Financing the next Silicon Valley.

AuthorIbrahim, Darian M.

TABLE OF CONTENTS Introduction I. THE SILICON VALLEY ECOSYSTEM II. THE BASE ELEMENTS OF AN ENTREPRENEURIAL COMMUNITY III. Funding For Local Innovation: The Deficiencies Of VENTURE CAPITAL A. Private Venture Capital B. State-Sponsored Venture Capital IV. FUNDING FOR LOCAL INNOVATION: THE PROMISE OF ANGEL INVESTOR GROUPS A. Angel Investing: Definition and History B. The New Face of Angel Investing: Angel Investor Groups C. Comparing Angel Groups to Venture Capital D. The Signaling Function of Angel Group Finance V. LAW AND ENTREPRENEURSHIP: DO THE SECURITIES LAWS IMPEDE ANGEL GROUP FINANCING? A. The Ban on General Solicitation B. Possible Broker-Dealer Issues CONCLUSION Introduction

How might a "non-tech" region transform itself into a high-tech entrepreneurial community? The success of California's Silicon Valley makes high-tech transformations the holy grail of economic development for regions that continue to lose jobs in manufacturing, agriculture, and other traditional sectors. Many of these non-tech regions have pursued high-tech transformations because of the high-paying new jobs, increased tax revenues, and educated workforce they bring. In light of Silicon Valley's success, there have been any number of "Silicon Prairies," "Silicon Forests," "Silicon Alleys," and "Silicon Beaches" attempted throughout the united States and abroad. (1)

Yet despite a few successes, most imitators have failed. (2) High-tech firms are important drivers of U.S. economic growth in today's knowledge economy, but gains from innovation-based economic growth are highly skewed toward a few regions. As economic developers in non-tech regions have learned, "there is no secret sauce" that will lead to a broader distribution of these gains. (3) Causal relationships are exceedingly difficult to draw in this area. We may find correlations, but causation remains elusive. Therefore, the best we may be able to do is learn from Silicon Valley's success to better understand the forces that drive entrepreneurship. Further, examining isolated successes like Silicon Valley may not be the best methodology since many failures share traits with their successful counterparts. (4) Still, with the limits of such an undertaking in mind, scholars from multiple disciplines have examined Silicon Valley in an attempt to understand its key elements. Their work has revealed the importance of the region's venture capital market, history, universities, industry, and culture. (5)

Most would-be imitators will not be so fortunate as to possess all, or even most, of the necessary elements. Probably the best that non-tech regions can do, even if successful, is create Silicon Valley "lites," or regions that possess the core elements of a start-up driven community, yet are less dynamic than Silicon Valley as a fully formed entrepreneurial ecosystem. As Martin Kenney astutely observes, the "ultimate result [of cloning efforts] could be regions that, although possibly not as dynamic as Silicon Valley, might become self-reinforcing hotbeds of innovation, with their own set of institutions dedicated to new firm formation." (6)

How might a non-tech region go about becoming a Silicon Valley lite? This Article will address one critical piece of that puzzle--the financing of local entrepreneurs. Financing is a critical piece for the following reason: while some non-tech regions will suffer from a lack of entrepreneurial talent, anecdotal data reveals that other regions are home to high-quality entrepreneurs who end up relocating their start-ups to Silicon Valley to be close to financing sources. (7) This may seem ironic, as globalization has generally diminished the importance of physical locality. But for reasons that will be discussed, entrepreneurial finance is different, where physical proximity continues to take on much importance. (8) It follows that non-tech regions must provide local finance to prevent entrepreneurial relocation and reap spillover benefits for their communities. otherwise, entrepreneurial relocation prevents a chain of events that might lead to new start-ups and new sources of financial capital in the non-tech region. (9) Given the importance of finance in the innovation equation, this Article offers the first comparative analysis of three possible sources of entrepreneurial finance for non-tech regions: private venture capital, state-sponsored venture capital, and angel investor groups. (10)

Private venture capital dominates the entrepreneurial finance literature, and with good reason: it has a demonstrated record of success in innovation funding. But when it comes to broader distribution of innovation-based gains, private venture capital fails to deliver due to its concentration in existing tech regions and preference for later-stage startups. Private venture capital is noticeably absent for those early-stage startups seeking funding in non-tech regions. State-sponsored venture capital programs correct these deficiencies but create new ones, namely a lack of market incentives and relevant expertise in technology funding. There is, however, another source of innovation funding that does not suffer from the drawbacks of venture capital. That source of funding is the angel investor group.

Angel investors are wealthy individuals who, unlike venture capitalists (VCs), invest their personal funds in high-tech start-ups. (11) As might be expected because they invest their own money, angels invest smaller amounts than private VCs. However, angels invest in more start-ups and, in the aggregate, supply $25 billion of annual funding to start-ups--the same size as the aggregate venture capital market. (12) There is a wide range of individuals who fall into the category of "angel," (13) but the most important angels for purposes of this Article are those professional investors who are now organizing into regional angel investor groups. Angel groups have many theoretical advantages for funding entrepreneurs in non-tech regions, including: wide geographic distribution and a preference for local investments; a preference for early-stage start-ups; market incentives to fund start-ups that will offer the best rate of return; and relevant expertise in technology businesses. All of these advantages will be explored, along with attendant disadvantages.

Finally, some angel group investors have revealed a concern that certain securities laws might cast a cloud of uncertainty over the typical angel group funding process. My "law and entrepreneurship" analysis, which focuses on private placement and broker-dealer laws, finds some cause for concern. of course, the securities laws are only one of many factors that may cause inefficiencies in the angel funding process. other legal and non-legal infrastructure could have the same effect. Further, there may also be affirmative steps that governments could take, over and above removing legal and non-legal financing impediments, to entice higher levels of angel investing. State or federal tax credits for angel investing are an example. However, my preference for letting entrepreneurial communities develop organically, rather than trying to force them, (14) causes me to leave discussion of affirmative government involvement to others.

At this point, two important caveats about this project must be set forth. First, my perspective is one of regional economic growth and the distribution of high-tech gains, rather than aggregate social welfare. In other words, I am not arguing that U.S. start-ups are underfunded, but instead that most of our start-up financiers are concentrated in existing-tech regions, which causes entrepreneurs to relocate to those regions. Entrepreneurial relocation may or may not decrease social welfare in the aggregate--this is an open question (15)--but it does keep the distribution of innovation-based gains skewed toward existing-tech regions. My focus, for better or worse, is not on aggregate social welfare per se but on broader distribution of innovation-based gains from existing-tech regions to nontech regions.

Second, my arguments in favor of angel groups from this distributional perspective should be seen as an attempt at ground-theory building, rather than a truism supported by empirical data. Angel groups are only about a decade old, but once they mature past their infancy, empirical studies should be undertaken to test these arguments. For now, it is important to construct a theory of comparative entrepreneurial finance that can then be tested.

With this framework and these caveats in mind, this Article proceeds as follows. Part I dissects the literature on Silicon Valley to discover the many elements at work there. Part II narrows the focus of this Article from all elements of Silicon Valley, as a fully formed ecosystem, to the base elements necessary to turn a non-tech region into a Silicon Valley lite; namely, human capital and financial capital. It argues that while human capital in the form of high-quality entrepreneurs with new ideas sometimes exists in non-tech regions, a lack of financial capital means that these entrepreneurs will relocate to be near funding sources. Part III narrows the focus of the Article even further and fixes its gaze on the funding problem, and in particular on the deficiencies of venture capital (both private and state-sponsored) as a solution. After finding venture capital wanting, Part IV moves into fresh territory by introducing angel investor groups as a promising alternative for innovation funding in nontech regions. Finally, Part V adds a "law and entrepreneurship" story to the entrepreneurial finance story when it examines some possible legal impediments to optimal levels of angel group financing.

  1. THE SILICON VALLEY ECOSYSTEM

    As the United States transitions from the "old" manufacturing economy to the "new" knowledge economy, non-tech regions (i.e., those heavy in old economy sectors) have attempted high-tech transformations for the...

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