illustration by Phillip Ortiz

Need Capital? Try Your State

April / May 2009 By: Eric Billingsley Volume 7 Number 2

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SenSound, a Grosse Pointe, Mich.-based technology startup, recently received a financial boost from the Michigan Pre-Seed Capital Fund. And the money couldn't have come at a better time for company CEO, Sergio Mazza. Mazza founded SenSound a few years ago, as a spin-off from Wayne State University College of Engineering. The company develops and markets software, testing services and integrated testing systems for aerospace, medical device, automotive, consumer appliance and industrial machinery manufacturers.

He funded the startup out of pocket, brought the technologies to market and gained distribution. But the economic downturn and venture capital firms being skittish to invest in the manufacturing sector made it difficult to grow to the next level, he says.

Last February, SenSound was awarded a $250,000 matching equity investment from the state-sponsored Michigan Pre-Seed Capital Fund. A Taiwanese distributor put up $100,000 and Mazza secured $150,000 from the Small Business Administration's Small Business Innovation Research Program.

"The investment will help us survive the economic downturn and help fund a new venture in China," says Mazza. "Michigan needs to diversify its economy, re-invest and innovate in areas it's good at."

SenSound is one of many companies benefiting from public/private partnerships. An increasing number of states are setting aside money and developing programs to invest in private companies, venture capital funds, and provide tax breaks and other incentives to spur the growth of early and later stage companies.
Venture capital investments are down nationwide andcompetition for those dollars is stiff. The souring economy has also dealt a blow to some state investment programs. But many of the programs remain strong and committed to innovation and job creation.

"Everybody's budgets are being cut," says Jim Jaffe, president and CEO of the National Association of Seed and Venture Funds (NASVF). "And what we're also finding is that there's an enormous interest in job creation. It's a dilemma to spend now or later."

At least 30 U.S. states have committed a total of $2.37 billion in investment capital for programs that encourage the growth of companies ranging from pre-seed to later stage, according to a March 2008 report by the NASVF.
Some of the largest programs include: New Mexico, $536 million; Texas, $290 million; Ohio, $212 million; Michigan, $204 million; and Pennsylvania, $68 million, according to the NASVF.

There is no consistent investment strategy from one state to the next, says Jaffe. Some hire a fund manager, some make direct equity investments into companies, and others distribute funding to a variety of economic development organizations in the state, or a combination of the above.

Regardless, "There's an enormous amount of money being invested by states out there and not a lot of people know about it," says Jaffe.

State officials hope that a percentage of equity investments will lead to substantial growth, mergers, acquisitions and job creation in their region. The return on investment is then put back into economic development coffers.

Since the 1980s, the Pennsylvania legislature has supported the Ben Franklin Technology Partners (BFTP), a statewide economic development network that helps startups with capital, product development, filling out management teams and assessing the strategic value of products.

"Pennsylvania has been very deliberate in providing a lot of resources to seed and early stage companies," says John Sider, director of venture investments for the Pennsylvania Department of Community & Economic Development. "We're unusual in the fact that we've been doing it a long time and both sides of the aisle are supportive."

The program seeks to grow companies in the areas of information technology, biotechnology, nanotechnology, electronics, communications, advanced manufacturing, advanced materials and alternative energy.

A recent impact study shows BFTP has returned $3.50 for each $1 spent and created thousands of high-wage jobs in the state.

In 2001, the state also launched a program to anchor venture capital funds locally. It provides some of the startup capital for funds. The fund managers, in turn, do not have to invest in strictly Pennsylvania-based companies, but they do need to achieve a four times return on investment for the state.

"What we want to do is organically grow venture capital funds in Pennsylvania," says Sider, adding the state is trying to address the capital needs of companies at every stage of their growth curve. "And the thing we want people to know is that risk capital is abundant in Pennsylvania."

The Michigan Pre-Seed Capital Fund receives money from the state's $109 million 21st Century Jobs Fund. The latter was created in 2006 to invest in research and development, university technology transfer and early stage companies. In addition, the state's $95 million Venture Michigan Fund is being used to anchor venture capital funds and fund managers in the state.

Target growth industries include life sciences, alternative energy, advanced automotive, manufacturing and materials —€”the category SenSound falls into—€”and homeland security and defense.

"The state is ready and willing to listen and we've got to take a risk at some point," says LeAnn Auer, executive director of the Michigan Venture Capital Association, adding the state's flailing auto industry makes these investments even more timely.

"It has already boosted the entrepreneurial industry here," she says. "Ten years ago we didn't see that type of activity."

New Mexico invests in venture capital funds that commit a certain amount of money to local startups and have an office in the state; co-invests into New Mexico companies; and provides guaranteed loans at no interest and a 25 percent tax credit to film projects being shot in the state.

Some of its target growth industries include film production, renewable energies, life sciences and aerospace. But the state does not limit its options.
"New Mexico is sector agnostic," says Greg Kulka, director of private equity and economically targeted investment for the New Mexico State Investment Council. "We are here to help New Mexico companies grow. The state has certain competitive advantages, so we're also trying to grow companies in those areas."

For every dollar the state has invested, it attracts $6.40 of outside money, says Kulka. But not every investment works out as planned. The state sunk millions of dollars into Albuquerque-based Eclipse Aviation, designer and manufacturer of a very light jet, which recently filed for Chapter 7 bankruptcy.

"Obviously Eclipse filing for bankruptcy is disappointing," says Kulka, adding but the state does not consider the investment a failure. "Up until then, the company ran for several years and provided hundreds of well-paying jobs."

State programs that provide capital, guidance on developing businesses, and other incentives may be a good bet for entrepreneurs, given the current state of the economy. But they should not assume these programs are "easy money."

The total number of venture capital deals in the U.S. dipped from 1,299 in 2007 to 1,171 in 2008. During that period, the amount of money invested dropped from $7.5 billion to $6.1 billion, according to the PricewaterhouseCoopers and National Venture Capital Association's MoneyTree Report.

Competition for investment capital is stiff across the board, says Mark Heesen, president of the National Venture Capital Association.

"Are entrepreneurs having a harder time finding venture capital? The answer is yes and no," says Heesen. "Those who have a realistic business plan and solid business background are going to have an easier time than folks who are unrealistic."

The Arizona state legislature recently dipped into the state's 21st Century Competitive Initiative Fund, which supported technological investments and innovation, to make up for a major budget shortfall. New Mexico put a freeze on making any new commitments to equity investment funds.

And some question whether states investing in early stage companies is a valid strategy for job creation.

The fact is, not all companies are going to make that big return on investment, says Susan Davenport, VP for business retention and expansion for The Greater Austin Chamber of Commerce and program manager for the Central Texas Regional Center of Innovation & Commercialization. But people need to see the larger picture.

"Without state capital many companies wouldn't make it at all," says Davenport. "Over time some will make a return on investment. And I'm hopeful the (Texas) state legislature will continue to recognize the benefit of these types of investments, and the need."

Texas invests 70 percent of its $200-plus million fund into early stage companies, 20 percent into attracting top-notch researchers, and 10 percent into research and development grants. Industries of interest include clean energy, biomedical, wireless, semiconductors and software.

Companies seeking state investments also must compete for those dollars regionally and at a state level, says Davenport. "We're looking to leverage capital on companies who will be seeking future rounds of investment," she says.

Sider says entrepreneurs need to tap every possible resource, including mentoring during the early stages, tax incentives, etc., to make themselves more competitive and viable.

"There needs to be a willingness to relentlessly reach out and network," says Sider. "That's the job of the entrepreneur and the state should be one part of that."

When it comes to whether or not these investment programs are creating jobs, you have to point to results, he says. Nationally, venture capital funded companies were directly responsible for just over 10 million jobs and $2.1 trillion in sales in 2005, according to the Venture Impact report by Global Insight. This represents 9.0 percent of total private sector employment and 7.8 percent of total sales.

The state of Pennsylvania invested $90.7 million in 2007. This resulted in 8,150 jobs, the formation of 259 companies, and $941.2 million in additional dollars leveraged in the state, according to the Pennsylvania Department of Community and Economic Development.

And one healthcare company Pennsylvania invested in completed a $500 million exit and created hundreds of jobs in the state, says Sider. The founder of the company returned to Pennsylvania, and with more help from the state, launched a $5 million venture fund. That fund has grown to more than $40 million.

"The trick with that is that the state's investment has come full-circle," says Sider. "That took about 15 years from beginning to end, but my gosh, what a return on investment."

Eric Billingsley is a freelance writer based in Los Angeles.