Is Imitation the Highest Form of Flattery? –

The success of the venture capital industry has raised our profile for entrepreneurs, investors, the media and, interestingly, policymakers in Washington and across the country. While it is important that we continue to educate members of Congress about importance of venture capital we must be clear about our industry’s role.

The VC recipe is a uniquely American phenomenon due to the fact that we have a country that a) encourages entrepreneurship, b) has liquid, transparent, flexible financial markets, c) protects intellectual property, d) has a highly educated workforce, e) has free and open domestic markets and access to foreign ones and f) has established governments, universities and corporations which are committed to both theoretical and practical science. Not surprisingly, the world has awoken to the benefits of venture capital and wants desperately to imitate it.

A recent study by DRI-WEFA reveals that our industry created 7.9 million jobs and $1.3 trillion in revenue for venture-backed companies in 2001. The study reinforces the fact that VC is an essential, but relatively small player in U.S. economic growth and productivity. We must be vigilant to ensure that policymakers, in particular, do not take the wrong lessons from the success of the venture capital model. While it is a precarious model in which all incentives are aligned with others; therefore, to only pick and choose various aspects of this model is, in fact, a recipe for disaster as we have seen. This industry is a creator of jobs, innovation, and great companies, it is not is a substitute for basic research and general economic stimulation.

The VC model has been misapplied by the government with disastrous results. The U.S. Department of Agriculture created the Alternative Agricultural Research and Commercialization Corp. (AARCC) in 1992 to “expedite development and marketing of industrial products made from agricultural and forestry materials and animal by-products.” This VC fund invested $40.3 million and returned only $1.2 million after eight years. Sugarcane waste was turned into furniture, sunflower seeds into motor oil, and milkweed into comforters. An audit by the USDA concluded that the AARCC had only minimal assurance that taxpayers’ monies had been properly expended and that its investment portfolio had been adequately protected from loss. In short, it was a complete failure.

Despite a poor track record the VC model continues to be misapplied. Last month a Washington-based think tank and law firm circulated a proposal to create a VC fund for anti-bio-terrorism efforts. The fund was to be started with federal seed money to develop anti-bio-terrorism research and early-stage technology companies and products. Congress would provide oversight for the privately managed fund of $250 million to $750 million directed at seed-stage investments.

These are just two of the several examples of federal policymakers attempting to apply the VC model to needs better served by other tools. There are similar efforts in states and local communities as well as countries around the world to create a venture industry in the name of and with the laudable objective of economic development.

It is imperative that we steer governments away from the certain calamities that await them if they try to create a venture capital industry. They will do themselves and us a better service if they instead focus on the ingredients of a successful entrepreneurial growth firm: ideas, talented employees and incentives like stock options.

To be sure, there is a limited, albeit important, role government programs can play. The Small Business Investment Company (SBIC), the Small Business Innovation Research (SBIR), Small Business Technology Transfer Program (STTR), and the Advanced Technology Program (ATP) are excellent examples.

SBICs are financial institutions, licensed by the U.S. Small Business Administration, created to make equity capital and long-term credit available to small, independent businesses. SBICs are privately organized and privately managed firms, which set their own policies and make their own investment decisions but are funded in part by government-backed, long-term loans.

SBIR, enacted in 1982, and ATP, started in 1990, fund pre-commercial, highly risky research whose benefits are typically too diffuse to be captured by an enterprise but whose benefits may be widespread. ATP has awarded over $1 billion in funding to over 300 high-tech projects conducted by U.S. companies and industry led joint ventures.

STTR is a program that expands funding opportunities in the federal innovation research and development arena by expanding public/private sector partnerships to include the joint venture opportunities for small business and the nation’s premier nonprofit research institutions. Each year, Departments of Defense, Energy, and Health and Human Services, the National Aeronautics and Space Administration, and the National Science Foundation are required by STTR to reserve a portion of their R&D funds for awards to small business/nonprofit research institution partnerships.

The government has absolutely no reason to engage in venture capital. It should remain risk averse in commercializing technologies and building companies. It cannot create the proper incentive structure to build a viable government venture capital program. But it can provide the infrastructure and incentives for the essential ingredients for entrepreneurial growth companies. We think it is enough and, more important, all we should ask the government to do.

Joe Aragona is a co-founder of Austin Ventures. Heis on the Board of Directors of the NVCA and chairs its Research Committee.