business

One strategy suggested for Minnesota's growth is to give tax breaks to investors to encourage more venture development. Is this needed and is it wise?

Do you really need venture capital (VC) to create ventures?

In the 1970s, Minnesota was one of the top VC centers in the country. Now, we have about a 1 percent market share. To thrive, a VC industry needs hugely successful ventures. We have not had many of those lately. So if investors can develop great new ventures in Minnesota and keep the jobs and benefits here, they have a strong case.

Of the 28 entrepreneurs in my book, "Bootstrap to Billions: Proven Rules from Entrepreneurs who Built Great Companies from Scratch," none got venture capital at the start of their first venture, and 80 percent never used such capital. It is possible to bootstrap and build great companies without VC.

And what return can angel investors expect?

Very few venture capital funds do well. Venture capitalists seek annual returns exceeding 20 percent to compensate for the risk. The average annual return of 17.3 percent in the 20-year periods ending in 1999 and 2005 were below VC targets despite being helped by the 1990s tech boom, one of the biggest bubbles in stock market history. There is also a huge variation in the returns as shown by the following studies.

• According to the Small Business Administration, four participating Small Business Investment Companies out of 184 (2 percent) accounted for 50 percent of profits of the entire group and eight (4 percent) accounted for 75 percent.

• Four percent of 1,200 VC firms accounted for 66 percent of market value from initial public offerings between 1997 and 2001, according to Business Week.

• According to Focus Ventures and Thomson Venture Economics, annual returns over 20 years for 904 venture capital funds showed that the overall weighted average was 10 percent while the average for the bottom three quartiles was 5.4 percent. Only the top quartile had an attractive annual return of 32 percent.

Why this huge variation in returns?

These results point to a hierarchy of venture capital firms where a few (about 4 percent) account for nearly all the profits. Why? VC returns depends on the proportion of ventures in their portfolio that are extremely successful ("home runs") or moderately successful or failures. VCs with more home-run ventures, all other things being equal, have higher returns.

Yet only a few ventures are home runs. Conventional wisdom in the venture capital industry holds that 20 percent are total write-offs, 20 percent are losers, 40 percent are in the middle and 20 percent are winners. Of the 20 percent of start-ups in the winners category, only two are said to be home runs.

According to author Gary Hamel, who wrote "Bringing Silicon Valley Inside" for the Harvard Business Review in 1999, out of 10 venture capital investments "five will be total write-offs, three will be modest successes, one will double the initial investment, and one will return 50 to 100 times the investment."

To do well, venture funds need home runs like Google, eBay and Intel. According to an industry rule of thumb, 2 percent of their investments are likely to become home runs. Between 1995 and 2004, the average annual number of venture-financed deals was about 3,745 deals, according to the Pricewaterhouse Coopers / Venture Economics/ NVCA Money Tree Survey. Two percent is about 75.

How many of these are likely in Minnesota?

Most of the home runs seem to be concentrated in California, as are most of the initial public offerings. Six states -- California, Florida, Illinois, Massachusetts, New York and Texas -- had 56 percent of the U.S. total. California alone had 21 percent. Most of the home runs have been in Silicon Valley.

All the evidence suggests that angel investors, who often make investment before venture capital funds, can only get a low risk-adjusted return. So let's encourage them if they want to take a risk and give them a tax break. But let's give it only if Minnesota benefits.

Even when investors do well, the area may not benefit. Successful ventures usually grow slowly at the start and faster after gaining market acceptance. Most jobs are not created until later. For the area to benefit, the venture needs to be in the area.

But angel and venture capital investors want to exit at some point. Usually that occurs through an initial public offering or a strategic sale to corporate buyers. Either of those outcomes may result in the company moving the venture out of the state, as happened with Minute Clinic. So Minnesota is not harvesting the fruits from Minute Clinic, although the investors may have done well. Tax benefits should be provided to investors to keep the jobs in Minnesota. Otherwise, what is the benefit for Minnesota?