When looking at ways to fund a startup, five general strategies are usually top-of-mind: bootstrapping (self-funded through savings, credit cards or retirement plans); friends and family; traditional bank loans; venture capital or angel investors; and most recently, crowdfunding. In some cases, government grants are also a possible source of business capital but their usefulness for funding a startup is very limited so with the exception of businesses targeting particular strategic governmental priorities, they are not considered a ‘go-to’ resource.
Each of the five startup funding resources mentioned above comes with its own unique set of advantages and disadvantages. For entrepreneurs seeking startup capital through venture capital, angel investors or crowdfunding, intense competition is one of the biggest hurdles that must be overcome to secure funding. Of these three, getting funded by angel investors or a venture capital firm are among the most difficult. Here, getting the pitch heard is among the most significant obstacles to success. Every day, venture capitalists (VCs) and angel investors (Angels) are inundated with countless pitches for funding. Many VCs and Angels won’t even look at a proposal unless it comes to them through someone they already know. Unsolicited pitches are often never reviewed or given consideration.
But did you know that there are VCs across the country that are actually hungry for pitches from startups and growing small businesses? These often untapped VCs are not run by wealthy individuals, banks or financial institutions but rather, by local, regional and state governments and quasi-governmental agencies. Government-backed VCs were developed as a way for cities, counties and states to attract new businesses and grow existing small businesses in order to create jobs and spur economic development.
The overwhelming majority of venture capital flows into just five metropolitan areas: San Francisco; San Jose; Boston; New York; and Los Angeles-Long Beach. Collectively, these five areas attracted more venture capital than the next top 95 cities combined. On average, each year, these five metro areas attract 55-60% of all venture capital deals in the United States. For some cities, regions and states outside of the top VC metros, operating a government-backed VC makes sense from an economic development perspective. They view having their own VCs as a way to incentivize startups and small businesses to launch, locate, relocate or expand in their communities.
Venture capital firms tend to congregate in areas where there are plenty of early stage startups and companies with investment-ready deals. And in order to grow a sufficient number of investment-ready, early-stage companies, an area has to have the proper startup ecosystem of services and resources, including access to capital (including angel investors and venture capital firms), talent, intellectual property law services, startup accelerators, incubators and more. Bringing together all of these resources requires a monumental effort to obtain the commitment and investment of dollars and resources from all the constituencies that stand to benefit from a healthy startup ecosystem. This includes the business community, universities and research institutions that develop future entrepreneurs and spin-out technologies, financial institutions, community leaders and investors.
For communities and states located outside the top VC metros, a government-backed venture capital fund is viewed as a way to jumpstart development of a healthy startup ecosystem. The hope is that by providing funding to early-stage companies, it will attract more startups and other resources that support the launch and growth of small businesses.
A government-backed venture capital fund operates much like any VC. Each is usually focused on supporting certain types of businesses in high-growth industries or sectors. Startups and early-stage companies that meet the basic criteria then pitch the government-backed VC just like they would to any private sector VC firm. Everything else follows a relatively straightforward path to funding.
At the state level, government-backed VCs generally operate in the following ways:
- In direct investment funds, state program managers serve in the role of VC fund managers; they actively network with entrepreneurs, source deal flow, perform due diligence, assist in the recruitment of co-investors and may set terms of the investment transaction.
- In co-investment funds, state VC programs invest alongside private sector investors in deals meeting certain requirements, and the state program manager’s role focuses on compliance rather than actively performing subjective evaluations of a company’s investment potential.
- In fund-of-funds, state VC program managers allocate capital to more than one VC fund that manages the processes of investing in businesses while monitoring compliance with SSBCI program restrictions.
- In 3rd-party managed funds, the state contracts with a single external firm to manage the investment process using a single fund structure that may or may not comingle private funds.
State programs also vary in the stage of company development targeted for capital investment.
- Pre-seed refers to “proof-of-concept” capital for entrepreneurs developing an innovation and working through the company formation stage
- Seed capital or early-stage capital refers to investments used to form a company or in companies already formed but with insignificant revenues and no profits.
- Expansion or growth capital investments are made in small businesses with revenues and sometimes even profits. These businesses need capital in order to “scale” the business into a larger enterprise.
- Later-stage or mezzanine capital investments refer to the most conservative stage of VC investments, which still carry a greater risk profile than loans from banks.
Just a few of the states that have government-backed VCs include Kentucky, Ohio, Texas, Pennsylvania, Nevada, New York and Florida. A handful of cities and counties around the country also offer venture capital to startups and early-stage companies.
Nationally, there is also a network of government-backed venture capital available through Small Business Investment Companies (SBICs) that supply equity capital, long-term loans and management assistance to small businesses. Overall, there are more than 300 SBICs licensed across the United States. Combined, these SBICS invest about $1 billion annually in small businesses. SBICs have provided funding to some of the world’s most recognized businesses including Apple, Costco, Intel, FedEx and Jenny Craig, among many others.
The U.S. Small Business Administration (SBA) has an online directory SBICs. You can view the directory at https://www.sba.gov/content/sbic-directory. Other than the SBIC director, there is no centralized database of government-backed venture capital funds. If you want to know if there are any in your area, check with your city, regional or state economic development agency and ask. While obtaining funding from a government-backed VC comes with all the same strings attached as any other deal, securing capital from these funds can often be less competitive than what you find in the private sector. In any case, it is certainly worth exploring as a possible source of capital for your startup or early-stage company.