State looks to build venture capital for high-risk startups

By Rick Haglund
Detroit Bureau

DETROIT -- If venture capital is mother's milk for young, fast-growing businesses, then Michigan firms are malnourished.

For decades, the state and much of the rest of the Midwest have been regarded as a venture-capital wasteland. The vast majority of venture funds that invest mainly in high-tech firms are concentrated on the coasts, where the most promising new companies in computers, biotech and telecommunications have typically been born.

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In the first three months of this year, Michigan ranked 21st among 37 states reporting new venture capital invested in businesses, according to a survey by PricewaterhouseCoopers, Thomson Venture Economics and the National Venture Capital Association.

But Gov. Jennifer Granholm's administration, lawmakers and a new state association of venture capitalists are working to pump up the flow of venture capital, which they say will help entrepreneurs create much-needed businesses and jobs in the state.

"Michigan is No. 2 in the nation for (the amount spent on) industrial research and development," Granholm said at a recent venture capital conference in Ann Arbor. "Research and development has led to an explosion of commercialization opportunities and launching pads for smart new companies."

Granholm says Michigan will direct some of its pension fund money to venture capitalists who invest in those smart Michigan companies. Other states are also using pension fund money for that purpose.

The proposed legislation, which has the early backing of the Granholm administration, would create a $150 million venture capital fund by offering fund investors tax credits to guarantee a certain annual rate of return, probably about 6 percent. The tax credits wouldn't kick in for five years.

Targeted investors for the fund, called a "fund of funds," would be Michigan corporations and pension funds. The "fund of funds" would invest with Michigan-based venture capital firms, which would provide "early-stage" capital to growing Michigan companies.

An early-stage company is one that typically has less than $15 million in annual revenue.

These efforts come at a time when Michigan's economy is shifting from heavy manufacturing to services and new technologies.

Such businesses, including computer software firms, factory automation equipment manufacturers and pharmaceutical companies, typically rely on venture capital to finance expansion because banks and other lending institutions regard them as too risky. The development of fuel cell technology, which promises to reinvent the automobile, could also benefit from venture capital.

Many promising young Michigan companies either can't find financing here, or they move to California, Massachusetts and other states where venture capital is more plentiful, experts say. Michigan lags those states due to its conservative financial climate and proliferation of large companies that don't depend on venture capital.

"If you're a young company, you go where the money is," said Dick Eidswick, a principal in Arbor Partners, an Ann Arbor-based venture capital firm. Eidswick also is the president of the recently formed Michigan Venture Capital Association, which developed the concept for the new state-backed venture capital fund.

As a result of a changing economy, Michigan's economic development efforts must shift away from attracting factories and other bricks-and-mortar projects, says state Treasurer Jay Rising.

Increasingly, he says, the state must help entrepreneurs create businesses out of research that's been done at the state's universities and major corporations.

"We need to develop a new type of economic development (model)," Rising said. "We need to pull and push technologies out of our research universities."

Access to more venture capital could help entrepreneurs develop products from patents sitting on the shelf of major Michigan companies, including Delphi Corp., he says. Companies often are willing to sell or give away patents they hold but don't have the resources to commercialize into new products.

Rising says the state's proposed venture capital fund could also attract more venture capital companies to Michigan.

Free-market proponents say the state's efforts will distort the market, encouraging venture capitalists to invest in Michigan companies they otherwise wouldn't consider.

Michael LaFaive, director of fiscal policy at the Mackinac Center for Public Policy in Midland, says he's particularly concerned about the state offering tax credits to lure investors to the new venture capital fund.

"What we have here is essentially an unbudgeted liability because we can't anticipate the losses that could occur," LaFaive said.

Supporters of the state-backed fund say big losses are unlikely. Oklahoma, which has had a similar program for 10 years, hasn't had to hand out any tax credits to make good on its guarantee, according to Jason Burr, an Ann Arbor venture capitalist who has studied the Oklahoma fund. Burr is treasurer of the Michigan Venture Capital Association.

If state-backed funds don't meet their guaranteed rate of return, the state must make up the difference in tax credits.

Utilizing a two-decades old state law, Rising says he will also use the state's $43 billion employee pension fund as a lever to attract more venture capital to Michigan.

That's a big shift in philosophy from the Engler administration, which invested mainly in non-Michigan venture capital funds to try to get the biggest financial returns for the pension fund.

Michigan entrepreneurs and venture capitalists complained that the approach often resulted in out-of-state venture capitalists financing Michigan start-up companies and moving them out of the state as they began to achieve success.

"I don't think they had a Michigan-centric mission," Rising said about his predecessors in the Engler administration.

State law allows the Treasury Department to invest up to 5 percent of state pension fund assets in venture capital.

Rising says he's promising more of the state's pension fund business to private fund managers who agree to invest in Michigan venture capital firms and Michigan companies.

Granholm has said she's only asking private fund managers to consider favoring Michigan firms if the potential returns are similar to those of out-of-state firms.

And Rising says he will not invest state pension funds directly with Michigan companies, as he did occasionally while serving as deputy state treasurer under former Gov. James Blanchard.

"It's not an efficient way to do it," he said.

State pension fund money will only be invested with venture capital firms, Rising says.

Several high-profile, direct-investment failures, including a Pontiac company that manufactured fuel-efficient motor homes, provided Engler with powerful political ammunition to help defeat Blanchard in 1990.

Rising also is working with lawmakers and the Michigan Venture Capital Association to establish the "fund of funds."

State Sen. Mike Bishop, R-Rochester, says he may introduce legislation to establish the fund as early as this summer.

Bishop said the fund could play a major role in helping to commercialize new technologies the state has been promoting, including fuel cells and other alternative power sources, he says.

Michigan is attempting to become the major center for automotive fuel cells through its $50 million NextEnergy initiative. Some auto industry leaders say the fuel cell could largely replace the internal combustion engine over the next 25 years.

"We should be the ones who are leading that charge," Bishop said.

Contact Rick Haglund at (248) 540-7311 or e-mail him at