Should state invest in startups?

NEW IDEAS: Amir Ata Ghofrani, co-founder and CEO of Quitbit, at a Betaspring open house last October. / PBN FILE PHOTO/TRACY JENKINS
NEW IDEAS: Amir Ata Ghofrani, co-founder and CEO of Quitbit, at a Betaspring open house last October. / PBN FILE PHOTO/TRACY JENKINS

With a relaxed, tech-sector optimism, Betaspring has come to embody the Providence startup scene at a time when Rhode Island is searching for an entrepreneurial antidote to the failure of 38 Studios LLC.
At its loft-style offices on Chestnut Street in a former factory, politicians and Web developers mingle at launch events while collaborations and networking bubble up across numerous industries. Where 38 Studios tried to realize the billion-dollar aspirations of a single video game, Betaspring nurtures the ambitions and ideas of dozens, and potentially hundreds, of smart, novice entrepreneurs.
Since the accelerator’s creation in 2009, co-founders Owen Johnson, Allan Tear and Jack Templin have raised more than $2 million from private investors and another $2 million in federal funds through a stimulus program for state-level investments in small businesses.
Tapping those federal dollars meant partnering with Rhode Island’s maligned state economic-development apparatus, which was rocked by the 38 Studios bankruptcy soon after investing in Betaspring and subsequently overhauled.
Now, nearly two-and-a-half years after the U.S. Treasury awarded Rhode Island $13.1 million from a stimulus program to help small businesses, it is investigating whether the state’s use of those funds, and its investment in Betaspring in particular, violated federal rules.
While many states have received and spent their entire allocations from the State Small Business Credit Initiative, Rhode Island has received only about one-third of its $13.1 million as a result of compliance concerns.
The investigation comes at an awkward time for Betaspring, which is nearing the end of its current investment round and is expected to begin fundraising to start a new fund by the end of this year.
And the timing could be even worse for the Slater Technology Fund, which is supposed to receive more than two-thirds of Rhode Island’s total federal award and use it to transition away from dwindling state support toward financial independence.
On a broader level, the investigation also raises new questions about the R.I. Commerce Corporation, which managed the federal money, and whether the state should be involved in startup investing at all.
Concerns about Rhode Island’s use of SSBCI funds first emerged from a state-commissioned audit of the program from Lyon Park Associates, a consultancy headed by a former U.S. Treasury compliance manager.
The Lyon Park audit concluded that Rhode Island’s Betaspring investment violated the rules of the SSBCI program because most of it ended up going to the accelerator’s operating expenses and not the startups themselves. The audit rejected the idea that accelerator services provided by Betaspring startups could count as investments. When Congress approved the SSBCI program in 2010, startup accelerators were a relatively new phenomenon and not a typical target of government small-business programs.
A February 2013 report on SSBCI venture-capital investments written by consultants listed Rhode Island as the only state in the country to use its funds in an accelerator. (The report doesn’t raise any compliance issues.)
In defending the Betaspring investment, R.I. Department of Administration Director Richard Licht argued that Lyon Park fundamentally misunderstood what an accelerator is and how the state’s program was intended to work.
While a traditional venture capitalist or private-equity firm invests cash in a young company while offering a smaller amount of advice and practical assistance, the bulk of an accelerator’s investment is the help and education designed to turn raw ideas into businesses.
Johnson said Betaspring invests between $12,000 and $20,000 in cash in each company that graduates from the accelerator (amounts depend on how many people are in the company), plus another roughly $40,000 each in services, which includes direct staff help, office space, mentoring and incorporation filing. (That doesn’t include pro-bono help to accelerator startups from more than 80 volunteer mentors from throughout the local business community or all the events Betaspring puts on each year.)
Funding for the accelerator, officially called Betaspring LLC, comes through the $4.1 million Betaspring Fund 100, which includes the $2 million in SSBCI money and $2.1 million from a group of angel and corporate investors.
The Betaspring 100 Fund takes a 6 percent stake in each company that graduates from the accelerator.
Through the SSBCI program, Rhode Island invested in the Betaspring Fund 100 as if it were a private investor, with the $2 million now comingled with the rest of the fund. In return, the state will receive a proportional stake in any future returns.
The question of whether the state’s Betaspring play is legal or not could hinge on whether accelerator services can be counted as an investment and whether the Betaspring Fund 100 can be considered separate from the accelerator. In his defense of the state’s investment, Licht said the violations identified in the report were matters of accounting, not substance, that would have been satisfied if Betaspring had given the startups cash and required them to buy accelerator services instead of taking the cash itself and providing the accelerator services.
While SSBCI does not say whether states can invest specifically in accelerators, the federal rules require specific levels of private leverage for each public investment.
One requires each SSBCI program, such as all Slater or all Betaspring investment, to in aggregate invest $1 in private money for $1 in federal money.
Another requires each individual deal to include at least 20 percent private capital.
If Betaspring can’t count services as investments, it wouldn’t comply with either rule.
The audit findings add fuel to broader philosophical questions about public investment in private, for-profit entrepreneurial ventures.
Swipely CEO Angus Davis is an investor in the Betaspring Fund 100 (as well as a Betaspring mentor) and acknowledges that he was concerned enough about the findings in the Lyon Park audit to seek more answers from the founders.
Since getting them, Davis said he is now comfortable with Betaspring’s structure and is pleased with what it is contributing to local entrepreneurship.
Still, Davis said with the amount of private capital flowing into the startup world these days, there are still questions about how much the government should be involved and, if it is, whether it’s more trouble than it’s worth for accelerators.
“Out of all the states participating, we are the only accelerator,” Davis said. “That program was set up for people like Slater, and the fact they tried to put Betaspring into it has caused big delays.”
On the other hand, Tear pointed out that unlike many SSBCI awards, which can be grants, Rhode Island’s Betaspring investment has the potential to repay the state through the equity it now has in 67 startups.
The Betaspring Fund 100 has not generated any returns yet, Johnson said, but isn’t expected to this early in the lifespan of its startups.
The 83 total companies that have graduated from Betaspring have gone on to raise $32 million in follow-on investment, Johnson said, with 16 of those startups graduating before the creation of the Betaspring Fund 100. Companies supported by the fund have raised $11.7 million in private follow-on capital. •

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  1. Here’s another question, this one regarding investment in Slater Technology Fund, but worth asking for all SSBCI investments: Should the state invest in any venture or initiative with no women or people from diverse backgrounds in leadership positions? From the website, Slater looks like business as business was done in the 1950s, before the Civil Rights Movement. Should that be legal?