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INNOVATION

Jumpstarting Sustainable American Jobs

Today’s Small Companies Are Tomorrow’s Biggest Employers

Entrepreneurs Display new wind turbine design SOURCE: AP Photo/Elise Amendola FloDesign Wind Turbine Corp. founder and vice president Stanley Kowalski III, right, shows off a new wind turbine design to to Massachusetts Gov. Deval Patrick. FloDesign's jet engine-inspired technology is designed to offer an alternative to the typical three-armed turbines used to capture wind power. But without access to equity finance from the venture capital community, innovative small businesses like this one may not be able to grow, create jobs, and commercialize new innovations.

The Great Recession has ravaged our companies and financial institutions, and our ability to compete in a vicious global economy. The challenge now before our nation is to create millions of jobs this year and throughout this decade. There are many ways to do this, but one of the most important ways is to increase access to equity capital, a powerful job-generating tool. Equity is the money that entrepreneurs, their friends and family, willing “angel” investors, and professional venture capitalists invest in young companies so they have the capital they need to hire workers, buy equipment, and borrow from banks to expand their businesses.

Small companies are the nation’s primary drivers of job creation. A few of today’s small companies will grow to become our next 21st century Googles and Genentechs. These young companies could become the next big publicly traded companies on the cutting edge of innovation, and many more could become the not-as-big but just as prosperous companies with the ability to raise equity and debt capital to expand their businesses and job opportunities. This kind of “bottom-up” innovation and entrepreneurial company creation is what defines our unique U.S. venture capital-driven economy, the world’s top performer that over the past several decades produced tremendous results.

But something important has changed since then—the pool of venture capital is dramatically smaller today, crimping the creation of new ideas into new businesses ready to hire Americans by the score. The headline in a recent Wall Street Journal article tells the tale: “Venture Capital Could Shrivel Away” because “fund raising has now come to a near halt.”

Indeed, in a recent presentation in the National Venture Capital Association’s Venture Capital Industry Update, October 14, 2009, NVCA president Mark Heeson shows that the steady, though historically slow, growth in VC fundraising from 2002 to 2007 began a considerable decline in 2008 such that the VC industry is at a new and much lower level.

Why is venture capital fundraising important to jobs growth? Well, a recent NVCA report shows that:

“In 2008, venture capital-backed companies employed more than 12 million people and generated nearly $3 trillion in revenue. Respectively, these figures accounted for 11 percent of private sector employment and represented the equivalent of 21 percent of U.S. GDP during that same year. These findings extend trends regarding venture capital’s outsized impact – or “ripple effect” – on the U.S. economy that stretch back to the first edition of this report, published in 2001.”

The upshot: Our nation’s unique strength, its venture capital industry, is in danger of drying up just when we need it the most.

Yet equity capital for small business remains key to growing the competitive companies that can create the millions of jobs we need for broad-based economic prosperity. Without equity capital, jobs will lag and the jobless recovery will continue. America needs to focus on jobs-ready, entrepreneurial-driven companies by providing equity capital for their growth. And yes, the federal government can help.

Today there is a special opportunity for the federal government to have a significant impact on job creation by joining forces in a public-private venture capital partnership. Together, the private and public sectors can invest equity in competitive, jobs-ready businesses—equity that can also enable other private and public sector debt financing for small businesses to work more effectively.

Before detailing how this public-private partnership would work, let’s first listen to what the co-founder of one of the 20th century’s most successful venture capital-backed companies sees as the key problem plaguing jobs growth in our nation today. Andy Groves, Intel Corp.’s co-founder, CEO and chairman, recently in Bloomberg Businessweek pinpointed the strategic decline in jobs creation in the United States. He says our economy is suffering from the ability to take technology “from prototype to mass production.” Grove rightly notes:

“This is the phase where companies scale up. They work out design details, figure out how to make things affordably, build factories, and hire people by the thousands. Scaling is hard work but necessary to make innovation matter. The scaling process is no longer happening in the United States.”

He’s right, of course. Jobs and scaling are two sides of the same coin. And it’s the equity capital piece, the most powerful driver in jobs creation, that’s missing from public discussion about how to solve the problem of America’s severe jobs problem. America has hundreds of these companies, all now job ready. It is these companies that equity capital can help and the ones that are ready to be a part of an American jobs strategy.

Here’s how an “equity jobs” program would work. Public and private venture capital funds would go directly to companies at the top of the list as potential jobs producers.  They would only go to companies that are ready to hire new employees to support their growth, whether the company employs only a handful of workers but is poised to launch a groundbreaking new product or service that can be quickly scaled up, or employs 300 hundred or more workers but needs the equity investment to expand their operations across the country or overseas, mostly likely in tandem with public and private debt financing, too.

As an investor, the federal government would be a limited partner in these funds, so all public money would be returned to the U.S. Treasury along with dividends as companies went public on U.S. stock exchanges or were acquired by other companies looking to expand their operations or tap new technologies with homegrown production. This would be a positive “double bottom line” for America.

Making this program churn out jobs would require a rigorous selection of savvy fund managers with track records of strength and quality of work. They would need to boast a variety of company building skills alongside financial and entrepreneurial acumen, but also the basic skills metrics of a good VC such as speed of exits, cash-on-cash returns, investment volume, and ability to build “home run” potential in their portfolios.

To provide investment services in regions in all 50 states, the program would employ 25 fund managers. Each would be required to show that they possess operational experience in firms with top quartile internal rate of return performance, and cumulative experience of ten years or more as board members of invested companies. Further they would have to demonstrate the capability to commit to and provide both return on investment and jobs creation outcome metrics.

The successful applicants would select jobs-ready companies on two key criteria. The first would be according to highest levels of order backlogs and current demand, one way venture investors select their most promising investments in companies close to “break out.” Consider an Orange County, CA-based technology company that recently failed to qualify for either bank or Small Business Administration financing because of lack of sufficient equity capital. The company, Applied Cardiac Systems, in business for 30 years, makes in America and sells worldwide its wireless devices to monitor heart functioning. Recently a change in government requirements of devices of this kind opened up a market of nearly $500 million. The company is a very strong global competitor in this market, and with adequate funding to support expansion, the company could scale up and add new local jobs. But the recent economic downturn reduced the company’s cash flow, disqualifying it for a loan. Equity capital is the only source of funds that can jumpstart this company’s growth.

Why is equity financing as a public policy priority so important to debt financing? Because the federal government right now is making strenuous efforts to direct debt capital to small businesses, but in many cases it isn’t working. Banks are reluctant to lend after the U.S. housing and financial crises, and banks are facing more stringent regulatory requirements precisely because of the lending excesses of the past decade. Elizabeth Warren, who overseas the $700 billion Troubled Asset Relief Program, or TARP, for Congress says ”there’s no evidence that the $700 billion bailout boosted lending to small business.”

Warren is concerned that the market can’t find qualified companies and worries that the government incentives to lend are not strong enough. And in fact, banks are less willing to grant loans to small- and medium-sized companies. But with an infusion of equity capital these companies become much more promising credit risks. The key is equity capital, a way to address these issues and to provide growth capital to those companies that have a future potential and who have a strong backlog of business and need to hire.

The second investing criteria for these new public-private venture capital funds would be in market-ready products based on disruptive technologies that meet rapidly emerging global demand. Everyone in America knows the rags-to-riches stories of venture capital backed companies such as Google and Yahoo Inc., but there are many other companies like them who boost job growth every day in our country. Cases in point where equity has ignited world class companies:

  • In 1987 Silicon Valley venture firm Sequoia Capital invested $2.5 million in data network gear maker, Cisco Systems Inc. for 30 percent ownership of the startup—within 10 years after going public Cisco employed 26,140 people.
  • Ebay Inc. received $6.7 million from Benchmark Capital in 1997, which provided them the opportunity to go public in 1999, and then further expanded by purchasing Paypal, creating thousands of jobs.
  • Intuit Inc. started with 2 guys working out of a modest apartment in Palo Alto, CA in 1983—venture backing helped it grow to $3.4 billion in revenues with approximately 7,800 employees today.

We need to support companies with disruptive technologies such as these—technologies that will define the 21st century global economy—by ensuring adequate equity capital for entrepreneurs with breakthrough applications in alternative energy, clean energy technology, life science, medical technologies and personalized medicine, cybersecurity, and more. America has an abundant supply of these technologies just waiting to be commercialized at a scale that creates jobs upon jobs. We just need to find them, provide the capital they need, and help them grow and create those jobs.

Those who understand the direct connection between equity capital and jobs creation know they need to make it happen. In 2009 a House of Representatives’ committee passed the ‘‘Small Business Early-Stage Investment Act of 2009’’ (H.R. 3738) co-sponsored by Reps. Blaine Luetkemeyer (R-MO) and Glenn Nye (D-VA) by voice vote that would establish an equity investment program for small business. Later almost identical sections appeared in the‘‘Small Business Financing and Investment Act of 2009’’ (H.R. 3854, Title VII), sponsored by Rep. Kurt Schrader (D-OR), which built around the idea of serving certain small businesses needing equity investment because they had “attributes of being highly capital-intensive enterprises whose business models are generally not amenable to financing through lending programs.”

This bill passed the House of Representatives on October 29, 2009, by a vote of 389-32. Alas, the bill was sent to the Senate and referred to the Committee on Small Business and Entrepreneurship, and its status as reported by Govtrack.us is “would seem to be abandoned.”

This year, however, a new bill, Small Business Jobs and Credit Act of 2010

(HR 5297), sponsored by Rep. Barney Frank (D-MA) recently passed the House of Representatives with the main features of H.R. 3854, but with an increased equity funding level to $1 billion (HR 5297, Title III). A companion bill “The Small Business Jobs Act of 2010” (H.R. 5297), stripped, unfortunately, of any provisions for improving equity capital for small business, is now before the Senate.

All this legislative effort has been a step in the right direction, but all, alas, lack a direct focus on jobs creation. We need the new legislation to establish a program now that can create jobs through job-ready companies. We need to amend HR 5297 to include strong provisions for jobs creation. These provisions should establish our proposed public-private partnership venture capital program that will reflect a tested venture investment model that has been shown to be successful for decades.

The new program should learn best practices from successful state programs and also mirror federally implemented venture investment programs, and in particular, In-Q-Tel, the venture capital arm of the Central Intelligence Agency. Such a program would start the near-term creation of jobs now critically needed to bolster the U.S. economy.

And we can learn from the states. The Iowa Capital Investment Corporation, Utah Fund of Funds, Oregon Investment Fund, Invest Michigan, New Mexico Private Equity Program, and other state fund of funds initiatives show that equity capital attracts equity capital and accelerates company growth along with new jobs. Most funds are capitalized from $200 million to $400 million and target investment opportunities in venture capital and small buyout stage companies with growth characteristics across a range of sectors. The immediate effect of establishing the funds is to boost the amount of risk capital available to entrepreneurs.

Economics 101 defines capital formation as the creation of productive assets that expand an economy’s capacity to produce goods and services. In short, equity drives the economy. But it’s a paradox of sorts that though equity has mammoth power to drive the economy, the amount needed is relatively small. On the floor of the New York Stock Exchange in the first hour on the first trading day of a new year more money changes hands than VC’s invest in an entire year.

Now the nation is faced with a sea-change in the underlying structure of our economy and capital markets. Equity capital resources are shriveling at a time when more is needed. We need now to establish regional investment funds all across the United States with mandates to invest in jobs-ready companies. It would put funds to work immediately to help launch exciting new companies with disruptive technologies run by brilliant entrepreneurs, creating whole new industries. And it would enable older companies with high growth potential to work with banks to scale up and double and triple the number of their employees.

Today we must have access to and greater availability of equity financing because only a few hundred institutions and venture capital firms invest each year in the nation’s new companies, and that number is shrinking every year. We can make it happen with a national fund of funds that will serve every state and every region. Waiting in the wings for us to act are America’s best companies that will create 21st century jobs and stop the jobless recovery.

Thomas Gephart is managing director of Catalyst Fund and founder and managing partner of Ventana Capital. As one of the first venture investors in San Diego and Orange County, he was a member of USC’s School of Engineering Board of Counselors for six years, working with new technologies and technology transfer. Currently, he advises multinational firms in search of innovative acquisitions.

Dan Loague is the Washington representative for Catalyst Funds. He is also a principal of Global Tech Exchange LLC, a company that provides technology commercialization consulting to venture capital and private equity investors, and executive director, Capital Formation Institute, Inc., a nonprofit organization serving a national network of leading seed and early stage investors, licensees, and commercialization professionals.

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