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Risk Capital in Arizona:

Prepared for:

The Arizona Bioscience Board

Observations and Recommendations to Accelerate the Growth of the State’s Innovation Economy Prepared by:

Contacts:

Eric Cromwell Founding Member Cromwell Schmisseur LLC eric@cromwellschmisseur.com Dan Schmisseur Founding Member Cromwell Schmisseur LLC dan@cromwellschmisseur.com

February 2016


Directors of the Arizona Bioscience Board, We are pleased to submit our report, Risk Capital in Arizona: Observations and Recommendations to Accelerate the Growth of the State’s Innovation Economy and thank you for the opportunity to work with your diverse team of leaders representing various regions and industries in Arizona. We commend the work of the Arizona Bioscience Board for its early success in harmonizing the voices of business executives and regional stakeholders around a single focus on capital formation. This is an area where Arizona is positioned to realize near-term outcomes and improve state competitiveness. While it is important for executives from various industry sectors to understand the potential economic and societal impacts of bioscience companies, as well as the financing, regulatory and workforce environments necessary to support bioscience industry growth, market inefficiencies in the supply of capital for developing and growing companies affects many industries dependent on innovation to drive future growth and competitiveness. The ABB recognizes that the challenge ahead requires business and government champions with diverse backgrounds. The purpose of this Report is to take a closer look at Arizona’s current competitiveness in accessing risk capital for high-growth potential technology companies. By highlighting some capital formation and venture development strategies that have yielded results in other states, our analysis aims to foster a constructive dialogue about how a customized strategic blueprint can be developed for Arizona that attracts more private investment more consistently. The important work commissioned by the Flinn Foundation to create, update and sustain the Arizona Bioscience Roadmap remains relevant as a comprehensive guide for developing the state’s bioscience industry sector over the long term. It is our opinion that the Bioscience Roadmap goals – Entrepreneurial Hub, Research into Practice, Talent, Connectivity, Collaboration – are the right goals for a thriving innovation ecosystem, but the goals will not be fully realized without addressing the transformative step of making risk capital more accessible to the state’s high-potential innovators. The good news is that Arizona has impressive innovation assets to leverage, entrepreneurial success stories to celebrate, and capable leaders from both the public and private sectors who are motivated to succeed. The sky is not falling, but there are opportunities to improve and an urgency to act. The ABB’s exploration of risk capital investment is an important initiative, and we look forward to seeing your work serve a convening and stimulating role that leads to a portfolio of development strategies for increasing the supply and accessibility of risk capital in Arizona. Sincerely, Eric Cromwell

Dan Schmisseur


About the Arizona Bioscience Board The Arizona Bioscience Board (ABB) is a select group of leaders from bioscience and other industries across Arizona who joined forces to serve as a catalyst for developing solutions to critical issues facing the biosciences and technology-driven industries in Arizona. The ABB envisions Arizona as a top five US destination for technology industries, with a specific focus on nurturing Bioscience opportunities. Its Mission is to educate and excite leaders across Arizona, in all industries and levels of government, on the value and positive impact of technology-driven industries on Arizona's short and long term economic status and to take specific actions that will help achieve this vision. Members of the Arizona Bioscience Board, as of the date of this report: Mara G. Aspinall (Chair), Tucson, GenePeeks / Health Catalysts Ron Shoopman (Chair), Tucson, Southern Arizona Leadership Council (SALC) Jennifer Anderson, Phoenix, Wells Fargo Paul August, Tucson, Sanofi Louis Breton, Tucson, Calimmune David Engelthaler, Phoenix, Translational Genomics Research Institute (TGen) Phil Francis, Phoenix, PetSmart (ret) Tom Franz, Phoenix, Greater Phoenix Leadership (GPL) Michael Garippa, Tucson, SynCardia Systems Harry George, Tucson, Solstice Capital David Hutchens, Tucson, Tucson Electric Power Jeff Jacob, Tucson, Cancer Prevention Pharmaceuticals Jack Jewett, Phoenix, Flinn Foundation Craig Johnson, Phoenix, Heliae Development TJ Johnson, Tucson, HTG Molecular Diagnostics Shaun Kirkpatrick, Tucson, Research Corporation Technologies Taylor Lawrence, Tucson, Raytheon Missile Systems Dewey Manzer, Tucson, Instant BioScan Judy Rich, Tucson, Tucson Medical Center Eve Ross, Flagstaff, W.L. Gore & Associates Janet Spear, Phoenix, Celgene Scarlett Spring, Phoenix, VisionGate Jeff Trent, Phoenix, Translational Genomics Research Institute (TGen) Richard Walden, Tucson, Farmers Investment Co. Sandra Watson, Phoenix, Arizona Commerce Authority Michael Zervas, Flagstaff, Flagstaff Forty Major funding and support for this project provided by: Southern Arizona Leadership Council, Tucson Electric Power, Flinn Foundation, W.L. Gore & Associates, Arizona Commerce Authority, Sanofi, and Translational Genomics Research Institute

Š The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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Salient Points Related to the Supply and Accessibility of Risk Capital in Arizona

Perspectives

Access to risk capital – or lack thereof – presents a real and present challenge to the development of innovation-based industries in Arizona o Venture capital investors are greatly underrepresented in Arizona o Arizona is well-positioned to meet this challenge with its solid foundation of innovation infrastructure and private/public leadership Arizona can build on strengths to achieve transformational results by increasing the supply and accessibility of risk capital for Arizona businesses o Arizona’s business and innovation ecosystems provide a solid foundation to leverage o Engaging new stakeholders, attracting more financial support, and implementing best practice strategies can improve outcomes

Defining Success

Goal: by 2025, the annual rate of venture capital investment in Arizona companies will meet or exceed the per capita national average o Use national, independent data sources, such as the PwC MoneyTree quarterly survey of venture capital investment, to measure progress o Use other quantitative metrics for initiative strategy subcomponents o From 2011-14, the rate of venture capital investments in Arizona companies was approximately 30% of the per capita national average

Leveraging Strengths

Arizona angel investor groups are a strength, with two of the nation’s best o Modest investments at the margins of what angel investors do independently could leverage this existing strength into a marketing force for attracting entrepreneurs and anchoring investments Cross-sector collaboration is active and effective in Arizona. o Arizona's research universities, government agencies, technology industry groups and philanthropic sector actively collaborate on various innovation “ecosystem-building” efforts o For a risk capital initiative to be successful, regional interests must align behind a single unified voice for state capital formation policy

Recommended Strategies

1. 2. 3. 4. 5. 6. 7. 8.

Celebrate the Angels Support university technology transfer efforts Host technology and investor events Connect Arizona companies with investment epicenters Build a pipeline of investor-ready companies Encourage equity participation from public investing entities Develop Arizona’s venture capital industry Create a unified voice for Arizona’s capital formation policy

© The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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Index

I.

Executive Summary Perspectives on Arizona’s Innovation Ecosystem Defining Success for a Transformational Risk Capital Initiative • Case Study: State-Sponsored Initiatives in Utah

II. III.

1 9 18 21

IV.

V. VI.

Understanding the Innovation Ecosystem • Case Study: BioEnterprise (Cleveland, Ohio) Principles for Risk Capital Initiatives Recommendations for Arizona’s Risk Capital Initiative 1. Celebrate the Angels 2. Support university technology transfer efforts 3. Host technology and investor events 4. Connect Arizona companies with investment epicenters 5. Build a pipeline of investor-ready companies 6. Encourage equity participation from public investing entities 7. Develop Arizona’s venture capital industry 8. Create a unified voice for Arizona’s capital formation policy

22

About the Arizona Bioscience Roadmap and the ABB Risk Capital Project

46

Endnotes

47

30 31 37 39 40 41 42 43 44 44 45

VII. VIII.

© The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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I. Executive Summary

The Arizona Bioscience Board (ABB) recognized capital formation as a top priority when it was formed by a diverse collection of executive leaders in 2014 to position Arizona as a top five U.S. destination for bioscience and technology-driven industries. This Report, sponsored by the ABB members, is intended to initiate and guide a productive dialogue between economic development organizations, leading corporate and philanthropic organizations, state universities and state policy leaders about needs, objectives, strategies and actions to increase the supply and accessibility of risk capital in Arizona. With regional stakeholders working together, the objective is to develop a realistic, actionable plan that grows and diversifies Arizona’s innovation economy. Context for the Scope of the ABB Risk Capital Initiative Early-stage companies focused on commercializing innovation – product innovation or service innovation – most often require financial capital to start, develop and grow. Unlike small businesses with physical assets to leverage for bank financing, these high-potential ventures focus on developing intellectual property that is not applicable to asset-based lending. Rules based lending by commercial banks is not a financing option for these firms at the early stages of business development. The capital requirements are even more significant for bioscience companies with the potential to transform healthcare. Whether the innovation relates to pharmaceutical companies developing novel drug therapies, medical device companies developing surgical equipment or implants, or diagnostic companies identifying more efficient and effective methods to identify disease conditions when treatments can be most effective, it is understood by industry experts that bioscience innovation requires specialized investors with access to large pools of risk capital. What is a “significant” risk capital requirement for high-potential companies in the bioscience industry? A couple of data points are helpful for context: •

The average total cost to develop a low-to-moderate-risk 510(k) medical device from concept to FDA clearance is more than $30 million (and more than $90 million of expenditures before they earn regulatory approval to begin selling for higher-risk medical devices).i The average total cost of developing a new prescription medicine is nearly $1.4 billion,ii with early-stage capital financing requirements ranging between $5 and $40 million.

While early-stage investors rarely fund the majority of total development costs for new devices or drugs and the developing company may access either public markets or strategic corporate investors for an early exit, it is nevertheless important to have reasonable access to venture funds and their investor syndicates in order to optimize the returns from a portfolio of high-risk, high-reward investments. Arizona bioscience startups in less capital intensive segments such as diagnostics or health informatics also need start-up funding and would benefit from increasing the available options for funding their strategies to develop high-growth businesses and return significant gains to investors.

© The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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I. Executive Summary

At this time, there are not enough venture capital fund managers actively pursuing bioscience investment opportunities in Arizona. As part of a comprehensive risk capital initiative, building instate investment capacity with specialized bioscience industry expertise and corporate connections should be prioritized to establish a critical mass of firms and talent in Arizona. A challenge immediately recognized by the ABB is that geography has implications for bioscience companies seeking risk capital. The geographic fundraising challenge is specific to a key link in the capital continuum – early stage venture capital, which is equity-based financing after the smaller sources of seed capital from grants, “friends and family” and “angel” investors are secured, but before growth-stage funds or large bioscience companies invest to scale the opportunity.

Stated simply, high-potential companies in Arizona need better access to venture capital investors. Data ranging from the personal testimony of bioscience industry entrepreneurs and investors to national venture capital investment surveys clearly informs that access to venture capital in Arizona is, and will continue to be, a limiting factor on the state’s capacity to develop transformational bioscience companies and effectively leverage the existing innovation infrastructure. While capital deficiencies for Arizona’s bioscience industry are acute, ABB recognized that other innovation-driven industries in Arizona are similarly constrained by “access to capital” issues. ABB also recognized that the impact of innovation industries is broader than just on the biosciences. Industries from defense to advanced manufacturing are suppliers to or customers of bioscience companies. Therefore, ABB leadership recruited board members that equally represent bioscience and non-bioscience industries in Arizona and designed the scope of this Report to include risk capital objectives, strategies and actions that include but extend beyond the bioscience industry. The ABB Risk Capital Initiative builds on a solid foundation of organizations, industry leaders and philanthropists that previously and continuously contribute knowledge, experience and recommendations to develop and expand Arizona’s economy. Nothing in this Report should be

© The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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I. Executive Summary

interpreted as criticism of the existing policies or priorities of well-established organizations supporting Arizona’s innovation ecosystem. To the contrary, this Report aims to put forth ambitious goals and challenging strategies because of the ABB’s respect for and confidence in the individuals and organizations working today to make Arizona an attractive destination for innovators, entrepreneurs and investors. We must always be looking forward and learn from the successes and challenges of other states and communities. Arizona’s Risk Capital Challenge Reflects a National Challenge – Extreme Geographic Concentration There are many states situated similarly to Arizona – competitive R&D from universities, improving entrepreneurial culture, solid corporate leadership, active angel investor communities, etc. – that also perceive high-potential technology companies in their states are underserved by private investors. Nationally, the venture capital industry is geographically concentrated to such a degree in regards to funds managed and invested that it counters the expected efficiency of capital markets. In the U.S., 70% of venture capital is invested in companies in three states, and 75% of venture capital is managed by firms in those same 3 states (California, Massachusetts and New York).iii Unlike venture capital firms, the geographic concentration of large commercial bank headquarters does not create barriers to securing a small business loan because the lending industry is broadly distributed through branch offices and makes highly quantitative investment decisions. In comparison, venture capital investment decisions are highly subjective, and proximity to the investment decision-makers at venture funds matters for making, supporting and harvesting equitybased investments. There’s even empirical data supporting the long-held belief that companies perform better when their investors are physically close enough to monitor them.iv

Note that these venture capital rich states are not “tax havens” for corporations or individuals. They are not attractive because of comparably low wages, affordable housing or pro-business regulatory environments. These states are producing hundreds of high-potential startups that, in theory, choose to start their ventures in these unique business environments with concentrated assets. The authors of this Report do not assert that it is impossible for high-potential technology businesses to raise risk capital in Arizona and become large, profitable enterprises. Success stories about scalable companies in Arizona do exist, and more successes are expected in the future, even if there is no change in the environment or market. However, it is viewed as significantly more challenging in Arizona for high-potential companies to raise both seed/early stage capital and later rounds of growth capital from venture capital firms that are predominantly based outside the region. Without more sources of smart, patient capital working within Arizona and making connections to investment hubs, Arizona is expected to underperform at attracting private capital in relation to its investment potential.

© The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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I. Executive Summary

Marketing and Human Capital Solutions to Create Better Access to Bay Area Investors San Francisco and surrounding cities, widely referred to as the “Bay Area,” is an anchor of the nation’s innovation ecosystem and the global leader in supporting innovators and entrepreneurs who create new industries and change the world. With just over 1% of the U.S. population, the Bay Area is the home of companies that receive more than one-third of the total amount of venture capital invested in U.S. companies. A key advantage to Bay Area companies seeking venture capital is that venture capital investors are concentrated in the region. Per capita, there is approximately $20,000 of venture capital managed in the Bay Area for every citizen in the region, compared to $50 of venture capital managed in Arizona for every citizen. The combination of market forces and development strategies that made the Bay Area the dominant region for innovation were largely determined 30-40 years ago. These market forces sustain the region’s dominance for transformational companies in spite of a comparatively high cost of doing business. While no region can realistically aim to replicate the innovation ecosystem of the Bay Area at a similar scale, Arizona can learn important lessons from what works and aspire to provide access to Bay Area investors and innovators. What does providing better access entail? •

Educating Arizona-based entrepreneurs and innovators about the Bay Area funds that have invested in successful businesses similar to theirs, and introducing their businesses to those funds before they need venture capital to sustain and accelerate their development. Facilitating early feedback on development strategies and business models from Bay Area funds, including recommendations for advisors and C-suite executives with domain-relevant startup experience and well-established credibility with Bay Area investors. Identifying Bay Area investors and entrepreneurs with Arizona ties (i.e., born or raised in Arizona, university alumni, prior work history, etc.) to visit Arizona repeatedly with a mix of resort accommodations, recreation, entertainment and opportunities to visit with multiple startups developing technologies of interest to them. Recruiting experienced C-suite executives to lead Arizona-based companies from San Diego, Boston and other regions that have developed pipelines to Bay Area investors, even where the executives retain their existing residences and commute. Leveraging relationships established by Arizona-based investors in Bay Area funds to receive thoughtful feedback and consideration for Arizona-based investments.

Compared to many regions in the U.S. with similar access to risk capital challenges, Arizona has the advantage of relative proximity to Bay Area investors. Combined with the implementation of venture

© The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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I. Executive Summary

facilitation models operated effectively in other regions, Arizona could significantly increase the rate of venture capital investment in Arizona-based technology companies in five years. Similarly, leadership should pursue strategies to improve access to investment resources in other regions like Boston, MA, Boulder, CO, Austin, TX and Seattle, WA, but the Bay Area is recommended as the focus of these efforts. Setting a Clear Goal for Arizona’s Risk Capital Initiative The ABB intends to build upon the collective knowledge and specialized experience of established organizations in Arizona that have championed and supported efforts to increase the supply and accessibility of risk capital for a decade or longer across the capital continuum. These efforts have created a solid foundation for increasing the flow of venture capital into the state and a good understanding of how to do it. For example: •

Arizona has two of the top 20 angel investor groups in the U.S. – Desert Angels in Tucson and the Arizona Technology Investor Forum in Phoenix.v They are working with nearly a dozen similar angel investor organizations in the western U.S. to syndicate deals and create greater access to capital for the most promising Arizona companies. The Arizona Innovation Challenge, sponsored and managed by the Arizona Commerce Authority, invests $3 million annually in early stage companies, more than any other statesponsored business plan competition. vi Applicants surveyed in the past 3 years reported that they had raised $740 million of capital from all sources (friends and family, angels, etc.). The state’s two largest research universities have initiated new commercialization initiatives and retained respected managers for their technology transfer offices. The Entrepreneurial Economy for Tucson Task Force, chaired by resident venture capitalist Harry George, published a “Vision for the Future” in the spring of 2012 that remains relevant for not only the Tucson region but the entire state. The Flinn Foundation commissioned a long-term strategic plan for the state’s bioscience industry in 2002, the Arizona Bioscience Roadmap, and retained the Battelle Technology Partnership Practice to update the Roadmap for a forward looking document in 2014.

To ensure that this Report builds on the established knowledge base, the ABB coordinated individual interviews and two roundtable discussions with regional stakeholders that collectively engaged more than thirty influential leaders in providing input. Section II – Perspectives on Arizona’s Innovation Ecosystem – summarizes the key themes from these discussions.

© The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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I. Executive Summary

In the most recent Flinn Foundation commissioned Battelle report, Arizona’s Bioscience Roadmap, 2014-2025: Advancing the Biosciences and Improving Health Outcomes, the following “transformative measure” was listed first: Risk Capital: Over the decade, Arizona should work to boost existing levels of investment in emerging companies to $25 million-$40 million annually in pre-seed and seed capital from private and public parties, and $100 million-$125 million annually in venture capital…This Roadmap sets a goal that Arizona reach a market share of national venture capital invested annually in the biosciences equal to its population share by 2025. This Report, as a complement to the Roadmap, focuses on this single transformative measure but with an expanded scope that includes all industries, including but certainly not limited to bioscience, for which venture capital is often used to develop and grow high-potential companies. Section III – Defining Success for a Transformational Risk Capital Initiative – references national data from the commonly referenced PwC Moneytree Venture Capital survey combined with population data from the U.S. census and proposes a quantitative goal for Arizona to see approximately $600 million of venture capital invested in Arizona-based companies by 2025, as measured by PwC Moneytree – a 300%-400% increase over recent investment levels. (Readers should note this data source excludes angel investments, non-VC private equity and bank financings from its data, which may result in variances from data reported by Arizona-based organizations with more localized knowledge of small business investments. While there are other credible sources for data on equity financings in private companies, such as CB Insights and Pitchbook, the PwC Moneytree survey is the oldest and most widely cited by national media, which influences perceptions about states and regions. For the sake of consistency and comparability, PwC Moneytree data was used for this report and recommended as an ongoing source of data for monitoring progress.) Demonstrating Why Venture Capital is a Leading Indicator of Economic Vitality Section IV – Understanding the Innovation Ecosystem – provides a basic overview of the innerworkings of an innovation/entrepreneurial ecosystem. This section describes the “key players” in an innovation ecosystem – innovators, entrepreneurs, angel investors, accelerators (including state and philanthropic organizations and university tech transfer operations), venture capitalists and global corporations – and analyzes what each “contributes” to an innovation ecosystem and what each “wants/needs” from it. Importantly, this section shows that Arizona has strong infrastructure in place that could produce substantial economic value on an incremental state/philanthropic investment. Furthermore, this section illustrates the need for a multi-faceted initiative that builds on existing resources in Arizona.

© The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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I. Executive Summary

Experiments in Other States – A Brief Guide to State Capital Formation Programs & Policy Simply throwing money – public or private – at the capital access problem will not solve it, as too many other states have demonstrated. The development of innovation ecosystems is complicated work requiring leadership, collaboration and alignment on basic principles. Section V of this report – Principles for Risk Capital Initiatives – uses lessons learned from other states to describe four basic principles required for an initiative to achieve real success: 1) Programs should be capitalized efficiently; 2) Investment managers should be selected competitively; 3) Investments should be restricted to areas not reasonably served by existing investors; and 4) Program financers –state or private – should participate pari passu in investment returns. Recommended Portfolio of Complementary Strategies for Capital Formation in Arizona Section VI concludes the report with eight recommendations for the Arizona Risk Capital Initiative: 1. Celebrate the Angels. Accredited investors, whether acting individually or through one of the highly acclaimed Arizona groups, are economic development heroes that should be celebrated as such. Already a destination for affluent retired executives, Arizona should cultivate this strength with the best policies and services for angel investors in the U.S.

2. Support university technology transfer efforts. Research commercialization and technology transfer initiatives associated with academic institutions should receive broad, sustained support. This support should be inclusive of SBIR/STTR grant matching programs, universitycentric seed investment funds, state business competitions and regional accelerators, for these programs prime the pump for Arizona’s regional innovation economies.

3. Host technology and investor events. Arizona thrives at creating memorable events and experiences for visitors. Investor and tech industry conferences provide natural tie-ins with existing tourism initiatives and sports and entertainment that can provide showcase opportunities for the state’s innovation assets and high-potential companies.

4. Connect Arizona companies with investment epicenters. There is a need to aggressively support homegrown companies in their efforts to attract venture capital wherever it is managed. The largest, closest venture investment hub is the greater Bay Area in California; however, connections to investment hubs along the East Coast should also be made. 5.

Build a pipeline of investor-ready companies. Improving access to risk capital is the priority need identified in Arizona, however, it is necessary to work diligently and continually on building a pipeline of “investor ready” companies in Arizona. This recommendation includes the development of venture facilitation models designed to increase the rate of venture

© The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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I. Executive Summary

capital investment in technology companies within five years of program inception.

6. Encourage equity participation from public investing entities. Public and private leaders should take a fresh look at addressing any rules and/or customs to allow state participation in best practice risk capital initiatives – on market based pari passu investment terms.

7. Develop Arizona’s venture capital industry. This recommendation will take the most time and capital to achieve, but a truly level playing field for Arizona companies requires bona fide venture capital firms residing in the regional markets and capable of leading syndicated deals with institutional venture capital funds.

8. Create a unified voice for Arizona’s capital formation policy. Aggregating the voices of industry groups, universities, angel investors and state government leaders into a unified chorus is essential for overcoming the challenges that stopped previous efforts short of success. These eight strategy recommendations were drafted as distinct components of a holistic risk capital initiative with a single performance metric – total venture capital invested in Arizona companies, as measured by the PwC Moneytree venture capital survey. Each of the distinct components will require existing organizations to collaborate in the development of detailed implementation plans and the negotiation of budgets and component-specific performance metrics with corporate, philanthropic, state and/or federal government sponsors. Some of the recommendations are relatively easy to implement and can be done so on lean budgets through a partnership approach. Other strategies will require inter-organizational collaboration and sizeable resource allocations. The scope of this report stops short of suggesting specific performance metrics for each of the component recommendations but recognizes the critical importance of negotiating and reporting component-specific performance metrics to ensure accountability towards the initiative’s singular goal.

© The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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II. Perspectives on Arizona’s Innovation Ecosystem

Section II: Perspectives on Arizona’s Innovation Ecosystem Highlights: o “Perspectives” summarized by authors based on personal interviews with 30 Arizona leaders from corporations, universities, philanthropies, and individuals experienced with starting, leading and funding seed and early stage technology businesses o Goal was to assess perceptions of “supply” issues that could cause innovation ecosystem to produce less than expected results: 1. Supply of Innovation; 2. Supply of Entrepreneurs; 3. Supply of Risk Capital o General consensus from participants that Arizona’s innovation ecosystems produce a quality supply of innovation and entrepreneurs, though many entrepreneurs in Arizona are perceived as having less startup experience than peers in the Bay Area and similar high-output ecosystems o Strong consensus from participants that “risk capital” was the most acute challenge restraining Arizona’s innovation ecosystems from producing more successful companies that could contribute to the state’s economy

© The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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II. Perspectives on Arizona’s Innovation Ecosystem

Arizona today is a good place for technology businesses to develop and grow…but by improving the supply and accessibility of risk capital for Arizona companies, we believe Arizona can become a great place for technology businesses to develop and grow. Arizona’s greatest economic development challenge relates to issues – real or perceived – about the relative supply and accessibility of risk capital for technology businesses needing more than $1-2 million to develop and grow to their full potential. *** The above statements represent a general consensus from the Arizona leaders interviewed individually or in a group setting for this report. Certainly there is not a unanimous point of view. With report research contributors including diverse leaders from corporations, universities, philanthropies, and individuals experienced with starting, leading and funding seed and early stage technology businesses, many perceived strengths and challenges were discussed. At times seemingly contradictory views were strongly communicated. The authors of this report processed this data, reviewed online materials gathered independently, and drew upon years of experience working in and around state-sponsored technology-based economic development initiatives to reach and articulate the consensus views of the interviewees. When states or regions perceive that they are underserved by venture capital investors, they generally look to one of three areas to see if there is a “supply” issue: 1. Supply of innovation 2. Supply of entrepreneurs 3. Supply of capital The authors asked interviewees for their perspectives on these components of “Arizona’s innovation ecosystem” and which components need the greatest focus to achieve the initiative’s goal. Perspectives on the Supply of Innovation Generally, interviewees had favorable views on the supply of innovation from the state’s universities, corporations and small business community. Recent efforts by the state’s research universities to emphasize entrepreneurship and technology transfer were noted by several interviewees as a positive development. Data from the National Science Foundation shows that Arizona’s public universities are competitive with public universities in the southwestern region and nationally. On a per capita basis, Arizona’s public universities exceed the national average by 12%. However, like its peer states in the southwestern region other than California, Arizona does not receive a benefit from R&D at private universities, because there are none. Therefore, for all university R&D, Arizona rates at 75% of the national per capita average.

© The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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II. Perspectives on Arizona’s Innovation Ecosystem

Higher education R&D expenditures, by state and institutional control: FY 2013 (Dollars in thousands) All R&D - % of State, institutional control, and institution

Population

United States

318,198,163

All R&D

Per Capita

expenditures

National Average

$

67,041,154

100.00%

     Public

$

44,870,141

100.00%

     Private

$

22,171,013

100.00%

$

1,065,136

75.10%

           Public

$

1,065,136

112.21%

                 AZ State U.

$

405,154

                 Northern AZ U.

$

30,516

                 U. AZ

$

629,466

$

8,367,060

102.35%

           Public

$

5,897,484

107.78%

           Private

$

2,469,576

91.34%

$

1,253,466

111.08%

           Public

$

1,232,540

163.20%

           Private

$

20,926

5.61%

$

153,427

25.65%

$

153,427

38.32%

$

403,776

91.89%

$

403,776

137.30%

$

688,972

111.12%

           Public

$

652,410

157.21%

           Private

$

36,562

17.83%

     Arizona

     California

     Colorado

     Nevada

6,731,484

38,802,500

5,355,866

2,839,099

           Public       New Mexico

2,085,572

           Public       Utah

2,942,902

SOURCE: National Sc ienc e Foundation, National Center for Sc ienc e and Engineering Statistic s, Higher Educ ation Researc h and Development Survey, FY 2013. Data from survey c yc le FY 2013, as of 31 July 2014.

© The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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II. Perspectives on Arizona’s Innovation Ecosystem

Arizona also appears to be reasonably competitive in science and engineering in comparison to other states. The below data from the National Science Foundation shows that Arizona ranks 15th in population and 14th in total R&D obligations from federal sources:

Š The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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II. Perspectives on Arizona’s Innovation Ecosystem

Perspectives on the Supply of Entrepreneurs The perspectives on entrepreneurship in Arizona is generally very positive but with caveats. Interviewees had very favorable impressions of entrepreneurship programs sponsored by the Arizona Commerce Authority and the state’s universities. In no way is Arizona lagging the nation in promoting an entrepreneurial culture, and many programs in the state are cited nationally as models for other states to emulate. Demographically, Arizona has both large retiree populations and large student populations, with total enrollments at the state’s three public universities growing fast and approaching 150,000 students. This is a great combination – a large pool of young, bright talent combined with a large pool of experienced mentors and prospective angel investors.

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On the other hand, angel investors interviewed expressed concerns that good ideas from Arizona entrepreneurs are not always paired with investment-grade business plans. This does not reflect a criticism of entrepreneurship education or the effectiveness of accelerators in the state. The concern reflects a relatively small (but growing) number of previously successful entrepreneurs in the ecosystem that instill knowledge on a peer-to-peer basis. Today, there’s just not enough Bay Area DNA in Arizona. This is a challenge for basically every region in the U.S. outside the Bay Area, and for Arizona, this is a solvable problem. Perspectives on the Supply of Risk Capital Angel groups in Arizona are well organized and nationally respected. Their leaders report that the supply for seed and early stage capital within their groups is greater than the supply of investmentready businesses. This does not imply that it is unnecessary to strategically grow the state’s base of active angel investors in technology businesses. From an economic development perspective, you cannot have too large a pool of potential investors. Many great businesses only found success after having been rejected by dozens if not hundreds of prospective investors. The name of the game for promoters of the region’s economy is to turn every good idea into a good business plan, and then get every viable business plan funded. A significant challenge for angel investors is the supply of capital for “post-Angel” rounds of greater than $1-2 million. There are some quality sources of institutional capital in Arizona, but like most states outside the leading investment hubs, resident capacity is not significant, and angels must be prepared to help the companies in which they invest look for the next round of capital out of state. © The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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II. Perspectives on Arizona’s Innovation Ecosystem

Notes from Interviews with ABB Risk Capital Initiative Participants A component of the project scope of work was an interview process to collect information, perspectives and opinions communicated by a diverse group influential leaders in Arizona’s investment and entrepreneurial communities. Speaking directly with Arizonans who have knowledge of historical and current market conditions, as well as prior efforts to stimulate capital formation, is critical to understanding perceptions about the supply and accessibility of risk capital in Arizona. Arizona Risk Capital Market Perceptions •

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A barrier to private investment is the perception – fairly or unfairly – that Arizona is more focused on being a destination of retirees as the “Sunshine State” than focusing on building regional ecosystems as destinations for entrepreneurial talent. There is a well understood history in Arizona of the private sector taking business investment risk. However, much of the private capital available for investment continues to flow towards property development and “old economy” industries. There is a need to improve understandings about emerging “tech” industries and to win the argument for in-state risk capital to be applied to new venture development. Arizona has companies and investment opportunities with world changing potential that justify investor due diligence but struggle to attract follow-on funding. Ultimately, success begets success and this is necessary to attract a flow of financial resources. Arizona needs more big successes that are likely to anchor future successes of high-potential companies growing some roots in-state and attract next stage capital. Arizona is like many states where institutional venture capital investors are moving downstream and requiring more evidence of product/service adoption and revenue generation before investing. The result is larger voids in the capital continuum for highgrowth potential firms that are even more exaggerated in the bioscience sector. There seems to be a hesitancy for outside venture capital investors to fund good investments in Arizona, which is understood to be because of an unwillingness to travel and lack of a “cluster effect” from a regional portfolio of investments. Arizona does not have an adequate base of resident venture capital firms. Venture capital under management in Arizona is small compared to regional markets of Colorado and Utah. Only in rare cases will an Arizona company seeking a significant “A Round” of venture capital not be required to expend significant time and resources looking for it out of state.

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II. Perspectives on Arizona’s Innovation Ecosystem

Perspectives on Market Need for Risk Capital §

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Nationwide, after the 2007/08 melt down, the much smaller number of surviving venture funds ended up being large funds with a greater emphasis on IT (at a loss to med device, diagnostics, drug), and this has created serious capital access issues all across the country. Venture funds that make Series A venture investments are gone in Arizona. The small business financing challenge is really the challenge of securing early-stage risk capital. Later stage venture capital operates at acceptable efficiency, with funds flowing to where there are good deals, and most of the institutional venture capital financing comes from out of state. Angel investors are the source of early-stage capital in Arizona, and the state does not seem to be lacking angel capital. The big gap in Arizona’s capital continuum is between angel investment and venture capital investment rounds, and angel investors and companies need upstream relationships. Just having more financial capital in Arizona will not solve the problem. Developing a quality, validated pipeline of investment opportunities is just as important. The primary funding gap may be around early-stage equity financings, but another challenge is scaling a company in Arizona to create a sustainable business in state. Because of the absence of active in-state investment funds, business control too often shifts to outside investors more interested in moving company outside the state. Extremely difficult to raise money in Arizona if an entrepreneur hasn’t raised money before and achieved a profitable exit. Arizona has a good pipeline of technical and business talent; however, an adequate supply of entrepreneurial talent can become an issue caused by the lack of access to risk capital. Some of the most promising entrepreneurs and business leaders often leave Arizona in search of risk capital outside the state. Thus, the lack of financial capital is contributing to the absence (or depletion) of in-state talent, specifically around the bioscience industry.

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II. Perspectives on Arizona’s Innovation Ecosystem

Strategy Considerations for Arizona §

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Participants in Arizona’s regional ecosystems are doing good work on supporting the funnel – innovation, commercialization, new venture creation – at the very early stage of the capital continuum. The real need is to figure out the right mix of development strategies to grow these businesses with follow-on financing after the seed/angel round. Arizona has experienced rapid growth in regional ecosystem activities with now more than 30 small business incubators/accelerators statewide. The Arizona Commerce Authority is viewed as an effective partner that is working to connect the support infrastructure and support university-based initiatives. What Arizona needs is a fully integrated statewide support system that matches market need with innovative solutions that are fueled with early stage investment capital. The support system should be focused on creating sustainable biomedical companies in Arizona. The overall strategy needs to be designed to help build a crop of fundable growth companies rather than just a one off success story. To increase private investment Arizona over time, we must build great companies in Arizona, and building great companies requires a focus on training/mentoring/educating/connecting the right people. The presence of more sophisticated entrepreneurs helps de-risk investments for private investors. The state legislature correctly made the [Angel Investor] tax credit more user friendly but should now be encouraged to expand the tax credit pool to stimulate private investment. It is important for the Arizona state government to send a strong signal to private investors that Arizona is a good location of innovation and entrepreneurship. State government should consider additional funding to extend the reach of existing investment programs and expand support offerings to support early-stage companies and fill out the program portfolio. Keep the strategic focus on the high-potential companies getting started and the small number of highly productive entrepreneurs who start them. Job creation follows capital investment…the business opportunities have to be supported for the employment opportunities to come. Thinking about what success would look like…Arizona needs not just one venture firm sourcing deals in-state, but four to five venture funds with domain expertise and unique connections to move the state’s entrepreneurial community forward.

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II. Perspectives on Arizona’s Innovation Ecosystem

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Over the past ten years, leaders have endorsed various efforts to engage state policymakers in efforts to jumpstart perceptions about the supply and accessibility of risk capital via statesponsored “fund of funds” programs. There are roles for both the private and public sectors to increase risk capital accessibility. The private sector can provide thought leadership and should look for ways to present collaborative solutions for government to come on board at meaningful scale at the appropriate time.

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III. Defining Success for a Transformational Risk Capital Initiative

Section III: Defining Success for a Transformational Risk Capital Initiative Highlights: o Argument for use of venture capital investments in Arizona companies as primary metric for Arizona Risk Capital Initiative o Alignment with and adoption of “transformative measure” from the Flinn Foundation and Battelle report, Arizona’s Bioscience Roadmap, 2014-2025: Advancing the Biosciences and Improving Health Outcomes: “This Roadmap sets a goal that Arizona reach a market share of national venture capital invested annually in the biosciences equal to its population share by 2025” o Data from PwC Moneytree venture capital investment survey from 2011-14 for Arizona and five states in its region (California, Colorado, Utah, New Mexico and Nevada) plus a calculation of the national per capita average for venture capital investment o Translation of data and Roadmap goal to estimate that the annual rate of venture capital investment in Arizona needs to increase 300% relative to the national per capita by 2025 – an achievable goal

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III. Defining Success for a Transformational Risk Capital Initiative

How do you measure success for an economic development initiative? Unfortunately, it’s not very easy, as there are no “generally accepted accounting standards” for economic impact reporting. In the absence of standards, finding success measures can be time- and resource-consuming, and the end results are often easily discounted by skeptics. Traditional programs typically report jobs “created” or “retained” and use economic models such as IMPLAN or REMI to impute economic impacts compared to costs invested. Unfortunately, there are many reasons why these models do not translate well to measuring the success of risk capital initiatives. First and foremost, there is rarely a direct correlation between early stage capital investments and job creation. At a macro level over long periods of time, one can absolutely show that venture capital investment is a leading indicator of economic vitality. For example, in 2011, the National Venture Capital Association reported that 11% of U.S. private sector jobs (11.9 million out of 107.3 million jobs) were “venture-backed jobs” – i.e., companies that received venture capital investments during early development or growth stages.viii However, the sample sizes for most regional programs are simply too small to extrapolate results or represent that past job creation data will be indicative of future performance. Second, IMPLAN and REMI models assume equipment investment and indirect employment impacts that simply do not fit startup technology business models. On the other hand, these models also do not forecast the economic impacts of the potential for wealth creation that can be realized when startup companies are acquired or sold to the public at large multiples to the earliest valuations. Third and perhaps most importantly, risk capital initiatives intentionally leverage private sector coinvestors, creating confounding questions about how much “credit” should be attributed to the initiative versus private investors or even other government programs. Many times well-performing state-sponsored organizations can deliver substantial value to a startup without investing any capital. In other cases, capital from government initiatives is often added to private sector deals that clearly would be completed with or without the stimulus. Is it fair to claim credit for a $20 million venture capital investment when your $500,000 loan was the last check written? For these reasons, the authors of this report recommend a single, independently reported metric for evaluating success of the comprehensive ABB Risk Capital Initiative: Total venture capital investments in Arizona-based companies, as reported by the quarterly PwC Moneytree Venture Capital report. The advantages of focusing on a single, independently reported metric include: 1. Alignment – Everyone shares in the success of the whole. Arizona cares most about winning the game, not who on the team scored the most points. 2. Credibility – The data is independently reported and verified by a global CPA firm. 3. Simplicity – No measure is perfect, but this data point is well known and understood.

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III. Defining Success for a Transformational Risk Capital Initiative

This recommendation is consistent with the most recent Flinn Foundation commissioned Battelle report, Arizona’s Bioscience Roadmap, 2014-2025: Advancing the Biosciences and Improving Health Outcomes, in which the following “transformative measure” was listed first: Risk Capital: Over the decade, Arizona should work to boost existing levels of investment in emerging companies to $25 million-$40 million annually in pre-seed and seed capital from private and public parties, and $100 million-$125 million annually in venture capital…This Roadmap sets a goal that Arizona reach a market share of national venture capital invested annually in the biosciences equal to its population share by 2025. For reasons explained in the executive summary, the ABB has determined that the Arizona Risk Capital Initiative should be inclusive of all technology companies, not just bioscience companies. With this approach the two major data points are 1) U.S. and State population data from the U.S. Census, and 2) venture capital investment data from the PwC Moneytree survey, as reported by the National Venture Capital Association.

Based on this data, had Arizona achieved the per capita national average for venture capital investment from 2011-14, total venture capital invested would have been $629 million, $579 million, $625 million and $1.023 billion, respectively, for an annual average of $714 million. On average over these four years, Arizona is achieving 30.2% of the national per capita average for total venture capital investment. To achieve the goal established by the Flinn Foundation, total venture capital investment in Arizona-based companies on an annual basis will need to be increased by approximately 300% from current rates by 2025. Is this possible? Yes. For example, Arizona’s neighbor, Utah, has demonstrated that a state can significantly increase its annual rate of per capita venture capital investment through public-private partnerships focused on entrepreneurial growth and consistently achieve or exceed the national per capita average.

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Case Study: State-Sponsored Initiatives in Utah Twenty years ago (1995), Utah’s per capita rate of venture capital investment was lower than Arizona’s, as it had been for nine of the previous ten years. On a per capita basis, the rate of venture capital investment in Utah companies was consistently below 50% of the national average. Ten years later (2005), Utah had emerged as a viable destination for entrepreneurs seeking risk capital for high-growth companies. Per capita venture capital investment exceeded 100% of the national average, a benchmark that Utah now consistently exceeds.

What happened? Was the transformational change in Utah the result of intentional execution of a capital formation strategy or serendipitous good fortune from a winning streak of successful companies? Certainly, successful companies like Netscape, Adobe, Novell and Silicon Graphics created local wealth and changed perceptions about the quality of ideas and entrepreneurs in Utah. But Utah also developed significant statesupported initiatives with the intent of expanding capacity in the state’s innovation ecosystem – the innovation supply and the risk capital supply – that helped change the reality. Utah Fund of Funds In 2003, the Utah legislature created the Utah Fund of Funds program, a $300 million economic development program capitalized by debt financing secured with contingent state

tax credits. Rather than restricting investments to Utah-based venture funds and Utah-based companies, the Utah Fund of Funds program made Limited Partner investments in a diversified portfolio of venture capital and private equity funds with the understanding that fund recipients would make a reasonable effort to consider investment opportunities in Utah companies. Through this program, Utah has partnered with 28 private equity and venture capital funds, including seed funds. Since inception, partner funds have invested $723 million in 67 separate Utah companies. These partner fund investments have created over 2,700 new Utah jobs and contributed over $35 million in new tax revenue to the state of Utah. Importantly, more than 350 Utah-based companies have been reviewed by fund managers, providing valuable feedback to innovators in the state’s entrepreneur ecosystem whether or not the review ultimately led to a financial investment. USTAR In 2006, the Utah Science, Technology and Research (USTAR) initiative launched with a $160 million building fund created by the state legislature for the benefit of Utah’s research universities, plus consistent annual funding of $15 million for USTAR’s Technology Outreach Innovation Program. The goal of USTAR is to increase the supply of innovation from scientific research at the state’s universities. USTAR funding is used to build research facilities and recruit teams of researchers with strong commercialization potential. These state programs, combined with an entrepreneurial culture and momentum from private sector successes, has taken Utah to a level of venture capital investment where it only trails Massachusetts and California for the rate of investment on a per capita basis.

© The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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IV. Understanding the Innovation Ecosystem

Section IV: Understanding the Innovation Ecosystem Highlights: o Profiles of the six components of an innovation ecosystem: 1. Innovators – primarily inventors from anywhere and scientists at research institutions and federal labs 2. Accelerators – includes university tech transfer offices and university or public/private incubators/accelerators working with pre-seed companies 3. Credible entrepreneurs – those with experience or rapid uptake of the skills necessary to develop and lead a high-growth business using investor capital 4. Angel investors – high net worth (“accredited”) investors using personal capital to invest in early stage companies, and often providing de facto mentoring services to the entrepreneurs 5. Corporate investors – large national or multinational companies making direct investments in early stage or growth stage companies aligned with its strategic business development interests 6. Institutional investors – venture capital funds investing capital obtained from family offices, endowment funds, pension funds and other large pools of capital managed by a professional staff o Discussion on strategies to increase the supply of institutional capital investing in Arizona businesses o Examples from two types of programs: corporate-sponsored venture capital (Renaissance Venture Capital Fund) and state-sponsored venture capital (InvestMaryland)

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IV. Understanding the Innovation Ecosystem

The word “ecosystem” is often used to describe individuals and organizations working in communities that aspire to develop technology-based high-growth businesses. The word describes the interdependence of multiple parties and the vulnerability of the whole should one element of the system be underdeveloped compared to the others. The ABB has prioritized an initiative to increase the supply and accessibility of “risk capital” because multiple parties have weighed in with their opinions that this is the weakest link in the state’s innovation ecosystem. Following is a brief analysis of six components of an innovation ecosystem, annotated with notes from discussions with Arizona experts: 1. Innovators • •

Contributes – New technologies, business models or improvements to existing technologies with market potential sufficient to merit the development of a new company. Needs – “Proof of concept” funding, often from employers or grant-makers; connections to entrepreneurs experienced in developing viable business models to commercialize technologies; reasonable opportunities to “transfer” intellectual property into private businesses. Includes – Research faculty at the University of Arizona, Arizona State University and Northern Arizona University; independent SBIR grant recipients; scientists at the Air Force Research Laboratory; any citizen with a great idea for a commercial product or service that requires OPM (“other people’s money”) to develop (i.e., can’t be bootstrapped).

Breakthrough innovation can truly come from anywhere and anyone, so well-functioning ecosystems are receptive to the outside-the-box concept from unusual sources. For volume, ecosystems primarily tap into university and industry clusters for “spillover” technology – intellectual property developed as a product of significant research expenditures but not readily licensable to major industry partners or a commercialization priority for a corporate lab. Like “baseball scouts,” there are special kinds of people that know how to find high-potential, undeveloped innovations in difficult to extract areas. They know how to converse with researchers in very technical terms, yet also translate ideas into laymen’s terms and help researchers understand how to communicate with potential sponsors and investors. The best tech transfer offices know how to find and recruit these innovation scouts to validate what they’re hearing directly from the researchers. The challenge is that many tech transfer offices are resource constrained and must prioritize the hiring of intellectual property attorneys to handle the basic functions of their offices. Generally, interviewees for this report were satisfied with the innovation infrastructure provided by research institutions and industry clusters. However, a common view was that innovation development could be accelerated by universities being more “customer oriented” in licensing processes and decisions. The good news is that there are proven measures to increase the supply and development of innovation, but require substantial resources and many years to produce results. Examples of innovation supply initiatives that have produced tangible outcomes include the Georgia © The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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IV. Understanding the Innovation Ecosystem

Research Alliance’s Eminent Scholars program, the Utah Science, Technology and Research (USTAR) initiative, and the Kansas Bioscience Authority’s support of a winning proposal to bring a new federal laboratory, the National Bio and Agro-Defense facility, to Kansas. Though nothing has been discussed as a clear and present opportunity for a major initiative to increase the supply of innovation, the ABB and advocates of the Risk Capital Initiative should generally support state and university efforts to increase innovation supply and look opportunistically for major opportunities to recruit major R&D operations, compete for federal lab expansions and recruit star researchers whose work is aligned with Arizona technology clusters. 2. Accelerators • • •

Contributes – Translational expertise to turn technologies into businesses. Needs – Discretionary resources to invest in “proof of concept” work; strong affiliations with universities and other sources of innovation; active participation by prolific angel investors. Includes – University technology transfer offices; university accelerators; public/private accelerators.

This is an area where Arizona appears to be hitting on all cylinders. Nationally, there’s been a swell of investment in events, facilities and advisors to help innovators and entrepreneurs start businesses. The Arizona Commerce Authority has a useful “Startup: Resource Directory” and many other resources to help innovators find communities best suited for them. A potentially helpful tool, that may already be in development, would be a statewide “pipeline analysis” that would survey known accelerators on a quarterly basis and aggregate basic information on companies from the earliest development stages. Robust data on startup activity can be a valuable asset for facilitating communications with Bay Area investors and interesting them in spending time in Arizona. The data can also be used to facilitate federal grant awards and explain the value of supporting innovation ecosystem activities to state legislators. University technology transfer offices are categorized as accelerators because they play a critical role in accelerating the flow of intellectual property into private businesses. Due to the nature of their gatekeeper role and the complex masters they serve, directors of technology transfer offices are often blamed for private sector frustrations with the speed of their due diligence or the demands they may make for ownership or royalty interests. Interviewees generally had positive reflections on the roles of Arizona Tech Launch (U of Arizona) and Arizona Technology Enterprises (ASU) in facilitating the development of companies commercializing university intellectual property. For innovation ecosystems to work at optimal efficiency, the leaders of these important organizations need to be fully engaged in the design and implementation of risk capital initiatives and supported in their efforts to access resources beyond the margins of their budgets. © The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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3. Credible Entrepreneurs •

Contributes – Experience managing nascent enterprises with high risk of failure and the need to shift between handling mundane tasks to developing credible business plans while persistently pursuing risk capital (and everything in between). Needs – Mentors, angel investors, support groups and networks to help them land the financing and talent they need, and the next gig whether or not the current one finds success. Includes – Some university researchers (rare), university students, software developers, engineers, doctors, recovering attorneys and CPAs…they come from all walks of life, but not everyone who self-identifies as an entrepreneur has the potential to lead an investor-backed technology business.

When investor-backed startups fail, the entrepreneurs generally shoulder the blame. All successful entrepreneurs were at first unproven. An entrepreneur with a previous successful exit will have a much easier time attracting investors for a new venture than one with no previous experience or only unsuccessful venture on a resume. Only in Silicon Valley are first-time entrepreneurs commonly entrusted with multi-million-dollar seed capital investments, and this is more a reflection on the confidence of the investors in their own abilities to mentor entrepreneurs and balance failed investments with a number of high-return successes. While complimentary of the entrepreneurial spirit in Arizona, many angel investors and institutional investors interviewed for this report commented that there were more good innovations than good business plans in Arizona, and that the state’s angel investors had more capital to invest than investment-grade opportunities to invest in. It can be a good thing for young entrepreneurs from Arizona to go to the Bay Area for a period of time and return with Bay Area venture experience on a resume. Some may never return, but that does not mean that they cannot be a resource for Arizona entrepreneurs and investors with whom they may retain an affinity. Importantly, it may be necessary and productive to engage in a “human capital recruitment” effort to bring experienced entrepreneurs from the Bay Area (or San Diego, which has a robust bioscience industry) to work with early stage Arizona companies. A competitive advantage for Arizona can be found in 30+ daily nonstop flights to Bay Area airports (San Francisco, Oakland and San Jose). It is reasonable for Bay Area entrepreneurs to commute to Arizona while bringing credible experience and established relationships with Bay Area investors to Arizona companies.

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IV. Understanding the Innovation Ecosystem

4. Angel Investors • • •

Contributes – Seed and early stage investment capital; mentoring of entrepreneurs; industry connections; relationships to potentially syndicate larger rounds with multiple angels. Needs – Well-developed business plans presented by experienced entrepreneurs; relationships with next-stage investors that respect their early stage equity interests. Includes – Individuals investing alone; individuals investing through groups; “super angels” investing at levels (1+ million) predominantly served by institutional venture capital funds.

Another area of strength for Arizona is its active angel investor communities. According to CB Insights, two Arizona angel investor groups – Desert Angels in Tucson and Arizona Technology Investor Forum in Phoenix – rank among the top 20 angel groups in the U.S. out of 370 angel groups evaluated. Arizona Technology Investor Forum ranked 6th nationally for investment follow-on rate.ix Angel investing accentuates the strengths of Arizona. The state is well-known as an attractive destination for active retirees. The state has significant tax advantages over neighboring California. There are numerous reasons why Arizona is already a great place for angel investing, and numerous more why angel investing – done the right way – should be a celebrated and promoted activity for accomplished accredited investors. The first priority for supporting angel investing as a competitive strength is to make it even stronger, and the best way to do this is to support and leverage the two strongest groups in the region. The leaders of these groups have already expressed their strong desire for the state to renew its angel investor tax credit program, a policy initiative strongly supported by the Arizona Commerce Authority and the Arizona Technology Council. Beyond lending support to this policy initiative, the ABB Risk Capital Initiative should explore ways to support these organizations in expanding their membership, developing new groups affiliated with them and adapting their best practices, and educating new angel investors across the state about how to invest successfully. One potential way to support angel groups in Arizona is to develop a network of “super angels” – family offices of high net worth individuals capable of bridging gaps between angel rounds and institutional venture capital investors. The request of super angels is not to meet as groups to hear pitches, but rather to commit their investment managers to meeting quarterly with facilitators to review information about 6-10 companies backed by local angel investors and looking for next stage capital from large family office or institutional investors. Potentially, Arizona super angels can deliver several benefits to the Arizona innovation ecosystem. First, many actively invest in companies at levels on par with institutional venture capital funds and may develop an affinity for a specific Arizona-based company. Second, many actively invest as limited partners in Bay Area venture capital funds, and they may be able to leverage certain relationships to obtain feedback on Arizona-based companies or make quality introductions to fund managers.

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IV. Understanding the Innovation Ecosystem

5. Corporate Venture Investors • •

Contributes – Direct investments in early to growth stage companies aligned with strategic business development interests. Needs – Visibility and access to early stage companies developing technologies that may impact existing or future products; healthy, vibrant business communities that attract and retain quality workers and create opportunities for trailing spouses. Includes – Corporate capital, whether or not allocated to a specific fund.

According to data recently released from the quarterly PwC Moneytree Report and the National Venture Capital Association, corporate venture capital funds invested $5.4 billion in 775 deals, the most since 2000. Of this, $1.1 billion was invested in life sciences companies, the most since PwC Moneytree began tracking corporate venture investments in 1995.x Nationally, corporate venture funds have followed boom and bust cycles, committing capital during the latter part of boom cycles and often pulling the capital back when markets cool off. However, one major Arizona employer, Intel, has managed a long-standing corporate venture fund, investing $11.4 billion in over 1,400 companies since 1991.xi Corporate venture funds are potentially ideal partners for state and regional risk capital initiatives. In addition to globally monitoring innovation relevant to their core businesses, corporations have a vested interest in the general economic vitality of regions where they have major physical plants and human capital investments. Potentially, corporate venture funds could be partners with state and local economic development organizations to attract high-potential companies receiving corporate venture capital investments to expand in or relocate to Arizona. 6. Institutional Investors – i.e., Venture Capital Funds •

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Contributes – Equity investments in high-potential technology businesses; lead investors for out-of-state syndication partners; investments and capital under management aggregated in nationally reported data commonly cited by media influencing perceptions of regional technology ecosystems. Needs – Limited Partner investors; quality investment opportunities aligned with industry expertise and size of deal appropriate for active funds. Includes – Small number of quality independent venture capital funds committed to investing regionally or nationally from Arizona.

The greatest challenge for Arizona’s entrepreneur ecosystem has nothing to do with the quality of the venture capital funds actively investing from a base of operations in Arizona. The challenge is that there are too few resident venture funds to lead and participate in value-add investment rounds. There are many challenges facing the venture capital industry. Some interviewees questioned whether the industry in ten years will be anything like it is today. Paraphrasing a quote from a hockey legend, one said, “Don’t chase the puck where it is, but skate to where it’s going to be.” © The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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IV. Understanding the Innovation Ecosystem

Where the puck is today shows the Bay Area tightening its grip as the world’s epicenter for technology business. The Bay Area has been dominant for 30 years and there’s no sign of abatement. The region’s market share for the U.S. venture capital industry approaches 50% - both measured by investments in Bay Area companies and venture capital managed by Bay Area funds. Fortunately, Arizona has an advantage over most capital-deficient states in the U.S. Arizona has more than 30 daily nonstop flights to the Bay Area. For some investors, a two-hour flight is not much more inconvenient than a rush hour drive from San Jose to San Francisco. With some effort, promoters of Arizona’s innovation ecosystem can facilitate access to Bay Area investors with greater effect and a lower total cost than other locations. While strategically accessing Bay Area investors in the near-term, it may also be strategic to preparing a foundation for a new generation of venture capital investors with strong ties to Arizona. One possible strategy could entail a strategic partnership with the Kauffman Fellows Program (KFP), a renowned leadership development program for the venture capital community led by an alumnus of the University of Arizona. For example, the ABB and its partners and sponsors could provide financial support to two Arizona-based Fellowship candidates a year for five years, selecting candidates with strong personal ties to Arizona and a long-term aspirational goal of becoming a general partner for an institutional venture capital fund based in Arizona. The Fellowship candidates would have Arizonabased mentors and maintain residences in Arizona while investing substantial time in the Bay Area developing industry relationships facilitated by KFP. The sponsorship structure could provide mechanisms for the Fellowship candidate to repay the value of the ABB financial commitment through active participation in ABB Risk Capital Initiatives for a multi-year period. Ultimately, the best way to increase the state’s base of venture capital investors is to strategically recruit and develop teams of individuals with the potential to raise institutional limited partner commitments for new funds they manage. As a start, ABB could sponsor a simple but robust research effort to identify every Bay Area venture fund partner or associate with a personal tie to Arizona. University alumni, expatriates, owners of vacation homes in Arizona, etc. From there, relationships can be developed and candidates identified that, with the right assistance and incentives, could be recruited to develop new Arizona-based funds. Finally, with the right structure, it may be possible to accelerate plans to develop a base of Arizonabased venture capital through a corporate- or state-sponsored venture capital program. •

Corporate-sponsored venture capital program – Ex: Renaissance Venture Capital Fund, Michigan

In this model, corporations make LP investments with a regional fund-of-funds manager that invests nationally in venture capital funds making seed, early and growth stage investments in technology companies relevant to the region’s industrial base. The venture funds receiving allocations of capital can invest in companies without geographic restrictions; however, they agree to meet regularly with accelerators in the sponsoring region to review seed and early stage companies from the region.

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Also, the corporate sponsors meet regularly with the venture capital funds to learn about innovations nationally or even globally in areas relevant to their industries. The first Michigan Renaissance Fund raised $45 million of capital in 2010. Without any requirements to invest in Michigan companies, many of the venture funds receiving allocations opened offices in Michigan and actively reviewed Michigan-based companies. By May 2014, Renaissance had increased its total capital commitments to $110 million across two funds. Sixteen Renaissance-backed venture capital funds with LP commitments of $80 million had drawn $22.4 million of capital from Renaissance for investments. During that same period, those sixteen funds had invested $472 million in 23 companies in Michigan, with 80% of the capital imported from out-of-state funds.xii Recently, Renaissance closed Fund II at $79 million for total capital under management of $124 million.xiii One early corporate LP in the Renaissance Fund, Proctor & Gamble, decided that it would like to see a similar model developed for Cincinnati, the location of its headquarters. Cintrifuse Fund Management LLC has now raised $57 million from 14 corporate investors in the Greater Cincinnati and Northern Kentucky region while also supporting a technology business accelerator under the Cintrifuse brand.xiv •

State-sponsored venture capital program – Ex: InvestMaryland

In 2011, Maryland passed legislation to commit $100 million of deferred insurance premium tax credits to the InvestMaryland program. The tax credits were sold directly by the state to insurance companies via an auction process, yielding $84 million of capital commitments over three years, beginning in March 2012. Two-thirds of the capital ($56 million) was allocated to the newly created Maryland Venture Capital Authority (MVCA), which hired an advisory firm to manage due diligence on more than three dozen applications from venture capital funds. By the end of 2012, InvestMaryland had committed $49 million to seven funds in allocations ranging from $3 million to $12 million.xv Although many of the funds receiving allocations are managed outside Maryland, the legislation mandates that 100% of the Maryland capital be invested in Maryland-based companies. State restrictions are often managed through the use of “sidecar” funds that invest alongside the primary fund but participate only in deals meeting the geographic restrictions. In 2013, the Commonwealth of Pennsylvania passed the Innovate in PA legislation, which commits $100 million of deferred insurance premium tax credits to finance innovation ecosystem programs. Once the tax credits are sold directly by the state, 45% of the capital raised will be allocated to a fund-of-funds program managed by the Ben Franklin Technology Development Authority.

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Case Study: BioEnterprise (Cleveland, Ohio) In 2002, following a national wave of venture capital investment in technology businesses, Cleveland’s corporate and philanthropic leaders perceived that their region was getting left behind. Despite a strong base of research in the life sciences at Cleveland Clinic and Case Western Reserve, scarce amounts of venture capital were finding its way to startups commercializing locally-developed technologies. An annual rate of $30 million of venture capital was considered too low for a region already battling negative perceptions of having an aging industrial base. Beginning with a strategic plan drafted by McKinsey consultants, civic leaders that would later form the Fund For Our Economic Future (FFOEF) studied more than 20 regions aspiring to develop a thriving life sciences industry before focusing on a “venture facilitation” plan. The model, uniquely designed for Cleveland, featured the following attributes: 1. Forced Collaboration – Civic leaders strongly encouraged the presidents of Cleveland Clinic and Case Western Reserve to serve on the board of the new entity and to commit their technology transfer officers to work actively together, participating in weekly meetings to share market feedback on early stage technologies. 2. Credible Facilitation Services – Civic leaders understood that the success of the initiative would depend on the quality of the human capital recruited to manage the flows of information between scientists and investors. “Sector leaders” for medical devices, biopharmaceuticals and health care services were recruited with competitive salaries and the challenge of coaching and persuading scientists to position their innovations for venture capital investment.

3. One Scoreboard – Civic leaders insisted that BioEnterprise focus on one metric – venture capital investment – and that it not parse credit for successes between collaborators. While BioEnterprise does track other data important to co-investors like job creation and average wages, its leadership has maintained its focus on venture capital investment, explaining that it is a leading indicator of economic vitality. The early BioEnterprise supporters raised financial support from foundations to recruit a talented leader from the McKinsey consulting team to launch the organization. Its board of corporate and university leaders ensured that the organization did not duplicate other regional initiatives financed in part by FFOEF, including the JumpStart seed fund and NorTech, a regional tech-based economic development group focused on developing industry clusters. 78% of the $15.5 million of funding received in its first six years of operations came from FFOEF and other private foundations. Within its first 30 months of operations, BioEnterprise formed, recruited or accelerated more than 40 companies that attracted $148 million in new funding. BioEnterprise and its partners have been able to sustain its early success, contributing to nearly $400 million of new funding in 40 companies in 2014.

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V. Principles for Risk Capital Initiatives

Section V: Principles for Risk Capital Initiatives Highlights: o Explanation of the four “principles” developed by report authors to evaluate or guide the development of risk capital initiatives: 1. Capitalize programs efficiently 2. Focus on the most underserved capital markets 3. Select managers competitively 4. Require pari passu financing returns to funding partners, including the State

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V. Principles for Risk Capital Initiatives

Most entrepreneurs and investors subscribe to the basic tenets of free enterprise. They generally believe in competition, free markets and minimal government intervention. They aspire to create superior products or services that businesses or consumers will purchase in recognition of their quality and value. Some entrepreneurs and investors hold steadfast to the belief that capital markets are always efficient, including the market for early stage, high-technology businesses. “All good deals get funded regardless of geography. If a company does not get funded, it’s not a good deal.” Common sense and data contradicts this notion. Though an entire report could be written on the inherent inefficiency of equity capital markets, two simple points are presented: •

Extreme geographic concentration of venture capital investment – There’s no justifiable reason for 40-50% of total U.S. venture capital investment to be made, year after year, in a geographic region representing approximately 2% of the U.S. population. If capital finds the best deals, why must the best deals move to a region where the cost of living and doing business is so high? Wealth is not similarly concentrated. Fortune 500 companies are not similarly concentrated. Competitive research awards to university scientists are not similarly concentrated. There are banks with capital to make quantitative risk assessments to prospective small business borrowers in every state and every region of the country. But the supply of equity capital investors ready to make qualitative risk assessments varies greatly by geography – a factor that should be irrelevant for most technology-based small businesses. Great investors sometimes, with hindsight, make bad decisions – Dozens of idea-stage startups have received $5+ million investments from elite Bay Area funds and lost 100% of the capital invested. Kleiner Perkins once invested in a company that repaired athletic shoes – a failed investment contemporaneous with the emergence of Nike. Bessemer Ventures, one of the nation’s oldest and largest venture firms, is so well-regarded for its many greatly profitable investments, such as Arizona-based Lifelock, that its website humorously lists its “anti-portfolio” – companies in which it had an opportunity to invest but turned down – which includes Apple, eBay, Facebook, Google, Intel, Cisco and FedEx, among others.xvi When Howard Schultz was raising an early round of capital for Starbucks, he made 242 pitches to accredited investors in a year, of which just 25 said yes. The 217 wealthy individuals and institutional investors from the Seattle area and beyond that thought consumers wouldn’t pay more than 45 cents for a cup of coffee lost out on a 100X return, assuming they sold at the time of the IPO.

The combination of these two points comprises the proof that “the playing field is not level” for Arizona-based companies competing with similarly-positioned Bay Area companies seeking risk capital investment. Simply put, a Bay Area based company can be turned down dozens of times by institutional investors in the Bay Area and still find a dozen more firms to pitch without ever presenting in front of the same investor twice. Getting rejected by Bessemer Ventures was not a definitive conclusion on the potential for Apple, Facebook or Google. In contrast, companies traveling to the Bay Area from other regions seeking risk

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V. Principles for Risk Capital Initiatives

capital to grow their businesses – and aspiring to remain where they are currently located – are often asked about investor support from regional funds closer to them. A recent article in Fortune, referencing the recent breakup of one of the few multi-billion-dollar venture capital funds outside the Bay Area, asked the question, “Are Austin startups better off without Austin Ventures?” The author introduced the concept of “signaling risk” with an excerpt from a letter from an unnamed reader: One benefit to entrepreneurs of the public dissolution of Austin Ventures is the removal of the ‘What about AV?’ question. Many VC firms from outside Austin would understandably have concerns about information asymmetry between themselves and AV when evaluating Austinbased investment opportunities. As such, many entrepreneurs felt obliged to ‘kiss the ring’ and had an understandable fear that a negative (or no) opinion of their startup within the halls of Austin Ventures could hamper their efforts to ever raise institutional venture money elsewhere. While AV’s prominence in early stage financing has declined in recent years, their formal and public exit should clear the air of some stale preconceived notions — to the benefit of Austin’s entrepreneurs.xvii Geographic distance and “signaling risk,” combined with many other factors, such as the supply of startup-experienced managers and talent, cultural acceptance of failure as a learning experience, and deep pools of angel investors comfortable with investing in portfolios of high-risk technology companies, present a complex challenge for policy leaders seeking the economic development benefits from high-wage jobs in high-growth companies that, with rare exceptions, need venture capital to grow. Because of this extreme concentration of venture capital that limits capital accessibility, Democrats and Republicans alike have supported legislation and public commitments of taxpayer funds to increase the supply and accessibility of risk capital investments in their states. Even in two of the nation’s leading areas for venture capital investing – Massachusetts and New York – there are substantial government-sponsored programs aimed at filling capital gaps and stimulating private investment. In some areas, the gaps are so wide that the innovation ecosystem simply does not function without government or philanthropic support. Arizona is fortunate to have well-functioning regional innovation ecosystems, but concerns about the supply and accessibility of risk capital has led many to conclude that policy and fiscal support from state government is necessary. There have been more than a few efforts in the past decade to pass legislation aimed at increasing the supply of venture capital in Arizona. Program models ranging from “certified capital companies” (CAPCO) to “fund-of-funds” have been proposed but not survived the legislative process. The authors of this report have substantial experience advising states on the design, implementation and management of risk capital initiatives. We understand the arguments for government intervention, but also appreciate that it takes time to build the necessary policy support for a targeted initiative that competes with many diverse policy priorities during a legislative session.

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V. Principles for Risk Capital Initiatives

In anticipation that leaders of the ABB Risk Capital Initiative may seek state government participation in the future to help achieve its objectives, the following “principles” developed by the authors from experiences advising other states may be useful: Principle #1 – Capitalize programs efficiently 44 states have at least an AA S&P credit ratingxviii, enabling them to issue bonds at historically low interest rates, yet many have implemented state programs with taxpayers bearing usurious financing costs to achieve modest economic development outcomes. One fairly common program format is so inefficient that nearly 50% of the state’s fiscal commitment is consumed by various financing costs. Comparable programs with more efficient designs can reduce financing costs to 13-20% of the state’s fiscal commitment, which on a $100 million program amounts to $30-37 million of savings. Also, proponents of certain models commonly recommend clawback provisions on tax credits that, rather than protecting taxpayers from nonperformance, serve to drive up financing costs and create barriers to competition for the benefit of proponents best positioned to meet the arbitrary statutory requirements of their design. Counterintuitively, states are very often able to finance risk capital programs far more efficiently than private sector firms. When state tax credits are used to create pools of capital for investment funds, the state is far better off selling the tax credits directly to taxpayers than allocating the tax credits to firms that then sell the tax credits to private investors. Recommendation: For any state-sponsored program intended to provide capital for small businesses, follow the money to determine the comprehensive financing costs for converting state resources to investment capital. Principle #2 – Focus on the most underserved capital markets Many state programs, contrary to the intentions or understanding of policy leaders, effectively subsidize private sector investors in areas where the supply of risk capital is greater and less geographically concentrated, such as later stage or “mezzanine” capital. By far, the greatest need for states like Arizona is access to early stage venture capital with connectivity to later stage investors. One way to protect against “scope creep” is to prohibit fund managers from making investments with the characteristics of debt. The various structures and labels can be confusing to policy makers, who may not understand that convertible debt typically has the characteristics of equity and redeemable preferred stock often has the characteristics of debt. To be clear, equity capital is most often the greater need, and it is the type of risk capital described as the greatest need in the research for this report. Recommendation: Avoid models that allow private firms with state subsidies to compete with banks.

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V. Principles for Risk Capital Initiatives

Principle #3 – Select managers competitively “The State should not pick winners and losers.” Never mind that state agencies do exactly this with various procurement processes designed to get the best value for taxpayers and insulate decisions from political influence. All 50 states have pension funds with carefully designed processes to make investment allocations to venture capital funds. The same processes can be readily adapted to select credible, independent fund managers for economic development programs. The best state programs do exactly this, while others go to great lengths to avoid making competitive selections, even to the extent of implementing suboptimal “first come, first served” allocation methods. Another type of program gaining in popularity relies on the legislative process to establish qualifications for fund managers rather than allowing state agencies to implement competitive selection processes. The model, marketed by proponents as a “mirror” to a popular federal program, uses the federally-managed competitive selection process as a proxy for the state, even when this excludes funds with far greater experience investing in the region merely because they do not participate in the federal program. Rather than legislating narrow requirements, there are better, more effective methods for state agencies to design fund selection processes that are open, fair and far more likely to produce the best possible economic development outcomes. Recommendation: Be good stewards of state resources by using effective governance processes and conflicts of interest policies to enable qualified agents with a fiduciary duty to the state design program requirements and select the best managers. Principle #4 – Require pari passu financial returns to funding partners, including the State When states finance risk capital programs for economic development purposes, they need two types of returns to justify the investment – direct financial returns and indirect economic impact returns. Too many states implement programs where the state sets its expectations of direct financial returns at zero. These programs generally allocate tax returns to funds in exchange for the funds making investments that meet certain objectives, such as making investments in low-income communities or making qualifying investments of certain amounts by certain dates instead of evaluating fund performance on reasonable financial measures. When the objectives are met, the funds and their investors keep the value of the tax credit. No capital is returned to the state. Effectively, these programs constitute a direct transfer of wealth from the public to private sector, and very often to funds that, prior to the legislation, had no base of operations in the state. The challenge for promoters of these programs is demonstrating that the economic value of the investments they make exceeds the cost of the tax credits. Very often, creative accounting methods are employed. Participants commonly claim that every job in the company at the time of an investment was “retained” by their investment, even when the investment is merely a loan to an established, profitable company. Participants also commonly claim that every job subsequently © The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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V. Principles for Risk Capital Initiatives

added to the company was “created” by their investment, even when other private sector investors, investing capital without state subsidies, lead the investment round and invest far more capital in the round than the state program participants. Promoters often hire economists to opine on the economic impact of the job counts they report, limiting the scope of work to exclude opinions on the reasonableness of job counts. The fact is that there are no “generally accepted accounting standards” for reporting job claims from risk capital investment programs. Even if there were, it makes no economic sense for a state to invest taxpayer capital – either directly or via a tax credit – and ask for no returns of capital. No reasonable private investor would do this. When capitalizing risk capital programs with state resources, the state should receive the exact financial returns as other investors – pari passu – “on equal footing.” Private investors in venture capital funds typically allow fund managers to earn a management fee, but that fee is merely a nonrecourse advance on the fund manager’s share of investment profits, which is typically 20%. When a fund is profitable, investors generally receive a return of 100% of the principal invested plus 80% of investment profits. When states implement similar requirements for risk capital programs, they generally will receive cash returns after 10-12 years ranging from 80% to 200% of invested capital. In the worst case, the economic impact returns need only to exceed 20% of the initial investment, as 80% was returned as cash. In the best case, the taxpayers are made whole on the initial investment, profits are also returned, and the economic impact is viewed as a bonus on top of a sound investment program. Recommendation: Develop measures for comprehensive returns that include direct financial returns on invested capital and economic impact measures from providing capital to underserved markets.

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VI. Recommendations for Arizona’s Risk Capital Initiative

Section VI: Recommendations for Arizona’s Risk Capital Initiative Eight Complementary Strategies for Arizona’s Risk Capital Initiative: 1. Celebrate the Angels – build investment capacity on existing strength 2. Support university technology transfer efforts statewide 3. Host technology and investor events 4. Make connections between companies and investment epicenters 5. Build a pipeline of investor-ready companies 6. Encourage equity participation from public investing entities 7. Develop Arizona’s venture capital industry 8. Create a unified voice for Arizona’s capital formation policy

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VI. Recommendations for Arizona’s Risk Capital Initiative

Each state requires a customized approach to developing the right mix of complementary strategies for increasing the supply and accessibility of risk capital that supports “homegrown” companies. While the goal is singular – achieve at least the national per capita average rate for venture capital investment in Arizona companies – the tactics to achieve the goal in this state are multiple. Arizona’s unique attributes considered in the development of the recommended strategies include: •

Fast-growing university enrollments at the state’s public universities, with approximately 140,000 students enrolled at the three major campuses and compelling initiatives to foster an entrepreneurial culture with students and faculty; Established, sophisticated angel investor groups with sufficient capital resources to finance the most promising startup companies through seed stage; Reasonable proximity to the global center of innovation investing – Bay Area – with approximately 30 daily nonstop flights between Arizona’s two major cities and San Francisco, San Jose and Oakland; Strong civic and corporate leadership aligned with the goal of the ABB’s Arizona Risk Capital Initiative and who are willing to collaborate on the strategies and tactics to realize success. Concerns about the appearance of deep cultural, political and philosophical reservations concerning direct state investments in venture capital funds, and perceived antibodies from multiple efforts to develop a fund-of-funds program supported by state government; and Concerns from angel investors and entrepreneurs that the most promising companies must work harder in Arizona to secure follow-on financing and would benefit from greater exposure to talent and investors in out-of-state technology investment hubs.

In consideration of these factors, the report authors developed a portfolio of eight recommendations with descriptions of basic implementation plans:

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VI. Recommendations for Arizona’s Risk Capital Initiative

Recommendation #1: Celebrate the Angels •

Key parties: Influential Angel Investors, Arizona Commerce Authority, Governor’s Office

Accredited investors, whether acting individually or through one of the highly acclaimed Arizona investor groups, are economic development heroes who should be celebrated as such and supported. Already a destination of choice for affluent retired executives, Arizona should cultivate and grow this advantage by creating and offering the best policies and services for angel investors in the U.S. Implementation plan for Recommendation #1: 1. Support reasonable, fiscally responsible legislative initiatives deemed important by influential angel investors, such as the Small Business Capital Investment Tax Credit designed to stimulate private investment by accredited individual investors in Arizona. 2. Develop a marketing campaign through ACA to declare Arizona as a leading destination for angel investors, creating awareness for the important roles served by experienced executives mentoring entrepreneurs and investing alongside peers in innovative companies. 3. Host educational events throughout the state for accredited investors interested in learning about angel investing and the resources available to support their investments. 4. Through established social networks, identify and recruit experienced executives capable of mentoring entrepreneurs backed by angel investor groups and connect them to next-stage capital sources outside of Arizona. 5. Routinely recognize a prolific angel investor with an official declaration by the Governor’s Office and host a private lunch or reception that includes the Governor’s participation. 6. Invite angels from neighboring states to events in Arizona and market Arizona as a great, active investment environment for successful angels. 7. Engage with leaders of active angel investor groups to find ways to support their meeting activities, member recruitment and deal flow development. 8. Cultivate a “super angel” network to serve as potential syndication partners for the most promising companies that need to raise larger amounts of capital than generally served by individual angel groups.

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VI. Recommendations for Arizona’s Risk Capital Initiative

Recommendation #2: Support university technology transfer efforts •

Key parties: Governor’s Office; Arizona Commerce Authority, Research Institutions

University technology transfer offices are perception drivers and essential anchors to the state’s innovation ecosystem, and university programs fostering tech entrepreneurship should be supported, improved, and expanded. University leaders should be encouraged to prioritize the licensing of Intellectual Property to entrepreneurial ventures in Arizona with flexible, reasonable terms, and these leaders should be “at the table” throughout the design and execution of capital formation initiatives. Improving university research commercialization and technology transfer initiatives is a priority and as integral to a comprehensive strategy as grant application assistance and matching programs, state business plan competitions and regional accelerators. These programs play unique, complementary roles and help prime the pump for investment in Arizona’s regional innovation economies. Implementation Plan: 1. Advocate for additional state investment in an innovation agenda on behalf of commercialization initiatives championed by universities and established tech-based economic development organizations. 2. Encourage and support private initiatives that create targeted investment funds to leverage university assets and stimulate early-stage capital formation. For example, the Catapult Corporation designed by Tech Launch Arizona, the technology transfer office at the University of Arizona, presents an innovative experiment to increase accessibility to seed capital for high-potential technologies developed within university laboratories. 3. Launch a talent engagement campaign to encourage influential business leaders to volunteer time and expertise to support the implementation and execution of best practice programs with entrepreneurs and new ventures as well as with faculty members looking to partner with new ventures. 4. Assist Arizona’s universities and TBED programs in benchmarking their programs with those in other states whose reputations they aspire to match and eventually exceed, identifying areas where state and/or philanthropic support could help them achieve transformational outcomes. 5. Support university goals for aggressive technology out-licensing through the State Board of Regents.

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VI. Recommendations for Arizona’s Risk Capital Initiative

Recommendation 3: Host technology and investor events •

Key parties: Governor’s Office; Arizona Commerce Authority, TBED Organizations, Investors

Arizona excels at creating memorable events and experiences for visitors. Its world class resorts and unique attractions can be leveraged to showcase the state’s innovation infrastructure, attractive business environment and high-potential companies seeking equity-based investments. Investor and industry conferences provide natural tie-ins with existing tourism initiative in sports and entertainment – intentionally target venture investors and roll out the red carpet. Recent examples include events surrounding the 2015 Super Bowl and the 2014 White Hat Investor Conference. Analogous to hosting corporate VIPs and international government dignitaries, resources should be allocated to attracting VC investors to Arizona events and providing them with unique experiences. Out-of-state VC and Angel investors merit first-class treatment from the state’s ambassadors due to the tremendous economic potential of their investment capital for Arizona’s innovation ecosystems. Implementation Plan: 1. Survey innovation ecosystem stakeholders to identify national conferences attractive to Bay Area investors and work with tourism and convention industry leaders to plan an effective recruitment strategy. 2. For hosted events, identify Bay Area and other venture capitalists investing in relevant industries and recruit them to participate with special accommodations and opportunities to meet Arizona-based companies and LP investors. 3. Leverage annual tourism attractions, such as spring training baseball and the Gem and Mineral Show to invite institutional venture capital investors to attend VIP experiences preceding or following meetings.

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VI. Recommendations for Arizona’s Risk Capital Initiative

Recommendation #4: Connect Arizona companies with investment epicenters •

Key parties: Philanthropic and corporate partners, venture development organizations

Arizona is well positioned to aggressively support the most promising Arizona companies in their efforts to attract institutional venture capital wherever it is managed, with a specific focus on Bay Area funds but also including connections to investment hubs on the East Coast and regionally. Arizona’s geographic proximity to California can be a significant advantage, but the success of venture development and promotion strategies directly correlates to the credibility of the leaders making the connections. Regional entrepreneurial ecosystems thrive when the innovation networks consist of credible people who are properly connected and properly aligned. This strategy must be executed with the right people promoting the right mix of companies at the right time. Implementation Plan: 1. Facilitate the exchange of information between Arizona innovators and investors in the leading investment opportunities, with emphasis on the Bay Area. Rather than making a pitch to venture capital investors for a specific deal, the facilitators should seek continuous dialogue with multiple fund managers about multiple Arizona companies, asking for recommendations as a means to gauging and developing sincere investor interest. 2. Work with a broad coalition of ABB stakeholders to identify Arizona-based [Limited Partner] investors in Bay Area venture capital funds. Then, in small, high-level conversations with these asset managers, start a conversation about Arizona as an attractive, yet underserved, market for venture investment that warrants a closer look at the most promising deals. 3. Recruit Arizonans with venture capital experience in the leading investment hubs – venture investors and venture investment-backed entrepreneurs – to mentor emerging leaders and make strategic introductions to funding sources. 4. Make geographic proximity a competitive advantage and market as a strength with 30 nonstop flights between Arizona cities and the regional Bay Area each day.

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VI. Recommendations for Arizona’s Risk Capital Initiative

Recommendation #5: Build a pipeline of investor-ready companies •

Key parties: Business Accelerators, Angel Investor Groups, Private Philanthropy

Core to this recommendation is the inclusion of best practice venture facilitation and development models serving Arizona’s entrepreneurs through a coordinated statewide support system. Arizona boasts a number of business incubator and accelerator programs. The focus of this recommendation is to support and strengthen existing organizations and filling gaps in the state’s entrepreneurial ecosystems as needed. The goal is not more accelerators, but rather supporting and connecting programs demonstrating success with measurable outcomes – quality of programs over quantity is key. Programs operating in Arizona such as BioAccel in Phoenix and the Center for Entrepreneurial Innovation in Tucson are examples of initiatives meeting market needs. Venture facilitation programs have been effectively used in other regions to increase private investment and help solve the “chicken vs. egg” challenge of equity-based investing. Two important features of successful programs are1) a focus on attracting executive-level talent with domain expertise to help “de-risk” a potential investment, and 2) an active information feedback loop between innovators/entrepreneurs and investors. 1. Educate Arizona innovators about the venture capital investment model, the “red flags” that discourage savvy investors and other coaching tips that prepare technologists and entrepreneurs for the adjustments required to manage the expectations of investors. 2. Recruit a core team of 4-5 executives who possess technology and venture development credibility with institutional investors in industries aligned with Arizona’s strengths (as evidenced by personal recommendations from multiple investors in targeted sectors). 3. Recruit university presidents/chancellors, corporate CEOs and philanthropic leaders to actively participate in organizations responsible for recruiting executive talent and monitoring their performance. 4. Recruit C-suite executives from the Bay Area to attach to projects developing Arizona-based companies, even where a commuting engagement is facilitated in lieu of a relocation. 5. Where practical, develop models to participate in the equity ownership of companies that successfully raise venture capital, thereby creating opportunities to ultimately offset continued philanthropic support with capital gains from the company portfolio.

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VI. Recommendations for Arizona’s Risk Capital Initiative

Recommendation #6: Encourage equity participation from public investing entities •

Key parties: Governor’s Office; Arizona Commerce Authority

Nearly all states have prohibitions against state government directly owning an equity interest in a private company. However, a majority of states have developed proactive strategies to stimulate private investment and economic development by allowing state funding participation in investment programs administered by independent, nonprofit or for-profit entities aligned with state interests. An important feature of successful state-supported risk capital initiatives is the treatment of public resources on market standards similarly to how private investors are treated – with pari passu investment terms. Implementation Plan: 1. Develop a straightforward communications plan with the Governor’s Office to explore the fairness and value of equity investment support programs, properly structured and managed, relative to loans, grants and tax credits supported with state funding. 2. Arizona should consider working through a specialized nonprofit entity to manage venture development and venture investment programs with requisite management expertise. Recommendation is to consider utilizing the Arizona Commerce Authority, if appropriate as structure and capabilities allow. Examples can be reviewed from states that have used statesponsored non-profit organizations to enable equity investments in private companies and identify any and all statutory restrictions that need to be addressed by legislative action.

Recommendation #7: Develop Arizona’s venture capital industry •

Key parties: Private/Corporate Philanthropy; Governor’s Office, State Legislature, Chambers and Industry Associations

Increasing the supply of venture capital that is managed by investment funds resident in Arizona or in close proximity to Arizona will take time and significant investment to achieve. But an entrepreneurial ecosystem that effectively fosters high-growth potential companies requires the presence of bona fide venture capital firms that are capable of leading syndicated investment rounds, supporting portfolio companies and making connections to markets. The venture investment community needs to grow in Arizona with the creation of new funds that can sustain investment activity across the financing lifecycle. Without these anchor investment partners in the ecosystem, Arizona will be expected to underperform in attracting private capital and realizing its full potential.

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VI. Recommendations for Arizona’s Risk Capital Initiative

Implementation Plan: 1. Begin an information campaign about options for state-sponsored venture capital programs. The campaign should include personal testimonies from Arizona investors and entrepreneurs and directly address reasonable criticisms of strategic interventions in capital markets. 2. Evaluate Michigan’s Renaissance Venture Capital Fund and Cincinnati’s Cintrifuse models. These innovative, professionally managed fund-of-funds programs are privately capitalized initiatives designed to increase investment in the associated regions, delivering financial returns to investors while providing access to innovative technologies for corporate LPs. 3. Explore state-sponsored venture capital initiatives designed to support established and emerging venture capital fund managers. Innovative state capital programs such as Invest Maryland and Innovate in PA use deferred state tax credits to invest public resources in private venture capital funds serving their region while aligning the fiscal impact with the anticipated economic development impact.

Recommendation #8: Create a unified voice for Arizona’s capital formation policy •

Key parties: Governor’s Office; Arizona Commerce Authority, Economic Development Organizations

There are many challenges to successfully advocating for policies and programs that increase capital formation in an individual region or state. Private equity investing is a niche asset class in the financial services industry that is not broadly understood, and there is a need to educate public officials and regional stakeholders on the fundamentals of venture investing. Aggregating the voices of industry groups, universities, angel investors, entrepreneurs into a harmonious chorus for education and advocacy is essential for overcoming the challenges that can stop large scale efforts. Implementation Plan: 1. Continue with the convening of diverse stakeholders to align interests around the critical need for a single, bipartisan, technology-independent plan to champion meaningful capital formation initiatives in Arizona. 2. Develop annual showcases and informational sessions for state legislators on technology industries, new technologies, market overviews, etc. 3. Begin with a working hypothesis structure of a Capital Formation Advisory Board staffed by the ACA and with thought leadership provided by private sector representatives. The board

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VI. Recommendations for Arizona’s Risk Capital Initiative

would be comprised of Governor appointed experts and with ex officio positions for the state’s university presidents and TBED organization leaders.

Arizona’s rise towards bioscience prominence began in earnest in 2002 thanks to the commitment of the Flinn Foundation, which led the creation of the Arizona Bioscience Roadmap. A decade later progress has been remarkable: • • • • •

Arizona Bioscience Jobs up 45% Arizona Bioscience Firms up 31% Arizona Bioscience Employee Wages up 44% NIH Funding for Arizona Bioscience firms up 19% Economic Impact of Arizona Biosciences approaching $29 B

Risk Capital was the one significant negative category, declining to $22 M by the end of 2014. Flinn’s updated 2014 Roadmap states that transformative steps are needed to make risk capital more readily available in Arizona. In 2014, ABB leaders made the commitment to lend their strong voices to a single pressing issue through this Board. The group agreed that the availability of Risk Capital in Arizona was the issue they would focus on over the next two years. The ABB decided that an independent perspective on Arizona’s current competitiveness for early stage, high-potential technology businesses in terms of the supply and accessibility of risk-based investment capital was needed. This review would result in a transparent, inclusive and data-driven analysis and blueprint for use by business, government and philanthropic leaders in Arizona with relevant information to serve as a foundation for future risk capital initiatives. Cromwell Schmisseur LLC was selected for this ABB project based on its unique combination of policy design and program implementation expertise in developing technology-based economic development initiatives, especially those addressing issues related to the supply and accessibility of risk capital. This report is ABB’s contribution to the statewide effort to increase the availability of risk capital in Arizona. Since its formation in 2010, Cromwell Schmisseur LLC has earned a reputation as a trusted resource to state governments and state-sponsored non-profit venture development organizations and has become a national leader in the field of entrepreneurial development and state-sponsored venture capital programs. A focus of the firm is to share best practice models for the development of customized strategies and new program offerings that achieve comprehensive economic development returns over the long term. A partial client and project list includes: The Federal Reserve Bank of Atlanta (Small Business Research Initiative), The U.S. Department of the Treasury (State Small Business Credit Initiative), Maryland Department of Business and Economic Development (Invest Maryland), Ben Franklin Technology Partners (Innovate in PA) and Empire State Development (New York State Innovation Venture Capital Fund). © The Arizona Bioscience Board and Cromwell Schmisseur LLC, 2016

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VIII. Endnotes

i

Josh Makover, MD, FDA Impact on U.S. Medical Technology Innovation: A Survey of Over 200 Medical Technology Companies, November 2010. ii Tufts Center for the Study of Drug Development, Cost of Developing a New Drug, November 18, 2014. iii Data from 2014 National Venture Capital Association annual report. iv Bernstein, Giroud and Townsend, “The Impact of Venture Capital Monitoring.” The Journal of Finance, October 13, 2015. v CB Insights, Top 20 Angel Groups by Investor Mosaic, August 2014. https://www.cbinsights.com/blog/topangel-groups-mosaic/#top20 vi http://www.azcommerce.com/programs/arizona-innovation-challenge vii Source Wikipedia pages for each university; 2013 data for ASU and 2014 data for U of A and NAU. viii National Venture Capital Association, “Venture Impact: The Economic Importance of Venture Capital-Backed th Companies to the U.S. Economy,” 6 edition, 2011. ix CB Insights, “Ranking Angel Investor Groups,” August 13, 2014. https://www.cbinsights.com/blog/top-angelgroups-mosaic/#followon x National Venture Capital Association, press release, “Corporate Venture Groups Deployed More Capital to Startup Ecosystem in 2014 than Any Year Since 2000: Software Companies Dominate but Life Sciences Companies Received More Corporate Venture Investment Dollars than Any Year on Record,” January 28, 2015. xi http://www.intelcapital.com/advantage/index.html xii Crain’s Detroit Business, “Report: Renaissance Venture Fund Attracts Out-of-State Biz,” May 18, 2014. xiii http://semichiganstartup.com/InTheNews/renaissanceventurecapitalfundannarbor0317.aspx xiv http://www.cintrifuse.com/fund-of-funds/ xv InvestMaryland Annual Status Report, January 1, 2013. xvi Bessemer Venture Partners “anti-portfolio.” http://www.bvp.com/portfolio/antiportfolio xvii Dan Primack, Fortune.com, “Are Austin startups better off without Austin Ventures?” February 23, 2015. xviii Tax Foundation, Map of state credit ratings as of February 1, 2013. www.taxfoundation.org

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Profile for Strongpoint_Marketing

ABB Risk Capital in Arizona  

Observations and recommendations to accelerate the growth of the state's innovation economy.

ABB Risk Capital in Arizona  

Observations and recommendations to accelerate the growth of the state's innovation economy.

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