This article originally appeared as a five part series. Below, the entire series appears as a single article.
In 2008, Charlie Grinnell found himself in the unenviable position of trying to raise Series A funding for his agricultural robotics startup Harvest Automation. There weren’t many venture firms investing heavily in agriculture and, despite many years of business experience, he had never run a venture-backed company before (a hold up for many VCs). To make matters worse, the economy was headed into what would be the worst recession since the Great Depression.
“It was really a tough slog,” said Grinnell. And yet by the end of 2009, his company had secured over $5 million in venture funding, thanks in part to early interest from an atypical venture investor: the Massachusetts government. Grinnell credits a funding commitment by the Massachusetts Technology Development Corporation (MTDC), a quasi-public venture fund created in 1978 by the Massachusetts state legislature, with helping to make his Series A possible.
Unlike other VCs, MTDC was interested in Harvest early on and not only committed funding, but helped introduce the company to other potential investors. For 15 months MTDC helped Harvest in its fundraising efforts, eventually joining Founder Collective and others in an A round to the tune of $500,000.
On the presidential campaign trail, Mitt Romney has been accusing President Obama of playing venture capitalist with companies like bankrupt solar manufacturer Solyndra, and in doing so has made the government’s role in startups a matter of national debate. Never mind that Solyndra and similar deals aren’t actually venture at all; should governments be acting as venture capitalists? And if not, why is Massachusetts doing so, not only through MTDC but also the Massachusetts Clean Energy Center (MassCEC)? Together, these entities invest millions annually into technology startups on behalf of the state in exchange for equity in the companies. Do these investments serve a legitimate purpose?
The Bottom Line
Through a series of interviews with state officials, VCs, academics and more, along with research into the structure and record of the state’s venture investing, two things became clear:
- The record of government venture investments in general is dubious at best. Many such efforts are poorly designed, badly implemented or both.
- Both MTDC and MassCEC are structured to avoid the many of common pitfalls of similar programs, are tasked with addressing real gaps in the marketplace, and are held in high regard by those in the innovation community with whom I spoke.
For reasons I will explain, assessing the success of these programs is extremely difficult, and the overall record of such initiatives should bias us towards skepticism. But despite going into this assignment with that mentality, I came away impressed. The Massachusetts government is acting as a venture capitalist, and by and large it is doing a good job.
Government Venture Funds Have a Lousy Track Record
In 1990, the state of Iowa, hoping to boost venture activity in the state, set up the Heartland Seed Capital fund. It seeded the fund with $15 million from the state’s Public Employees Retirement Fund, and after issuing a request for proposals, it selected the investment firm McCarthy Weersing to run it. Over the next three years, the fund made only a single investment of $1 million – perhaps partially explained by the fact that the firm had no investors based in Iowa – while collecting a fat three percent in management fees. When the state decided it had made a mistake, the investors sold back their one equity investment to the company to recoup for themselves management fees that the state refused to pay, and promptly sued the state of Iowa for a tidy sum.
“Unfortunately, these experiences are more the rule than the exception,” writes Harvard Business School professor Josh Lerner in his 2009 book Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed – and What to Do About It. In Lerner’s telling, the record of government venture investment is dismal. From New York City to Malaysia, such efforts have been plagued by poor program design and implementation. But as Lerner notes, these failures are not inevitable. In fact, there is reason to believe that, when done properly, venture investments by government can help address critical market gaps, thereby boosting a city, state, or region’s innovation ecosystem.
Why Is Massachusetts Playing the VC Game?
Before we can begin to judge the success of Massachusetts’ venture programs, we need to determine their aim and gauge whether it’s worthwhile in the first place. The Commonwealth is in a somewhat unusual position, in that the state is already home to one of the largest concentrations of venture dollars and entrepreneurial activity in the world. So unlike many forays by governments into venture capital where the goal is jump-starting some modicum of startup activity, Massachusetts needs to justify its activity with reference to specific gaps in the state’s innovation ecosystem.
In the case of the Massachusetts Clean Energy Center (MassCEC), that gap is fairly straightforward. There is a recognized lack of seed and series A funding in cleantech, and promising technologies often face a “technological valley of death” in which they lack the capital required to hit certain “proof points” that would lower risk to the point where venture investors would be interested. This is far from the only market gap in the energy space, and perhaps not the only way in which MassCEC’s investments are adding value, but it offers a basic justification for the fund’s existence.
The justification for the Mass. Technology Development Corporation’s (MTDC) existence begins much the same. Its website points to a survey it conducted that claims to identify a capital gap for smaller investments under $3 million. As has been widely noted in the tech press, seed funding for web and internet companies has been plentiful lately, but broader VC trends offer some support for MTDC’s diagnosis. Venture investments are becoming larger and coming later. (Angels have partially filled this gap, but with an emphasis on internet and healthcare deals. And the Massachusetts angel community is much smaller than California’s.)
To that, MTDC adds a few other areas in which it tries to add value: by backing less experienced management teams and by investing in industries “out of vogue” with venture capitalists (it avoids energy and biotech which are covered via equity or grants by other agencies). As I’ll discuss, these roles are somewhat more suspect.
What Does Success Look Like?
The fundamental difficulty in assessing a government venture program is that to succeed, it must toe the line between investing in viable companies and filling a market gap. It shouldn’t be duplicating private sector efforts by simply joining in the most promising or lucrative deals; on the other hand, it shouldn’t be wasting taxpayer dollars by dumping money into nonviable companies.
To do this, it must aim to address a market failure large enough to justify its own existence, but small enough that, by bringing to bear some government capital, it can ultimately attract private investors to the companies it funds.
“There certainly is a balancing act there,” Josh Lerner, the HBS professor, told me. “When you look across public sector interventions in the public space, often you find investments which fail on both counts.”
One of the best ways to achieve this balance, according to Lerner, is to require the funds to co-invest with private investors, thereby ensuring that the government fund cannot become too divorced from the realities of the market.
But that’s hardly the only challenge government venture funds face. They must also work to attract highly talented staff, they must be set up with enough independence to avoid any political pressures in the investment process (like pressure to invest equally across geography to please legislators), they need to properly align incentives for fund managers, and they need to fundamentally understand the nature of venture capital, so that deals are structured in a way that invites rather than deters subsequent private investments.
Returns are an important metric, but unlike private venture funds they are far from the only one.
At the Mass. Clean Energy Center, a Talented Team Takes Aim at a Clear Market Gap
Having looked at what the Massachusetts government hopes to achieve with its venture efforts, and after pointing out typical pitfalls of such programs, it’s time to attempt to evaluate the structure and records of the state’s two venture funds.
I start with the Massachusetts Clean Energy Center (MassCEC) because in some ways it is a simpler case. First, founded in 2008, it is much younger than MTDC, which means there isn’t yet much to say about its investment record. (Remember that in any venture portfolio, failures are likely to surface faster than home runs.) MassCEC budgets about $4.5 million per year for early stage investments. The market gaps are also widely agreed upon in the clean energy space.
“I don’t think it’s hard to find well-defined market failures which are and should be the best rationale for intervention,” said Mark Muro, a senior fellow at The Brookings Institution, who recently cited MassCEC as a model for other states to follow in a paper on state support of clean energy. “The market failures are pretty clear here.”
Not only is there an early stage funding gap, cited earlier, but clean energy is generally under-funded by the private sector thanks to the externalized costs of fossil fuels, including air pollution, greenhouse gas emissions, and more.
“They are playing a very important role in an area where there is a very significant private sector gap,” said Peter Rothstein, president of the New England Clean Energy Council (and, full disclosure, my former boss).
So MassCEC is addressing a legitimate gap, but what about its structure and implementation? Here again, early assessment seems positive. The fund requires matching private investment –a key recommendation of HBS’s Josh Lerner – to ensure that its investments don’t stray too far from market forces. And, critically, the MassCEC has attracted a high level of talent to staff the fund.
“A huge part of why the MassCEC has been successful, at least in my opinion, is that they’ve gone out and hired really talented people,” Rob Day, a partner at Black Coral Capital, told me. “The real lynchpin here has been [MassCEC Executive Director] Pat Cloney’s ability to attract a great team.”
At the fund’s helm is Arif Padaria, formerly a venture investor at Pilot House Ventures who previous to that managed strategic investments for Microsoft.
As for other common failures in government venture funds, a MassCEC spokesperson told me they do not factor geography into their investments, suggesting needed political independence. Padaria and his team are paid based on salary rather than the incentive scheme Lerner advises, but by keeping the team in-house they avoid the most common staffing pitfall for such funds: hiring a private firm to manage the fund and letting it reap large management fees.
As time passes, MassCEC’s ability to generate returns as well as to retain top talent will be crucial. (So far it claims two exits and an exit multiple of 1.4x.) But between its focus on a real market failure, its commitment to co-investing with private investors, and its ability to attract staff with venture experience, MassCEC checks nearly every box for a well designed and implemented government venture fund.
MTDC Puts the State’s Money Where Its Mouth Is
It may be hard to believe, but Boston wasn’t always a tech hub.
“In the late 70?s Boston was not known as an innovation hub; it was known as an economically decaying city,” said Jerry Bird, president of the Massachusetts Technology Development Corporation (MTDC). ”There was a lot of technology strength around here because of MIT and other companies but they had a hard time finding sufficient capital.”
In 1978, under the Dukakis administration, the state legislature created MTDC, which was seeded with $2 million from the federal government the next year that was used to provide loans. In the early 80?s, the state appropriated $4.2 million to create a venture fund under MTDC which has operated ever since as an “evergreen” fund, meaning that returns are used to finance the program and go toward new investments.
Like with MassCEC, the first step in evaluating MTDC is its justification for existence, the market gap it claims to fill. As noted earlier, VCs have retreated from seed stage investing, which backs up MTDC’s claim. And though angels have stepped in to fill some of that gap, their investments have been largely concentrated in internet and healthcare. Notably, conversations with investors for this series suggested that MTDC’s activity does not crowd out – and may even induce – angel activity.
MTDC also cites backing first time entrepreneurs as a reason for its existence, but here I’m more skeptical. It’s for good reason that the venture community places such emphasis on the backgrounds of management teams. It should be up to the state to explain why it thinks there is a market failure in this area, why the private sector is under investing in first-time founders.
Its final mission – to focus on “out of vogue” sectors – might appear to raise a red flag since one of the key ways in which such programs fail is by ignoring the marketplace. But MTDC avoids this mistake by requiring matching funds by private investors in all of its deals. In this way, it strikes exactly the balance such efforts should: neither duplicating private efforts nor ignoring the demands of the market.
Eric Paley, an investor at Founder Collective, which joined MTDC in its Series A for Harvest Automation, said that having a venture investment arm helps to give the state more credibility as it seeks to promote its economic development agenda.
“It’s hard to be an advocate without having some skin in the game,” he said.
Over the course of its 30+ year existence, MTDC claims a gross internal rate of return of 16.5%. By comparison, Cambridge Associates says U.S. venture funds earned returns of 21.7% over the last 30 years, including carry claimed by investors but excluding management fees and expenses. So MTDC’s IRR is significantly lower than the private market, but given that its mandate goes beyond finding the best returns – indeed it is instructed not just to duplicate the market – it would be unreasonable to expect at or above market returns. Taxpayers should be focused on its social benefits and pleased that the fund is providing adequate returns to support an “evergreen” structure.
Bird admits that geography is a factor – a warning sign for government venture – but claims that it acts more like a tie-breaker between equally worth investments.
“We’re mostly within 495,” he told me.
Like MassCEC, MTDC does not offer the fund’s managers any incentives; they are paid on salary. Though Bird has a background in venture, he admits that attracting staff with the appropriate background is an issue.
“It’s rare to get someone who has venture capital experience,” he told me. “But it’s not hard to get someone who has experience financing technology companies.”
Like with MassCEC, I came away from my research thinking MTDC was doing a lot right. It is attempting to address what appears to be a real market gap, it is tied to the market through matching private sector funds, and it received high marks from the private co-investor with whom I spoke.
But I remain skeptical of the need to focus on first-time entrepreneurs (a minor gripe) and it would most likely benefit if it could attract staff with previous venture experience. Moreover, as the rise of angel investing and startup accelerators like TechStars have filled the seed stage for internet companies, and if these and other mechanisms like crowdfunding begin to creep into other sectors, MTDC and the legislature will have to honestly consider its strategy going forward.
For now it seems clear that MTDC is bolstering the state’s innovation economy.
When It Comes to Promoting Innovation, Better to Err By Doing Too Much
The importance of startups to the economy – the jobs they create, the growth they promote, the new technologies they bring to market – is well documented. So it is a legitimate goal of any government to further startup activity. Particularly here in Massachusetts, where technology and innovation are keys to our success, this is appropriately a focus of policymakers.
In this piece, I’ve zeroed in on government equity investments in startups. But it’s worth zooming out and noting that most of what government ought to do to support innovation has nothing to do with providing venture capital. It’s about setting a level playing field, funding research and development, educating the workforce, and developing markets for new technologies.
But as we’ve seen, the government’s role need not necessarily stop there. Though the history of government venture programs is littered with failures, Massachusetts efforts through both the Mass. Clean Energy Center and the Mass. Technology Development Corporation are playing a supportive role in the state’s innovation ecosystem.
Throughout this article I’ve relied on the criteria set forth by HBS’s Josh Lerner, which I’ve supplemented with interviews. In doing so my aim is not to endorse in full his view of the appropriate role for government. Rather, by anchoring this analysis around a set of concrete recommendations by one of the world’s foremost experts in this field, my hope was to identify any obvious failings in the state’s efforts, and raise a host of issues that would prompt further discussion within the community. I’m hopeful that both MassCEC and MTDC will take the opportunity to offer their own thoughts directly via guest posts at BostInno next week.
One thing that was clear in the process of researching this article is that Massachusetts has avoided some of the common pitfalls that government venture efforts face because it is home to so much venture capital. Basic mistakes like demanding too much equity, structuring the deals in a way that turns off future private investors, and similar issues never came up simply because our state has enough exposure to the venture community to know better.
Mark Muro, the Brookings fellow, argued that states are better positioned than the federal government to undertake this activity because they have more information about the local environment, and that view seems vindicated by the Massachusetts experience.
I asked Dharmesh Shaw, CTO of Hubspot and an active angel investor, about the role of the government as an investor, and about potential conflicts between angels and government funds. He framed the problem nicely, suggesting that having the government do too much for startups is a better problem than having it do too little.
“As much as I’d love for it to be otherwise, most early-stage entrepreneurs have a paucity of committed investors — not a surplus,” he told me by email. “In terms of the ‘market distortion’ risk, that could be a problem, but I don’t think it’s significant enough. I’d love to see the government assist so many startups that it starts to create a distortion problem.”