Why Wisconsin shouldn’t spend $100 million in taxpayer money to invest in private enterprise

By Andrew Hanson for the Badger Institute

The Evers administration has proposed a $100 million public venture capital fund in the state budget. The Republican-controlled Legislature, which jettisoned 400 items from the governor’s budget proposal, left this one intact. Both parties should reconsider since this idea is at best a dubious risk for taxpayers and at worst a bastion for political favoritism.

The idea is to have state government, specifically an oversight board established by the Wisconsin Economic Development Corp. (WEDC), distribute funds to new businesses that have also secured funds from a private source. In the proposal, the state would not allocate funds directly to businesses. Instead, it would allocate funds to an advisory board that would allocate to a sub-fund, which then would allocate money to businesses.

For those unfamiliar with how venture capital funding typically works, think of the reality television show “Shark Tank” — big money investors looking to partner with and advise small start-ups in need of cash in the hope of growing the business and making profits.

Venture capital works because it is a risk-reward proposition for both the investor and the small business. The investor seeks a return on capital and uses industry knowledge and skill to choose the best place to employ that capital. Investors necessarily think this through carefully. If the business they invest in is not profitable, they could lose their entire investment.

The small business owners are equally careful. They are giving up a share of potentially lucrative profits and want to be sure they will be sharing their business with a skilled partner.

There are numerous examples in which venture capitalists chose poor investments or the partnership didn’t work. Former companies such as Webvan, Pets.com and Procket Networks represent some of the worst venture capital investments of the 21 st century, having lost hundreds of millions of dollars for their investors before either going bankrupt or being acquired by other companies for bargain prices.

Such failures are not surprising. There are hidden problems within companies; ideas that sound great might not be ready for public consumption; markets change; competition enters and evolves. Even the smartest investors cannot predict the future with infallible accuracy. But along with the spectacular failures are resounding successes — companies such as WhatsAppFacebook and Groupon have made their initial venture capital investors billions of dollars in recent years. Many have results somewhere in between. But even incredibly smart, experienced, savvy investors risking their own money (and sometimes their careers) do not have anything close to a perfect record.

This begs the question: Why would we expect state government to do better?

To start, the state has no real experience or expertise in making such choices, and what experience it does have has brought dubious results at best. The state has used taxpayer dollars to attract established businesses to Wisconsin, with the primary recent example being Foxconn.

While a final verdict isn’t in on the state’s deal with the Taiwanese electronics manufacturer, the recent tenfold downgrade in estimated jobs at the Mount Pleasant facility (thankfully with an accompanying reduction in subsidy) certainly offers a clue. In the past four years, while the Foxconn project shifted, we can imagine how many private investments were changed, delayed or canceled as the news cycle about this behemoth was in constant flux.

It seems safe to say that most folks were hoping for better. And that is just the thing — state governments rarely get it right when putting together incentives for large, established businesses. Why then should we believe this gives states any advantage in choosing which small start-ups, with no track record to examine, to fund?

The Evers administration venture capital proposal calls for a WEDC oversight board to facilitate the new funds, presumably to inject some business expertise into the investment process. But the board surely would be chosen by politicians, not venture capital experts. The board would be tasked with the selfless work of making the best investment choices for the state, but without having their own skin in the game, can we really expect that to happen?

With no private gains accruing to board members for their work, and all losses being absorbed by the public, the incentives are not aligned to produce the best decision. If we see such catastrophic venture capital failures when the incentives are aligned, what should we expect these investments to look like when they are not?

The plan to have a board allocate the initial funds to several separately managed funds might provide some insulation to the incentive compatibility problem on paper, but this is really just kicking the can down the road, not solving the problem. The sub-fund managers who ultimately disburse the dollars certainly understand that state money is not the same as their own money.

On the other side of the coin, there is the real potential for conflict of interest. Board members and sub-fund managers in charge of doling out $100 million of taxpayer money might use it to curry favor with business insiders. They might choose to reward start-ups to which they are connected, that are otherwise politically connected or that would provide benefits to their own business interests. Or they might avoid funding potentially successful ideas that compete with their own business interests.

Even in the event that the WEDC board (through the sub-fund managers) chooses to fund an incredibly successful start-up and that company turns a profit, is it even possible for the government to retain an ownership stake? The proposal is not specific about what will happen in the unlikely event of success, but this highlights why state-run venture capital isn’t a good use of taxpayer funds.

Taxpayers are exposed to all of the downside risk if the start-up fails but receive none of the upside if the start-up succeeds. A simple solution might be to allow the state to retain its ownership stake, but that quickly turns problematic. There would be potential for conflicts of interest if the business finds itself bidding on state contracts. Regulators might be inclined to treat that company favorably. None of this would be fair to privately held competing businesses.

According to The Wall Street Journal, 95% of start-ups fail to meet specific revenue growth or break-even dates, 30% to 40% are forced to liquidate and lose all investor money and only 35% survive until their 10 th anniversary. Three-quarters of venture capital-backed firms never fully return their original investment, let alone a profit for their investors.

Why would we want state government taking such a risk with taxpayer dollars? The government cannot offer potential start-ups anything in terms of business advice. The state would be merely a source of “dumb money,” rather than a strategic partner.

Furthermore, the proposal calls for funding companies that already have a match of private investment dollars. Do these small businesses need taxpayer dollars to be successful if that is the case? If the answer is yes, what does it say about the types of start-ups that taxpayers will be funding? The program is likely to have a severe adverse selection problem — meaning that those who apply are exactly the type of start-ups that we do not want to invest in, which will result in even lower success rates than what is observed in the broader market.

Finally, the state already seems fairly well-positioned in the venture capital market relative to its size and recent history. According to the National Venture Capital Association, Wisconsin had over $1 billion in venture capital assets under management as of 2018 — more than Minnesota, Iowa and Indiana and similar to levels in more populous states such as Georgia, North Carolina and Ohio. Perhaps more important, venture capital assets under management in Wisconsin doubled between 2012 and 2018, while the same measure of investment was cut in half in Minnesota during that period. The private market already has answered the call for venture capital investment in Wisconsin, leaving no appropriate role for the state to intervene.

Wisconsin would do well to focus the $100 million in funds earmarked for state-run venture capital on other uses. There are many tried and true policies that would promote economic growth in the state that are less problematic and certainly less risky with taxpayer dollars. Sending a stimulus check to taxpayers, lowering marginal income tax rates or the sales tax rate, spending on education and worker training programs and even improving infrastructure are all ideas that would make better use of the funds.

Andrew Hanson is an associate professor in the Real Estate Department at the University of Illinois at Chicago and a Badger Institute visiting fellow. Reposted from the Badger Institute with permission.

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