When States Become VCs

Companies in high growth sectors such as Cleantech, IT, and biotechnology are coveted by states around the country.  To facilitate the establishment of companies in those sectors, many states offer a variety of incentives, including grants and tax abatements.  More recently, states have focused on capital investment in venture capital funds as a way of attracting high-growth companies.  As VCs have historically invested in high-growth sectors, many states have chosen to either align themselves with existing venture funds or start their own state-affiliated funds.  

In 1976, Connecticut started the first state-promoted venture endeavor, the Connecticut Product Development Corporation (CPDC).  Through direct equity investments by the state, the CPDC enabled entrepreneurs with compelling ideas to obtain early stage capital.  This model proved to be quite successful and was eventually copied by a number of other states.  Today, there are approximately 150 state-affiliated venture (including Fund of Funds) funds.

Should States Act as VCs?

As the competition for jobs has ramped up, many states have felt the urge to provide a guiding hand to drive companies to their state.  State assistance is often seen as necessary since few states organically have the tools (abundant capital, cheap real estate, and abundant human capital) necessary to draw companies to their state.

While most states recognize the need to promote start-up creation, few are in a position to effectively deploy the capital and resources necessary to manage a cohesive start-up promotion program. 

Running a cohesive start-up programs requires:

• Consensus building between the legislature, venture community, and the corporate community
• Defined strategy - direct investing, tax incentives, grants, etc.
• Requires the state bureaucracy to make informed business decisions
• Requires the state to take on venture capital-like risk with tax payers’ money
• Requires talented program managers at the state level to run an investment program within a bureaucracy 

These are real challenges that need to be fleshed out before a state decides to allocate significant capital into start-up creation.  

Investment Structures Used by States

Unlike state pension funds which invest from a defined pool of capital, state capital investment programs often borrow money to make their investments.  States are able to obtain low-interest loans from banks by using future tax receipts as collateral.  The loan is then used by  the state to invest in venture funds.  If the state’s investments in venture capital funds return all of the invested capital plus interest, then the state’s investment will be cost neutral.  However, should the venture funds not provide enough return to cover the loan plus interest (excluding other costs to keep things simple), then the state is required to make up the difference by tapping into its tax receipts.    

Below is an example of how state capital investments are structured:

The opportunity cost of capital for the state is quite substantial in this model due to the various management and service fees that have to be paid yearly to the venture funds, fund of funds, banks, lawyers, and auditors.  In aggregate, these fees have an 8-10% cost structure built into the state’s capital investment.  Therefore, the structure I outlined is only cost neutral if the investments provide an IRR greater than 10% - meaning that the state’s pooled venture capital investments must return at least double the capital invested just to break even.  

That being said, setting up investment structures like the one I charted out can be quite effective, even if the venture funds do not perform all that well.  For instance, by requiring venture funds to make investments in local companies, those funds will contribute to local job creation and a larger tax base.  Even if tax payer money is needed to pay off the LOC to the bank, that money will have contributed to job formation in the state.

Pennsylvania

I don’t think any one state has perfected an incentive model for start-up creation, but I do think Pennsylvania does a pretty good job of supporting start-up creation.  

Pennsylvania is fortunate to have numerous top tier research universities within its borders, and can leverage the talent at those universities to spur technology transfer and start-up creation.  Additionally, numerous corporate headquarters are located in the state and provide a large and stable talent base for start-up companies.

Even with great research centers and corporate support, Pennsylvania is in a constant race to attract companies that can generate jobs for the Commonwealth.  Over the last 30 years, Pennsylvania has launched three major initiatives (I refer to them as the “Three Waves”) to promote job creation.

First Wave - Ben Franklin Technology Partners

Started in 1982, Ben Franklin Technology Partners (BFTP) operates four regional non-profit organizations to serve and promote companies across the state.  BFTP’s activities are subsidized by a yearly budget of $20 million to make investments in start-ups that range between $30,000 and $150,000.  The effect of BFTP on start-up creation in the state has been profound and BFTP has become the go-to source of start-up capital for most start-ups.  Since inception, BFTP has invested over $173 million that has been subsequently matched by over $408 million of private investment. 

In 2008, the U.S. Economic Development Administration, an arm of the U.S. Department of Commerce, named Ben Franklin “the most effective regional economic development organization in the nation.”

Second Wave – The Tobacco Settlement

As part of the Master Settlement Agreement of 1998, the major tobacco companies were required to contribute funds to ease states’ burdens in caring for residents with tobacco related illnesses.  With some of the proceeds generated from the tobacco settlement, Pennsylvania approved two one-time appropriations for strategic areas of investment - the Health Venture Investment Account and the establishment of three regional biotechnology research centers known as the Life Science Greenhouse program (LSG).

The Health Venture Investment Account invested $60 million in four life science venture capital funds that pledged to invest that capital in Pennsylvania companies.  Those funds also pledged to match every public $1 with another $3 from private investors, thus turning the state’s $60 million commitment into a $240 million war chest. 

The Life Science Greenhouse program was created to address a lack of valley of death (gap between academic work and early product refinement needed to attract VCs) capital for start-ups.  The three Greenhouses provide not only early stage capital (up to $1.25 million in companies over the life of an investment), but also mentoring and consulting services.

Third Wave – Venture Capital Investment Programs

In 2004, then-Governor Ed Rendell, put forth an ambitious $2 billion stimulus plan to help boost job creation in the state.  Knowing that Pennsylvania lagged its peers in start-up creation, Gov. Rendell carved out $310 million from the stimulus plan to directly fund two new venture programs: PA Venture Guarantee Program and the PA Venture Capital Investment Program.

Launched in 2007, the PA Venture Guarantee Program sought to leverage $250 million of capital to attract VC investors to the state’s start-ups and businesses.  The Guarantee Program was quite novel in that it incentivized VCs to take on more risk in high growth businesses by protecting against the potential loss of investors’ principal.  In return for investors committing at least $15 million of capital to a Pennsylvania start-up, the PA Venture Guarantee Program would cover the first loss of the aggregate amount of principal invested in the company up to 50% of the total principal invested (i.e. $7.5M covered on a $15M investment).  This program essentially encouraged VCs to double down on investments made in Pennsylvania companies. 

To participate in the program, the state created a prerequisite that the recipient (VC fund) would maintain an office in Pennsylvania staffed with at least one senior-level partner for the duration of the guarantee

Philadelphia and Pittsburgh attract the lion’s share of start-up capital, leaving vast regions of the state without funding sources.  Structured as a $60 million Fund of Funds, a second venture program - the PA Venture Capital Investment Program – was launched to promote investment outside of metropolitan areas.  Like the Health Venture Investment Account, the Venture Capital Investment Program has a 3:1 matching component, turning the state’s $60 million investment into $240 million of capital. 

The success of the PA Venture Capital Investment Program has been quite remarkable over the last five years and the program currently has 12 participating venture funds, 5 of which were 1^st time funds.   Those 12 funds have collectively invested over $117 million in 45 Pennsylvania companies.   

Concluding Thoughts

Like entrepreneurs who are looking for their first seed funding, VCs often struggle to find anchor investors.  Given the current economic climate, states might want to consider playing a greater role in spurring venture fund creation and helping maintain the capitalization of existing funds. 

Five first time funds were funded over the last few years through the PA Venture Capital Investment Program.  Without the state stepping up to the plate as an anchor investor, it is hard to believe that those funds would have been raised during the economic downturn.  Yet, it is in such down economies that VC dollars are so impactful – providing needed capital to start-ups as exit windows remain closed and creating jobs through the funding of new companies.  

With the proper incentives and prerequisites in place, capital investment in venture capital funds by states is a proven driver of job formation via the growth of start-up companies.

Stimulating Start-up Culture

“Entrepreneur’s Fund”: During a recent car ride Marc Singer, another member of the Osage team, suggested a radical idea to entice successful entrepreneurs to start their next company and help stimulate a start-up culture.  Marc’s idea (one of several he has pitched me) is to provide $1 million of seed capital to successful entrepreneurs with relatively few strings attached.  $1 million should be enough money to entice an entrepreneur to roll the dice for a year, develop a business, and attempt to market it to investors.

Fund Capital: Capital for the concept would be provided by either the local government and/or private foundations.  Sustainability is key, as program awareness is needed in order to successfully recruit the most promising entrepreneurs to leave their current job posts.  A 5-year program would produce 25 award winners from the program directly, and indirectly spur numerous other entrepreneurs to join the start-up bandwagon.

Selection Committee: The selection committee would ideally be comprised of a representative group of start-up stakeholders from the region.  Possible members would include local members of government, economic development managers, investors, academics, technology transfer professionals, and repeat entrepreneurs.

The selection committee would be tasked with a simple goal, identify 25 promising entrepreneurs in the region and convince 5 of them to join the program.  The 25 nominees would be culled from a pool of senior-level managers who were at the helm of local start-ups that were recently sold and/or had a positive impact on the region.  Identifying backable repeat entrepreneurs is integral to the success of the program as they have a higher likelihood of raising outside capital and successfully managing a start-up company as they have done it before.

Investing in Talent:  The riskiest and most innovative part of this fund idea is that capital will be awarded based solely on the steering committee’s belief that one entrepreneur will have a better chance of successfully launching a start-up over another entrepreneur.  VCs like to say that they would rather invest in a mediocre idea that is being developed by a rockstar entrepreneur over a groundbreaking idea being led by a mediocre manager.  Well, this model puts such an investment thesis to the test.     

$1M Loan:  Awards will be granted in the form of a $1 million loan to the entrepreneur.  At the time of the award, the entrepreneur receives 20% of the loan to cover salary and other fees.  The rest of the equity ($800K) is held in escrow for up to 12 months while the entrepreneur looks for a technology to develop into a start-up.  Upon finding a technology and developing a business plan, the remaining equity is unlocked.  Should the entrepreneur fail to secure a technology within the 12 month timeframe, the $800K must be returned to the steering committee.

While I am a big fan of the loan idea, there are a number of other financing options that could be employed.  Instead of providing $1M of capital contingent on pulling together a company concept, the grant could be awarded in the form of a matching investment of up to $1M.  I am less enthusiastic about this idea as most entrepreneurs realize that raising the first $1M, even if it has matching funds associated with it, is always the hardest.  Another idea would be to offer downside protection for investors who invest in the first round of outside capital.  Should the entrepreneur raise $1M of outside capital, then the start-up’s investors would be eligible to receive compensation of up to $500K should the company fail to raise a second round of capital or successfully grow.  Offering such downside protection might entice more investors to get into the early stage mix, which would take some of the capital risk off of the table for entrepreneurs.

Measuring Success:  Over a 5 year period, the program should strive to have an 80%+ success rate (20+ awards granted) with regards to award winners receiving the full $1M.  Of those winners, 75%+ (15 companies) should be expected to raise at least one round of outside capital.  Of those 15, 80% (12 companies) should be expected to raise a second round of capital and have their doors open after 5 years.  Ultimately, 6 of the remaining 12 companies would hopefully be successful companies.  I would define success as being in business for at least 10 years and employing at least 25 people at the time of the company’s 10th year.

In the context of economic development, success can also be measured through long-term tax revenue generation.  Let’s say that those 6 successful companies each employee on average 25 people over a 10 year period and that the average salary is $80,000.  To use Pennsylvania as an example, its state and local tax burden is 9.8% (to make the math easier, I will round up to 10%).  On income taxes alone, those 6 successful companies would generate approximately $1.2M in income tax revenue per year, or $12M over 10 years.  Indirect tax payments through corporate taxes and consumer spending could easily nudge that revenue generation number closer to $15M.  While the $15M does not fully catch-up to the $25M investment, the delta on the investment should gradually close over time as the soft benefits of such a program (more start-ups, higher salaries, more jobs) build up.  

There is no quick fix or easy-to-follow manual for creating a start-up culture, but a collaborative economic development program could help pry some of the talent away from the corporate world and into start-ups.