State Venture Capital.

• Date: 22 June 2024
• Author: Rose, Paul

INTRODUCTION 438
                I. THE ROLE OF VENTURE CAPITAL 441
                A. Scarcity in a Time of Plenty 441
                B. Parochial Venture Capital 442
                II. THE CASE FOR GOVERNMENTAL INTERVENTIONS 445
                A. Public Funds and Public Goods 445
                B. A Theory of State Venture Capital and Other Small Business
                Subsidies 447
                1. The Increasing Demands on State and Local Governments 447
                2. The Political and Economic Justifications for State Venture
                Capital 451
                III. THE LOGIC OF STATE VENTURE CAPITAL 453
                A. The Traditional Development Formula: Supporting and
                Retaining Large
                Businesses 453
                B. The New Formula: Supporting Economic Development Through
                State
                Venture Capital Programs 457
                1. VC Program Examples: Nevada, Florida, New York, and
                Connecticut 461
                a. Nevada 461
                b. Florida 461
                c. New York 462
                d. Connecticut 462
                C. Federal Government Strategies in Support of State and
                Local Economic
                Development 463
                IV. STATE VENTURE CAPITAL HEADWINDS 465
                A. The Potential for Corruption 465
                B. The Potential for Rent Seeking 466
                C. Incentive Mismatches 467
                D. Poor Performance 469
                E. The Inevitability of Geography 471
                F. Lack of Accountability 473
                G. Potential Inequities 474
                V. PROSPECTS FOR LEGAL AND POLICY REFORM 474
                A. Program Elimination 475
                B. Developing A Better Small Business Ecosystem 476
                1. State Policy and Investment Prescriptions 477
                a. State Taxes 478
                b. Higher Education 479
                c. Technology Infrastructure 480
                C. Establishing Best Practices in State Venture Capital 481
                1. Managing Agency Costs 483
                2. Additionality and Investment Selection 484
                3. Co-Investment 485
                4. Optimizing State Venture Capital Contract Design 486
                CONCLUSION 487
                

INTRODUCTION

Beyond the borders of Silicon Valley and a handful of other startup hubs, entrepreneurs struggle to find the financing and innovation infrastructure that support early-stage businesses. (1) The lack of funding and concentration of venture capital (VC) funding in a small number of locations has important recursive effects: the rich venture ecosystems in California, New York, and Massachusetts get richer while talent and capital drain away from other states.

Responding to the relative lack of capital outside of these hubs, state governments are increasingly shifting government development expenditures from mere tourism-support operations to broad economic development mandates, including venture investment and small business incubation. At least 37 states have some form of state-managed venture capital fund. (2)

The reasons for channeling economic support through venture capital are twofold. First, by structuring the investment through a venture vehicle, the state can simulate a standard VC fund. This allows the fund to borrow some of the efficient contractual forms and business structures that enable private VC deals. Common, comfortable structures also encourage co-investment, allowing government funds to leverage private funding, often by a multiple of as much as ten private dollars for each government dollar invested. (3) States are thus more likely to make a greater impact in support of entrepreneurship-related social goals, such as supporting women- or minority-owned businesses that might otherwise struggle to obtain funding. (4)

Second, the venture capital model tends to produce superior results compared with bank financing or other capital-raising models; venture capital-funded firms tend to outperform other firms (5) across multiple metrics, including superior job creation, market values, and revenues. (6) So, the logic goes, if VC works in the private sector, why should the government not attempt to harness the power of VC for public purposes?

This Article challenges the standard logic driving the creation of state venture capital programs and argues that the structure of many state venture capital programs is deeply flawed. State venture capital theoretically serves as a catalyst, shock absorber, and transition tool. It is meant to fill financing gaps and provide an overall smoothing effect on increasingly volatile capital and labor markets, and, for some states, it may be envisioned as a mechanism to help the states transition to a high-technology economy. However, rather than remedying inequities between states and within states--for instance, in the urban/rural divide that is a feature of most states' political economies or the lack of funding for women-and minority-owned businesses--state venture capital is more likely to perpetuate and even exacerbate inequality. (7) Furthermore, it introduces the potential for waste and corruption jeopardizing governmental legitimacy. From a legal entity perspective, state venture capital uses existing private financing and accompanying legal infrastructures to channel financing and remedy market gaps, particularly for marginalized entrepreneurs. By co-opting private entity forms, state venture capital often (purposely) avoids the administrative mechanisms designed to safeguard public funds.

Despite its laudatory goals, state venture capital has not been able to overcome the daunting market barriers that necessitate its existence. Persistent economic and geographic constraints make it likely that venture programs in most states will struggle to produce positive returns. However, state venture capital is not bound to fail. By investing in an entrepreneurial ecosystem that supports small businesses, allowing venture capital to grow organically, states may be able to better support small businesses than through direct funding. For states that have existing programs, the Article suggests several reforms, including accountability mechanisms, investment selection criteria, and contract design mechanisms that give state venture capital a greater chance at success.

The Article proceeds as follows. In Part I, the Article describes how venture capital financing fills in funding gaps at the early stages of a company's development, then outlines how government investment has come to play an increasing role in VC funding. The Article describes the market failures state governments intend to address through their interventions and describes analogous efforts at the national level. In Part II, the Article details specific strategies for economic development by state agencies and shows how the mandates of these agencies have expanded over time to include venture investing. Part II provides examples of how state agencies and funds fill these varying roles and also describes the extensive federal government efforts to develop and sustain state venture capital.

Part III provides a political and legal explanation for the use of state venture funds. The legal structures used in state venture capital yoke private investment forms to state financing, theoretically allowing the state to harness the animal spirits of the market to achieve important social goals. However, these structures are not always a good fit, and the expectations of state venture capital often exceed its capabilities. Part IV describes the headwinds facing venture capital and describes how the synchronicity of talent, capital, and legal know-how that enables vibrant venture capital markets cannot be simply transported to new jurisdictions. Successful state venture capital programs are not simply a consequence of political desire and abundant capital. Part V thus suggests that state investment funding should be de-prioritized, and that other kinds of social infrastructure spending should take precedence, including educational, technology, and physical infrastructure expenditures that are more likely to disperse benefits more broadly, and with much more potential impact, than the concentrated spending of state venture capital programs. For programs already in place, Part V also suggests a series of reforms to help ensure that state venture capital is better protected against waste and corruption, that state investments do not cannibalize private venture activity, and that state venture contracts are designed to create appropriate incentives for both state governments and recipient entrepreneurs.

I. THE ROLE OF VENTURE CAPITAL

State venture capital has arisen as a response to gaps in small business funding. Such gaps have always existed, of course. Famously, Steve Jobs was unable to obtain a bank loan when he and Steve Wozniak first founded Apple, and initial funding came through the sale of Jobs' VW bus and Wozniak's HP calculator. (8) Many states have determined that they can fill at least some of these gaps, and states' desire to fill these gaps is driven in part by a desire to remediate economic dislocations related to technological innovation and, to some extent, local effects created by globalization, such as the outsourcing of manufacturing. (9) Venture capital can thus be viewed as a mechanism to help communities transition from basic manufacturing-based economies to higher-skilled manufacturing or knowledge-based economies. Relatedly, state officials may worry about migration out of the state, the erosion of the state's tax base, a general lack of competitiveness with other states. The development of new businesses can help mitigate some of these concerns.

This Part describes the core financing problems affecting startup businesses and then identifies why these problems may, in theory, result in a "market failure" justifying state intervention in private financing markets. Because these funding problems occur at the local, state, and national levels, this Part also describes national efforts to remediate early-stage funding deficits through national government-funded investment programs.

A. Scarcity in a Time of Plenty

Venture capital, the investment of funds by professional fund managers in private, early-stage companies, (10) has been key to the growth of many of the country's largest public companies. (11) Recent years have seen record-breaking VC funding. In 2021, for instance, global venture funding reached a record $621 billion, more than twice the amount in 2020. (12)

And yet, despite ample dry powder, many...