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My idle thoughts on tech startups

The devlish details of government backed VC

Lee Hower
March 3, 2009 · 3  min.

For those who haven’t seen it, Reid Hoffman wrote a very thoughtful piece which appeared in the Washington Post today.  The thrust of the column was that entrepreneurs, through the creation of new ventures not simply researching new technologies, can play a vital role in rejuvinating the US economy.  I strongly agree with Reid on the role of innovation in economic recovery, as well as a number of the tactical recommendations he makes like lifting H-1B visa caps and reforming and injecting new capital into small business lending programs.

Reid’s 3rd suggestion is to have a federal program to match the investment of VCs and angel investors into new innovative startups.  On this one I have to disagree slightly with my old boss and longtime mentor, though I certainly applaud the goals of such an initiative.  Unfortunately prior attempts like this have not necessarily generated the sorts of results that government or ultimately tax payers are pleased with, either in terms of return on invested capital or in the creation of lots of large enterprises that are sustained in the long run.  
Government matching or sponsorship of angel and VC investing is one of those things where the devil is indeed in the details.  On the VC side the best example is the SBA’s “Participating Securities” program which began in the 1990s providing matching dollars to small VC funds. Venture firms had to raise some amount of capital from private LP invesetors and then could supplement the private capital (typically up to 2:1 ratio) with cash from the SBA who in essence became an LP in hundreds of small funds.  Back in 2005 the program had already generated $2.7B in losses on total commitments of over $11B.  The SBA ultimately cancelled commitments to new funds from this program because of these results.
The state where I now reside (Rhode Island) implemented a program in 2007 providing tax credits offsetting investments in qualifying startups made by individual angel investors and other states have contemplated similar initiatives.  Again, I think trying to spur angel investment is certainly laudable and the RI program is still in it’s infancy, so time will tell how well the program succeeds at this goal.  But even programs like this face challenges.
The “devilish details” really fall into a couple buckets:
1) Administration by a government beauracracy –> this isn’t a criticism of government officials, who in most cases set out w/ great intentions and certainly work hard in the public service.  But the reality is that in most cases programs like these are administered by folks who aren’t naturally in the investment management business.  Selecting investment managers, actively overseeing a large number of LP commitments, and generally stewarding such programs are skill sets which these administrators aren’t necessarily well-equipped for. Programs that have tended to work well are those managed by third party advisors or fund of funds, many of which have been initiated by large state investment pools.
2) Selection bias –> those VCs who can attract sufficient private capital are usually among the most capable.  This phenomenon is particularly acute when government matching funds come with lots of strings attached directing how VCs must invest the capital, how returns are divided, and so on.  Thus the VCs that seek matching funds from the government are often either less capable or at least unproven.  
The best argument I’ve heard in favor of government matching, which I think is genuinely pursuasive, is Matt Harris of Village Ventures who favors potential federal funding to help support talented young VCs setup their own first time funds (i.e. this is somewhat unproven but high potential bucket, not demonstrably less capable).  If government matching meant these talented young VCs got their firms off the ground it would be a win win, and ultimately federal programs should be targeted less at follow-on investments in these VC’s future funds.  The ones that succeed will have ample access to private capital and the ones that don’t shouldn’t continue existing simply on the government teat.  Again to make this work you have to rely on government beauracracy to choose wisely.
3) Fund net new ventures –> another challenge is to ensure that government funds are directed to VCs investing in new venture creation, i.e. not engaged in later stage investing in existing enterprises (the successful ones typically have ample access to capital).  Our shared goals of creating new startups are only realized if the VC funds government backs are investing at the seed and early stages, thus creating new companies and new jobs.
So net net, I’m certainly not opposed to federal matching of VC and angel funds as Reid proposes. But given the challenges that prior programs have faced, precisely how we craft and administer such programs matters immensely as to whether they are genuine investment (i.e. returns on tax payer dollars and the creation of exciting new ventures which spur our economy) or simply another budget expense with little tangible return to us all.


Lee Hower
Partner
Lee is a co-founder and Partner at NextView Ventures. He has spent his entire career as an entrepreneur and investor in early-stage software and internet startups.