Mike O'Donnell | Jun. 26, 2019

Is Venture Capital an Important Tool in the Public Policy Tool Box?

On my travels around Colorado, I often hear the sentiment expressed that wouldn’t it be peachy keen (well, perhaps not those exact words) if Colorado companies could attract more venture capital? The general perception is that we would be a much stronger state if that was the case.

Of course, the underlying presumption here is that the more venture capital deployed or invested in a state, the better off that state is. States that have businesses that attract a lot of venture capital therefore must be much better off than those that don’t.

But better how?

Anyone who has read my little missives in the past will know that I don’t accept the widely held view that using incentives or taxpayer funds to recruit a new company to town is necessarily good for a community. They aren’t. Such policies are rarely effective because they mostly re-allocate funds from the public sector to a few private sector potential winners with very little net gain to the overall community.

In Colorado, for example, in twenty out of the last twenty-four years ALL of the net new jobs created in this state were created by small businesses less than one year old who typically can’t access incentives or tax credits. Businesses older than that, on average, shed jobs.

Accordingly, if creating meaningful jobs is important in the broadest possible sense, the economic policies of local and state government agencies ought to focus on helping entrepreneurs start new businesses rather than incentivizing already established firm to move into a community. But they usually don’t.

So where does venture capital fit in as a tool of public policy?

The latest issue of Venture Monitor shows that $32.6 billion worth of capital investments occurred nationwide during the first three months of 2019. This was the second highest quarter for investments in the last decade indicating that 2019 is on track to be a record-setting year in the world of venture capital. But even though the dollar volume of investments is growing, fewer deals are being done, continuing a trend that has been building over the last few years.

For anyone who can remember the Global Financial Crisis of a dozen years ago or the dot-com bubble burst of 2001, one lesson that emerged from all those shenanigans was the importance of diversifying risk. So, while adopting an investment strategy of putting-more-eggs-in-a-smaller-basket isn’t prudent in the long run, it could result in large gains if the companies the venture capitalists back all turn out to be winners. But not every investment ends up being a winner, as every venture capitalist and angel investor already knows. Or at least used to. But I digress … which I do a lot.

Two-thirds of all the venture investments consummated during Q1 2019 were made into late-stage firms (average deal size $39.8 million), with early-stage firms accounting for 28.5% of all investments (average deal size $19.1 million), and startup seed-stage firms accounting for 5.5% of all investments (average deal size of $2.3 million).

One interesting observation here. While the deal count across all sectors of venture investment has been falling, the seed-stage category, which tracks investments from individual angels as well as venture funds, has seen the largest drop-off with the number of transactions almost halving from a peak of 1,483 in Q1 2015 to just 828 in Q1 2019.

And remember that it is the seed-stage companies, the ones less than one year old, that create all of the net new jobs in many states.

And speaking of interesting observations, there isn’t all that much diversity in the wonderful world of venture investment either. Female-founded companies accounted for only 5.5% of the projects in Q1 2019 albeit only 2.2% of the funds deployed. (As a point of reference, about 39% of all small businesses nationwide are woman-owned.)

The venture market itself is organically now beginning to address this very obvious and widely publicized lack of diversity, with social impact investors and venture funds emerging specifically focused on making investments to female-founders, minority-founders, people-of-color-founders, etc. Change is in the wind here. It is just taking its time to get here.

There is less geographical diversity too. More than 80% of all venture investment in the United States is concentrated in just four states: California (which gets almost half); Massachusetts, New York, and (to a much less degree) Texas.

Colorado is #8 on the list but only about 1.6% of venture investment finds its way here.

Does that mean that Colorado isn’t as strong a state as the other four?

I would suggest not.

In fact, let me go out on a metaphoric limb and suggest that Colorado is an economically stronger and certainly much more diverse state that at least three of the four, and just as strong, if not stronger, than the fourth, and let me explain why in words that even a child would understand. (In fact, it was an eight-year-old child that explained this to me.)

The underlying premise for my assertion is that the way that an economy grows is by adding meaningful jobs. People with meaningful jobs are relatively happy and tend to invest in their community both directly (by buying and supporting things) and less directly (by paying taxes), which allows the community to keep growing and getting stronger. Lots of strong communities collectively make a strong state.

According to the Bureau of Labor Statistics, every three months in the United States about 184,813 new small firms with employees start up (we see about 4,500 each quarter in Colorado) so the fact that only 828 nationally, a paltry 0.44% of all startup firms, receive some sort of seed-stage venture investment, isn’t anything to write home about.

If you’ve ever traveled over in the direction of the setting sun, you probably already know that a lot of people live in California. In fact, almost seven times more people live there than in Colorado. (And you thought our traffic was bad?) Because California gets so much of the venture capital pie, about 30+ times more than Colorado does, you would think that California would create relatively more jobs each year than Colorado does. But no. It doesn’t. It creates relatively a lot fewer jobs each year than Colorado does.

The same is true for the next three states on the list even though so much more venture capital flows into businesses located in those states then will ever see the light of day in Colorado.

At the risk of belaboring this point, in 2018 businesses in Massachusetts received around $2.6 billion in venture capital funds, about 7.8 times more than all the firms in Colorado did. Massachusetts, as a state created, about the same number of startup jobs as Colorado did (even though very little venture investment goes to startups) but overall some 17,504 fewer net new jobs than Colorado did, even though Colorado has a significantly smaller population base.

Another comparison: Business Insider’s Q4 2018 ranking of state economies placed Colorado as the fourth best in the nation and Massachusetts as seventh best. (California was ranked sixteenth.)

So where have I been heading with this discussion?

Well, even though neither of my two readers is involved with enacting public policy at a state or national level, the message is pretty clear.

There isn’t any real connection between how much venture capital is deployed in a state and the economic vitality of a state. Accordingly, states and the federal government ought not have a role in anything venture capital related.

Yes, there might be bragging rights associated with a geographic area attracting more venture capital than another area, but that is about it. The fabled Unicorn firms, which everyone looks for, are hard to find irrespective. It is said that there only about 350 companies in the US that can be classified as Unicorns which means that only about 1% of firms that ever receive venture capital are likely to become one.

Gazelles, which were a thing before someone came up with Unicorns, are hard to find too. However, if you really like the even-toed-ungulate / hoofed-mammal analogy fad that seems to be popular with business writers looking for examples in nature to explain the entrepreneurial world these days, you can’t do any better than a Zebra. Zebras are who we like to work with at Colorado Lending Source. And I have it on good authority that Zebras are way cooler than Unicorns or Gazelles. (If you would like to learn more about Zebras visit zebrasunite.com)

Be that as it may, venture capital does create headlines and it has made some astute investors very rich while also spawning the odd low-IQ television show or two in the process, but it doesn’t necessarily create more meaningful jobs in a community. It just doesn’t create meaningful jobs.

And if doesn’t help communities be stronger by creating more meaningful jobs, it isn’t a tool that belongs in the public policy toolbox.

QED

And if you would like to learn more on this topic, tune in on Tuesday, July 2nd at 3pm for my Facebook Live event!