Friday morning I will be testifying to an economic policy subcommittee at the request of Senator Jon Tester of Montana. The overall event’s topic is “the role of federal research and universities in capital formation and job creation.” I will be specifically addressing the role of venture capital investment and entrepreneurship in the US economy, including recommendations for federal policy changes.
The testimony will be in Bozeman at Montana State University; for those of you in the area, feel free to stop by. My oral testimony will be a significantly shorter summary of the written testimony below.
Senator Jon Tester’s Economic Policy Subcommittee Roundtable
September 30, 2011
“The Role of Universities and Federally Funded Research in Capital Formation and Job Creation”
Testimony of Trevor Loy, General Partner, Flywheel Ventures
Senator Tester, Members of the Economic Policy Subcommittee, Invited Guests, and Colleagues, thank you for the opportunity to participate in this important discussion.
My name is Trevor Loy and I am the founder and a General Partner of Flywheel Ventures, a venture capital investment firm based in Santa Fe, New Mexico. I launched the firm 11 years ago after over a decade of experience in Silicon Valley as an entrepreneur, investor, engineer, and teacher of entrepreneurship at Stanford University. Our focus at Flywheel is on investing in entrepreneurial technology start-up companies across the American West, with an emphasis on underserved areas like Montana. I have colleagues in Arizona, New Mexico, and California’s Silicon Valley; in addition, I am pleased to be joined today by my Missoula-based colleague Clyde Neu, a former venture-backed entrepreneur and professor of entrepreneurship at the University of Montana who represents Flywheel Ventures in Montana and across the northern Rockies.
Flywheel directly manages approximately $40 million of equity capital. This capital is supplied by my colleagues and me from our personal savings, combined with additional equity capital from over 50 investors. These investors, known as “limited partners,” include university endowments, state public funds, charitable foundations, private family offices, and high-net-worth individuals. Interestingly, none of our investors are from Montana, so every time we invest in a Montana start-up company, we are importing 100% of that capital from elsewhere into your state.
Since 2002, we have invested this capital in 36 start-up companies across the American West, including in Montana, and over 2/3 of these investments have been made in companies with origins in of the region’s research universities, R&D organizations, and national laboratories. We are nearly always the first institutional investor in these entrepreneurial start-ups. Our initial investments typically range from $50,000 to $500,000, and for those companies that demonstrate promising initial progress, we provide up to $2-3 million in additional growth capital. We also assist these entrepreneurial companies to accelerate their growth in a variety of ways. Our typical assistance includes helping to recruit and relocate experienced executives, securing additional follow-on growth capital from larger national and global investment firms, and establishing overseas customer and distribution partner relationships. We are particularly focused on investing in American companies that capture the majority of their revenue by exporting their products and services to foreign markets, with an emphasis on global emerging markets. Our relationship with these companies typically lasts 5 to 10 years. Ultimately, our goal is for these companies to one day become viable, market-leading public companies or be acquired by larger corporations so that our capital can be attractively returned to our investors and so that the these companies’ innovations can reach millions of people.
In addition to my responsibilities as a venture capital investor, I am also a member of the Board of Directors of the National Venture Capital Association (the NVCA) based in Arlington, Virginia. The NVCA represents the interests of over 400 venture capital firms in the United States which comprise more than 90 percent of the venture industry’s capital under management. During my term on the board of directors, I have served as Chairman of NVCA’s Political Action Committee; Chairman of our Membership Services Committee; and I now serve as Chairman of a newly-formed committee on “Emerging” Members, with the goal of encouraging an increase in venture capital firm formation and investment activity in underserved regions of the country like Montana and the broader American West.
It is my privilege to be here today to share with you, on behalf of the industry, the role of venture capital investment in the technology transfer process and my perspective on possible federal policy avenues to accelerate the growth of the technology economy nationwide and in Montana.
The importance of venture-capital-fueled entrepreneurship to the US economy cannot be overstated. US-based companies that received venture capital investment now account for $3.1 trillion in annual revenue, equivalent to about 21% of the entire annual American GDP. (Source: 2011 IHS Global Insight study) US-based companies that received venture capital investment now employ about 12 million workers in the USA, which represents about 11% of all private sector jobs in America. (Source: 2011 IHS Global Insight study). Amazingly enough, this economic impact has been produced by a total amount of venture capital investment that represents just 0.2% of GDP.
What led to this unique and dynamic source of competitive advantage for the American economy? In my view, there are four fundamental elements. These four elements are entrepreneurs, innovation, capital markets, and the macroeconomy. The USA has historically maintained specific competitive advantages in each of these separate areas. The healthy combination of the four elements, however, is the true source of American economic dynamism, particularly over the past 35-40 years.
The first, and most important, element of success is entrepreneurs. The USA has long been the “magnet” for the world’s entrepreneurial talent, including those entrepreneurs born in the USA and those who have chosen to immigrate to pursue the American dream. For domestically-born entrepreneurs, the quality and consistency of the public K-12 educational system is paramount. So, too, are initiatives that encourage entrepreneurial risk-taking.
A key theme in enabling such risk-taking is supporting employee mobility. Simply put, entrepreneurs need maximum mobility to pursue their entrepreneurial dreams. This mobility includes positive incentives, such as ensuring favorable tax treatment for stock and stock options given to those involved in starting and growing companies. Otherwise, the potential compensation from joining an entrepreneurial company may not outweigh the higher cash salaries typically paid by large companies. Mobility also includes ensuring an adequate social safety net that is not tied to keeping one’s current job. Eliminating exclusion of pre-existing conditions by health insurance companies was a key step forward in encouraging employee mobility; ensuring that small start-up companies are spared from a crushing burden of the cost of providing health care to employees remains a challenge not yet solved.
Finally, mobility includes widespread, affordable and accessible infrastructure so that employees are not constrained by the geography in which they have chosen to live. Such infrastructure should include nationwide, ubiquitous, affordable broadband Internet access, which in my view, is even more essential to today’s society than rural telephone access was in the early 20th century. Such infrastructure also includes efficient transportation networks, including air, rail and highway infrastructure.
A particular concern for Montana, in my view, is the inadequate nature of its airport infrastructure and flight access. Historically, a key driver for economic growth was a region’s proximity to rivers and ports; later, to railroads; still later, to interstate highways. Many experts believe that in the 21st century, the key transportation infrastructure hub is the airport. I concur; while broadband Internet and electronic communications eliminate the challenge of distance for many activities, periodic face-to-face interaction remains critical for business success, especially as the pace of change and volatility accelerates. Particularly for venture capital investment, periodic face-to-face interaction with entrepreneurs is essential. Venture capitalists sometimes refer to our profession as a “return-on-time-with-entrepreneurs” business rather than a “return-on-investment” business. While we provide capital to fund company growth, the shared resources, mentoring, advice, and oversight we provide to entrepreneurial companies are of greater importance.
For this reason, most venture capital investors limit their investments to a single metropolitan area, or even a single zip code, and this is why Silicon Valley and a handful of other areas such as Seattle, Boston, and New York have such a concentration of entrepreneurship and venture capital activity. A minority of VC investors, which includes me and Flywheel, believe it is possible to invest over a wider geographic area; however, as part of that strategy, we must be able to visit our entrepreneurs frequently, and that typically demands frequent availability of non-stop flights. At Flywheel in particular, we are only half-joking when say that our success depends on Southwest Airlines, and its vast network of point-to-point, non-stop flights. I am not joking at all when I say that the inability to reach your airports frequently via convenient and affordable flights is the top barrier to my ability to consider greater investment activity in Montana. To be especially clear, distance is not the factor; from New Mexico, I can reach Seattle or Boise in half the time and at half the cost. As a result I can visit with the same number of entrepreneurs in those areas twice as often as Montana, or at the same frequency of visits, I can spend time with twice as many entrepreneurs in those areas. Given that my time spent with entrepreneurs is my scarcest resource; this means that an entrepreneurial company investment in Montana must be twice as promising as those in other areas to warrant my attention.
Hopefully these thoughts about empowering risk-taking and mobility for domestic entrepreneurs are helpful. Ensuring that American remains the global “magnet” for entrepreneurs born elsewhere is equally essential. Of all private VC-backed companies in 2006, about 47% were founded by immigrants. (Source: NVCA member survey, 2006). Of all public US companies that received VC investment in the past 20 years, about 25% were founded by immigrants. (Source: Stuart Anderson study commissioned by NVCA). The enormous economic contribution of immigrants to the American economy has also been demonstrated well beyond those who receive venture capital funding. Immigrant entrepreneurs founded 25 percent of all U.S. high-tech and engineering companies between 1995 and 2005. (Source: President’s Council of Economic Advisers). Perhaps most stunningly, more than 40 percent of Fortune 500 companies were created by an immigrant or the child of an immigrant (Source: Partnership for a New American Economy).
Unfortunately, the evolution of immigration policy in the USA has begun stifling this critical source of job creation and economic growth. As Mayor Michael Bloomberg has stated, we are committing “national suicide” with our current national immigration policy. Several immediate changes are needed. First, we need to dramatically expand the ratio of visas given for economic reasons. Second, we should adopt a policy of incentivizing all foreign students who complete engineering and science degrees at American universities to stay in the US after graduation. Put more succinctly, we should “staple a green card to their diplomas.” Finally, we should create a new category of visas for entrepreneurs who start their own companies, raise a meaningful amount of capital, and hire a minimum number of American workers. One such proposal for this idea is the “Startup Visa,” an initiative recently launched by VC investors and entrepreneurs who were seeing the most promising and talented people in our companies forced to move away from the USA. This proposal is more fully detailed at www.startupvisa.com.
The second main element of American entrepreneurial success has been the strength of our innovation system. This includes the bedrock support our federal government has provided for basic R&D funding at universities. To be clear, here I am not talking about government programs that support specific businesses or specific industries; the so-called “picking winners and losers” that is particularly controversial today. I am not even talking about “applied” research and development. Rather, I am speaking of programs ranging from the Defense Advanced Research Projects Agency (DARPA), which as we all know provided the funding that launched today’s Internet, to DARPA’s newer cousin for energy research known as ARPA-E, to the significant leadership role that NIH plays in life science research, to federal SBIR grant programs, to federal funding for university R&D.
Over 2/3 of the three dozen companies in which Flywheel has invested had their origins at R&D institutions that received federal support for basic R&D. We are in the business of assessing the real-world applications and riskiness of research breakthroughs once they have been fully developed and proven. We will take the risk of translating a new innovation into a commercial product. Investors are not in the business of taking scientific or basic technology risk, so it is critical that this activity have support from elsewhere. Again, I want to emphasize my support for the importance of federal funding of *basic* R&D – the so-called ‘blue sky” research with no clearly defined application or value. It is precisely the role of these basic researchers – who work primarily at universities – that has led to the most important, life-changing, and economically-significant breakthroughs. As Isaac Asimov famously said, “The most exciting phrase to hear in science, the one that heralds new discoveries, is not “Eureka” but “Hmm, that’s funny…”.
At the same time, once these basic scientific breakthroughs have been proven in an R&D setting, it is critical that entrepreneurs who want to build companies based on these innovations have open access to private sector funding, including that from venture investors. In recent years, under the misleading banner of protecting government contractors who are small businesses, we have witnessed attempts to make entrepreneurs who receive SBIR or similar federal R&D funding support subsequently ineligible to receive private sector funding from venture investors. It is precisely the combination of federal support for basic research, and private sector support for commercialization of that research, that yields the most successful economic outcomes and produces the most job creation.
The third critical element of American entrepreneurial advantage in recent decades has been the health of capital markets. These capital markets not only provide the initial investment capital to entrepreneurs, but also provide the eventual liquidity to entrepreneurs and return on investment to venture capitalists, so that we can then recycle that capital into new investments. Prior to 2000, approximately 56% of venture-backed companies that achieved a successful return on investment – a so-called “exit” in the venture capital nomenclature - did so via an initial public offering (IPO) on a US stock market exchange. Since 2001, only 18% of successful exits have come via IPO, with 82% of companies exiting via M&A, and a substantial portion of even those 18% achieving IPOs have been foreign-based companies, especially those from China.
To be clear, the sale of an entrepreneurial company via M&A is a perfectly fine and respectable outcome, and often the preferred route. However, the valuation achieved at exit via M&A is typically significantly less than an IPO. Moreover, when a company exits via M&A, it no longer controls its own destiny; the acquiring parent company now does. This has particularly profound implications both nationwide and regionally. Nationally, studies show that 90% of the long-term job creation from VC-backed entrepreneurial companies occurs _after_ companies achieve an IPO. This is not surprising; large independent public companies employ significant numbers of operational, finance, managerial, and support personnel. In M&A situations, the acquiring parent company typically already has adequate staffing for such positions, so only product and engineering-related employees survive the sale of the company. Regionally, in places like Montana, an M&A sale of a local startup will all-too-often also lead to the relocation of the business to another location, typically wherever the acquiring parent company is located. In such situations, local or regional economy of a place like Montana will not end up yielding the full long-term job creation, economic growth, and tax revenue benefits of keeping their most promising companies at home.
The more critical change in capital markets since 2000 has been the demise of the small-growth-company IPO. For decades up until 2000, smaller growth company IPOs were the rule, not the exception. Prior to 2000, over 80% of all IPOs were for companies raising less than $50 million. Since 2000, less than 20% of IPOs are for such companies. We have several examples in our portfolio of companies we funded at the seed stage that have now grown to over $100 million in annual revenue. For most of the last 50 years, such companies would have executed an IPO in a straightforward fashion, generating liquidity and wealth for the founding entrepreneurs and early investors, but the companies themselves would have continued growing and creating jobs in their original communities. Today, we are forced to decide between selling these companies to larger acquirers, in order to get a minimum return, or wait until these companies grow even larger themselves, perhaps to $250 or even $500 million before an IPO will become feasible.
The debate over how to reverse and improve the stagnation of US capital markets for IPOs of smaller growth companies is a complex and technical one, so I will only summarize a few key recommendations. First, a number of well-intentioned regulatory rules and protections were put in place for publicly-traded companies in the mid-2000’s, following the well-publicized problems at Enron, Worldcom, and others. The Sarbanes-Oxley “section 404” rule is one such example. Such rules, however, only typically provide meaningful protections for investors in the largest public companies. Yet, they are imposed on all public companies, including private entrepreneurial companies just entering the public markets. Providing a scaled-back “Sarbanes-Oxley Light” version of the rules for newly-public companies with either a time-window or maximum-size limit would be especially helpful.
A second driver of the decline in smaller IPOs has been an unintended consequence of the so-called “Spitzer Decree.” As part of the effort to eliminate conflicts of interest at investment banks, these banks were precluded from using revenue from their banking business to pay for the research coverage and expert analysts who cover publicly-traded companies. As a result, most investment banks dramatically reduced or eliminated their staff of research analysts, particularly with respect to those covering smaller or newly-public companies. What the rule makers failed to anticipate was that, without adequate research analyst coverage, most large investment institutions (such as mutual fund companies) are prohibited from buying the stock of a company. As a result, many of the smaller growth companies that did manage to execute an IPO in recent years are now trapped in what we call “small cap hell,” incurring all of the costs of being a public company but enjoying none of the benefits. In many cases, their existing investors cannot sell a meaningful amount of their stock in the company, for without analyst coverage, there are simply no allowable buyers of that stock. A simple recommendation would be to amend the Spitzer Decree to allow banks to re-employ equity research analysts using revenues from their banking business, while continuing to adhere to an amended set of guidelines to preserve the independence and objectivity of those analysts.
A third element of addressing the dearth of smaller IPOs involves ensuring the growth and access to alternative liquidity mechanisms for entrepreneurs and investors. In recent years, several “secondary” market exchanges such as SecondMarket, SharesPost, etc. have emerged to allow knowledgeable experts to buy and sell the shares of private technology companies such as Facebook, Twitter, etc. These exchanges have allowed founding entrepreneurs and early investors to sell a portion of their stock and generate a return on their investment, while enabling the companies themselves to remain independent and privately held. In the absence of a viable public IPO market, these new secondary exchanges have filled a crucial need for entrepreneurs and investors. Unfortunately, thus far, these markets are only open to industry insiders, and not to the wider investing public. In addition, a lack of clarity from the SEC with regard to the rules and regulations affecting such “secondary market” transactions has limited the use of these exchanges to a handful of companies and investors. Encouraging the SEC to quickly review, decide, and publicly publish the “rules of the game” for these markets – including determining how the broader investing public can participate – would be helpful.
Finally, a number of tax policy changes could be adopted to not only improve the health of US capital markets for IPOs, but also to encourage increased private market investment in entrepreneurial companies. As a starting point, the current policy of reduced tax rates for capital gains from long-term equity investments in private companies should be maintained. An additional “staggered” or “laddered” reduction for longer holding periods might provide additional incentive for those investors who provide “patient capital” to entrepreneurs trying to grow companies over a 5 to 10 year period or more. An outright exemption, or at least a substantial tax holiday, from all taxation on investments made in qualifying types of startup businesses would be especially useful to incentivize the movement of investable cash from personal and institutional balance sheets into investment support for entrepreneurs. Similarly, exclusion from ordinary income tax for a portion or all income received by employees via equity stock options would help improve the attractiveness of smaller growth companies for employees.
In considering the health of the venture-backed technology economy, I have provided a brief perspective on the importance of entrepreneurs, of innovation, and of capital markets. The fourth and final element I will address is the stability of the broader macroeconomy. I am not a macroeconomist and not an expert on many of the technical issues and debates among economists today. So I will limit my observations to a few items that specifically affect the entrepreneurial economy. In many ways, the technology industry and the entrepreneurial startups we invest in have been spared from the worst of the global recession that began in 2008. Because our companies are typically more nimble, more productive, and more focused on selling products and services to emerging market customers where growth has continued, they have done surprisingly well. To assist our American-based companies with this export-driven growth, my colleagues and I spend significant time each year outside of the USA. Last year, for example, I moved my entire family to China, so that I could more effectively represent and work on behalf of our portfolio companies to negotiate trade agreements, joint ventures, distribution partnerships, and customer contracts. Our portfolio companies at Flywheel have collectively grown their aggregate revenue by over 50% per year every year since 2008 – almost entirely through increasing their export sales to overseas customers. As a result these companies have continued to make pay raises, hire more employees, and generate additional tax revenues.
At the same time, structural weaknesses in the broader domestic and global economy remain an ever-present challenge and threat to the continued success of entrepreneurial growth companies. In particular, I am concerned about four key structural challenges. These are the housing market, the labor market (unemployment), declining K-12 educational achievement (particularly in science and mathematics), and the difficult balance between the need and timing of short-term stimulus versus long-term deficit reduction. No doubt, you have access to expertise beyond mine on each of these issues. So, for today, I will comment briefly only on the degree to which one of these challenges, the housing market, is causing a specific problem with regard to entrepreneurship.
Relative loan-to-value percentages have caused a substantial number of borrowers to become “underwater” on their mortgage loans. Even though most borrowers continue to make their mortgage payments on time, these borrowers face a significant psychological “negative wealth effect” from the lack of positive equity in their homes, and this depresses consumer spending and sentiment, reducing overall demand in the domestic economy, including domestic demand for the products and services offered by entrepreneurial growth companies.
More importantly for entrepreneurship, most entrepreneurs have typically funded their initial startup ventures with some type of borrowing against home equity. The lack of access to such credit as a practical matter, despite theoretically low rates of interest, has significantly hampered the ability of many entrepreneurs with otherwise solid plans from getting started.
Even if they can secure funding elsewhere, entrepreneurial ventures often also require an entrepreneur to relocate geographically to be closer to customers, universities, or other clusters of innovation. The current situation in the housing market often precludes such relocation because the entrepreneur (or his/her initial employees) cannot sell their prior home. For many years, a driver of the success of Flywheel’s portfolio companies was their ability to attract top managerial talent from Silicon Valley, Boston, Seattle and other locations to the American West. The attraction was made easier by the quality-of-life and cost-of-living advantages of our wonderful geography. In the last few years, however, we have encountered a practical difficulty in our ability to relocate these executives: they cannot sell their existing homes in the larger markets from which they would be moving. As a result, we increasingly are forming “dual location” companies with the original product R&D employees in the university or lab towns where they begin across the American West, but establishing corporate headquarters, finance, sales, and marketing employees in west coast metropolitan areas. This strategy has significant challenges to productivity and communication, as well as significant additional costs. However, it is the only practical response to the inability of the top executives to relocate, and that is a direct result of the structural barriers in the housing market.
Finally, long-term mortgage rates are theoretically at historic lows. If such rates could be practically accessed by entrepreneurs, it would represent a significant means of lowering their cost of capital. Unfortunately, from a practical perspective, most entrepreneurs I know – even those with outstanding credit, a flawless mortgage payment history, etc. – cannot actually complete a refinancing transaction. The key to reversing these challenges, in my view, is to achieve a practical method of enabling widespread modifications to current loan-to-value ratios, eliminating the “underwater” problem for borrowers while reducing the likelihood of outright default and foreclose for lenders. Additionally, borrowers must have widespread and practical ability to refinance their mortgages at today’s lower rates, even if no other alterations to loan amounts are made. These two changes would substantially increase the ability of prospective entrepreneurs to pursue their startup ideas.
Senator Tester, your support for the entrepreneurial economy in Montana and nationwide has not gone unnoticed by those of us in the national venture capital investment community. We very much appreciate both your past support and your continued focus on further improvements. I particularly appreciate the opportunity to discuss today the key role of venture-capital-backed entrepreneurs in our American economy, and the specific issues related to entrepreneurs, innovation, capital markets, and the macroeconomy. I thank you again for the honor and invitation to present my thoughts on this important issue, and look forward to working with you, your staff, and all of the key players you have gathered here today. Thank you.