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How Economic Developers Can Manage the Regional Deal Flow Pipeline
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editorial

How Economic Developers Can Manage the Regional Deal Flow Pipeline

At the State Science & Technology Institute's September conference in Portland, Thomas Vass, of the Private Capital Market, Inc., is going to address the conference on how the new Regulation D 506(c) rules can promote regional economic growth. His presentation is titled “How Economic Developers Can Fill The Crowdfunding Capital Market Gaps In Regional Innovation Ecosystems: Economic Developers Can Manage The Regional Deal Flow Pipeline.” The second part of his presentation, which we are sharing below, addresses how Reg D offerings fit into the regional deal flow pipeline. You can view the full paper here.

The State Science & Technology Institute (SSTI) is a national research consortium comprised of hundreds of regional economic development member agencies, all of which believe that technology-based economic development provides great economic and social benefits to metro regions in terms of job creation and increased incomes.

Related:
- Busting The Five Prevailing Myths About the Reg. D Private Capital Ecosystem

The SSTI September conference in Portland is called “Dynamic Innovation Ecosystems: Bringing It All Together,” and is focused on how research, capital, workforce, and manufacturing fit together into a coherent strategy. One of their sessions is dedicated entirely to how crowdfunding can be integrated into a regional innovation economic strategy.

Integrating Title II Reg D Rule 506 offerings under the JOBS Act into regional economic development strategies will require a completely different method of promoting technology-based economic development than the prevailing university tech transfer – venture capital model currently favored by members of SSTI.

The best way for SSTI members to fit Reg D crowdfunding into regional innovation economic policy is to promote a division of labor between crowdfunders and economic developers, so that each group specializes in what they do best.

That would mean having economic developers doing the tasks that crowdfunders cannot do themselves in managing the regional deal flow pipeline. In order to manage the deal flow pipeline, members of SSTI need to have a mental map of how the entire capital market contributes to regional economic growth.

The chronology of events in deal funding related to job growth at year three, year seven and year ten of a technology company can be placed into an intellectual framework that looks like a deal flow pipeline. At the top of the pipeline, there is a big funnel, into which ideas and capital are poured. Then, the deals and the capital work their way down the pipeline timeline. The death rate of deals is very high at every stage of the pipeline.

Regional economic growth is caused by commercially successful innovation investments, not by productivity improvements or greater efficiency in the use of factor endowments. The greatest economic growth for creating new jobs and wealth is, ironically, caused by the most risky radical innovations at the top of the deal flow pipeline. 1 

As a way of explaining how the deal flow pipeline combines capital with ideas, the diagram below is helpful because it delineates the topic areas of knowledge creation, capital markets, and managing the pipeline of deals.

The top of the pipeline, deal mapping does not produce revenue, and managing the entire deal flow pipeline does not generate any profits.

This is the major reason why non-profit economic developers should manage the deal flow pipeline. No one in the private sector can manage the pipeline chronology of events because managing it does not make any money. When technology is commercialized successfully, however, the deal flow pipeline creates jobs and incredible amounts of wealth and increased regional income.

Deal Mapping

Some of the elements of the private sector small business deal creation pipeline have analogous components in the university tech transfer model. For example, in the deal mapping part of the tech transfer model, professors attend academic conferences, publish papers, and apply for grants, seeking to extend their knowledge.

In the private sector deal creation pipeline, engineers, scientists, salespeople and executives attend trade shows, play golf with each other, swap stories in beer drinking sessions, and dream up new products, seeking to extend their markets and income.

The big difference for members of the economic development community in shifting to the small business crowdfunding model is that knowledge creation and diffusion in the private sector is primarily based on face-to-face tacit knowledge creation and diffusion.

Because tacit knowledge is based upon personal human interaction, it tends to occur in distinct geographical areas, leading to the creation of distinct regional technological knowledge. 2

In the university tech transfer model, the knowledge exchange is formal and codified in the form of research grants, published articles, and mentoring students about specialized scientific areas of knowledge. In contrast to tacit knowledge having a geographical component, codified knowledge is geographically ubiquitous. As soon as an article is published by a professor, it is immediately available any place in the world for all the other professors to read and criticize.

Deal mapping and idea creation at the top of the pipeline does not generate revenues and consequently, the market of ideas suffers from what economists call “incomplete information.” Most information in the market is in the form of prices that attach to goods and services that can be exchanged, and ideas do not have prices attached to them.

In issuing its rules on public solicitation of Reg D deals, the SEC noted this problem of incomplete or inadequate information as one primary justification for changing the rules on Reg D offerings to allow public knowledge diffusion and information exchange.

As the SEC stated in its report, “For example, one seminal study suggests that if some investors have incomplete information and are not aware of all firms in the economy, risk sharing is incomplete and inefficient. Information that makes investors aware of the existence of these firms and enlarges the investor base leads to improved risk sharing and lower cost of capital. 3 

The very top of the deal creation pipeline is characterized by the public good of tacit knowledge, whose management and administration would add great social and economic benefits to regional economies.

Tacit knowledge does not have a market price attached to it, and consequently, the creation and diffusion of regional technological knowledge in the deal flow pipeline by economic development non-profit agencies is constitutionally justified. 4

In managing this part of the regional deal flow pipeline, economic developers would create multiple crowdfunding forums and events around the idea of technology innovation, product commercialization, and the growth plans of companies in the region’s nine high tech cluster value chains.

The crowdfunding events would not need a lot of formal structure or agenda, mostly business social networking and presentations by entrepreneurs, scientists, and CEOs of local companies who would like to tell their story to the bigger business community. Under the new SEC rules for public solicitation, the entire business community would be invited to attend the events, because, unlike the old rules for angel events, everyone in the business community can now hear about crowdfunding deals.

The main tool economic developers would use to identify the most promising sectors to promote in their regional economy is the Feser econometric model. Feser’s method has the great benefit of uncovering potential technology partners in the regional economy, which would not have been obvious, based upon conventional economic analysis.

Managing and administering the Feser model is not a revenue-generating activity, so no private sector entity is going to conduct this function. But, the results of the model would be very valuable information for the entire business ecosystem, and non-profit economic development agencies are in the best position to manage this tool. 5

Deal Creation

The professional product development community calls the deal creation component of technology commercialization, the “fuzzy front end.” The fuzzy front end is a very confusing time for most technology entrepreneurs, and the most recent data from the Panel Studies of Entrepreneurial Dynamics indicates that up to 35 percent of all entrepreneurial ventures get stuck in the fuzzy front end for up to four years, trying to launch their venture.

Obviously, a great social benefit could be provided by economic developers in managing the deal flow pipeline if they would just rescue the poor entrepreneurs from wandering around for four years in the fuzzy front end. Economic developers would want to create a coherent professional business community that efficiently converted ideas into ventures that were ready to go to the capital market.

In the university tech transfer model, this deal creation and the fuzzy front end is generally managed by the tech transfer agents, who package up the professor’s research into deals that the venture capitalists can fund.

In shifting to the small business crowdfunding model, economic developers would rely on the regional business community of professional advisors who give advice to companies on how to issue securities and raise capital. 6

The three main business professional categories that would be organized into regional innovation groups by the economic development agencies are all the product design and development firms, all the local CPAs who have an interest in providing services to companies that are issuing Reg D securities, and all the securities attorneys, who provide legal advice to private companies on a Reg D offering.

Deal Funding

During the time that a new venture or new product is moving towards the marketplace through the fuzzy front end, the firm or entrepreneur is trying to identify the best sources of capital investment to fund the idea.

As noted above, the private capital market is huge and complex for small firms to understand, including the new Reg A offerings contained in Title IV of the JOBS Act. Most of the media attention has focused on crowdfunding in Title III, and the new Reg D rules in Title II.

But the most significant new source of capital for small technology companies may turn out to be securities issued under Reg A of Title IV of the JOBS Act. The reason for the importance of the Reg A provisions under the JOBS Act are related to the new “runway” they create to the small public stock exchanges that are becoming operational. It is likely that the connections between the private capital markets and the small public stock exchanges will strengthen as a result of Reg A offerings.

Reg A does not appear to be on the SSTI radar screen, and in moving towards a new crowdfunding model, economic development professionals would want to become familiar with the provisions of Title IV Reg A, as well as all forms of asset based lending, investment banking, and the new rules for transition from the private markets to the new small public markets. 7

In other words, in the division of labor involving crowd funders and economic developers, the most important job of the economic developers is to help implement a comprehensive regional capital market infrastructure that contains all of the components of the entire market. 8

Often, the right type of capital for a new product idea in a new venture is entirely different than the source and form of capital for an existing company with operational cash flows from existing product sales. Most of the Reg D offerings in the past four years have been by operational companies, not new ventures.

For new ventures, especially the kind that originate in the university tech transfer model, the venture capital partnerships that currently fund tech transfer deals will continue to be important in the future. Just like the non-venture capital crowdfunding deals that can now solicit investors, the university tech transfer deals will be able to solicit investors, which means that existing close relationships between selected venture funds and universities may be disrupted as a result of the rules on public solicitation about university deals. 9

In the division of labor between crowdfunders and economic developers, it would not be the job of economic developers to conduct private placement offerings, handpick capital market favorites, or to intervene in the private capital market place as a crowdfunder, any more than it would have been the job of economic developers in the earlier industrial recruitment model to build the bridges, roads, and sewer lines that created the infrastructure for industrial recruitment.

The capital market infrastructure that funds regional technology innovation, however, functions in the same way that roads, bridges, and sewer lines functioned in the older industrial recruitment economic strategy. Like that earlier infrastructure, metro regional economies which implement the new capital market infrastructure will gain an enduring competitive advantage over communities that do not have an adequate capital market infrastructure to fund technology innovation in small technology companies. 10

One important function that the economic developers could perform is doing the upfront work in organizing a regional closed end capital growth fund that targets new ventures, existing businesses, and the down stream merger and acquisition funding that keeps home grown companies at home when the bigger players come calling to recruit them. 11

The upfront organizational costs of registering a closed end fund with the SEC are about $150,000. No private sector entity in its right mind would front this kind of money because the management of a regional economic development mutual fund would never recoup the organizational costs.

Unlike the current model of venture capital private funds which seek a fast exit, the economic development funds would be seeking long term sustained viability of its portfolio companies, and without the fast exit, there would not be a quick capital gain profit. The parties who make money on the closed end fund are the investors, not the managers and administrators of the fund. 12

On the other hand, $150,000 is a small amount compared to the tax incentives provided to large companies to entice them to locate in a region. And, unlike industrial recruitment incentives, the organizational costs are a one-time event. Once the fund is created, however, it generates profits for investors for the long term.

One of the possible investors in the closed end regional growth fund are local chambers of commerce, local units of government, and charities and trusts with a mission to stimulate local economic development. In addition to, or as a replacement of, the use of industrial recruitment incentives, the investments made in the regional closed end fund would generate a continuing stream of profits that would be available for reinvestment in the local economy.

As an example to illustrate this idea, in 2005, the state of North Carolina gave Dell approximately $300 million in incentives to locate an assembly plant near Winston Salem. In return, Dell had promised to create a very large number of jobs. 13

Several years later, Dell shut the North Carolina operations, and moved the jobs to Mexico. Those jobs that were promised by Dell are never coming back when the economy improves, they are gone forever.

If the $300 million in incentives had been invested by a closed end fund in 300 small technology firms in the Triad region of North Carolina, those firms would be in about their eighth year, and creating permanent, high wage jobs. In about two more years, for the surviving firms, in their tenth year, they would be creating an exponential rate of jobs, going from around 20 jobs per firm, to about 70 jobs per firm.

Given the high death rates of technology firms, there would only be about 100 firms out of 300 left, resulting in a job gain of about 7,000. That is about the same number of jobs that Dell promised to create in North Carolina over a five-year period.

Alternatively, if North Carolina had used part of its investment in the closed end fund to buy a specially created Dell preferred stock in 2005, as an alternative to giving away tax dollars for free, they would have owned stock at around $25. Applying today’s dividend yield rate of 8 percent on the Dell common stock, taxpayers would be enjoying a decent return on their investment, with the upside opportunity for the cash bonanza on the preferred stock, when Dell goes private. A closed end fund would be used in conjunction with the Feser model to target capital investments into the region’s most promising industrial clusters.

Deal Exits

Small business job creation enables a platform for investing so that profits from one generation can stay in the regional economy and can be reinvested in the next generation of innovation. 14

As noted above, the deal creation pipeline has a different end goal, and a different public mission of economic growth than the current venture capital model. Both Schumpeter and Leontief explained why the capital gain profits from one generation of deals to the next were vital for sustained growth, and in moving to the new crowdfunding model, members of the SSTI economic development community would want to implement strategies that allowed profits from regional deals to stay in the local economy. 15

At the top of the deal flow pipeline, economic developers would facilitate crowdfunding into small technology firms that would promote regional technology based economic development. At the tenth year of the deal flow pipeline, economic developers would facilitate the reinvestment of profits back into the next generation of small technology firms.

As is the case with the use of tax benefits related to industrial recruitment, sometimes the deal exit’s component can be made more beneficial to everyone involved if certain taxes from the first generation of investments are delayed or forgiven if they are re-invested in the subsequent investment rounds. This reinvestment of profits would be the preferred outcome for closed end fund investments held by local government agencies and non-profit economic development organizations.

Non-profit economic development agencies have a mission to promote the general economic welfare of the citizens in their region, and that mission means having a much longer-term perspective about economic growth than private sector entities directly involved in private capital transactions.

Economic development agencies are in a much better position than crowdfunders to manage the deal flow pipeline in their regions over a long period of time because they are not under the competitive gun to generate top line revenues and bottom line profits.

The longer term, to paraphrase Lord Keynes, is ten years. It is the goal of economic development agencies to manage the deal flow pipeline so that private companies survive to age ten, by creating the capital market infrastructure that delivers capital to the companies at age three, age seven, and age ten.

If the small private technology companies can survive to age ten, and get a small amount of growth capital on its tenth birthday, their rate of job creation will be exponential and regional economic growth will be explosive.

1. Rooting Out an Embedded Prejudice in the Literature on Venture Capital and Economic Growth, The Private Capital Market, January 11, 2009
2. Exploiting Knowledge: The Importance of Regional Allegiance and Territorial Loyalty in Implementing a Regional Small Business Innovation System, The Private Capital Market Working Paper No. 09-01-01, February 25, 2009
3. See Robert Merton, A Simple Model of Capital Market Equilibrium with Incomplete Information, Journal of Finance 483 (1987)
4. Adding a Geographical Component to an Equity Crowdfunding Project. The Private Capital Market, Crowdsourcing.org, March 13, 2013
5. Using Feser's Input-Output Model of Technological Affinities to Target Innovation Investments to Regional Industrial Value Chains, The Private Capital Market, December 1, 2008
6. The Crowd Funding Business Bonanza for Lawyers, Accountants and Consultants: Professional Business Advisors about to Surf a Financial Tsunami of New Crowd Funding Business, The Private Capital Market, April 11, 2013
7. Establishing the Capital Market Transition from Private Capital to Public Capital, The Private Capital Market, May 29, 2008
8. The Nexus of Financial and Political Interests between Crowd Funders and Regional Economic Development Professionals: The New-New Innovation Economics,The Private Capital Market, July 8, 2013
9. Successful Tech Transfer = Market Commercialization, The Private Capital Market, Private Capital Market Working Paper No. 2008-09-03 September 24, 2008
10. Do Cities Still Matter? The Economic Strength of Cities and the Economic Failure of Globalism in Promoting Regional Technological Innovation and Economic Prosperity, The Private Capital Market, April 20, 2013
11. Creating the Private Capital Market Infrastructure for Sustainable Innovation Economics, The Private Capital Market, October 2, 2008
12. Bootstrapping Capital for Regional Innovation Economic Growth: New Regional Securities Markets, The Private Capital Market, September 5, 2008
13. The Real Economic Danger in the N. C. Dell Deal Gone Bad, The Civitas Institute, October 13, 2009
14. Why Does Economic Growth Occur in Some Cities and Not Others? The Importance of Small Amounts of Capital for Small Businesses Innovation, The Private Capital Market, February 4, 2010
15. Why Exits Matter for Future Innovation Investments, The Private Capital Market, Private Capital Market Working Paper No. 08-10-01, May 9, 2008

Thomas Vass is the owner and manager of The Private Capital Market, Inc., a Reg D fee-based subscription crowdfunding website. Much of the analysis of this article is based upon his economic research and theory of technology, contained in Predicting Technology (2007). For more of his scholarly papers, click here.

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