Can state and local governments sow the seed?

Entrepreneurs and small business owners nationwide are feeling the effects of a lack of early-stage (or seed) business funding. The gap for seed funding in Northeast Ohio alone is about $50 million annually, according to an oft-cited 2005 NorTech report.

This means that entrepreneurs may have increasing difficulty in finding necessary money to finish developing and testing products, obtain patents and certifications, prototype commercial products, conduct market testing, hire critical staff and services, purchase capital equipment, and build-out facilities.

Angel investors and venture capital firms rarely invest in very early-stage companies, because investments are too risky. However, state and county governments are coming to the aid of entrepreneurs, implementing investment, grant and low-interest loan programs using both governmental and private contributions.

In response to a study, which showed that less than 2 percent of Indiana investment went to seed funding, the state created its own fund to take equity in and provide oversight to emerging companies while offering investments of $50,000 to $500,000.

The Michigan Pre-Seed Capital Fund, founded in February 2007, has screened 58 technology-based companies in the past 10 months, investing $4 million in 18 of the applicants. According to the fund's website, sponsored companies have attracted $6.5 million in matching funds and retained 87 jobs thus far.

Northeast Ohio counties, including Lorain and Cuyahoga, have also started innovation and small business development funds. The Innovation Fund of the Lorain County Community College Foundation offers technology and business validation grants of up to $100,000 to companies throughout the region. In the first round of funding, Innovation Fund committee members reviewed 15 applications, recommending three for funding.

In addition to a Commercial Redevelopment Fund that supports companies in renovating abandoned or underutilized commercial space, Cuyahoga County's New Product Development and Entrepreneurship Loan Fund offers $10,000 to $100,000 loans to county manufacturing companies on a seven-year repayment schedule. In operation since 2004, the new product fund has awarded $2 million of its $3.3 million budget, approved funding for 75 of its 450 applicants, created 117 jobs, and attracted $12.5 million in follow-on funding.

However, most counties are struggling to find ways to provide this kind of support. Investing public money in for-profit companies is a tricky business. If it works, the officials are heroes. But it is unlikely to provide high returns, which can hurt politicians who need to justify their actions to get re-elected.

What does an Angel look like?

Angel investors are affluent individuals who offer money to start-up companies in exchange for equity, repayment with interest or the option to buy stock later at a reduced rate. Unlike venture capitalists who manage the pooled money of others, angels generally invest their own funds. Angel groups, which typically have about 50 members offer a social network for individual investors, holding regular events at which carefully screened companies give presentations and request money.

From the Angel Capital Association’s 2008 Angel Group Confidence Report, here are some enlightening statistics on the nature of nationwide angel investment:

• Angel groups invest early with 82 percent saying they invest in seed and start-up companies and 85 percent investing in early stage companies. Only 45 percent invest in expanding or later stage companies.
• The average angel group invested a total of $1.9 million in 4.5 new companies and 3 existing portfolio companies in 2007. They invested an average of $150,000 per funding round.
• Angels invest alone, as 77 percent of groups allow individuals to choose whether they will invest.
• Angels put money in hot industries. Software, medical devices and equipment, business products and services, industrial and energy, IT services, and biotechnology were among the most invested in industries with more than 50 percent of groups saying they have an interest in each category.
• Community counts for angels with nearly 30 percent saying they prefer to invest within two hours of their metro area.
• Angel groups are picky. The average angel group screened fewer than 180 companies and presented fewer than 20 for investment in 2007.
• Angel investing is a tough bet. Only ¼ of angel groups had at least one investment that exited through a merger, acquisition, initial public offering (IPO) or positive exit in 2007.
• Angel groups are growing. Sixty-eight percent of responding angel groups were formed since 2002 and almost 50 percent said they grew slightly or significantly in number of participating accredited investors. Only 13 percent said their membership decreased.
• Things are looking up for angel investors. About 45 percent of angel groups said that both quantity and quality of applying companies increased. Responding angel groups also said that they expect to see continued increases in number of investments and total dollars invested (55 percent), quantity and quality of presenting companies (48 percent), and number of individual member investors (36 percent).
• Big money-makers are unlikely. More than 60 percent of angel groups think that fewer than 5 percent of their investments will exit in 2008.
• Angels are all around. The Midwest leads North American regions in number of angel groups with 24 percent of respondents located there. Other high concentration areas include California (18 percent), the Northeast (17 percent) and the Southeast (15 percent).

See the full report on the Angel Capital Association’s website.

The Big Idea

While flipping through TV channels the other evening, I watched a program called "The Big Idea," yet another media vehicle propagating the idea that someone can make millions off of an idea alone. (Billy Bob Teeth and Worm Poop Spray Fertilizer come to mind as examples.) The behind the scenes work of raising money to develop, test, refine, pilot produce and test market a product to make it into something an investor will financially support was ignored altogether. The show also failed to point out the trade-off of equity in the company for that investment.

The reality is that investment in an idea is extraordinarily rare. Investors, licensees and big business are unlikely to throw millions at a thought (or even a patent) that has not been developed into a product or service, much less a viable business. Even if products "work" in a laboratory, this is no promise of commercial success. After all, if an inventor won't create a commercial product from his idea, who would?

For an idea or patent to truly have value, it must be developed, proven and introduced to the market. It can take millions in development and market testing before an idea is worth investing in. The media generally glosses over the outside funding process, where inventors often must pitch their product, give up part of their company and subject themselves to stringent benchmarking schedules to secure funding from investors expecting high returns through the sale of the company within five years of investment.

Realistically, a big idea needs to be a bit more comprehensive, a bit more complete, a bit well … bigger than a fleeting notion on a piece of paper. Big ideas must have as components plans for commercialization of products, business creation and securing funding. Entrepreneurs pursuing big ideas should work through a plan with milestones to focus their efforts, as well as the realistic understanding that they might need lots of their own money to get an idea off the ground.

Tune in next week. We'll be gunning for Oprah. I hear she's giving big.