News Column

Is startup investing too risky for Texas taxpayers?

February 2, 2014

By Laylan Copelin and Lori Hawkins, Austin American-Statesman

Feb. 02--Two promising Central Texas technology companies -- boosted with taxpayer money from the state's Emerging Technology Fund -- have fallen on hard times, reigniting a debate over whether taxpayers' money should be invested in risky startups.

Xtreme Power Inc., a 10-year-old energy storage company that got $2 million from the state fund in 2007, is in Chapter 11 bankruptcy. Calxeda Inc., which pioneered low-power servers with a $1 million state investment in 2009, has essentially shut down its operations. Both have laid off most of their employees while the companies try to restructure and rebound.

State officials say they aren't surprised. Investing in startups, by all accounts, is a risky business. Using public money only adds scrutiny and second-guessing. But defenders of the tech fund offer a counterintuitive argument: that taxpayers win even when they lose.

"I'm not surprised that any of the companies that aren't profitable run into trouble," said Terry Chase Hazell, who runs the tech fund for Gov. Rick Perry. "You would like for someone to go from zero to fantastic without ever taking two steps back. But it's not unusual for growth companies to take a step back -- sometimes more than once."

Some Texas officials don't buy that argument. Three Republican candidates for lieutenant governor -- Agriculture Commissioner Todd Staples, Land Commissioner Jerry Patterson and state Sen. Dan Patrick -- say they want the state to phase out the emerging tech fund.

"It appears the government is in the business of picking winners and losers," Staples said. "It infuriates voters."

Even Lt. Gov. David Dewhurst and House Speaker Joe Straus, who with Perry make the awards, say they are rethinking how the state should be involved in incentives for technology startups.

Weighing the return

At Perry's urging, the Legislature in 2005 created the emerging tech fund to expand and diversify the Texas economy by assisting fledgling startups and encouraging commercialization of university research.

Since 2005, the state tech fund has awarded $200 million to 142 companies -- with more than 25 percent of that money going to Austin-area firms. Although the tech fund has had failures before, none were quite like Xtreme Power and Calxeda.

The two companies frequently topped the list in the number of jobs created by state tech fund investments. In 2013, they accounted for 10 percent of the 1,661 jobs reported by the state fund. In some years, it was twice that percentage.

The governor's office also touted both companies in its reports on their respective industries.

Outside investment followed.

In 2009 Michigan outbid Texas with $200 million in incentives for Xtreme Power to locate a manufacturing plant that officials said would employ 2,500. Although that deal later fell through, Xtreme Power still had customers from Hawaii to Detroit to West Texas.

Duke Energy matched the federal government's $22 million grant for Xtreme Power to create the first large battery storage system in connection with a wind farm near the West Texas town of Notrees.

Likewise, Calxeda over the years attracted $100 million in private investment, including money from Austin Ventures and Silicon Valley'sBattery Ventures, but it also was attracting heavyweight competitors.

Intel Corp., Texas Instruments, Qualcomm and Samsung, among others, joined the competition.

In December, Calxeda's investors flinched, deciding not to write more checks.

In a similar vein, Xtreme Power's cash-flow problem was the result of too much competition in a market that wasn't growing fast enough.

Chase Hazell, who reviews the companies' quarterly financial reports submitted to the governor's office, said she could see the problems coming. She said there is always risk when companies must rely on raising capital for operations as opposed to having a healthy cash flow and profits.

On Friday, the governor's office filed its annual report about the tech fund as required by the Legislature. It is a snapshot of the health of the overall fund as of August 31. The statistics don't include the fallout from Xtreme Power and Calxeda.

Overall, the tech fund has awarded almost $425 million since 2005 -- $200 million of that going to 142 companies. The bulk of the remaining millions has been grants to promote university research or commercialization.

Of the 142 companies receiving taxpayer investments, nine have been purchased or had other successful exits from the tech program while 18 have ceased operations, often failing to repay the state. The jury is out on the others. Nationally, about 40 percent of venture-backed companies fail, 40 percent return moderate amounts of capital, and 20 percent or fewer produce high returns, according to the National Venture Capital Association.

The tech fund's annual report shows that the value of the state's investment in companies -- at least on paper -- has grown almost $30 million.

Some legislators had envisioned the tech fund becoming a revolving, self-funded account, but so far the investments have returned less than $40 million of the $200 million that has been awarded.

One reason is because the state has an investment timeline of seven to 10 years. Many of the fund's companies are nowhere near the end of that timeline or near a successful exit that would replenish the fund.

The state doesn't disclose whether the companies are profitable, but Chase Hazell said many firms are making money with innovative products.

The tech fund's investments in companies slowed dramatically in fiscal 2013 with only five new business ventures. That was in part because the governor's office was trying to persuade the Legislature to replenish the fund. Also, the state has toughened the application process and, in recent years, awarded 75 percent of its money to universities where officials hope to encourage commercialization of research.

But Chase Hazell said there will always be a need to invest in companies because they are best at turning university research into innovative products.

"Only companies can deliver products to market," she said. "Universities are not set up to do that."

The political debate

Against that backdrop, politics has affected the tech fund's past and will determine its future.

Under the current structure, Perry, Dewhurst and Straus appoint 17 business advisers who recommend which companies to fund. The elected officials, however, make the final awards.

Investing public money in private companies can become controversial in GOP primaries where there is a tension between business interests that favor economic incentives and libertarians or Tea Party loyalists who question the government's involvement.

All three of Dewhurst's GOP opponents -- Staples, Patterson and Patrick -- say they'd prefer to phase out the emerging tech fund.

Patterson said he sees a difference between giving tax breaks to companies versus giving cash. Staples prefers to phase out the state business tax. Patrick is targeting property taxes.

"Instead of giving special deals to individual companies," Patrick said, "I want us to deal with the underlying problem of high property taxes."

As the incumbent, Dewhurst was lieutenant governor at the creation of the tech fund and has approved the awards. But he is now distancing himself from that effort.

In a written statement, Dewhurst noted that he ordered an audit of the tech fund in 2010 that led to more transparency on the companies' performance and "the way the fund is managed by the governor's economic development team."

Dewhurst also called for the same periodic review of the state's incentive programs that state agencies undergo. "As a career businessman and fiscal conservative, I maintain a healthy skepticism on any program that utilizes our citizens' tax dollars, including the Emerging Technology Fund," Dewhurst said.

Straus also has instructed the Legislature to study how to improve Texas' ability to attract venture capital before legislators return next year.

"I expect these committees to take a thorough look at the Emerging Technology Fund and other programs before recommending how to improve them moving forward -- or whether they should move forward at all," Straus said.

State Attorney General Greg Abbott, a Republican who is running for governor, has expressed doubts about government picking winners and losers, but he didn't respond to a request for comment on the emerging tech fund.

State Rep. John Davis, R-Houston, tried unsuccessfully last year to remove the governor, lieutenant governor and speaker from the investment process to eliminate the appearance of politics in the decisions. He also wanted a professional investment manager.

Dewhurst killed the bill after it passed the House, but the Legislature appropriated $50 million to continue the tech fund.

Still, Davis is a defender of the tech fund.

"No one likes to see people shut down or run out of funding," Davis said. "We understand it's high risk. But I think it's worth it because of the synergy it creates with other venture capital money."

Benjamin Powell, director of the Free Market Institute at Texas Tech University, said state government shouldn't be in the business of investing in companies.

"If these businesses were good bets they should be able to attract private capital," he said. "The venture capitalists who have money are the ones who have a track record of picking the winners. There's no such sorting mechanism for state bureaucrats using other people's money."

"In the cases where private markets wouldn't fund them, that's a signal that the expected return is negative, and that the government shouldn't do it either," Powell said. "Why do we think government investment planners are smarter than the competitive market?"

But economist Bernard Weinstein at Southern Methodist University'sCox School of Business said the money that state has invested in early-stage companies played an important role during the economic downturn.

"Having access to ETF money may have been helpful to a number of small startup companies during the great recession and slow economic recovery when there just wasn't much venture capital available," Weinstein said.

"It's a nice thing for the governor to have in his economic development tool kit when he's out selling Texas," Weinstein said. "It's a risky business, but I think as long as the level of state funding is small, I don't have any concerns."

Barry Evans, Calxeda's CEO, said the $1 million investment from Texas taxpayers was crucial.

"We wouldn't have gotten off the ground without it," he said.

Whether or not Calxeda is resurrected, Evans said, taxpayers got a healthy return on their investment.

He said much of Calxeda's $100 million in private investment was spent in Texas. He said Calxeda spent $62 million, including $42.4 million in salaries and benefits, in Texas and paid $1.24 million in sales taxes.

Analyst Patrick Moorhead, president of Moor Insights & Strategy in Austin, said Calxeda's low-power chips helped at least three local companies, including Dell Inc., in their server business and spurred competition in the creation of low-power chips for servers.

"Unfortunately, they had to shut down," Moorhead said, "but they inspired innovation."

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Why it matters

Central Texas is one of the biggest beneficiaries of the Texas Emerging Technology Fund. Almost $53 million has been awarded to 34 Austin-area companies involved in biotechnology, energy, advanced manufacturing and computers. Millions more have gone to the University of Texas at Austin and Texas State University in San Marcos to support research and the commercialization of research.

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(c)2014 Austin American-Statesman, Texas

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Source: Austin American-Statesman (TX)


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