300 business assistance organizations in Wisconsin found that 60 percent had no clients in either research-and-development or high-technology fields, and virtually all remaining respondents said such companies made up less than 25 percent of their client base.
A report by the Kaufman Center for Entrepreneurial Leadership showed that the vast majority of state financial assistance programs were loan-based, and just 10 percent involved equity-type investments. Based on responses from 47 states, less than 1 percent of all state funding for economic development went for entrepreneurial development, the study reported.
Another critical obstacle for start-ups is being "capital ready," or being able to put any incoming capital to its best use. Yet despite clear opportunities to help entrepreneurs become more capital ready, "states focus more on increasing the supply of capital," the Kaufman report said. It found that only one of 36 state programs designed to overcome capital problems specifically addressed the capital readiness of firms. The other 35 were financial in nature, as were all 94 state-based programs identified in the NGA report.
Policymakers might also be careful of what they wish, because none of the existing programs has yet been tested in a down market. Indeed, the recent crash of many technology companies and stocks has chastened the private venture capital market, whose average returns dropped into the red in the fourth quarter of last year, according to the National Venture Capital Association. Wells Fargo announced in June that its venture investments lost more than $1 billion in the second quarter of this year alone.
Institutional investors are pulling back as a result. Venture capital investments dropped from $17 billion in fourth quarter 2000 to $10 billion in first quarter this year, and the number of deals also dropped 34 percent, according to the most recent PricewaterhouseCoopers/VentureOne MoneyTree Survey. Given the economic slowdown, a nationwide decline in venture capital investments for this year is possible, if not probable, and would be the first such annual decline since 1993, according to Venture Economics.
Pooh-poohs and exit strategies
For those who "pooh-pooh" the idea of government involvement in entrepreneurship and venture capital, "the invisible hand of government has been around more than people will admit," said Steve Mercil, president and CEO of Minnesota Investment Corp., a for-profit venture capital fund that was initially capitalized by a state grant and targets businesses outside the Twin Cities. "The private [financial] market is not perfect," Mercil said, and it's a myth "that every good deal gets done in a timely fashion."
But neither do public officials know whether government can and will do a better job than the private market when it comes to entrepreneurial investments. John Taylor, vice president of research for the National Venture Capital Association, agreed that "the right kind of public policy can absolutely help" the venture capital industry in a state.
But government's strength is not on the supply side of venture capital, because government often has goals that differ from the narrow, financial-return goals of venture capitalists, Taylor said. The VC industry "is tough enough to be successful in," and for a public venture capital program to focus on anything but investment return is like starting "with one hand behind your back," Taylor said. "Probably the biggest thing to help the venture business get going [in a state] is to help technologies get visible."
Leazer, from the Wisconsin Technology Council, agreed that public programs hoping to increase investment capacity within the state had to aim squarely at producing investment returns. Such a focus includes its own exit strategy as well, Leazer said. "If this is successful, the market will start to crowd out government" for these investments.