What's Wrong With Washington Playing Venture Capitalist?

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Two simple rules for governments helping entrepreneurs: (1) Don't help the most promising startups, and (2) Don't help the most hopeless startups. Where does that leave Washington?

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In 1990, the state of Iowa, hoping to boost entrepreneurship in the state, set up the Heartland Seed Capital fund, a government funded venture capital program. It seeded the fund with $15 million from the state's Public Employees Retirement Fund. After issuing a request for proposals, it selected the investment firm McCarthy Weersing to run it. Over the next three years, the fund made only one investment of $1 million - perhaps partially explained by the fact that the firm had no investors based in Iowa - while collecting a fat three percent in management fees. When the state decided it had made a mistake, the investors sold back their one equity investment to the company to recoup for themselves management fees that the state refused to pay, and promptly sued the state of Iowa.

When Mitt Romney and other politicians claim that the government makes for a lousy venture capitalist, stories like the Heartland Seed Capital fund and Solyndra figure prominently in their anecdotal evidence. Are these skeptics right?

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Maybe not. I recently finished reporting a series for BostInno about the Massachusetts state government's efforts that confirms that government venture activity can succeed in boosting innovation. Such programs existed during Romney's tenure as governor of the state and one such fund was even created by his administration. And while it would be a mistake to equate state and federal programs, understanding the role that government venture capital can play in principle casts doubt on Romney's attacks.

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Why do governments consider getting into venture capital in the first place? The importance of new, innovative high-growth startup companies to the economy -- the jobs they create, the growth they promote, the new technologies they bring to market -- is well documented. So it is a legitimate goal of any government to encourage startup activity. Venture capital funds raise money from pension funds, universities, and other large institutional investors and then make investments into early stage companies in exchange for partial ownership, and are a key driver of startup growth.

Sadly, the Iowa debacle is indicative of the broader record of government venture efforts.

"Unfortunately, these experiences are more the rule than the exception," writes Harvard Business School professor Josh Lerner in his 2009 book Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed - and What to Do About It. In Lerner's telling, the record of government venture investment is dismal. From New York City to Malaysia, such efforts have been plagued by poor program design and implementation. But as Lerner notes, these failures are not inevitable. In fact, there is reason to believe that, when done properly, venture investments by government can help address critical market gaps and boost a city, state, or region's innovation ecosystem.

The fundamental challenge for a government venture program is that to succeed, it must toe the line between investing in viable companies and filling a market gap. It shouldn't duplicated private sector efforts by chasing after the most promising deals. But it also shouldn't waste taxpayer dollars by dumping money into nonviable companies. Where is the happy medium?

We can learn from the success stories. As I've reported, Massachusetts has done a good job in its venture efforts, through multiple state funds that have deftly avoided most of the common pitfalls of such programs. The funds are viewed positively by private investors and entrepreneurs, who credit the state's investments with attracting follow-on funding from the private sector and supplementing angel funding (smaller startup investments by wealthy individuals) for nascent companies.

In 2008, Charlie Grinnell found himself in the unenviable position of trying to raise Series A funding for his agricultural robotics startup [Harvest Automation](http://www.harvestai.com/). There weren't many venture firms investing heavily in agriculture and, despite many years of business experience, he had never run a venture-backed company before (a hold up for many VCs). To make matters worse, the economy was headed into what would be the worst recession since the Great Depression. And yet by the end of 2009, his company had secured over $5 million in venture funding, thanks in part to early interest from the Massachusetts Technology Development Corporation, a state venture fund that not only committed capital but helped introduce the company to other potential investors. Since securing its Series A, Harvest has grown to over 30 employees and secured [an additional $7.8 million in private investment.](http://www.boston.com/business/technology/innoeco/2011/11/harvest_automation_raises_78_m.html)

Over the course of its 30+ year existence, MTDC claims a gross internal rate of return of 16.5%, predictably lower than average venture returns for that period, given that the state's mandate goes beyond finding the best returns, but well above the S&P. These returns are automatically reinvested into the fund, so that it operates without any additional burden on taxpayers.

It's worth zooming out and noting that most of what government ought to do to support innovation has nothing to do with providing venture capital. It's about setting a level playing field, funding research and development, educating the workforce, and developing markets for new technologies. But as Massachusetts demonstrates, the government's role need not necessarily stop there.

I asked Dharmesh Shaw, founder of the prominent inbound marketing startup Hubspot and an active angel investor, about the role of the government as a venture capitalist, and about potential conflicts between private investors and government funds. He framed the problem nicely, suggesting that having the government do too much for startups is a better problem than having it do too little.

"As much as I'd love for it to be otherwise, most early-stage entrepreneurs have a paucity of committed investors -- not a surplus," he told me by email. "In terms of the 'market distortion' risk, that could be a problem, but I don't think it's significant enough. I'd love to see the government assist so many startups that it starts to create a distortion problem."

This article is adapted from a series on the Massachusetts government's venture capital programs originally published at BostInno.

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Walter Frick is a Staff Writer at BostInno covering technology and venture capital. He has also written for The Atlantic, Nieman Journalism Lab, and The Energy Collective, among other publications.

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