This post was updated on September 30, 2021 to include a reference to Kentucky’s manufacturing industry.
Regions across the country, striving to foster dynamic, diverse growth, are launching initiatives aimed at supporting the scale up of the technology and advanced-economy companies that inordinately drive the economy.
Yet, technology startup formation remains heavily skewed toward Silicon Valley, New York City, and Boston.
At the same time, regions that were previously anchored by sectors such as manufacturing and industrials sorely need more of such growth.
Nonresident Fellow - Brookings Metro
Senior Fellow - Brookings Metro
These metro areas have struggled to keep up with the large coastal cities that serve as hubs of innovation. Significantly, this owes at least in part to their inability to attract financing for early-stage technology companies. To thrive, therefore, it is imperative for regional economies to overcome the funding problem and build local technology ecosystems to drive their local economies and provide good jobs.
But how? One answer may be to leverage innovation financing mechanisms sharply different from but also complementary to the high-profile venture capital (VC) that backs so many companies and entrepreneurs. Additionally, recent federal recovery and pending innovation programs hold out an opportunity to support such new models of financing—ones that can back a wider array of companies and a more diverse group of entrepreneurs.
Our suggestions flow from the structure and goals of VC. Though venture capital has been championed as a popular financing mechanism for innovative technology companies for decades and provided over $164 billion to startups in 2020, it funds fewer than 1% of new businesses in the United States.
VC, in this regard, is not a good fit for many types of entrepreneurial enterprises. Venture capitalists embrace a high-risk, high-reward investment model of backing companies at the earliest stages of their lifecycles because of the companies’ potential to grow and scale quickly in gargantuan markets. Consequently, they often seek asset-light, capital-efficient companies that focus on growth over profitability. And those cluster in metros with emerging or robust technology ecosystems.
Companies that may achieve steady or uneven—but not rocket ship—growth are often not great fits to receive venture financing. Such companies may have long sales cycles, sell into markets with big—but not $100 billion—revenue potential or require significant capital expenditures or regulatory approvals prior to scale. The disincentives for venture capitalists to invest in such companies are reflected in the industries on which they do focus: in 2020, the internet and software sectors consumed over 47% of the nation’s VC investment, while the industrial sector hovered at 4% and agriculture and energy/utilities each did not crack 1%. Sectors like agriculture, government, and manufacturing thus see limited VC-driven innovation due to the incompatibility of the venture financing model with these sectors’ sales cycles, market potential, and growth trajectories. However, even technology companies operating in industries more attractive to VC may not be able to access such financing if they do not exhibit the rapid growth trajectory sought by venture capitalists, leaving many sustainably growing technology companies with limited funding options.
All of which has stark implications for Heartland economic development. Quite simply, when regional economies are powered by industries that traditional venture financing shies away from or that do not meet venture capital’s growth targets, regional technology innovation may stall without the use of alternative financing methods.
Many regional economies with strength in legacy and advanced-economy industries that struggle to attract venture capital are cases in point.
Kentucky, which boasts a 19% manufacturing share of GDP and has 13% of its workforce employed in manufacturing, is a producer of goods within sectors such as transportation equipment, chemicals, and machinery. Despite the strong footprint of advanced manufacturing in the state and expansions of already existing corporations, Kentucky trails other states in its ability to attract VC to support new technology-driven companies, with less than 0.2% of U.S. venture capital flowing to companies in the state in 2020. A similar story is playing out in Nebraska, which is powered by the agriculture, food processing, and transportation industries. Despite gains in venture capital investment since 2019, Nebraska captured less than 0.1% of venture capital in the United States.
In sum, for places like these across the nation’s interior, venture capital is unlikely to work as the sole type of financing mechanism to drive technology innovation and entrepreneurship. Given that, innovation-oriented policymakers looking to foster the growth of resilient and tech-driven economies in the Heartland will need to look beyond venture capital and explore a diversity of financing mechanisms to support technology companies in their regions.
What are some potential responses to this quandary?
To grow their technology ecosystems, metro areas should take a strategic policymaking approach to support diverse types of financing options for technology companies. In that vein, while VC may be a fit to bolster some businesses, revenue- and profit-share financing models and strategic grants should also be considered as tools to back businesses critical to regional economies.
Revenue- and profit-share financing models are an attractive first option for many successful firms that should be supported as funding options by state and local governments hoping to grow their technology ecosystem. Revenue and profit-share financing models are debt-like structures that support founders whose businesses are largely funded by paying customers and take capital only as necessary.
These models have been gaining prominence in recent years as some entrepreneurs reject the growth expectations, dilution, and constant fundraising cycles that come with raising VC. Revenue- and profit-share models often look for steady and recurring revenue, healthy gross margins, and stable cash flows. They may be structured as a multiple of monthly recurring revenue or fixed revenue amount with repayment caps based on a company’s underlying economics, business model, and funding needs. A model employed by the Calm Company Fund (formerly Earnest Capital) utilizes a shared-earnings agreement, which acts as a substitute for an equity-like structure in which an investor provides upfront capital and receives a percentage of founder earnings (essentially profit), up to a cap. Another model is revenue-based financing offered by Lighter Capital, which provides founders with growth capital in the form of a loan in exchange for a percentage of monthly revenues up to a repayment cap, paid flexibly based on company performance. In contrast to an early-stage venture capital fund model dependent on a minority of portfolio companies driving most of the fund’s returns via an exit event, revenue- and profit-share models rely on a greater number of portfolio companies providing moderate returns with no pressure to exit, thus aligning incentives of founders and investors to build profitable, enduring, and steadily growing businesses without the pressure of growth-at-all-costs and high risk of failure.
In addition, while efforts are underway to address the small share of venture capital dollars going to underrepresented founders (only 2.3% of venture capital dollars went to Black and Latino founders and only 11.5% to founding teams with at least one female founder in 2019), some revenue- and profit-share financing models arguably provide a more data-driven approach to early stage capital provision that reduces bias and allows founders to build wealth by retaining more ownership.
To leverage revenue- and profit-share financing mechanisms, governments should consider providing matching financial support to emergent funds utilizing these approaches. Traditionally, such government participation has been used in the VC space to attract risk financing to places hoping to grow technology ecosystems. In 1993, for example, Israel launched the $100M Yozma initiative to develop its nascent venture capital industry, through which the government provided up to 40% of capital raised by outside investors to develop funds and invest in Israeli startups, with funds being shepherded by private and international investors. The success of many Yozma funds attracted new fund managers to Israel and by the late 1990s, much of the initial government stake was bought out by private investors as the technology and investment ecosystem became self-sustaining. Now, technology is one of Israel’s top-contributing economic sectors.
The Yozma experience suggests how governments can use hybrid fund structures to support the growth of revenue- and profit-share fund models in the U.S. An example of how government funding has supported revenue-share financing models has been demonstrated by Colorado, which has used government funds to back businesses in strategic geographies. The Greater Colorado Venture Capital Fund, a privately managed $17.5 million fund to which the state of Colorado awarded an initial $9.1 million of financing, focuses on providing capital to seed stage companies located in rural Colorado through a revenue-share financing structure. Given that revenue- and profit-based financing fund models are more likely to rely on the success of a greater swath of companies than venture fund models, such models may better align with the goals of economic development leaders who prioritize sustainability and stability in the technology ecosystem they aim to build. With that said, it should be noted that supply-side measures like government-financed and hybrid venture capital funds are no substitute for key foundations of a technology ecosystem such as highly skilled labor, universities, and an existing corporate base. Experiments with revenue- and profit-share fund models will need to be paired with efforts to promote the sort of ecosystems in which technology startups can be built and scaled.
Outright grants are another option. Grants—awarded by governments—can serve as a critical early financing mechanism to support companies operating in industries crucial to national or regional interests. Such awards can usefully complement venture capital by helping companies operating in sectors like advanced manufacturing that struggle to raise venture capital due to high upfront capital expenditure needs. One of the most prominent federal grant programs is the Small Business Innovation Research Program (SBIR), which encourages companies to engage in federal research and development efforts critical to the United States government. The SBIR program operates through a three-phase program; Phase I to establish technical merit, feasibility, and commercial potential, Phase II to continue the research and development efforts based on the results of the Phase I program, and Phase III to continue the commercialization objectives from the prior Phases. SBIR programs are matched by some states and can sometimes match private investment up to a cap.
Continued federal support for such programs, as well as the expansion of grant programs to critical industries that drive regional economies, can provide the necessary initial financing to prove out the technical strength and commercial demand necessary to attract venture capital. And here it bears noting that elements of both the Economic Development Administration’s Build Back Better Regional Challenge (BBBRC) as well as elements of the regional tech hubs initiative proposed in the United States Innovation and Competition Act of 2021 (USICA) hold out intriguing opportunities for accessing federal support for such grants. In particular, the Strategy Implementation Grants and Cooperative Agreements to be awarded to regional hubs chosen through the USICA could allow prospective hubs to propose structures that attract new private investment and establish regional venture and loan funds. Dedicating a portion of such funds to cultivate hybrid revenue- and profit-share financing vehicles and industry-strategic grants that can de-risk venture capital investment into advanced economy industries could catalyze investment into a broader swath of technologies.
States and local governments can also leverage grants (funded by Washington or their own resources) to offer an attractive non-dilutive financing option to startups to support industries and initiatives critical to their economies, supporting such startups by de-risking the research and development phase for startups needing future risk financing. Such an approach may help regional economies that have a more concentrated industry mix in sectors that require large amounts of upfront capital to scale by attracting focused venture capital. However, funding the right grants at the right stages of a company’s lifecycle will be critical. Research suggests that providing grants during the earliest stages—focused on establishing feasibility and commercial viability rather than commercialization efforts—has a demonstrably stronger impact on the probability that a firm will receive venture capital, achieve revenue, and have a successful exit, versus later-stage awards.
In sum, national and regional governments have options as they address the critical financial side of economic development. While venture capital remains an important tool in supporting a subset of highly innovative and fast-growing businesses, its model caters to the financing needs and goals of rapidly growing software companies, and not often to capital expenditure-heavy “hard tech” or sustainably growing businesses in need of patient capital. For policymakers looking to revitalize innovation in critical industries or support a wider swath of sustainably growing technology companies founded by a diverse set of entrepreneurs, it is important to take stock of what kinds of businesses their financing programs encourage and consider cultivating private and public funding sources that meet their goals. Luckily, a signal opportunity exists to facilitate financing support for funds and grants that would back a wider range of technology companies, such as through federal or own-source regional funding. By looking beyond venture capital and supporting diverse growth paths for technology companies that best align the goals of entrepreneurs, investors, and the community, policymakers can play an important role in encouraging regional innovation that helps counter economic divergence and achieves a broad-based prosperity.