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November 1, 2010 Venture Builder

Small money | A private sector pullback leaves room for feds to fill a seed capital void

The Obama administration is doing its best to put its money where its mouth is in terms of funding innovation, whether it’s increasing R&D budgets for key federal science agencies, creating the new Advanced Research Projects Agency for clean energy (ARPA-e, modeled on the Defense Advanced Research Projects Agency), focusing on education generally and on STEM education specifically, promoting export issues for businesses, investing in growth knowledge industries such as biosciences and clean energy, or advocating for regional innovation clusters across agencies (see my Oct. 4 column, “Bottoms Up”).

However, these focused initiatives may not deliver the goods if the private sector can’t or won’t step up to finance and work with the innovative technologies that may emerge from these investments. As an early-stage investor, I know from personal experience that timely infusions of seed and other funds coupled with hands-on venture development work are critical to translating technologies, whether from a university, federal lab or an entrepreneur’s garage, to the commercial market. For these and other reasons I outline below, I’m offering a slightly new role for the federal government in the earliest stage of startup support.

VC history

Once upon a time, players in the venture capital market worked with small pools of capital and understood (and presumably enjoyed) the greater demands of helping incubate, nurture and grow infant ideas into toddlers and then toddlers into young adults that could thrive and succeed in the world of well-established, well-funded industry giants.

As the VC industry gained success in the 1970s and 1980s with early-stage investing, it became a victim of its own success. Small fund managers who delivered returns to their investors raised larger pools of capital, increasing the average size of their early-stage investments from hundreds of thousands of dollars to millions. Today, the top early-stage funds, located in Boston and Palo Alto, manage funds that range from $400 million to $1 billion. Funds of this size demand that their managers deploy much larger initial investments — $5 million to $10 million versus $250,000 to $500,000.

Fast forward to today and the picture is much worse. As I described in July 2009 (see “Mind the Gap”), the recession reduced not only the availability of early-stage venture capital but also that of individual/angel capital. The market for early-stage risk capital of the small variety (under $1 million) was not exactly robust pre-downturn and now is as bad as it’s been since the VC industry formed. Here in Maine, we’re incredibly lucky to have the Maine Technology Institute and the Small Enterprise Growth Fund, two organizations with “small money” to assist in that increasingly wide capital gap.

So, what is an appropriate federal role in relation to these critical “small money” investments? The federal government has tried its hand at providing VC funding through its Small Business Investment Company program, a more than decade-long program that is mostly dormant given the losses it endured in the late ‘90s. The SBIC program had been successful for a lot of years — funding Apple Computer, Federal Express and Staples — and provided commercialization funding (equity and unsecured, high-risk debt) to fill that part of the capital gap.

Meanwhile, the federal government considers another program, its Small Business Innovation Research program, to be relatively successful at providing research dollars to small businesses in this country. The SBIR program was designed to ensure that the nation’s small, high-tech, innovative businesses are a significant part of the federal government’s research and development efforts. As noted earlier, the government seems quite comfortable in its role as a supporter of research.

So here’s an idea. As a way to bridge the gap between these two programs, why not broaden the definition of “research” to include research into the first baby steps of commercialization? Uncle Sam could create a “Small Business Commercialization Research” program that provides federal resources for this first step out of universities and labs to facilitate the combining of research with early-stage business development/commercialization expertise. Granted, this puts the government in the seed capital business, but I don’t see the private sector being in a position anytime soon to play this role. Absent a replacement for the private market’s historic and present aversion to high-risk seed investing, I can’t think of another way to deal with this financial part of the equation.

As I noted in an October 2009 column, “Shifting Gears,” seed capital is necessary but not sufficient; venture development and commercialization talent is critical to make that money work. But without seed funds, all the venture development expertise in the world won’t move potential technologies into a marketplace bereft of capital. I’m not bullish on anything terribly novel getting done in this political climate, but this is a very big piece missing from the president’s innovation agenda.

 

Michael Gurau is president of Clear Innovation Partners, a Maine-based cluster development organization. He can be reached at mgurau@clearinnovationpartners.com. Read more Venture Builder here.

 

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