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Are Venture Capitalists Lazy?

That’s the question at the heart of Issue 1, on the ballot today in Ohio. If Issue 1 succeeds, Ohio’s fantastically successful Third Frontier program will receive an infusion of about $700 million over the next four years. If not, the Third Frontier will run out of funding in two years, and Ohio will lose a powerful tool for spurring innovation and reaping the benefits.

Although most Ohioans haven’t heard of it, Third Frontier is a significant job engine for the state. An independent analysis found that the state’s $681 million expenditure so far has yielded $6.6 billion in economic activity, including 41,300 jobs, since 2002. Third Frontier’s various programs provide invaluable help in translating the ideas generated in Ohio’s universities into valuable products and processes for sale by focusing on companies in their earliest, most vulnerable stages.

If markets functioned perfectly (can anyone even type that with a straight face anymore?) Third Frontier wouldn’t be necessary. Venture capitalists would find and fund good ideas wherever they found them, supplying cash at all the critical stages of a company’s development.

But that doesn’t happen. VCs are lazy, in the way that all of us are lazy. They (we) rely on short cuts and familiarity and other efficiencies to maximize returns while minimizing their expenditures of time and effort.  An analysis of venture capital investing in the Great Lakes region explains that venture capitalists are searching for needles in haystacks. To make their searches as efficient as possible, they look in haystacks where they’ve found needles in the past, and haystacks close to home. That’s usually Silicon Valley or greater Boston, or places with a reputation for having rich, promising array of start-ups.   

The “twenty-minute rule,” whereby VCs won’t invest in companies more than a 20 minute drive from their headquarters may be an exaggeration, but it’s true that California alone absorbs half of U.S. venture capital investment, and Massachusetts gets 10 percent. (Ohio doesn’t even get a full one percent.) This, despite the fact that Ohio and other Great Lakes states are powerful sources of innovation and of public pension venture fund money (as my colleague John Austin pointed out.)

Further compounding the problem of new companies in places like Ohio, VCs are increasingly less venturesome these days, which leads them to invest in companies that have solved many of the problems that bedevil very early stage endeavors and have established a bit of a track record. 

Third Frontier corrects for the geographic and company phase biases, or flaws, in the venture capital market. Critics have charged that this is a fancy version of corporate welfare. But it’s not. It’s actually an example of governments doing one of the things that it must, correcting market failures. 

My colleagues have written  about the necessity of government support for innovation extensively. The bottom line is, the private sector doesn’t provide enough support for basic research, nor for the transition from research to market entry. Innovation, like roads, schools, and armies, needs taxpayer funds. “The market” won’t save the day, not in Ohio, not now.

UPDATE: Ohio Issue 1, extending Third Frontier until 2016 at the cost of $700 million is passing solidly with more than 85 percent of precints reporting.