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March 14, 2016

Funding growth – why equity stakes should matter for government funders

Amongst the biggest questions facing Canada’s new government with respect to funding for innovation and economic growth is how to kickstart more business growth, or scaling up. Our latest series of reports honed in on this, as has much of our work over the past couple of years.

DEEPCENTREBABI5In our September 2015 capstone report on “Accelerating Growth and Innovation” we led with a recommendation that policy must devote “greater attention and resources” towards firms possessing a high-potential for growth. While we noted that this process of targeting should be led by more specialized support organizations, the recommendation is nonetheless controversial as it implies directing a higher concentration of resources towards specific firms. Capital is certainly part of what’s needed to promote these high-growth firms. So too are far more effective immigration and talent development strategies (more on this later in the week).

Focusing in on capital and access to finance, what distinguishes the Canadian ecosystem of accelerators and incubators is the predominantly publicly-funded nature of the over 140 support organizations. The financial support that flows from these organizations, as well as the support that flows through other granting agencies and arguably through indirect support systems like SRED and IRAP, is primarily focused on non-repayable grants and interest-free loans. The result is a system that relies near exclusively on re-injections of public dollars to fund future programs and support the next iteration of clients.

While support organizations are increasingly looking to corporate sponsors/partners for hosting agreements to help fund operations, this begs a question as to why more support organizations (and granting organizations) choose not to take equity in the firms they support, in particular the more mature and/or later stage ones. Early stage examples of equity/support exchanges have, understandably, struggled under the far longer timelines to success and the far lower rates of exit and growth. However as we push towards a focus on high-growth potential firms (using data to identify them), exchanges of support for equity should be the norm where public dollars are part of the input. It’s true that governments, including both federal and provincial governments in Canada, have pumped millions into venture capital funds, however here again the gains from exit or growth accrue primarily elsewhere.

Some might argue that public funders already win when private firms do via increased taxation revenues, both personal and corporate. That’s certainly true. However an argument can also be made that upfront and high-risk grants should be compensated in the form of equity shares in order to provide a means of recouping some of its investment should a company liquidate its assets or be sold and/or moved.

One example of this type of equity-taking public behaviour is shown by the Ben Franklin Technology Partners (BFTP) headquartered in Harrisburg, Pennsylvania. It’s a publicly-funded, third-party agency that leads the State’s innovation and growth efforts. I met with several BFTP executives as part of my doctoral research on the role of the state in the economy. In my research I note, “While initial BFTP funding focused on either academic-industry partnerships or direct grants, BFTP programs have transformed from dispersing grants to a direct investment model that gives BFTP a 3 percent stake in the company being funded…The BFTPs new investment model provides the state with an ongoing stake in any long-run gains experienced by the funded company, thus providing a more direct means of substantiating the funding provided at the outset.” Fred Beste, chair of the BFTP Board for Northeastern Pennsylvania, highlights how the BFTP model developed: “in the beginning the funds were provided to portfolio companies in return for a royalty on sales … the potential return on a royalty stream was abysmal… Centres (then) gravitated to funding these companies with equity… when client companies have great success, that 2 or 3 or 4 percent of the companies we own can then be reinvested.”

Switching to an equity model is by no means a silver bullet. The data produced by the BFTP highlights impressive numbers however as a result of a lack of transparency and centralized reporting in Ontario/Canada, it’s impossible to properly compare results. That said,  as we move to focusing support on high-growth potential companies, and in taking bigger risks in doing so, we need to make sure that we don’t create a system that is reliant on ongoing if not growing insertions of public funding. Rather, while public funding is necessary to create a vibrant foundation for growth, we can’t take for granted the limits on the public purse. Building equity models alongside grant, loan and other targeted contributions can and should be part of the new Federal government’s innovation agenda and its directives to funding agencies and the support organizations public money funds.

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