If you look closely at PitchBook’s annual report, you might notice something unusual about the most active investors in the Midwest/Great Lakes regions (PitchBook has split the broader Midwest into a few smaller regions). Whereas the West Coast’s most active investors are all financially focused, private investors, the Midwest contains many government-backed direct investment organizations. I’ve listed off the major public investors here for easy reference:
|Organization||State / City Focus||# of Deals|
|Rev1 Ventures||Central Ohio||31|
In prior years, we’ve seen the Wisconsin Economic Development Corporation (focused on Wisconsin) and Invest Detroit (focused on Detroit) make the most active investor lists, as well.
Now, while this may seem normal to someone native to the Midwest’s tech ecosystem, it is highly unusual on a national level. In extremely competitive ecosystems like those in the West Coast and New England, there is no room for government organizations to get involved. In fact, government programs would typically be out-bid by a robust community of accelerators, pre-seed, seed, and Series A private investors. Plus, these investors are solely focused on a financial return and place few constraints on geographic or economic development metrics. This begs the question — if the global startup hubs of Silicon Valley, NYC, and Boston don’t have local or state government involvement in the early-stage financing of their startups, why do we? And is it helpful or harmful to our ecosystem’s growth?
Gaps in our capital ecosystem
State governments didn’t just create these programs out of the blue — they were responding to a market inefficiency. Risk capital can be slow to react to demand — we have lazy investors with a supermajority of all global VC dollars who are refusing to invest outside a one-hour radius of their home in Palo Alto. The market is slowest to react to this inefficiency when it comes to earlier-stage small financing rounds — transaction costs are not much less than for larger rounds, so it takes even more convincing to get VCs to fly all the way to Omaha, Detroit, or Indianapolis for an under $1 million check. This is starting to change — slowly but surely — and some Midwest ecosystems (like Chicago and Minneapolis) attract enough local and national capital that their local governments don’t provide direct-investment programs, though they may still subsidize growth through angel tax credits and state-focused funds-of-funds.
But these programs can be a double-edged sword. While they provide much-needed capital to compelling founders when they need it most, the programs are also laced with restrictions. Many organizations can’t lead a round and often need at least as much matching private capital, limiting their speed and independence. Most of these programs have tight geographic restrictions in terms of where they can invest and require companies to stay in a location long after the capital is used up. And they sometimes have unique reporting requirements — such as jobs created, average salaries, and other economic impact metrics — that betray their ultimate priorities.
The goals of the company and the goals of the government are usually aligned, but sometimes they aren’t, which can cause difficulties. For example, if a founder believes she needs to hire remote developers overseas or move her company’s headquarters to another state, that could be at odds with the government-backed investor who may or may not be sitting on her startup’s board.
Shifting tactics with maturity
In the end, these programs should be temporary. Either we will discover there was no real market inefficiency to fill and the costs of maintaining these program will override the public’s desire to continue funding them, or — more likely — the private market will catch up. In the meantime, the programs will evolve to fill funding gaps. Many states offer angel tax credits to encourage more conservative high-net-worth individuals to back tech startups. Other states offer a fund-of-funds to kickstart VC formation, helping alleviate transaction cost barriers and ideally starting a cycle of successful VC firms. The initiatives can also be extended to cover other VC market efficiencies, which was the goal behind the minority-focused startup tax credit that Minneapolis tested.
Overall, I’m of the opinion that the benefits of these government-backed programs outweigh the risks. A lot of rising startups across the Midwest wouldn’t be where they are today without public capital. From our experiences, these government-backed groups cooperate and co-invest well with private partners and generally perform strong due diligence, make good investment decisions, and support their founders as well as anyone. Ultimately, the existence of these programs is a sign of a still-developing ecosystem. Of course, we will want to rethink these initiatives if competitive private capital eventually comes in to take their place.
One thing is certain — when it comes to new venture formation and growth, it is better to have these programs than not. PitchBook’s league tables illustrate the other side of the coin — regional ecosystems more nascent than those in the Midwest, in regions where both private and public funding sources are virtually non-existent. So for now I think it’s a worthy use of my tax dollars … or at least better than many other government spending initiatives!
Victor Gutwein is the founder and managing director of M25, a Midwest-focused VC firm targeting early-stage tech companies. Over the past few years, Victor has invested in over 50 startups in 10 Midwest states. Here, Victor writes every month to share his thoughts from his travels and experiences working with founders, VCs and others in the region.
This story originally appeared on Americaninno.com. Copyright 2018