1. State Seed Capital Funds: Models to Enhance Seed/Early Stage Capital Presented to Connecticut Academy of Science and Engineering August 2005 © 2003 ICF Consulting Group, Inc. All rights reserved.

2. 1 How do States Have Increased Seed Capital ■ Capitalization of Development Agencies  Capitalize venture capital funds run by public agencies, authorities, or institutions  Enable chartered non-profit and for profit economic development corporations to use some non-market rate of return placements to bridge capital needs ■ Placements in Private Venture Funds  Place public capital from appropriations, bonds or pension funds under management of private venture funds with expectations of market rate of return — Designed to leverage private capital investment within the state ■ Tax Credits or Incentives to Foster Investment  Provide tax credits to insurance companies in return for investment in capital companies thus increasing supply of venture capital. — Includes permitting write-off of a percent of losses from placements ■ Foster Angel Networks  Fund intermediaries to identify high net worth individuals and organize “angel networks” for pre-seed and seed capital — Purpose is to improve the volume and quality of early-stage “deals” in the state. ■ Encourage Venture Forums and other Deal Generation Activities  Fund intermediaries to plan and organize “venture forums” or venture capital “fairs” and programs to identify, screen and prepare local “deal volume” and facilitate interaction between investors and local entrepreneurs.

3. 2 States Increase Seed Capital for Different Reasons. ■ To Enhance Economic Development: Encourage overall economic development by enabling business creation and expansion and job creation. ■ To Build Financial Infrastructure: Enhance the VC infrastructure, deal volume and management capacity within the state  Sometimes achieved by augmenting the potential for private venture capital investments ■ To Accelerate New Enterprise: Enhance potential for growth of early stage or seed capital investments ■ To Retain Industry: Target certain stages in the company lifecycle where there are perceived gaps in investment and retain existing businesses as they expand ■ To Expand Opportunity: Target geographically isolated regions and economically disadvantaged populations

4. 3 Why Seed Capital is a Challenge? ■ Need for Deal Volume and Quality  Unless the volume and quality of deals are high, investors will show little interest in a state as a source of candidate deals.  Many states have low levels of entrepreneurship and a fewer start-ups and spin-offs ready to receive capital.  Unless prospective investors are educated about and see the returns from early stage investment the volume of transactions will remain low. ■ Need for Capital Sources  Fund and deal size have increased. Average deal size near $7.3M today. Many funds that start out offering seed capital “graduate” to providing later-stage capital. As such, seed funds need to be re- created often.  VCs exiting Seed/Startup-there has been a steady decline from 18% total in 1995 to 2% today. Most VC’s are not willing to wait the 10-15 years to collect returns on investments in seed companies.  Difficulty Starting New Funds--Money follows existing funds and individuals with significant experience. In the first quarter of 2005 only 7 new funds raised money, compared with 41 funds who raised follow-on funds. In 2000, 245 new funds were created and 390 follow-on funds were created by existing venture firms.  Geographic Concentration of Venture Capital Persists-CA and MA are over 50% of venture capital in the US.

5. 4 How They do it: Comparative Variables for Technology Seed Capital Funds ■ Organization Managing Funds: State (6); Quasi-State (2); Non-profit (3); LLC (4), CAPCO (1) ■ Funded Amount to date $M: 0-10 (5); 10-20 (5); 20-40 (2); >40 (4) ■ Structure: Evergreen (13); LLC (2); CAPCO (1) ■ Other Funding Criteria: Geography (11); Size of company (3); jobs (2) ■ Structure of Deals: Equity (9); Debt (8); Requires co-investor/match (8); Can lead (4); Limited % Ownership (5); Rules regarding Board Seat (6) ■ Deal Flow: Evaluated efforts to date funded directly approx. 630 companies as well as invested in nearly 4 dozen funds. Each $1M of direct company funding represents 3-8 companies if no follow-on; 1-3 companies if follow-on possible.

6. 5 Lessons Learned Publicly funded-Publicly Managed Programs Face Challenges ■ Greater State Control: Programs can be created specifically to meet State policy objectives and a strong case can be made that this benefits the State’s treasury. ■ State Policy Determines Investments: Investment choices are can be skewed toward policy needs. ■ Political Support Difficult: Political support is difficult to maintain especially in the face of investment failures or resistance to varying policy needs. ■ Harder to Attract Skilled Staff: Often more difficult to attract and retain seasoned talent than it is in privately managed funds. ■ Reluctance from Private Follow-on Investors: Private investors and private funds often resistant to invest in public funds, making leverage difficult. ■ Reluctance from Private Co-Investors: Private investors sometimes reluctant to co-invest if there is a perceived lack of skill on behave of the State fund. ■ Sustainability in Question: Publicly-managed funds are often questioned about their sustainability, both politically and financially. ■ Few Achieve Self-Financing: Few can be truly revolving or evergreen. Reasons include limited fund size and quality of investments and returns.

7. 6 Lessons Learned Publicly Funded-Privately Managed Programs are more flexible  Less State Control: Programs can be created to target policy objectives, but there will always be a tension between returns of the fund and policy goals.  Financial Benefit to State: A strong case can be made that such programs benefit the State’s treasury.  Close Date More Likely: Privately managed funds have a definitive life as opposed to a revolving structure.  Political Support Difficult: Political support is difficult to maintain especially in the face of investment failures or resistance to varying policy needs  Easier to Attract Skilled Staff: Often easier to attract and retain seasoned talent, although most experienced managers still reluctant to have any restrictions.  Private Investors More Eager to Co-Invest or Follow on: Private investors more likely to invest yielding leverage and co-invest.  Public funds can create leverage and reduce risk: Public financing for seed capital funds when of significant size and accompanied with minimal restrictions will attract private funding. To the private investor the additional leverage and frequent coupling of additional company support helps reduce risk.  CAPCOs have struggled: Generally considered unsuccessful. Many have evolved into high fee loan programs; Industry lobbies to continue programs.

8. 7 Other Applicable Lessons  Experience is Crucial: Experienced and skilled management is critical. Funds that compensate management for performance have more experienced managers.  Appropriate Level of Funding: Funds that were capitalized fully, or have appropriate and consistent appropriations, have better success generating quality deal flow.  Networking Maintains Good Deal Flow: The most successful funds focus on generating good deals by attending networking events, partnering with existing entrepreneur training efforts, and maintaining relationships with angel networks and later stage funds. In many instances, the actual seed funding was just one element of the support received from the fund and associated state programs  Limited Geographic Focus More Difficult: Funds that have a limited geographic focus have a more difficult time maintaining good deal flow.  Limiting Public Oversight is Critical: Public oversight should be limited to maintaining its mission, not to the program’s investments.  Insulate State from Politics: States often use a quasi-public agency or non-profit to invest state funds to help insulate the program from political influence  IRR vs. State Mission: Public sector funds can still be successful in terms of achieving State policy goals even though they are turning out a lower IRR than a pure privately managed fund.  Focus on IRR: Focusing on IRR is critical. If there are not real successes in the fund’s portfolio, support and sustainability are not possible. Is every company capable of 20- 30X?  Fund Size Impacts Numerous Factors: Need for annual allocations, sustainability, ability to attract private capital, attraction of skilled talent, influence/perceived importance;% overhead; ability to make follow-on investment.

9. 8 An Increasingly Popular Alternative Angel Investors ■ States use Various Ways to Support Angel Financing  Money for coordination, marketing, etc.  Staffing angel group and assisting with due diligence  Tax credits  Guarantees on loss ■ Examples  Maine, Missouri, West Virginia, North Carolina, Missouri, Ohio offer tax credits ranging from 25-60%  Arkansas: Permits investors to exclude capital gains from qualified angel investments  Hawaii: 100% tax credit over five years for angels investing in high tech.  Michigan allotted funds to subsidize management fee for qualified funds  Nebraska appropriated funds for angel education  Oklahoma via the Oklahoma Technology Commercialization Center: staffs angel groups, provides structure for matching angels with entrepreneurs, gives tax credits, educates angels, tracks investments  Pennsylvania’s Ben Franklin Investment Partnership Program ($2M/yr) is a venture guarantee financing vehicle that provides a guarantee up to 25 percent of the loss of an angel's investment in a qualifying company. In exchange, the BFIP will receive a guarantee fee of 1.5 percent per annum of the guaranteed amount, plus an option to purchase, at the angel's cost, up to 15 percent of the investment.

10. 9 Connecticut’s Objective: Strengthen Access to Seed and Early Stage Capital Questions Connecticut must answer: ■ Scale of Need: What is the failure in Connecticut’s capital marketplace? Deals: A shortage of quality early stage deals that can attract investors. Capital: A lack of investors with capital for early stage investment that are aware of and ready to make placements in Connecticut deals. ■ Preference for Intervention: How should Connecticut act to achieve its objective? Inform: Support Deal Generator programs, Venture Forums, and Angel Networks to Improve the volume, quality and visibility of early-stage deals. Enable (create more capacity): Introduce legislation that permits investment of state pension funds in privately venture funds who then compete for public placements. Also, permit use of bond funds to capitalize new early stage fund that can be repaid from the new fund. Examine augmenting funding for CI as more funds mean more competition and co-investing. Induce: Provide tax incentives that permit venture funds to write-off a portion of capital losses up to a specific percent of the placement, create specific incentives for angel networks. Sustain: Use public appropriations of general funds or general obligation bonds to fund programs focusing on generating higher deal volume and quality. Examine programs to increase amount of Federal dollars (SBIR in particular). Explore matching grant program to assist companies with commercializing their federal R&D merit awards. ■ Metrics of Success: How will Connecticut’s success be measured? Input Measures: Measure by the size and quality of the deal volume. Output Measures: Measure by the number of early stage placements. Examine the number of transactions and capital volume leveraged in early and later stage rounds.