how economic developers can fill the crowdfunding capital market gaps in regional innovation...

7/27/2019 How Economic Developers Can Fill The Crowdfunding Capital Market Gaps In Regional Innovation Ecosystems: Ec

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How Economic Developers Can Fill The Crowdfunding Capital Market Gaps In RegionalInnovation Ecosystems

Economic Developers Can Manage The Regional Deal Flow Pipeline

Thomas E. Vass, The Private Capital Market, Inc. A Subscription Based Crowdfunding Website

Building a Regionally-Focused Crowdfunding Strategy

The State Science & Technology Institute (SSTI) has placed the topic of crowdfunding on its to-do agenda.

SSTI is a national research consortium comprised of hundreds of regional economic development memberagencies, all of which believe that technology based economic development provides great economic and socialbenefits to metro regions in terms of job creation and increased incomes.

Since its inception in 1996, SSTI has developed a nationwide network of economic development practitionersand policymakers dedicated to promoting commercialization of science and technology. SSTI acts as a research

consultant to assist states and communities build tech-based economies by providing research on best practicesand trends in tech-based economic development.

Crowd funding advocates believe in the economic benefits of technology commercialization too, but in a moreheuristic kind of way. They know from experience that capital market investments in technology firms leads tojob growth, and assume that everyone else in the world shares this view, as self-evident.

Even though crowd funders and economic developers share the same belief about the benefits of technologycommercialization, they speak a different language about how private investments stimulate technology basedeconomic growth.

Early on in their formative years, the members of SSTI knew that technology based economic developmentconnected to private capital markets, but have been uncertain about how best to make that capital connectionwork. Economic developers are primarily economists and political professionals who do not, usually, havedirect banking or capital market work experience.

Over the years, the members of SSTI have migrated to an angel and venture capital funding model, which hastended to emphasize university technology transfer projects that seemed amenable to this type of fundingmodel.

In this approach, the very large corporations fund the university professors who conduct research, and then theprofessors hand any promising research with commercialization potential off to the university tech transfer

office. The university tech transfer office packages the research up into a commercially viable deal that venturecapital firms can fund.

Generally, the venture capitalists, after vetting the project, hand the venture back off to large corporations, andif the venture is successful, the university gets an on-going stream of royalty revenues from the universityintellectual property.

With the passage of the JOBS Act in 2012, the SSTI staff started to mull over how crowdfunding could fit intotheir regional innovation economic development business model. They like the idea of crowdfunding so muchthat they dedicated their upcoming national annual conference to exploring how all the innovation pieces fittogether.


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The SSTI September conference in Portlandis called Dynamic Innovation Ecosystems: Bringing It AllTogether, and is focused on how research, capital, workforce, and manufacturing fit together into a coherentstrategy. One of their sessions is dedicated entirely to how crowdfunding can be integrated into a regionalinnovation economic strategy.

Integrating the crowdfunding model into regional economic development strategy will require a completelydifferent method of promoting technology based economic development than the university tech transferventure capital model.

SSTI members tend to be very fond of the notion of ecosystems, and they use the term a lot to describe theirwork. As they mention on their website (www.ssti.org), a regional ecosystem provides a climate whereeconomic growth occurs organically through science, technology and innovation.

The terms organic economic growth and ecosystems are probably not yet on the radar screens of manycrowd funders, but they need to sit up and take notice. The same set of political actors who influenced thepassage of the JOBS Act, and intervened in the SEC rule-making on general public solicitation of investors forcrowdfunding, populate the universe of SSTI members, and they are a powerful political force in influencingthe future of crowdfunding.

The best way for SSTI members to fit crowdfunding into regional innovation economic policy is to promote adivision of labor between crowd funders and economic developers, so that each group specializes in what theydo best.

That would mean having economic developers, such as the members of SSTI, doing the tasks that crowdfunderscannot do themselves, in managing the regional deal flow pipeline.

Busting The Five Prevailing Myths About the Private Capital Ecosystem

The SSTI session on crowdfunding is built around the question: How can, or should, crowdfunding beintegrated into a regional capital market investment strategy?

The best place to begin the inquiry is to place crowdfunding within the bigger framework of the private capitalmarket, and then to visualize how each component of the capital market contributes to successful technologycommercialization. The main idea is to view innovation as a deal pipeline, similar in concept to an industrialsupply chain, where value gets added to a product as it winds its way to the finished goods, final demandmarket.

In the capital market deal pipeline, different forms of capital are added to a new product idea, as the idea makesits way from the back of the napkin to commercial market viability. Product design and developers like to callthis idea listening to the market, and what that means is that all along the way, capital is added to the idea asthe market whispers to the developers what features the new product needs.

The regional deal flow pipeline is much bigger than the smaller pipeline of university tech transfer deals, andthe range of capital involved in funding the regional deal flow pipeline is much bigger than just the venturecapital firms and angels who are involved in the tech transfer model. If economic developers want to integratecrowdfunding into regional economic strategy than they will need to accommodate this bigger reality, andovercome five prevalent myths about how the entire private capital market functions.

Members of SSTI would want to debunk the myths surrounding Reg D offerings before they go too far inintegrating crowdfunding into their economic development strategies
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As a way of describing the size of the bigger capital market, it is useful to examine the data provided by theU. S. Securities and Exchange Commission from its July 10, 2013 document on general public solicitation ofinvestors for Reg D Rule 506 offerings.

From the Statement at the SEC Open Meeting by Chairwoman Mary Jo White, U.S. Securities and Exchange Commission,Eliminating the Prohibition on General Solicitation and General Advertising in Certain Offerings, July 10, 2013, Washington, D. C.

Myth #1: Private capital market transactions that promote economic developmentprimarily involve venture capitalists and angels as the primary sources of capital.

Part of accommodating the bigger reality of capital markets for economic developers is to include Rule 144Aofferings into their crowdfunding strategy in order to promote a smooth transition from the Reg D part of themarket to the 144A part of the capital market.

The Reg D Rule 506 private placement market in 2012 provided about $800 billion in capital to deals, and the144A market added about $700 billion in 2012.

For comparison, the best guess of all venture capital in 2012 invested in private deals was about $26.5 billion in3,698 deals. (MoneyTree Report by PricewaterhouseCoopers LLP and the National Venture Capital Association(NVCA), based on data from Thomson Reuters).

In other words, the entire amount of VC/angel capital invested in 2012 deals was about 1.5% of the total capitalinvested in private deals, allowing for some minor statistical data issues of double counting from both sourcesof data.

The important point about this data as it relates to myth #1 about private investments in promoting technologybased economic development is that Rule 144A capital is nearly as big, and as important, as all Reg D capital,but members of SSTI generally do not have 144A offerings on their to-do agenda.


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Myth #2: There is rampant fraud in private securities offerings.

To listen to the critics of crowdfunding in the U. S. Senate debate on the JOBS Act, echoed by the formerchairwoman of the SEC in explaining her reluctance to issue crowdfunding rules, one could easily get themistaken impression that the entire private capital market is one huge snakepit of fraud.

Section 501 of the 2002 Uniform Securities Act, titled General Fraud, states that it is unlawful, inconnection with the offer, sale or purchase of a security, to employ a device, scheme or artifice todefraud; to make an untrue statement of material fact; to omit to state a material fact; or to engage in anact, practice or course of business that operates as a fraud or deceit upon another person.

As described by this cautionary note from a recent press release and report by the North American SecuritiesAdministrators Association (NASAA), Although some opposed to lifting the ban (on public solicitation) fearthat it will cause an uptick on fraudulent offerings, it is widely believed that the lifting of the ban is worth therisk, given the opportunity for start-ups, among other issuers, to reach a much-needed public audience for theirofferings.

They continue, So, the JOBS Act provisions related to crowdfunding, a much publicized method for startupsseeking capital, are not yet available and will not be until sometime in 2013 to legitimate businesses. Evenwhen the relaxed rules and registration exemptions are effective, they will not make investments in smallbusinesses less risky just more prevalent. And the JOBS Act provisions do not eliminate fraud, an unfortunatecommon feature of Internet securities activity.

NASAA is comprised of U. S. state securities officials, who coordinate regulation of state investment advisorsand stock brokers, across state lines.

Each year, NASAA prepares a report on the cases of fraud that its members investigate. The survey traditionallygauges the extent and prevalence of enforcement efforts by state securities regulators, and identifies trends and

issues in national investor protection.

The 2012 NASAA enforcement report states, The majority of fraud cases featured unregistered individualsselling unregistered securities. More than 800 reported actions involved unregistered securities, and more than800 actions involved unregistered firms or individuals. (2012 Enforcement Report, Prepared by NASAAEnforcement Section, Washington, D. C., October 2012).

A total of 632 reported actions involved unregistered individuals, the Report continues, and 485 actionsinvolved unregistered firms. This compares to 399 reported actions against investment adviser firms, the largestnumber of actions in any registered category and nearly double the reported investment adviser actionsthe year before. There were 359 reported actions against registered broker dealers and 297 actions

against registered broker dealer agents. In addition, 151 actions were taken against investment adviserrepresentatives.

To place this data in its accurate context, NASAA members regulate about 20,000 state registered investmentadvisors, and in 2012, there were about 18,000 new Reg D Form D filings for private offerings. As stated by theSEC report on public solicitation rules, For the year ended December 31, 2012, 16,067 issuers made 18,187new Form D filings, of which 15,208 issuers relied on the Rule 506 exemption. Based on the informationreported by issuers on Form D, there were 3,958 small issuers.


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In other words, out of 20,000 state registered investment advisors, and over 18,000 Reg D private securitiesofferings, involving 4000 companies, NASAA captured 151 advisor representatives and captured about 800firms who were not properly registered in 2012, mostly for private securities fraud.

NASAA splits its regulatory oversight of private offerings securities fraud with the U. S. SEC, as a result of thedivision of labor between states and the Federal government, contained in the 1997 National Securities MarketImprovement Act (NSMIA).

The SEC provides regulatory oversight to about 10,000 investment advisors. In other words, there are about20,000 state registered investment advisors, and about 10,000 federal registered investment advisors, for a totalinvestment advisor population of about 30,000, in 2012.

In its data related to rules on public solicitation, the SEC described the issue of fraud by citing an economicresearch article on actions involved with rights of rescission of contracts, when a Reg D offering goes bad. Inthis case, investors in a bad deal have the right to rescind their contract, and get their investment money backfrom the company.

As the SEC reports notes, A more recent study has identified 245 lawsuits (both federal and state) involving200 venture capitalists as defendants between 1975 and 2007, and has shown that VC funds that are older and

have a larger presence in terms of size and network are less likely to be sued. (Vladimir Atanasov, VladimirIvanov, and Kate Litvak, Does Reputation Limit Opportunistic Behavior in the VC Industry? Evidence FromLitigation Against VCs, 67 Journal of Finance 2215 (2012).

To summarize, in a 22 year period of time, in both state and federal courts, the SEC report notes a total of 245lawsuits involving venture capital firms related to Reg D offerings, some of which may have involved fraud.

This would not constitute evidence of a Reg D fraud crime wave.

Economic developers interested in integrating crowdfunding into regional economic strategy certainly need tobe aware of the issue of fraud, and need to be able to know it when they see it. But, the myth about fraud is not

about the bad effects of fraud, which is not an epidemic.

The myth of fraud is related to the political purpose it serves in scaring the public about the possible effect ofcrowdfunding and about limiting the effect that crowdfunding may have on the existing capital market statusquo.

In the new crowdfunding economic model, the companies themselves issue securities directly to investors, in aprocess the SEC calls a self-underwriting. In a crowdfunding self-underwriting, there will generally not be abroker intermediary between buyers and sellers of capital, and thus, there will not be a commission paid to abroker for assisting with the crowdfunding Reg D offering.

According to the July 10, 2013, data released by the SEC on the rules for public solicitation, the averagecommission paid to broker intermediaries in a $1 million private offering was $250,000.

As the SEC report states, An analysis of all Form D filings submitted between 2009 to 2012 shows thatapproximately 11% of all new Regulation D offerings reported sales commissions of greater than zero becausethe issuers used a broker intermediary. The average commission paid to these intermediaries was 5.9% of theoffering size, with the median commission being approximately 5%. Accordingly, for a $5 million offering,which was the median size of a Regulation D offering with a commission during this period, an issuer couldpotentially save up to $250,000 if it solicits investors directly rather than through an intermediary


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In other words, over a 4 year period, only 11% of the Reg D offerings involved the payment of commissions,yet this 11% of the market is driving the political agenda at the SEC in issuing rules on crowdfunding.

It should be noted for accuracy, that the SEC data on commissions primarily involves the direct commission,negotiated between companies and brokers at the beginning of the contract period to raise capital. The SECreport does not cover the tail-end commission paid to venture capital firms called carried interest. Carriedinterest commissions generally amount to about 20% of the capital raised.

For an even more comprehensive view of fees and commissions in the venture capital Reg D offering, theadditional costs of warrants needs to be added to the upfront commissions of 5%, the tail-end carried interestfees of 20%, and the warrants, which usually amount to around 5% of the profits in the exit deal.

The myth of fraud is useful for political reasons in convincing regulators and elected officials that the status quoarrangement of capital is the best public policy for limiting fraud, as opposed to the risky, new crowdfundingmethod, which, as the NASAA report concludes, the JOBS Act provisions do not eliminate fraud, anunfortunate common feature of Internet securities activity.

The important point for members of SSTI in attempting to integrate crowdfunding into economic strategy is thatcrowdfunding will save the private company about $250,000 in direct commissions, with a very minor effect on

fraud.

Myth #3: Most Reg D private offerings involve new venture, entrepreneurial startups,just like the deals that come from the university tech transfer office.

The public media hoopla about Title III of the JOBS Act would leave the mistaken impression thatentrepreneurial new ventures are the primary focus of crowdfunding. This is a myth that needs to be debunkedby economic developers.

Most Reg D offerings have been for established, operational companies, with top line revenues in a range ofaround $1 million, according to the SEC report on rules for public solicitation. The median size of the Reg D

offering was $1.5 million in 2012.

As the amount of capital raised increases, the commission percentage paid to broker intermediaries goes downto around 1.5%, while the average size of the offering goes to $30 million, for all offerings. In other words, thereally big deals in Reg D offerings skew the median size from $1.5 million, to an average size of $30 million.

The interpretation of this data, for busting myth #3, is that there a many small Reg D deals, involving smallamounts of capital for existing operational companies, many of whom are in technology manufacturing sectors.This will be the primary target for economic developers as they integrate crowdfunding into regional economicdevelopment strategy.

As the SEC report states, For the year ended December 31, 2012, 16,067 issuers made 18,187 new Form Dfilings, of which 15,208 issuers relied on the Rule 506 exemption. Based on the information reported byissuers on Form D, there were 3,958 small issuers.

The SEC report continues, Offerings conducted in reliance on Rule 506 account for 99% of the capital reportedas being raised under Regulation D from 2009 to 2012, and represent approximately 94% of the number ofRegulation D offerings. The significance of Rule 506 offerings is underscored by the comparison to registeredofferings. In 2012, the estimated amount of capital reported as being raised in Rule 506 offerings (includingboth equity and debt) was $898 billion, compared to $1.2 trillion raised in registered offerings. Of this $898


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billion, operating companies (issuers that are not pooled investment funds) reported raising $173 billion, whilepooled investment funds reported raising $725 billion.

In other words, private offerings were nearly as big as all U. S. public offerings, including all IPO offerings.The operational, existing small companies raised about $173 billion in 2012 in Reg D deals. This part of thecapital market will increase under Title II of the JOBS Act involving Reg D offerings, and this is whereeconomic developers need to focus to create the greatest increase in jobs.

Evidence on job growth from existing small manufacturers who obtain growth capital in their seventh year ofoperation generally go from around 10 jobs to about 20 jobs. The greatest job growth is from small existingoperational companies, not from entrepreneurial new ventures, even though those new ventures, like the onesthat come from the university tech transfer office, are more lucrative for the venture capital funding model.

Which is one reason why the myth #3 about entrepreneurial new ventures needs to be busted by economicdevelopers when they integrate crowdfunding into regional economic strategy.

Myth #4: There are not many investors who will be interested in crowdfunding, andtherefore the status quo approach under Title III of the JOBS Act is the mostimportant focus.

On the one hand, critics of crowdfunding scare the public with tales about fraud involving Grandmasretirement account, and then, on the other hand, they suggest that there just are not many accredited investorswho would actually invest in a crowdfunding deal.

For example, the NASAA report on fraud states, The 2012 JOBS Act significantly relaxed therestrictions on the manner in which Regulation D Rule 506 offerings can be marketed to the generalpublic, eliminating the previous ban on general solicitations (advertising). Once the rules implementingthis change are finalized by the SEC, investors will begin to see a variety of advertisements related toprivate placement offerings, even though only a very small percentage of the population will be eligible toinvest.

Suggesting that there are only a small number of potential accredited investors in crowdfunding is a myth.

There are about 5 million U. S. households with incomes that would qualify as a Reg D accredited investor forcrowdfunding. More importantly for regional economic development strategy, clusters of very wealthyinvestors exist in distinct geographical locations, primarily in the 350 U. S. metro regions with over 150,000population.

According to the data in the SEC report on solicitation, about 234,000 accredited investors made Reg Dinvestments in 2012. As the SEC report states, In 2012, approximately 153,000 investors participated inofferings by operating companies, while approximately 81,000 investors invested in offerings by pooled

investment funds.

The 153,000 investors who made direct investments in operating companies are the target market for economicdevelopers who want to integrate crowdfunding into regional economic strategy. They were primarilyindividual investors, not venture capitalists, who made investments in existing operational companies, notentrepreneurial new ventures.

The 81,000 investors who made Reg D investments in pooled funds, primarily invested in venture capitallimited partnerships, and the VCs then turned around and invested in private deals, primarily the deals that looka lot like the ones that come from the university tech transfer office.


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The common language used describe these 81,000 investors in a venture capital fund is angel investor. Thelanguage used to describe the bigger population of 153,000 investors is lone wolf investors.

In busting myth #4, economic developers would want to target the 153,000 lone wolves as participants inregional crowdfunding strategies, and implement policies that attract the potential pool of the other 5 millionlone wolves who may want to gnaw on a crowdfunding bone.

If they just knew where to look to find their crowdfunding bone.

Myth #5: The financial interests and legal rights of non-accredited investors should bethe primary public policy focus on implementing crowdfunding rules.

In its September 2012 proposed rules on eliminating the prohibition on general public solicitation of a Reg Doffering, the SEC combined a long and complicated list of factors that a company must first assess, before theycould raise capital. The SEC stated, These factors are interconnected, and the information gained by looking atthese factors would help an issuer assess the reasonable likelihood that a potential purchaser is an accreditedinvestor, which would, in turn, affect the types of steps that would be reasonable to take to verify a purchasersaccredited investor status. (Federal Register/Vol. 77, No. 172/Wednesday, September 5, 2012 /Proposed Rules).

The JOBS Act was not passed by Congress in order to help an issuer assess the credentials of an investor. TheSEC logic contained in the proposed rules had the intent of Congress exactly ass-backwards. Economicdevelopers should recognize this myth about non-accredited investors for what it is, a political red-herring beingdragged across the floor to delay and hamstring crowdfunding.

The final rules issued on July 10, 2013, continue to get the public interest in crowdfunding backwards, as if theinterests of non-accredited investors was a more important public policy issue than the public purpose containedin the preamble of the JOBS Act. (Comments by Thomas E. Vass, Owner/Manager of The Private CapitalMarket, Inc., A Crowd Funding Website, on Eliminating the Prohibition Against General Solicitation andGeneral Advertising in Rule 506 and Rule 144A Offerings. Submitted September 24, 2012).

This backwards public policy concern continues to be the primary reason, as noted by the former chairwoman inDecember 2012, why the SEC will not issue final rules on Title III of the JOBS Act. (An EvolutionaryEconomic Explanation of the SECs Delay In Issuing Crowdfunding Rules, Crowdsourcing.org May 13, 2013).

As the SEC report on July 10, 2013 noted, 90% of the Regulation D offerings conducted between 2009 and2012 did not involve any non-accredited investors.

More than 2/3s of all Reg D private offerings in 2012 had 10 or fewer investors, and less than 5% of allofferings had more than 30 investors.

In other words, 95% of Reg D offerings involved less than 30 investors, per deal and involved very smallamounts of capital, invested in very small operational companies, with very few non-accredited investors. Thisis the target market for SSTI members interested in integrating crowdfunding into regional economic strategy.

Most of the small Reg D deals between 2009 and 2012 involved equity, and almost 1/3 of all offerings duringthat period involved the issuance of bonds, not stock or equity interests.

As the SEC noted, Between 2009 and 2012, approximately 66% of Regulation D offerings were ofequity securities, and almost two-thirds of these were by issuers other than pooled investment funds.


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Another more straight-forward way of saying this is that most of the small deals between 2009 and 2012 weremade by lone wolf investors, who bought stock in the private companies.

Most of the small deals between 2009 and 2012 did not involve venture capital firms, because, as the SECexplained, the small equity deals were not big enough or lucrative enough to interest the venture capital firms,and the deals did not involve a fast exit strategy, such as the deals that arise from the university tech transferoffice.

The main public policy issue addressed by the JOBS Act is not protecting the financial interests of non-accredited investors, it is how to stimulate economic growth and job creation by small technology companies.

The survival and growth of the small companies is in dire jeopardy in America because they are starved forcapital.

In their economic analysis of what happened to small Silicon Valley companies, after a capital raise, Tian Luoand Amar Mann describe the high death rate of most small high tech companies. (Survival and Growth ofSilicon Valley High-tech Businesses Born in 2000, Monthly Labor Review September 2011).

As they explained, by 2009, fewer than 1 in 5 high-tech startups born in 2000 were still in business. Most

survived for one year, because as the Luo and Mann note, The reason is that new businesses often have enoughinitial reserves to survive for at least 1 year.

The great majority of tech firms in their study born in 2000 died in 2003.

The important point in busting Myth #5 for economic developers interested in integrating crowd funding intoregional economic policy is to focus on helping small companies raise crowdfunding capital in year 3 of theirexistence.

In year 3, the companies do not need a lot of capital to survive, generally around $1 million.

The other major implication of the Luo and Mann analysis is what happens to small high tech companies if theycan survive to age 7, when they will need another slug of capital to survive and grow. The economic evidenceon job creation is that if the small companies can get around $1.5 million in year 7, they will increase jobs fromaround 10 to around 20.

Then, if they can get another slug of capital at year 10, job creation is exponential. The evidence on job creationin small high tech companies in year 10 suggests that they go from around 20 jobs to around 70 jobs. That is themother-lode of job creation that SSTI members should target with crowdfunding.

The public policy goal of crowdfunding, it is not protecting the interests of non-accredited investors. It isgetting high tech companies to survive to year 10.


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How Economic Developers Can Manage The Regional Deal Flow Pipeline

The chronology of events in deal funding related to job growth at year 3, year 7 and year 10 of a technologycompany, can be placed into an intellectual framework that looks like a deal flow pipeline. At the top of thepipeline, there is a big funnel, into which ideas and capital are poured.

Then, the deals and the capital work their way down the pipeline timeline. The death rate of deals is very high atevery stage of the pipeline.

Regional economic growth is caused by commercially successful innovation investments, not by productivityimprovements or greater efficiency in the use of factor endowments. The greatest economic growth for creatingnew jobs and wealth is, ironically, caused by the most risky radical innovations at the top of the deal flowpipeline. (Rooting Out an Embedded Prejudice in the Literature on Venture Capital and Economic Growth, ThePrivate Capital Market, January 11, 2009).

As a way of explaining how the deal flow pipeline combines capital with ideas, the diagram below is helpfulbecause it delineates the topic areas of knowledge creation, capital markets, and managing the pipeline of deals.

The top of the pipeline, deal mapping does not produce revenue, and managing the entire deal flow pipeline

does not generate any profits.

This is the major reason why non-profit economic developers should manage the deal flow pipeline. No one inthe private sector can manage the pipeline chronology of events because managing it does not make any money.However when technology is commercialized successfully, the deal flow pipeline creates jobs and incredibleamounts of wealth and increased regional income.

Figure 2. The Small Business Deal Creation Pipeline

Deal MappingTo convertknowledge andideas into smallbusiness venturesand new products

Deal CreationTo prepare newventures or productideas to enter themarket

Deal FundingTo find capital tofund commercialventures

Deal ExitsTo manage thereinvestment ofprofits from the firstgeneration of ideasinto the nextgeneration ofinnovation

Deal Mapping

Some of the elements of the private sector small business deal creation pipeline have analogous components inthe university tech transfer model. For example, in the deal mapping part of the tech transfer model, professorsattend academic conferences, publish papers, and apply for grants, seeking to extend their knowledge.

In the private sector deal creation pipeline, engineers, scientists, salespeople and executives attend trade shows,play golf with each other, swap stories in beer drinking sessions, and dream up new products, seeking to extendtheir markets and income.

The big difference for members of the economic development community in shifting to the small businesscrowdfunding model is that knowledge creation and diffusion in the private sector is primarily based on face-to-face tacit knowledge creation and diffusion.
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Because tacit knowledge is based upon personal human interaction, it tends occur in distinct geographical areas,leading to the creation of distinct regional technological knowledge. (Exploiting Knowledge: The Importance ofRegional Allegiance and Territorial Loyalty in Implementing a Regional Small Business Innovation System,The Private Capital Market Working Paper No. 09-01-01, February 25, 2009).

In the university tech transfer model, the knowledge exchange is formal and codified, in the form of researchgrants, published articles, and mentoring students about specialized scientific areas of knowledge. In contrast totacit knowledge having a geographical component, codified knowledge is geographically ubiquitous. As soon as

an article is published by a professor, it is immediately available any place in the world for all the otherprofessors to read and criticize.

Deal mapping and idea creation at the top of the pipeline does not generate revenues and consequently, themarket of ideas suffers from what economists call incomplete information. Most information in the market isin the form of prices that attach to goods and services that can be exchanged, and ideas do not have pricesattached to them.

In issuing its rules on public solicitation of Reg D deals, the SEC noted this problem of incomplete orinadequate information as one primary justification for changing the rules on Reg D offerings to allow publicknowledge diffusion and information exchange.

As the SEC stated in its report, For example, one seminal study suggests that if some investors haveincomplete information and are not aware of all firms in the economy, risk sharing is incomplete and inefficientInformation that makes investors aware of the existence of these firms and enlarges the investor base leads toimproved risk sharing and lower cost of capital. (See Robert Merton, A Simple Model of Capital MarketEquilibrium with Incomplete Information, Journal of Finance 483 (1987).

The very top of the deal creation pipeline is characterized by a public good of tacit knowledge, whosemanagement and administration would add great social and economic benefits to regional economies. Tacitknowledge does not have a market price attached to it, and consequently, the creation and diffusion ofregionaltechnological knowledge in the deal flow pipeline by economic development non-profit agencies is

constitutionally justified. (Adding a Geographical Component to an Equity Crowdfunding Project. The PrivateCapital Market, CrowdSourcing.Org. The Industry Website, March 13, 2013).

In managing this part of the regional deal flow pipeline, economic developers would create mutlitple forumsand events around the idea of technology, products, companies in the nine high tech cluster value chains. Theevents would not need a lot of formal structure or agenda, mostly business social networking and presentationsby entrepreneurs, scientists, and CEOs of local companies who would like to tell their story to the biggerbusiness community.

The main tool economic developers would use to identify the most promising sectors to promote in theirregional economy is the Feser econometric model. Managing and administering the model is not a revenue-

generating activity, so no private sector entity is going to conduct this function.

But, the results of the model would be very valuable information for the entire business ecosystem, and non-profit economic development agencies are in the best position to manage this tool. (Using Feser's Input-OutputModel of Technological Affinities to Target Innovation Investments to Regional Industrial Value Chains, ThePrivate Capital Market, December 1, 2008).

Deal Creation

The professional product development community calls the deal creation component of technologycommercialization, the fuzzy front end. The fuzzy front end is a very confusing time for most technologyentrepreneurs, and the most recent data from the Panel Studies of Entrepreneurial Dynamics (PSED) indicates
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that up to 35% of all entrepreneurial ventures get stuck in the fuzzy front end for up to four years, trying tolaunch their venture.

Obviously, a great social benefit could be provided by economic developers in managing the deal flow pipelineif they would just rescue the poor entrepreneurs from wandering around for four years in the fuzzy front end.Economic developers would want to create a coherent professional business community that efficientlyconverted ideas into ventures that were ready to go to the capital market.

In the university tech transfer model, this deal creation and the fuzzy front end is generally managed by the techtransfer agents, who package up the professors research into deals that the venture capitalists can fund.

In shifting to the small business crowdfunding model, economic developers would rely on the regional businesscommunity of professional advisors who give advice to companies on how to issue securities and raise capital.(The Crowd Funding Business Bonanza for Lawyers, Accountants and Consultants: Professional BusinessAdvisors about to Surf a Financial Tsunami of New Crowd Funding Business, The Private Capital Market,April 11, 2013).

The three main business professional categories that would be organized into regional innovation groups by theeconomic development agencies are all the product design and development firms, all the local CPAs who have

an interest in providing services to companies that are issuing Reg D securities, and all the securities attorneys,who provide legal advice to private companies on a Reg D offering.

Deal Funding

During the time that a new venture or new product is moving towards the marketplace through the fuzzy frontend, the firm or entrepreneur is trying to identify the best sources of capital investment to fund the idea.

As noted above, the private capital market is huge and complex for small firms to understand, including the newReg A offerings contained in Title IV of the JOBS Act. Most of the media attention has focused oncrowdfunding in Title III, and the new Reg D rules in Title II. But the most significant new source of capitalmay turn out to be securities issued under Reg A of Title IV.

Reg A does not appear to be on the SSTI radar screen, as is the case noted above about Rule 144A offerings,and in moving towards a new crowdfunding model, the members of SSTI would want to become familiar withthe provisions of Title IV Reg A, as well as all forms of asset based lending, investment banking, and the newrules for transition from the private markets to the new small public markets. (Establishing the Capital MarketTransition from Private Capital to Public Capital, The Private Capital Market, May 29, 2008).

In other words, in the division of labor involving crowd funders and economic developers, the most importantjob of the economic developers is to help implement a comprehensive regional capital market infrastructure thatcontains all of the components of the entire market. (The Nexus of Financial and Political Interests betweenCrowd Funders and Regional Economic Development Professionals: The New-New Innovation Economics,The

Private Capital Market, July 8, 2013).

Often, the right type of capital for a new product idea in a new venture is entirely different than the source andform of capital for an existing company with operational cash flows from existing product sales. As indicatedabove, most of the Reg D offerings in the past four years have been by operational companies, not newventures.

For new ventures, especially the kind that originate in the tech transfer model, the venture capital partnershipsthat currently fund tech transfer deals will continue to be important in the future. Just like the non-venturecapital crowdfunding deals that can now solicit investors, the university tech transfer deals will be able to solicitinvestors, which means that existing close relationships between selected venture funds and universities may be
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disrupted as a result of the rules on public solicitation about university deals. (Successful Tech Transfer =Market Commercialization, The Private Capital Market, Private Capital Market Working Paper No. 2008-09-03September 24, 2008).

It is not the job of economic developers to conduct private placement offerings, hand-pick capital marketfavorites or to intervene in the private capital market place as a crowdfunder.

The capital market infrastructure that funds regional technology innovation functions in the same way that

roads, bridges, and sewer lines functioned in the older industrial recruitment economic strategy. Like that earlierinfrastructure, metro regional economies which implement the new capital market infrastructure will gain anenduring competitive advantage over communities that do not have an adequate capital market infrastructure.Do Cities Still Matter? The Economic Strength of Cities and the Economic Failure of Globalism in PromotingRegional Technological Innovation and Economic Prosperity, The Private Capital Market, April 20, 2013).

One important function that the economic developers could perform is doing the upfront work in organizing aregional closed end capital growth fund that targets new ventures, existing businesses, and the down streammerger and acquisition funding that keeps home grown companies at home when the bigger players comecalling to recruit them. (Creating the Private Capital Market Infrastructure for Sustainable InnovationEconomics, The Private Capital Market, October 2, 2008).

The upfront organizational costs of registering a closed end fund with the SEC are about $150,000. No privatesector entity in its right mind would front this kind of money because the organizational costs would never bere-couped by the fund management of a regional economic development mutual fund.

Unlike the current model of venture capital private funds which seek a fast exit, the economic developmentfunds would be seeking long term sustained viability of its portfolio companies, and without the fast exit, therewould not be a quick capital gain profit.

The parties who make money on the closed end fund are the investors, not the managers and administrators ofthe fund. (Bootstrapping Capital for Regional Innovation Economic Growth: New Regional Securities Markets,

The Private Capital Market, September 5, 2008).

On the other hand, $150,000 is a small amount compared to the tax incentives provided to large companies toentice them to locate in a region. And, unlike industrial recruitment incentives, the organizational costs are aone time event.

The fund would be used in conjunction with the Feser model to target capital investments into the regions mostpromising industrial clusters.

Deal Exits

Part of small business job creation business creates a platform of investing so that profits from one generation

can stay in the regional economy and can be re-invested in the next generation of innovation. (Why DoesEconomic Growth Occur in Some Cities and Not Others? The Importance of Small Amounts of Capital forSmall Businesses Innovation, The Private Capital Market, February 4, 2010).

As noted above, the deal creation pipeline has a different end goal, and different public mission of economicgrowth than the current venture capital model. Both Schumpeter and Leontief explained why the capital gainprofits from one generation of deals to the next were vital for sustained growth, and in moving to the newcrowdfunding model, members of the SSTI economic development community would want to implementstrategies that allowed profits from regional deals to stay in the local economy.(Why Exits Matter for Future Innovation Investments, The Private Capital Market, Private Capital MarketWorking Paper No. 08-10-01, May 9, 2008).
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As is the case with the use of industrial recruitment tax incentives, sometimes, the deal exits component can bemade more beneficial to everyone involved if certain taxes from the first generation of investments are delayedor forgiven if they are re-invested in the subsequent investment rounds.

Increasing Technological Investment Opportunities in The Local Economy

The SSTI September conference in Portland is called Dynamic Innovation Ecosystems: Bringing It All

Together, and is focused on how research, capital, workforce, and manufacturing fit together into a coherentstrategy.

In order to fit all the pieces of innovation together, economic developers will require some type of mental imageof technological innovation in order to put the right pieces together. The mental image of innovation foreconomic developers will be completely different than the current model of innovation that occurs in theuniversity tech transfer model.

The big picture of innovation involves a theory of technology, and one possible way of thinking abouttechnology is to make believe that technology is like genetic evolution. In other words, the theory of technologywould apply the metaphor of genetic evolution in order to explain technological change.(Predicting

Technology, Thomas Vass, Wingspan Press, Raleigh, N. C. 2007).

The metaphor between genetic evolution and technological evolution can be described with the help of adiagram:
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One benefit of viewing technological innovation as genetic evolution is that it is easier to understand the ideathat from the moment a new product or idea is commercialized, it is on its pathway to technologicalobsolescence, or to apply the genetic metaphor, to extinction.

This is one reason why exits matter. The first generation of technological innovation only has a life of aboutfive years. The profits from the first product need to be re-invested in the next generation to avoid marketdecline and regional economic death, such as the case of Detroit demonstrates.

Most new goods enter the market at a higher price, and then as a result of price competition and technologicalcompetition, the price declines.

Almost all of technological evolution can be explained in terms of how technical knowledge is created anddiffused among firms within a regional economy. This is a big difference between the crowdfunding model andthe university tech transfer model because the crowdfunding innovation model involves face-to-face tacitknowledge creation and diffusion. (Who Innovates? The Regional Economic Impact of Private CorporateInnovation Investments, The Private Capital Market, October 19, 2008).

The diagram below is useful for describing how knowledge from two distinct industrial sectors create theconditions of technological evolution, or to apply the favorite phrase of SSTI members, dynamic ecosystems.

Economic developers will be relieved to see that the idea of industrial clusters is relevant to understanding how

technology evolves and creates regional economic growth. In other words, members of SSTI do not need to geta Phd in genetics to understand the idea that whenever two distinct industrial clusters in a metro region happento be within 50 miles of each other, the foundation for a dynamic ecosystem exists.

The job of economic developers in fitting all the innovation pieces together is to create the forums forknowledge creation and diffusion within the regional economy by managing the deal creation pipeline.Economic developers can get a big boost in understanding where to look for the most promising technologicalcrossovers in their regional technology clusters by administering the Feser model.
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Both new and existing small manufacturing firms need one essential ingredient in common in order to innovate.They need new product ideas. The companies who innovate are existing companies and entrepreneurs with newideas, and new-to-the-world product innovation creates the greatest economic impact.

But, job creation and economic growth resulting from innovation happens about 10 years down the road.

Technological innovation occurs in geographical market habitats that have multiple diverse networks of actorswho share cognitive maps about innovation. These shared cognitive maps are geographically-bounded. In mostcases, the shared maps occur within 50 miles of the metro regional boundaries, just about the same distance thatregional private capital markets function when financing innovation projects.

The overlap between regional innovation markets and regional capital markets is not happenstance. Regionallydynamic markets create the environment for radical innovation, which is the best perspective to begin ananalysis of why some regions have higher rates of technological innovation than others, especially the mostvaluable form of innovation: radical innovation in new-to-the-world products.

It is also the best place to answer the SSTI question about how crowdfunding fits into their future model ofeconomic development.

Thomas Vass is a regional economist with a research interest in the relationship between regional technologicalinnovation, regional capital markets and regional economic growth. He is the author or Predicting Technology:Identifying Future Market Opportunities and Disruptive Technologies (Wingspan Press, 2007). His work


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involves a commercial application of the Feser Technology Cluster methodology to selecting technology stocksfor investment portfolios and identifying private capital investments in regional economies. He is the holder of apatent on technology stock selection. (Vass 7,251,627 July 31, 2007, Method of identifying a universe of stocksfor inclusion into an investment portfolio). He is a registered investment advisor, and the manager of asubscription based equity crowdfunding website, The Private Capital Market. He graduated from the Universityof North Carolina at Chapel Hill and has a Masters of Regional Planning. He is located in Calabash, NorthCarolina.

how economic developers can fill the crowdfunding capital market gaps in regional innovation...

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