A Business Decision

When it comes to making loans to local companies, should a city act like a banker or a venture capitalist?
April 1, 2007 AT 3:00 AM
William Fulton
By William Fulton  |  Columnist
Director of the Kinder Institute for Urban Research at Rice University and former mayor of Ventura, Calif.

When I first got into the economic development field some 20 years ago, I heard a talk by a consultant who specialized in advising cities on business-loan programs. Cities, he warned, had to be very cautious and make sure that the business owners they made loans to were good credit risks. If there were too many bad loans, it would look bad for the city.

The consultant made a lot of sense. The political fallout from bad loans could be considerable, especially if the loans were made to political cronies. In another way, however, it made no sense at all. Shouldn't the government target business owners who could help the local economy but for some reason couldn't get a reasonable loan anywhere else? If the government is going to get into the business of providing capital for businesses, shouldn't it specialize in riskier investments?

The question, in a nutshell, is this: Should cities be bankers or venture capitalists?

Bankers specialize in low-risk, low-reward situations. They lend money to businesses and expect to get paid back in full every time. Venture capitalists focus on high-risk, high-reward situations. They don't loan money to established businesses; rather, they invest in start-ups. They know most of these fledgling businesses will fail. They expect to lose every penny on nine companies they invest in, hoping that the 10th will turn out to be Google.

It is very difficult for a city -- or any government -- to know how to straddle the line between banker and venture capitalist. There's little point in being just a banker, unless the city can find good business opportunities in places, such as poor neighborhoods, where conventional financial institutions are unlikely to underwrite business. But that requires great skill that, frankly, rarely exists in the public sector.

But playing the venture-capitalist role is tricky, too. The nature of the investment and the risk-reward ratio is different for a city, county or state than it is for a private venture capital firm. The government is not necessarily interested in financial return but in the creation of private-sector jobs, private-sector wealth and possibly increased tax revenue.

In the 20 years since I first heard that consultant suggest that cities should focus on being cautious bankers, things have changed. The American economy has created vast -- even unprecedented -- wealth. There is more capital looking for places to invest than ever before. Yet the wealth and the capital are far from evenly distributed. Most venture capital in this country comes from Silicon Valley and Boston, and not surprisingly that's where it gets invested. As a result, geographically, the rich have been getting richer and the poor, poorer. That's what's known as the "Big Sort."

So maybe it's time for cities and other government agencies to think about playing the role of venture capitalist -- especially in places that are losers in the Big Sort. It's not a good idea for cities to invest directly in specific businesses. After all, cities have a wide range of responsibilities, including regulation of business, that would create conflict if cities actually own businesses. But cities, along with counties, states and regional economic development consortia, certainly could create programs that marry their own loan funds with venture-capital money.

The underlying idea, of course, is to use government loans to lure venture capital to areas without it, thus dispersing venture capital throughout the country. In this kind of a partnership, the venture capitalist would invest in a company and the city would loan the company money. The venture capitalist would seek a large financial return, and the city would be looking for other payoffs, such as jobs and local wealth creation. In this way, the city wouldn't literally be taking a stake in specific companies but, like the venture capitalist, would have to tolerate a high failure rate in hopes of hitting a home run.

Safeguards have to be put in place for the venture-capital idea to work. Cities would have to be extra-careful about cronyism. And the loans would have to be made in a strategic way, building on the region's economic assets. Otherwise such a loan program would be a scattershot effort and even successes might not yield the returns a city wants.

But as the Big Sort creates more and more inequity, cities and other governments and their agencies will have to become more creative to counteract the trend.