Venture Capital Benefits State Economic Development

by Thomas E. Galuhn
General Partner, Longworth Ventures
and Paul A. Dillon
Director Government Services, Price Waterhouse & Co.

INNOVATIVE public/private cooperative financing techniques to encourage the growth of emerging industries is a topic of considerable interest in the economic development departments of state and local government today. One of these financing techniques is venture capital.

The objective of most venture capital firms is to generate capital gains through the development of a portfolio of high return investments. This typically involves providing equity financing at an early stage to businesses with rapid growth potential. In order to achieve this goal, a venture capital firm develops a continuing flow of investment opportunities, screens these opportunities against strict investment criteria, monitors and works closely with its investments during the company building process, and realizes gains on its investments when its companies go “public” in the financial markets or are acquired by other companies.

As a broad generalization, most venture capitalists look for companies with the following characteristics:

Current sales up to $15 million per year.

Sales growth potential at least 30% to 50% per year.

Market the market leader, presently or potentially, in an expanding overall market.

Product/ service/ competition-innovative or proprietary product/service.

Management experienced, dedicated and complete team.

Return on investment in excess of 40%, compounded annually on equity based investment.

Time frame financial return (liquidity) in three to seven years.

Companies that meet these superior expectations obviously play an important role in a region’s economy, supporting job growth and an expanded tax base.

The ingredients of a fertile environment for venture capital investment and high growth business development include technically oriented universities, government research labs, mature technology based companies, a plentiful supply of technical and management personnel, an entrepreneurial spirit, successful role models and visible capital sources. The following are just a few of the examples of recent attempts by states to directly promote venture capital investment activity:

Illinois has combined appropriations from the state’s general fund with investment from private capital sources to establish a seed capital fund. The Illinois Venture Fund, managed by an experienced independent venture capital firm, is used to invest in young high growth companies located in Illinois.

Indiana has used tax incentives to attract private capital. The Indiana Corporation for Innovation and Development is similar to the Illinois fund in its objectives, but it has been capitalized by private investors in return for an investment tax credit of 30% of their investment and a dividend tax exemption from the state’s income tax.

The Connecticut Product Development Corporation (CPDC) has focused on new product development to stimulate job creation. In return for providing risk capital, the CPDC receives royalty payments from the new products as a percentage of sales. The CPDC has funded more than 50 projects and created hundreds of jobs relating to these products.

A blend of financing sources, including state and corporate pension funds, was used by local businessmen through Cleveland Tomorrow to establish the Primus Capital Fund in Ohio. For the first 18 months Primus will invest exclusively in Ohio, after which only 50% of its investment activity need be Ohio based.

Many states, including Washington, Illinois, Oregon, Minnesota and Michigan, have recently changed state laws to allow their multibillion dollar public pension funds to invest in independent venture capital partnerships. Because of fiduciary responsibilities, these funds invest to achieve the highest rate of return and generally have no geographic restrictions.

Local governments are also initiating supportive activities, including the sponsorship of organizations, associations and conferences. The city of Chicago created the Chicago High Tech Association within its Department of Economic Development. A year later, the city provided the seed money for the association to spin off as an independent not for profit organization supported by private sources. The association is becoming one of the key networking organizations linking entrepreneurs, ideas and resources to encourage local business growth.

These examples demonstrate the new involvement of local governments in the venture capital process. Some states have established venture capital funds solely for local investments, while others have fewer geographic restrictions on their investments. Funding for these activities have come from various sources, including a state’s general fund, private capital and public pension funds.

Local independent venture capital firms with a regional investment focus can be an attractive investment vehicle for state capital resources because of their necessary emphasis on return and their support of local economic development. By raising capital from both in state and out of state sources, these firms can ultimately increase the total capital available within a region.

Which strategy or combination of strategies a particular government employs depends largely on its economic development goals, the specific economic conditions that exist at the time, and the financial and human resources that are available within the state or local government area. The 1980s have been labeled the decade of the entrepreneur. Undeniably, both the venture capital industry and governments have the opportunity and joint responsibility to foster this new spirit of entrepreneurship.

Commerce, July, 1985

Used with permission of the Chicagoland Chamber of Commerce