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While Washington has staked hundreds of billions of dollars on increased spending to stimulate growth in the economy, statehouses across the country are poised to cut allocations for sponsored venture funds in a bid that could hurt their ability to fund high-tech start-ups.

Most U.S. states do some kind of venture investing, often taking LP stakes through pension funds and other vehicles. But roughly half the states also make direct investments, or have affiliated agencies that do. Since the 1980s, dozens of legislatures have formed agencies to make direct equity or convertible note investments in start-ups to promote high-tech economic development and job creation in their states. Typically they behave like early-stage venture firms, except that the limited partner is the state.

Like VC firms, the state organizations take equity positions, so any returns that would come from an M&A or initial public offering would return to the fund vehicle. The returns do not automatically return to the state; vehicles in Michigan, Pennsylvania and Connecticut have varying degrees of autonomy from their sponsoring governments.

But state governments retain control over budgets and in some cases have access to returns, and as they try to assemble budgets in an era of severe shortfalls, many of them are tempted to take the axe to their state-sponsored economic development corporations or early-stage venture firms.

Such is the case in Michigan, according to Ned Staebler, vice president of program administration at the Michigan Economic Development Corp. "We are in the midst of configuring our budget for 2009, but it will likely contain some cuts to our office," Staebler said.

On The Chopping Block

Michigan's main venture effort, the 21st Century Jobs for Michigan Fund, was founded in 2005; the main direct investment portion invested $30 million in 2008 and is budgeted this year for $25 million for early-stage companies. That's a number that could easily be trimmed from Staebler's line item allocation.

"With a number of these funds or programs, some may be looking to consolidate with other state programs and some may have budget cuts or reductions in the amount of investments they can make," said Richard Bendis, a board member of the National Association of Seed and Ventures Funds, or NASVF.

Bendis has established a public/private nonprofit partnership called Innovation America LLC, which is spearheading an ambitious effort to raise a $2 billion fund from federal, state and local governments and private sources to shore up regional economic development funds.

In the meantime, state fund managers said they are evaluating proposed cuts and trying to figure out how to keep the damage to a minimum.

"We're not going to take the approach of taking 20% out of 18 funds," said Rebecca Bagley, deputy secretary for the Technology Investment Office of the Pennsylvania Department of Community and Economic Development, which divides allocations between 18 funds that themselves make the direct investments. "We're going to take a fine-tooth comb and see if they overlap a little bit."

Bagley said her office, which oversees firms such as the Ben Franklin Technology Development groups and the Life Science Greenhouse, may aim to consolidate some of the agencies under her aegis.

Where Does The Money Come From?

In setting up venture funds, states traditionally relied on two funding sources - line item money from the general budget or proceeds from bond issues - or a combination of the two. In recent years, some states have added proceeds from the Tobacco Master Settlement Agreement of 1998, particularly for life science investments.

Bagley said her Pennsylvania agency gets relatively little money from the general budget: $40 million since that revenue stream opened up in 2001. In comparison, her office has received $215 million in tobacco money since 2003 and $310 million in bonds since 2005. That balance means the impact of budget cuts on the Pennsylvania program is not as harsh as it is for Michigan, which relies almost exclusively on general fund allocations.

Peter V. Longo, president and executive director of Connecticut Innovations, said his firm has not relied on budget allocations at all since 1995, investing from the proceeds of a $63 million bond issue. That model, he said, gives his firm some protection from the vicissitudes of the state's budget. "From a returns-first perspective, because we are established this way, we have some autonomy," he said.

Connecticut Innovations invested $11.5 million in 19 companies in 2008 and $6.5 million in 11 companies in 2007.

But even a fund that has become self-reliant on cash from returns may still find itself vulnerable if the state is hunting for money to plug budget holes.

"Since 1995 our equity program has been self-funded and our operations have been funded through our returns, but that doesn't mean they leave us alone," Longo said. "The plan now is to take $9.5 million out of our returns to plug the deficit and revenue shortfall."

Longo said this is not the first time the legislatures in Hartford have come looking for cash. Between 2002 and 2004, he said, Connecticut Innovations paid $17.5 million to the state. While he said he understands the needs of the state, he said it restricts his efforts to fund as many companies as he would like. "I think this is the worst time to sweep funds," he said. "That would impact our ability to do investments."

Filling A Need

Many state venture funds aim to plug the "valley of death" between seed and angel money and a start-up's Series A venture round. But with those early venture rounds harder to come by, these public entities indicate they may be forced to invest more than usual in existing companies rather than add new ones to their portfolios.

"We are still going to feed the pipeline," Pennsylvania's Bagley said. "But I think you will see more investments in some of our existing companies and fewer new ones we'll invest in."

Despite the pressures on their operations and potential deal flow, investment managers said their saving grace is the ability to create and maintain jobs during a recession.

"The statistics are that the companies adding between one and 10 jobs represent 75% of the jobs created post-recession," NASVF's Bendis said. "So if we want to get high-range jobs growing, we have to go with early-stage companies."

The job creation card can be an important one to play in the statehouse, fund managers said, highlighting the need for state-managed funds to find a champion in the legislature or governor's office.

"The future for Michigan is in a tech-oriented economy, and we're really fortunate our governor understands how important this is," Michigan's Staebler said. "There's nothing worse that you can do after starting a program like ours and kill it off after two to three years."