If you are an early stage technology entrepreneur I am going to tell you something you already know – there’s not enough early stage risk capital available in our economy.  Since the aftermath of the Internet bubble, the aggregation of capital has largely moved away from early stage, high risk technology businesses.  It went to different places – real estate (remember real estate?), hedge funds, private equity/buy out funds and foreign markets to name the most prominent examples.  And, the capital that has remained available for technology businesses has largely pooled in a concentration of larger venture capital funds, which are generally poorly configured for investment in early stage businesses. 

All these trends were in place and affecting entrepreneurs before the current credit crunch, and are being accentuated by current market conditions.   Why does this matter?   It matters because emerging businesses, particularly emerging technology business, are a major driver of economic growth in the US, and as the world economy continues to integrate, they are the businesses that are most likely to be internationally relevant and provide significant wealth opportunities for their owners and good job opportunities for their employees. 

There are a number of conditions that need to be satisfied to foster the creation of successful emerging technology businesses; these conditions are often described as a “technology cluster” because when they occur together a region becomes a hot bed of new technology businesses.  Generally, a technology cluster has the following core attributes:

·         One or more local centers of technical excellence, providing a pool of highly skilled entrepreneurs looking to establish emerging technology businesses.

·         A supportive class of experienced and knowledgeable service providers.

·         Suitable and affordable infrastructure.

·         Access to capital.

There are many regions around the US that have the conditions to be successful technology clusters – the DC region is one of them.   And, there are many things that government, the private sector and the academic community have done to foster cluster development both here and elsewhere in the US.  Indeed, you would be hard pressed to find any successful technology cluster that hasn’t been the result of a multidisciplinary effort.   What is different is the level of known cooperation – i.e., do the various constituencies act in concert as part of a policy, or does it happen by “accident” as respective actors follow their own priorities.  The experience in Silicon Valley is one where the conditions were created largely through independent actions coalescing into a cluster.  The success of the Research Triangle in North Carolina is an example of explicit coordination between the various communities.  Other successful clusters, including those in the DC region, were created with a level of coordination that lays between the  Silicon Valley and North Carolina experiences.

The important point here is that much successful effort has gone into creating technology clusters.  And, clustering is something that is particularly amenable to policy driven initiatives.  But, there is a large exception to this – governments traditionally have not been able to provide sufficient early stage capital without the participation of private capital sources.  This is where and why institutional venture investors and angel investors are important – they have the ability to aggregate larger pools of capital to finance the establishment and expansion of early stage businesses.  Early stage technology businesses in particular need risk tolerant capital to grow. 

The problem is that without risk tolerant capital you can’t grow emerging technology businesses, and in our economy capital is largely free to go where it can get the best economic return, even if that return opportunity is outside of the US.  Economic return is the maximization of income coupled with the minimization of risk required to get that income. Capital doesn’t always go to the least risky investment opportunity – it goes to the opportunity that most appropriately balances the risk and the reward.  Think about this – would you place your entire wealth on a roulette wheel for a 100X return if your chances of winning were one in a million?  How about it the chances were one in ten?  How about even money?  You see the point – it’s not just the return, it’s the risk you must take to get it.

The reason why there is a lack of early stage capital is because the market generally believes that the risk and return opportunities are not as compelling as other investment opportunities.  Now, I have argued in past blogs (and elsewhere) that markets are often slow to acknowledge changes and trends and that early stage investing is actually a very compelling opportunity, particularly today.  Over time, this will be borne out, and the market will adjust.   But, in the meantime, there will be many emerging businesses that won’t be able to obtain sufficient capital.  If my life as an early stage investor is any indication – I am seeing many more committed and deserving entrepreneurs that are backable and worthwhile than I could finance out of Amplifier. And, I am sure that anyone who is committed to investing in early stage businesses has a similar impression. 

The question -- in light of the importance of emerging technology businesses to the US economy – is whether the Federal government could or should do something to alleviate the early stage capital gap rather than waiting for the market to correct.  Although I am a free market economist by training, I do feel that there are times where government support is necessary or helpful.   My thinking is that some tweaks in existing government programs, and modifications in tax treatment, could accomplish a significant change in the risk/reward trade off of early stage investing.  This would encourage the formation of more funds like Amplifier, and support individual and angel investing.   I am not suggesting that all of the changes below would be necessary, but some combination of them would make a material difference.   Moreover, these proposals could be applied generally, or could be targeted towards businesses in specific technology areas, or towards businesses or venture capital funds of a particular size.

• Capital Gains.  If I did nothing else I would keep the capital gains tax low, or eliminate it entirely, on sales of capital stock by the founders and early institutional and individual investors of an emerging technology business.  The capital gains rate is the tax rate that most directly applies when an entrepreneur or investor reaps the benefit of their hard work and acumen.  A low or zero capital gains rate would increase the “after tax” return, and favorably affect the economic return of early stage investing.
• Use of Government Grants.  Governments, both Federal and local, have many programs that provide capital for research and development of technology.  In some important instances those programs discourage entrepreneurs from seeking outside capital.  These rules could be modified, or other rules adopted, which would encourage the use of outside capital. For instance, if the availability of a Phase III SBIR was tied directly to an outside venture capital investment, this would provide encouragement for the entrepreneur to seek outside capital, and provide the investor with government leverage of its investment.
• Re-Enact the SBIC Program.  Until recently, the Federal government had a program that provided capital to venture funds that invested in emerging small businesses. This program required the raising of outside capital into the funds, and provided a significant advantage to the outside investors – they could leverage their own investment with Federal dollars.  Many well known local and national venture capital organizations got their start as SBIC funds.
• Tax Treatment of Fund Managers.  Fund managers, particularly managers of smaller investment funds, are financially motivated by their ability to participate in the capital gains of their investors.  Currently, when this occurs the manager’s gains are taxed at the same rate as its investors. There have been rumblings in Congress to change this treatment, so that in the event of capital gains fund managers  would pay higher tax rates than their investors.   While this change will be a big deal to every professional venture fund manager, it will be a profoundly big deal for the managers of smaller funds, since the economic benefit of managing a smaller fund is primarily the participation in capital gains.  Leaving this tax treatment in place will at the minimum not discourage the formation of smaller venture capital funds, which structurally are more suited for early stage investing. And, if the treatment of larger funds was changed – a distinct possibility in the next Congressional Term – leaving the treatment unchanged for smaller funds would provide a comparative encouragement.
• Encourage Non Profit Participation.   An investment in a venture capital fund to finance an early stage company is treated as a taxable activity, but giving money to a university to encourage entrepreneurship is not.  In fact, charitable contributions have the effect of directly reducing taxable income and estate tax liabilities.  There is a growing trend of venture philanthropy – charitable contributions that are intended to reward entrepreneurship for social good.  Why not go the next step and allow charitable contributions to early stage venture capital funds?   It’s not as crazy as it sounds, if you consider the social good of new company formation. If this change was made, a venture fund could use charitable contributions the same way it would use the access to capital of the SBIC program, or government grants, to provide leverage for the outside investors seeking economic return.
• Government Venture Capital.  Another way for the government to address the early stage funding gap is to become directly involved in early stage investments.  The Federal government is already successfully doing this through In-Q-Tel in certain technology areas relating to Homeland Security.  This template could be applied to other areas where early stage capital and expertise are lacking – for instance alternative energy, materials science or space exploitation.  What the In-Q-Tel model has shown is that when the government provides a backbone of technical expertise and access to a meaningful customer, both entrepreneurs and their outside investors are encouraged to develop new technologies and businesses.

As you can see there are many things that could be done, and there are many other proposals that I am sure you could come up with.  What do you think? Is this a problem that government should address?  What would you do?