Current Issues Affecting Pittsburgh's Future

The Need for More Angel Investors in the Pittsburgh Region

Overview

• Future economic growth in the Pittsburgh Region depends on increasing the rate of creation of startup firms that commercialize technologies coming out of the region’s universities, medical center, and corporate R&D centers.
• An essential step in the growth of startup companies is finding seed-stage capital – more money than family & friends can provide, but less than most venture capital firms are currently willing to invest.
• Angel investors – high net-worth individuals making investments of $25,000 to $250,000 in startup companies – play a critical role in providing seed-stage capital.
• Pittsburgh has far fewer angels than it needs to support greater entrepreneurial growth, and has fewer angels than many other regions.
• The easiest way to become an angel investor is to join an angel network, like BlueTree Allied Angels, or to invest in an Angel Fund, such as the fund currently being developed by Innovation Works.
• Although angel investing is risky, if done with proper due diligence and assistance, investors can make significant returns on their money – better than later-stage venture capital and other equity investments.
• An individual who is an accredited investor can become an angel investor with investments of as little as $25,000 in individual companies; a commitment of approximately $250,000 allows the investor to diversify across multiple companies.

The Opportunity for Entrepreneurial Growth in the Pittsburgh Region

How can the Pittsburgh Region create more jobs? Economic development research suggests that two factors are essential: Innovation (creating new ideas), and entrepreneurship (turning ideas into new companies). Without entrepreneurship, innovation won’t create many jobs. Without innovation, entrepreneurs can’t build major businesses.

The Pittsburgh Region may well have greater strength in innovation today than at any time in history:

• It has more university research & development than 32 of the 50 states and more than all but a dozen other regions. Research spending at Pitt, UPMC, and Carnegie Mellon has grown faster than the national average, and now totals $900 million per year.
• It has more corporate R&D than most states, with over 150 corporate R&D facilities, including major R&D Centers for Alcoa, Bayer, Crucible, Heinz, Kennametal, Mine Safety Appliances, PPG, Seagate, U.S. Steel, and many others.

But that innovation won’t translate into rapid job growth without entrepreneurship. Unfortunately, compared to the other 40 largest regions in the country, the Pittsburgh Region has the lowest ranking on measures of new business creation, and it ranked 50th out of 50 in Entrepreneur Magazine’s 2005 list of Hot Cities for Entrepreneurs.

If the Pittsburgh Region can provide the environment and resources needed to foster more startup companies, it can translate its tremendous innovation assets into new jobs and higher economic growth.

The Critical Need for More Seed-Stage Capital

An essential step in the growth of a startup technology firm is finding seed-stage capital – investments that enable the company to refine its business plan, create and test its product, build its management team, and prepare for sales to initial customers. These investments can range from $100,000 to $2,000,000 per company, depending on the type of business.

Although in the 1990s, a number of venture capital funds across the country made seed and early-stage investments in startup companies, very few do today. As venture funds have grown larger, it has become impractical for them to make many small investments, and so they seek larger investments in fewer companies. As a result, however, a company that ultimately needs venture capital may never reach the point where it can qualify unless it can find seed-stage funding from another source.

Innovation Works has estimated that out of the estimated 150-200 new technology companies formed in the Pittsburgh Region each year, about 12-18 will ultimately have an enterprise value of $20 million or more, and about 6 will reach a size of $50-$100 million or more. Of these, almost all will need significant seed-stage funding, and the smaller firms may never need larger venture capital investment. Consequently, without an adequate supply of seed-stage investment, the majority of potentially successful firms may die for lack of capital. If the region is successful in increasing the rate of formation of new companies, the need for seed-stage funding will also grow dramatically.

Local economic development agencies have attempted to fill the seed-stage capital gap, particularly Innovation Works, which has invested $28 million in 82 technology startup firms over the past 7 years. But the public funding for seed capital is limited, and the more an organization like Innovation Works invests in any one company, the fewer companies it can help, particularly at even earlier (pre-seed) stages.

The Role of Angel Investors

What’s the answer to the seed-stage capital gap? Angel investors – high net-worth individuals making investments of $25,000 to $250,000 in startup companies.

Some angel investors have the money, time, and expertise to make well-informed seed-stage investments on their own, but most do not. That’s why many angels choose to join an angel network – an organized group of angels, perhaps with a professional staff, that helps perform due diligence on startup firms and carries out the necessary legal and financial steps to close and monitor investments. Members of an angel network don’t invest in every company that the network invests in – they can pick and choose which subset of deals they will invest in. Having an angel network is also good for entrepreneurs, because it makes it much easier for them to find angels, rather than trying to locate them one by one through networking.

There is also a growing trend toward creating angel funds – these funds enable individuals who don’t have the time or interest to actively participate in an angel network to make an upfront investment, which is pooled with the investments of other high-net worth individuals and invested in a diversified portfolio of early-stage companies. These pooled funds can either be managed by a professional fund manager, or can be structured as a “sidecar” fund that invests along with an active angel network. Either way, these funds expand the amount of seed-stage capital available to promising companies, thereby creating the equivalent of a larger network of angels.

Angel investors have been a critical part of the Pittsburgh Region’s economic development for over a century. Alcoa, for example, is here in Pittsburgh because 118 years ago, Pittsburgh had angel investors willing to invest in an entrepreneur with a new technology, and Ohio didn't. When Charles Martin Hall invented an inexpensive method of smelting aluminum, he came to Pittsburgh from his home in Oberlin, Ohio because he was unable to find investors in his home state. Alfred E. Hunt and a small group of investors provided the $20,000 in seed capital that gave Alcoa its start.

The Need for More Angel Investors in the Pittsburgh Region

The Pittsburgh Region is fortunate to have one professionally-managed angel network – Blue Tree Allied Angels. Blue Tree has 43 current angel members, and has invested $3.8 million in 10 companies to date.

However, the most successful angel networks around the country have at least 80-100 members, and several regions of the country have two or more angel networks. Moreover, there is no active angel fund in Pittsburgh. Although Innovation Works is currently working to develop one, its success will depend on the ability to recruit individuals to invest in the fund.

The relatively small number of active angels and the lack of an angel fund in the Pittsburgh Region creates several problems:

• Fewer angels means that each angel has to make larger investments in each company in order to meet its capital needs. That increases the angels’ level of risk, reduces their ability to fund more companies, and reduces their ability to invest in companies needing large amounts of seed capital.
• Because it typically takes 5-10 years to receive a return on an angel investment, once angels become fully invested, the network’s ability to invest in new companies decreases, unless new angels join.
• The ability to evaluate deals depends heavily on having angels or fund managers with expertise in the technologies and industries being pursued by startups. Fewer angels means some companies may be rejected simply due to lack of understanding or comfort with the technology and its potential market.

Currently, there are many signs of an acceleration in technology-based entrepreneurship in the Pittsburgh Region. Fourteen new companies were started in the past year using technologies developed at Carnegie Mellon, the largest number ever. The University of Pittsburgh ranked sixth in the nation in the number of start-up companies created in 2004. However, without a sufficient pool of angel investment for these startup companies, they may fail or move to other regions.

Once angel investing reaches “critical mass,” it can become self-sustaining, since the founders of angel-funded companies can themselves become angel investors. But the Pittsburgh Region needs to “prime the pump” to create enough successful startups to reach that point.

How Much Money Does an Angel Need, and How Much Can They Make?

Although someone could become an angel investor in a individual company with as little as $25,000, they will need to be able to make multiple investments in order to find the one or two successful companies that will offset losses from the unsuccessful ones. A typical angel investor might expect to invest $150,000 to $250,000 over a period of several years. (The individual will also need to have sufficient net worth to meet SEC requirements as an accredited investor, and the amount they commit to angel investing should represent 5% or less of their investable assets in order to insure good portfolio diversification.)

How much can they make? Data from the National Venture Capital Association show that seed- and early-stage investments can have the best return potential of any private equity investment. The most recent report says early/seed capital funds had a 41.4% 10 year internal rate of return, compared to 10.7% for later stage venture capital, 8.9% for buyouts, and 7.2% for the S&P 500.

Here’s an example, based on conservative rates of failure and return for startups. Suppose an individual commits $250,000 to angel investing:

• Over a three-year period, they invest those funds in eight different startup companies, with individual investments ranging from $20,000 to $60,000.
• Over the next seven years, three of the companies fail completely (the angels lose their investment), four break even or have modest success (angels get back 1-4 times their investments), and one is a “home run” that returns 10 times the original angel investments.

Over the ten year period, the angel investor gets a return of $840,000, or $590,000 net of the original investment, the equivalent of 16% interest compounded annually. And in the process, the investor helps to create five new companies, at least one of which is likely to spark significant job growth in the region.

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Creating a Regional "Front Door" for Entrepreneurs

One of the most common complaints by entrepreneurs in the Pittsburgh Region is the difficulty of finding the right place to get assistance in growing their businesses. In most cases, the problem is not that the services don't exist; the problem is that the entrepreneur has to go from agency to agency to agency trying to sort through eligibility requirements and criteria until he or she finds an agency/service that matches their needs. That wastes time and energy which could be better put to use in actually building their business.

The Pittsburgh Region is not alone in the need to create "no wrong door for entrepreneurs."   But the importance of growing the entrepreneurial base in southwestern Pennsylvania makes it a particular priority here to do this successfully.

A group of entrepreneurs in the Pittsburgh Region called HELP (Helping Entrepreneurs Learn from Peers) is currently working to create a user-friendly web portal for entrepreneurs who are seeking advice and assistance. The types of features that will be included:

1. A directory of the agencies and services that are available to help entrepreneurs. (Ideally, this would be structured in a customer-friendly "types of needs we address" rather than an agency-centric "types of services we provide" format.)
2. A search mechanism or "expert system" that would enable an entrepreneur to quickly find the subset of agencies and services most likely to be a match for them, based on the type of business, where it is located, who owns/runs it, etc.
3. An on-line forum where entrepreneurs could pose open-ended questions and requests for advice that other entrepreneurs and service providers could respond to.
4. A searchable directory of entrepreneurs so that other entrepreneurs, investors, service providers, etc. could find entrepreneurs providing products and services of interest to them. (One entrepreneur called this the "Entrepreneurial Yellow Pages.")
5. A common application form that would be used by all major service providers, so that an entrepreneur could fill out one form and have it considered by multiple agencies, rather than having to fill out a different form for every agency. (The Commonwealth of Pennsylvania has a Single Application Form for all of its programs, so at least the service providers the state funds could work toward the same thing.)

This kind of web portal for entrepreneurs won't just be seen by entrepreneurs in the region. It will be seen by investors elsewhere who were looking for entrepreneurial firms in which to invest, and it could be seen by entrepreneurs in other parts of the country/world who are looking for a supportive environment in which to locate and grow their business.

HELP's new portal will be an easy way to accelerate regional support for entrepreneurship.

HELP's plan for the website is available here.

The Need for Regionalism in State Policy

In today's global economy, regions compete for jobs, investment, and talent, not states. Businesses decide to locate in Buffalo, Cleveland, or Pittsburgh, not merely New York, Ohio, or Pennsylvania. People live and work within economic regions, and so they don't move to "Florida," "North Carolina," or "Pennsylvania," they move to the Miami region, the Charlotte region, or the Pittsburgh region.

Pittsburgh's Competitiveness Depends on Harrisburg

So if southwestern Pennsylvania is going to attract jobs and investment, it needs to be competitive with other regions, on things like taxes, energy costs, school quality, and environmental quality. Unfortunately, in a number of key areas, the Pittsburgh region can't make it itself more competitive because the policies that determine competitiveness are made in Harrisburg, not Pittsburgh. For example:

• the vast majority of business taxes on manufacturing firms in Pennsylvania are legislated and collected at the state level, not the local level. In many other states, including most of Pennsylvania's neighboring states, the majority of business taxes on manufacturers are defined and collected locally. For example, the Pittsburgh region is helpless to change the fact that Pennsylvania's Corporate Net Income tax is the second highest in the country.
• energy costsare regulated in Harrisburg, not Pittsburgh. When Duquesne Light tried to restructure electricity rates for industrial customers in 2004 to make them competitive with other states, the state Public Utility Commission turned it down.
• transit funding is collected and distributed in Harrisburg, not Pittsburgh. There is currently a transit funding crisis in Pittsburgh because unlike many other regions around the country, almost all transit funding in Pennsylvania comes from the state, and Pennsylvania state government won't create a predictable, adequate funding stream.
• highway funding decisions are also made in Harrisburg - PennDOT decides how much of both federal and state gas tax funds come to southwestern Pennsylvania. Although the Southwestern Pennsylvania Commission (the Pittsburgh Region's transportation planning organization) can veto a project that the Pennsylvania Department of Transportation (PennDOT) wants, PennDOT can veto a project that SPC wants. And if SPC and PennDOT can't agree on how to spend highway funds, PennDOT can simply take the money and spend it somewhere else in the state.
• most of the major economic development programs in Pennsylvania are administered primarily out of Harrisburg. Even though in some programs, regional agencies take applications and make recommendations regarding funding, the final decisions are made in Harrisburg. There is no flexibility to create special programs or move money from program to program to respond to regional needs -- all programs have to be statewide, and the funding amounts and program guidelines are established in Harrisburg.

Southwestern PA Issues Are Different

It would be one thing if each region in Pennsylvania faced the same problems and opportunities, and if they competed with the same set of regions in other states, but they don't. Southwestern Pennsylvania has different competitor regions and different competitive issues:

• Energy costs are competitive with states to the east and uncompetitive with states to the west, which puts southwestern Pennsylvania at a competitive disadvantage. The average electricity price for industrial users in Pennsylvania in 2005 was 5.96 cents, which was lower than New York (6.76 cents) and New Jersey (7.92 cents), but higher than Ohio (4.75 cents) and much higher than West Virginia (3.84 cents), and Kentucky (3.19 cents), the states just across the border from Pittsburgh.
• Land and infrastructure issues differ across the state. For example, it is extremely difficult to find flat land for industrial development in southwestern Pennsylvania, and perhaps too easy in southeastern Pennsylvania. A priority in southwestern Pennsylvania over the past decade has been finding money for industrial site development, while a priority in southeastern Pennsylvania has been controlling development of farmland.
• Water issues differ dramatically across the state. Southwestern Pennsylvania has an abundance of water, but has problems keeping it clean, since it has more sewer overflows than any region in the country. Southeastern Pennsylvania has been plagued by droughts, making access to water a bigger issue than cleanliness.
• Innovation and entrepreneurship opportunities differ dramatically across the state. Southwestern Pennsylvania has two major research universities, one of the two largest academic medical centers in the country, and dozens of major corporate R&D centers. As a result, southwestern Pennsylvania has a much greater opportunity for turning research into companies and jobs than any other region of the state except for Philadelphia, yet most state technology development programs provide funding proportionately across the state.

Two Pennsylvanias?

There is growing evidence that there are at least two different Pennsylvanias - one south and east of the mountains (Allentown, Bethlehem, Harrisburg, Lancaster, Philadelphia, York),and one north and west (Altoona, Erie, Johnstown, Pittsburgh, Scranton, Wilkes Barre):

• Differences in quality of life concerns. IssuesPA polling shows that residents in the southcentral and southeastern parts of Pennsylvania have very different concerns than those living in the rest of the state. The top issues in most of the state are jobs and economic opportunity, followed by taxes. In contrast, the top issues in the southcentral/southeast part of the state are traffic congestion, taxes, and preserving open space. (See the 2004 IssuesPA Benchmark Poll for more detail.)
• Differences in job growth. It's not surprising that jobs are a bigger concern in the southwest. Overall, the number of jobs in Pennsylvania grew slightly (by 1.1%) over the past three years, and the southeastern regions of the state grew at several times that rate, but most of the regions in the north and west grew more slowly.

• Most strikingly, while jobs grew slightly in the state as a whole between 2002 and 2005, the Pittsburgh region actually lost jobs. In fact, Southwestern Pennsylvania was one of only two regions of the state to lose jobs over the past three years (the other was Philadelphia), and it lost jobs at a higher rate than Philadelphia. More significantly, southwestern Pennsylvania had the second biggest drop in job growth compared to the previous three years of any region in the state (the worst was State College). In 1999-2002, the Pittsburgh Region was actually growing faster than the state average, and matched the U.S. growth rate during that period, but in the following three years, it not only stopped growing, but lost jobs.
• Differences in municipal health. Analyses conducted by the Pennsylvania Economy League show that most of the municipalities that are fiscally distressed are in the northern and western parts of the state. This is substantially due to slow job and population growth in those regions.
• Differences in satisfaction with state action. These economic and quality of life differences are being reflected in voter concern about the state and state government. The IssuesPA benchmark poll taken in December, 2005 shows that more than half of the voters in the suburban southeastern portion of the state are satisfied with the way the state is going, but less than a third of the voters in the southwest feel the state is on the right track. (See the 2005 IssuesPA Benchmark Poll for more detail.)

Southwestern Pennsylvania Is Disadvantaged Relative to Other Regions

Most of the top 25 regions in the country dominate their state's policy-making, either because of their size or because they are the capital of the state. For example, Boston is the state capital of Massachusetts and the Boston region contains the majority of the state's population. The Minneapolis-St. Paul region contains both the capital of Minnesota and the majority of the state's population. The Seattle, Washington and Portland, Oregon regions contain the majority of their states' populations, and are located only an hour's drive from the state capitals.

In contrast, southwestern Pennsylvania represents less than 20% of Pennsylvania's population. It is not the largest region in the state. It is not the state capital, and is more than a three hour drive away. Among the top 25 regions in the country, only two other regions are similarly disadvantaged - San Diego, and Tampa/St. Petersburg.

Is it any wonder southwestern Pennsylvania has a hard time getting attention for its issues in Harrisburg?

The Need for A More Regional Approach to State Policy and Programs

A more regional approach to state economic development policy is both desirable and feasible. The founders of our country decided that a federal system provided the best structure for administering government - those functions of truly national character should be administered from Washington, while the rest should be left to the states. Pennsylvania could follow a similar approach - continue to operate some functions at the state level, but delegate others, particularly those that are economic development-related, to each region.

Southwestern Pennsylvania has already demonstrated that it can effectively plan and set economic development priorities at the regional level. Through the Southwestern Pennsylvania Growth Alliance (the region's 10-county, public/private coalition for economic development advocacy) and the Southwestern Pennsylvania Commission (the region's 10-county metropolitan planning organization), the Pittsburgh Region has been very successful in identifying priorities for infrastructure investment and business climate improvements. However, the best that either of these groups can do today is advocate that the state follow their recommendations, and hope that the state listens, since the state can (and sometimes does) choose to ignore the region's priorities.

The state should truly delegate funding and decision-making authority to regional bodies and let them decide what their region needs. This would not have to be done uniformly across the state - regions that have effective regional planning and decision-making mechanisms in place could be given authority to allocate state funding, while the state would continue to administer programs in regions that are not willing or able to do so.

Ultimately, the state could even decide to shift some taxing powers to the regional level, allowing the regions to decide whether tax reductions or program spending would be better for regional competitiveness.

A regional approach to state economic development programs would recognize the diversity of opportunities and challenges across the state, and enable each region to position itself most effectively for growth. Each region, and the state as a whole, could benefit tremendously.

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