NC State Innovation Incentives and Startups

A recent article on reports on Governor McCrory pitching funding for innovators…or rather that “North Carolina should invest more in turning the innovations developed at the state’s public and private universities into marketable products.”

The article continues with Governor McCrory’s comments to the UNC Board of Governors, where he says that his aim was to turn the Research Triangle area into an innovation center that rivals Boston and Silicon Valley. One of these ways he says is figuring out ways to turn research dollars coming into the state into products.

I don’t believe that incentives to “lure established companies” to North Carolina, or pouring more dollars into University driven research is the best way to go here and won’t have the kind of impact on job growth that other approaches might have.

Before I get to that, I should mention that last year North Carolina ended tax incentives for film production in the State, replacing it with a limited grant program, effectively nerfing it. Showtime’s Homeland moves to South Africa (filmed in Charlotte and Wilmington), and it looks like Fox’s Sleepy Hollow is on its way to Atlanta if the series is renewed for a third season (filmed in Wilmington and New Bern).

Also repealed last year was North Carolina’s Qualified Business Venture (QBV) program, which basically afforded accredited investors up to a 25% tax credit on investments in startups with QBV status. This program was instrumental in very early fund-raising efforts for several startups I have been involved in over the years, and I know it has helped many others get off the ground as well.

I think that North Carolina needs to change its approach and focus more on helping startups. Here is how:

1)      Renew the QBV program. ASAP. I’d use this as an opportunity to engage with well-known and active investors in NC as well as entrepreneurs that have had experience with the program to evaluate how it has worked in the past, and look for a few ways to improve it.

2)      Pass legislation for crowd funding. Note that a bill for this was defeated last year (it was linked to some other tax-capping bill) and a new bill is now on the table. 

3)      Reinstate the film tax credit (and improve it to make it competitive with other states in the region). I think we had a good thing going and bringing a lot of talent and jobs to NC from this, and I hate to see it leave for greener pastures.

4)      Matching Funds Grant...One of Governor McCrory’s steps listed in the article that was targeted at growing new NC companies was investing $120M in new venture capital companies. In this case, these new venture funds would need to raise at least at least $2 for every $1 of state money invested.

This sounds good in theory, but I think that it would be better served to take that $120M and use it as grant funding directly to startups as sort of a matching-fund model. Keeping with the 2:1 ratio, a startup that raises $200k could get an additional $100k in a grant from NC. I would maybe cap it at a total of $500k. In this case, it would limit the funding to go towards early stage startups, supplementing funding from angel investors, incubators, or early stage angel networks.  I think this would also attract out of state capital, primarily from private angel investors, or established early stage venture funds that have had North Carolina on their radar but have chosen not to open an office here.

If I can sidebar for a moment, the venture funding ecosystem here in North Carolina is somewhat broken and fractured in my opinion. It is extremely difficult finding initial capital (commonly referred to the friends and family stage) and very difficult finding seed stage capital. There are sources here for both, but more often than not the startup is expected to have a product, customers, revenue, and at the starting point of scale. This is more appropriate in my opinion for startups going after their first full round of funding (Series A), but the tendency here is to want to do smaller investments at low valuations (the sweet spot seems to be a few hundred k at a pre-money valuation of under $1M) for companies that are at the stage of growth.

There is a fantastic infographic on why startups fail (from the Startup Genome) here.  In my experience, and the same goes for a good number of my friends and colleagues, is that NC early stage funding sources want to invest in startups that are at in the third activity stage of “efficiency” (that is, refining the business model, improving customer acquisition, and scaling), but treating it like other regions (i.e. Silicon Valley) would treat a startup in the first or second stage (“discovery” and “validation” respectively).

You would be amazed at how many times I have been asked (and others) to provide five year financials for a software startup that is still in the prototype/seeking customer validation stage. Anyway, take a look at that infographic. Good stuff there.

Getting back to #4, I think the secret to competing with Silicon Valley, Boston, New York, Austin, and several other hotspots of startup activity and innovation, is a focus on making it easier for startups to attract and find that very very early stage funding. If NC adopts the stance of investing (through grants) directly to startups that are already getting vetted by sophisticated angel investors, tech incubators, or other funding sources, the funding will have an immediate impact, and we should see a flurry of new startups, and new capital being invested. I would also predict new capital coming to the State to take advantage of this and effectively leverage the State dollars.

Other advantages to this approach would be minimal government involvement in determining where this grant funding would go. One of the other McCrory steps would be a $10M per year program to “help start-up companies transition from concept to marketable product”. How exactly are those companies going to be selected? Will there be an onerous application process with rewards throughout the year? How much could a company get? $25k? $50k? $500k? How much exactly does it take to transition from “concept” to “marketable product”? I have an idea for a rubber spoon. I can make it marketable by making it come coated in candy flavors and for sale at $1.00. That doesn’t mean it will be a successful product (anything can become marketable in my opinion). Wouldn’t it be better to have a simple process where the market (investors, early customers, etc.) validate the idea and demand by their investment dollars? This is why I think matching funds works much better…if a startup can’t get a prototype or proof of concept developed and attract some capital, making their concept “marketable” isn’t going to do much other than waste dollars.

Moving on…

5)      Eliminate the State Capital Gains Tax: Other steps mentioned by Governor McCrory are a) eliminating North Carolina’s capital gains tax rate for “innovation-related companies” and b) taking steps to lure North Carolina natives “involved in innovation” back to the state.

Well, I’m not sure how you would quantify “innovation-related” or “involved in innovation”, but I do believe that there are more opportunities and more available capital outside of North Carolina, especially for startups. You can graduate, create a startup, and struggle to find $100k-$200k, or you can move to San Jose and spend less effort to find ten times the capital, plus be in an environment that is vibrant, vigorous, and culturally driven by innovation and startups.

Yes, dear readers, I’ve had people on the West Coast tell me I am an idiot for staying in North Carolina. That happened to me more than once, and one of those occasions was in the office of a venture capital fund in Menlo Park.

But North Carolina has so much fertile ground. Everything is here, and the State is awesome. How many times have you heard about cities in NC ranking in the Top Ten, Top Five, or Number One places to live in America? We have great cities, great Universities, great companies (big ones too!), and great beer. What we don’t have, is a great system for cultivating innovation and the early stage funding necessary to go from Napkin to MVP or an early launch with those valuable first customers.

The NC legislature has the opportunity to do some pretty amazing things and put NC up in front. We can’t just do little things here and there. If you want to play with the big boys (Silicon Valley, New York, Boston, etc.) you have to be aggressive. Yes, there is a dollar cost to all of this, and startups are always a very risky proposition. But if you want to light a bonfire of innovation, job growth, excitement, and draw in talent and even more capital, we need to fix the funding ecosystem in the State.

In summary…reinstate the QBV program, bring back the film tax credit incentives, improve both, create a grant fund that matches investment dollars (a 2:1 ratio with a cap sounds good), approve crowd funding legislation, eliminate the capital gains tax, and maybe create another incentive for startups to collaborate with Universities and their tech-transfer programs.

This will result in more startups, more activity, more capital flowing, more jobs, and an accelerated rate of new products and ideas getting to market.

One side note: I think a lot of people associate startups mostly with tech startups in the mobile, consumer and app spaces. When I say startups in this article, I mean any startup (software, hardware, bio, textile, energy, whatever) in any sector, but generally with some type of technology or innovation. This excludes new businesses…like a restaurant or a company that develops web sites.

If you are a startup founder, please email me directly with your experiences raising early stage capital in (and out of) North Carolina. I’d also like to hear from you if you were able to leverage the QBV program (or if this is the first time you are hearing of it).

If you are a member of the NC Legislature, I would strongly suggest that you reach out to startup founders in North Carolina (call me!). We have lots of ideas, and we know how to make them reality. It is what we do. Innovation is brightest and fastest in startups…and much slower in large companies and universities. Innovation is life or death for a startupyou don’t get that kind of motivation elsewhere. Talk to us.

Thank you for reading.

PS: I wasn't joking about the beer in NC

Header image of NC Legislative Building Source: Wikimedia Commons, JMTurner Photographer