State should venture only as limited partner

Super angel investor Tom Shannon meets with the CEO of Somna Therapeutics, a recent spinout from the Medical College of Wisconsin, every Monday morning to go over an activity report. He and CEO Nick Maris look at what got done the previous week, what needs to happen in the coming week and progress against critical milestones as they prepare to bring to market a device for the control of acid reflux.

Tom Schuster, an investor in Somna and a fellow angel investor with me in NexVex, a recent startup out of the Fifth Ward in Milwaukee to create a web marketplace for roofs, has followed suit and is meeting with the NexVex CEO William Bazeley every week on a wide range of startup milestones.

Both startups are holding regular board meetings to make sure their investments stay on track toward a profitable and early exit.

This kind over hands-on oversight by seasoned business people has proven to produce the highest returns for early stage investing of any asset class. It is intimate investing. A study by the Kauffman Foundation put average returns for early stage investing at north of 20%, and it is the personal attention that makes the difference.

Another term for this brand of investing might be called tough love. It’s love for the entrepreneur, but it is also tough-minded oversight. The entrepreneurs accept the help, because they have the biggest interest in a profitable exit from the venture.

They don’t just sign up for the early stage money, known as the A Round; they generally welcome experience, connections and guidance from the seasoned angels.

Shannon, for example, had a highly successful exit from a flu testing company called Prodesse. He knows the ropes for building value in a company.

What angel investors bring to the table, besides their money, is their scar tissue. I often joke that my next book is going to be: “Everything I Learned About Business I learned by Screwing Up.” The lessons were hard earned. Those mistakes don’t need to be repeated by an entrepreneur who has angel guidance. Hence, there’s a higher probability of success.

All of the above is context for the political palaver about the wisdom of putting state matching money into early stage funds. The private investors are putting their own money in first. The do so because they expect to make a profit.

So, if the state goes in as a limited partner, they should expect to make the a profit for the taxpayers. Done properly, the state is not putting in a subsidy; it is making an investment.

Nor are political leaders picking winners and losers, as some opponents of state matching funds assert. Structured properly, the managers of the private funds make the calls on what companies deserve investment, not the politicians.

That the state is an investor, equal to other investors, needs to be a fundamental principle in any venture capital bill going forward in Wisconsin.
Private investors always have reservations about bring in public money. It could be more brain damage than it’s worth. Some choose to turn down the funds, and that has happened recently in Wisconsin. Business decisions, which always carry some degree of risk, don’t lend themselves to public scrutiny. And bureaucratic oversight doesn’t sit well with many investors.

Still, Wisconsin remains in the backwaters of venture investing. Silicon Valley launched high growth 1100 companies last year. Wisconsin launches a couple of dozen per year.

This is not an insignificant matter. Our leaders generally talk the talk on job creation. But they have few reliable ideas about how to get it done. The current job doldrums bear that out.

There are many ideas out there: recruit from other states, cut taxes and regulations, do real estate developments, fill existing openings through better training programs, reform education, offer expansion credits. They all have some merit.

But business creation, which brings job creation, is the one sure path. No economic theorist debates that.

Wisconsin made a bold move in 2005 when the legislature passed Act 255. It offers a 25% tax credit to accredited investors to reduce some of risk of early stage investing. That credit has had a cumulative positive effect on entrepreneurial ecosystem in the state. We have more angel investors than ever before. The deal pace is steadily growing.

This act spreads its benefits across the state, even though Dane County claimed most of the credits in the early years. There are entrepreneurs everywhere, and that is being recognized in the state.

The question before the state now is whether state government should do more. (Disclosure again: I have a dog in the fight as an angel investor.) On balance, with the trade-offs understood, my view is that the state should become an investor. We need another jolt for business creation. And there just aren’t enough accredited investors in Wisconsin to lift the economy.

The foundations in the state could also fill that role. They could invest closer to home with a small part of their portfolios.

Business and job creation are the job of major player in the state.

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  • michael drescher

    “That the state is an investor, equal to other investors, needs to be a fundamental principle in any venture capital bill going forward in Wisconsin” just a very solid point of view, thank you John…..the likes of Mr. Shannon, Mr. Schuster, and yourself are much better “bets” for the state to make, by far!!

  • Steve Anderson

    John, I hope what you describe can be implemented. Most important, ” Done properly, the state is not putting in a subsidy; it is making an investment.” Don’t forget Bob Zobel who successfully managed a huge SWIB private equity pool twenty years ago. Yes, it was mostly mezzanine, but he did it by himself.

    • JohnTorinus

      Yes, he did. And he personally attended almost all board meetings, including mine, religiously.

  • Daniel P. Armbrust

    I support an expansion/streamlining of the Act 255 QNBV credit to stimulate more business and job growth here in WI. The state should educate investors/high net individuals on the Act 255 credit for seed/angel investments in start-ups which create jobs.. This could be done through joint gatherings with accountants, lawyers or other advisers to these accredited individuals or the state could hold it’s own meetings periodically.

    I suggest this education because I reviewed how many qualified investors actually take part in this QNBV/Angel program/investing by taking the credits on their tax returns? The most recent information from the WI Department of Revenue 2009 indicates that there were 48,341 taxpayers with WAGI >$200k of which 2,949 tax returns had WAGI >$1M. The total amount of taxpayers which claimed either the Angel or Seed Investment credit was 460 returns on the >$200K WAGI group or less than 1%. Specifically for the group >$1M there were 105 taxpayers which took the deduction out of 2,949 returns or 3.5%.(there are breakdowns for $>500K-$1M as well and it’s @ 2% which took either credit) This may include duplications if a tax payer declared both credits Angel/Seed Investment credits on their return which was not broken out so the actual number would be lower. What a wasted opportunity for all these potential Angels and the State…

    Is it a lack of knowledge that these credits exist, limited good deal flow(companies to invest in), not knowing where to find start-up investments or a combination of factors which determines why so few accredited investors actually utilize the credits available to them and invest in start-up? Regardless of the reason, based on the numbers, there are more than enough accredited investors within our state even if only 50% of > $1M taxpayers make investments in the start-up community. So we do not have a shortage of accredited investors here in WI, we have a shortage of informed and engaged accredited investors. I do agree with your comment that getting foundations involved in seed/angel investing would provide additional capital to launch more businesses and create jobs as well.

    If the State is compelled to do anything, it should support entrepreneurial efforts in our colleges, tech and high schools throughout Wisconsin. I also am an angel investor/serial entrepreneur and do not want the state investing money into the companies we are accelerating and backing. The State should not be picking winners or signalling through funds they invest in and ultimately invest in companies even if it would benefit me or the companies I’ve invested in. My company was #11 and #29 for two consecutive years on the Inc 500 when we were first starting out and we took no state or federal money to do it. The state should return any excess money to all the taxpayers rather than redistributing our money through a fund/venture bill and stick to what the State Constitution says it should be doing..

    • JohnTorinus

      Good information of low percentage of Act 255 filers. Thanks for digging it out. I agree we could have a lot more angels in the state. It’s a good program. And it’s relatively easy to use.

      Regarding your thoughts on using state money for investments, yours is an informed viewpoint. It’s a policy that can be argued many ways. Some states like Ohio are doing a lot of investing with taxpayer money. Some do none. The legislature will have to sort it out.

      President Obama’s Startup America has $50 billion available for early stage investing, but it has lots of strings. Very little of that SBIC federal money is being deployed in Wisconsin.

      • Dan Armbrust

        John, I do agree with your mentoring approach/comments. It certainly does make all the difference in trying to accelerate start ups…I realize that I may not be in the majority of how the state may or may not end up spending our money. I hate to have the government doing anything that private industry/the free market is already doing. Dan