[Senate Hearing 112-315]
[From the U.S. Government Publishing Office]
S. Hrg. 112-315
ACCESS TO CAPITAL: FOSTERING JOB CREATION AND INNOVATION THROUGH HIGH-
GROWTH STARTUPS
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
ECONOMIC POLICY
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
ON
EXAMINING POTENTIAL STARTUPS TO CREATE JOBS AND SPUR ECONOMIC GROWTH
AND INNOVATION
__________
JULY 20, 2011
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Dawn Ratliff, Chief Clerk
Will Fields, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Economic Policy
JON TESTER, Montana, Chairman
DAVID VITTER, Louisiana, Ranking Republican Member
MARK R. WARNER, Virginia ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina MIKE JOHANNS, Nebraska
TIM JOHNSON, South Dakota
Alison O'Donnell, Subcommittee Staff Director
Travis Johnson, Republican Subcommittee Staff Director
(ii)
?
C O N T E N T S
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WEDNESDAY, JULY 20, 2011
Page
Opening statement of Chairman Tester............................. 1
WITNESSES
Ted D. Zoller, Vice President of Entrepreneurship, Ewing Marion
Kauffman Foundation............................................ 2
Prepared statement........................................... 24
Elizabeth Marchi, Founder and Fund Coordinator, Frontier Angel
Fund, LLC...................................................... 5
Prepared statement........................................... 25
Robert F. Bargatze, Executive Vice President, Chief Scientific
Officer, LigoCyte Pharmaceuticals, Inc......................... 7
Prepared statement........................................... 56
Responses to written questions of:
Senator Hagan............................................ 65
(iii)
ACCESS TO CAPITAL: FOSTERING JOB CREATION AND INNOVATION THROUGH HIGH-
GROWTH STARTUPS
----------
WEDNESDAY, JULY 20, 2011
U.S. Senate,
Subcommittee on Economic Policy,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 10 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Jon Tester, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF CHAIRMAN JON TESTER
Chairman Tester. I call to order this hearing of the
Economic Policy Subcommittee. The title of this hearing is
``Access to Capital: Fostering Job Creation and Innovation
Through High-Growth Startups.'' I want to welcome the
witnesses. We will get into a description of them very, very
soon here.
I look forward to hearing from you folks this morning about
the potential startups to create jobs and spur economic growth
and innovation, provided that they have an essential resource
for growth, and that resource is access to capital.
Capital provides new opportunities for Main Street
businesses and families in Montana and across the Nation. It
creates jobs and it boosts local economies. Clearly, we have
work to do to rebuild our economy and to make sure that we
strong investments. Smart investments foster innovation and pay
dividends into the future for us, our kids, and our grandkids.
The role of startups in creating jobs and driving
innovation has been well documented, provided that they have
access to financing to scale and grow their firms, and to make
sure capital markets are in reach for startups. Understanding
this potential, it is critical that we empower these businesses
with the tools that they need to survive and thrive, creating
new jobs and growing our economy. We must respond to the unique
challenges that small businesses face in accessing financing,
giving the relative risks associated with new and innovative
firms and the difficulty in collateralizing assets. And we must
ensure that these young companies are able to access the long-
term capital that they need to bring innovative ideas and
products to the markets.
Today I hope that we can examine the challenges and
opportunities that face innovative startups and their ability
to access capital in various stages of their development, the
significance of capital to the success or failure of these
startups, and what public policies we can better facilitate the
formation of innovative startups and enhance their ability to
access capital.
I look forward to hearing from all of our witnesses this
morning. I am particularly pleased that we have two Montana
witnesses here with us. I know they will be able to address
some of the unique challenges and opportunities facing startups
in rural communities. They are entrepreneurs, and they clearly
reflect America's entrepreneurial spirit, which is part of what
keeps rural America strong and makes our economy the most
innovative in the world.
Senator Vitter is due to come, and when he comes, we will
kick it over to him, as well as some other potential
Subcommittee Members if, in fact, they did not get tied up with
something like debt limit conversations.
So with that, I think we will start with our witness
introductions, and once again I'd like to welcome all three of
you. I am going to start with Ted Zoller, and we will just go
from my left to right.
Ted is vice president of entrepreneurship of the Ewing
Marion Kauffman Foundation, where he guides the foundation
entrepreneurship programs. He also serves as executive director
of the Center of Entrepreneurial Studies at the University of
North Carolina, Kenan-Flagler Business School, and the founder
of Commonwealth Ventures, a private equity and venture
accelerator firm. I want to welcome you, Dr. Zoller.
Elizabeth Marchi hails from Polson, Montana, currently
served as the fund coordinator of the Frontier Angel Fund,
Montana's first angel fund, and is cofounder of Northfork
Strategies. She is also working with the Governor's Office of
Economic Development to build the Montana Angel Network and
Innovate Montana and is an entrepreneur herself, selling all
natural Montana-raised Kobe beef from a ranch outside Polson.
Finally, last but not least, Dr. Robert Bargatze joins us
from Bozeman, Montana, and is founder and executive vice
president and chief scientific officer of LigoCyte
Pharmaceuticals, which is developing innovative vaccine
products, including a product to prevent norovirus. He has 27
years of experience in immunological research and also serves
as chairman of the Montana Bioscience Alliance, the public-
private partnership to grow and sustain the biotech industry in
Montana.
I welcome you all. Before we get to your testimony, I want
to kick it over to the Ranking Member, Senator Vitter, for his
opening statement.
Senator Vitter. Thank you, Mr. Chairman. I am going to save
my time. I want to hear the witnesses, and I would rather save
my time for discussion and questions.
Chairman Tester. Absolutely.
We will start with you, Dr. Zoller. Thank you for being
here.
STATEMENT OF TED D. ZOLLER, VICE PRESIDENT OF ENTREPRENEURSHIP,
EWING MARION KAUFFMAN FOUNDATION
Mr. Zoller. Chairman Tester, Ranking Member Vitter, and
other Members of the Subcommittee, I am Ted Zoller. I am vice
president of entrepreneurship at the Kauffman Foundation. I am
also a business faculty member at the University of North
Carolina at Chapel Hill. I am a business owner, I am an
investor. I just wish I was a Montanan. That would round it
out.
[Laughter.]
Mr. Zoller. I would invite Members of the Subcommittee this
morning to put yourself in the shoes of a founder of an
American firm, and I am guessing with all the deficit wrangling
going on right about now, that sounds pretty good.
As a promising entrepreneur, your business concept solves a
problem and fills a customer need. As you know, starting any
new enterprise requires capital. The investment period every
business experiences until it reaches cash-flow--a concept
called the ``J-curve''--is a perennial issue to any startup.
This need for investment is precipitated by capital
requirements, labor costs, and the negative cash-flow you will
experience until your business is established in its market.
The J-curve can only be remedied by access to capital, and when
capital is not forthcoming, this represents a substantial
barrier to new firm starts. While a small percentage of firms
can be ``bootstrapped'' or self-financed, the vast majority of
all new enterprises--and in particular high-growth firms that
rely on innovation and capital investment--require outside
funding in the form of equity and debt to shoulder the J-curve.
The picture I paint for you this morning is that,
unfortunately, your job is harder today than it has been prior
to the financial crisis because both equity and debt financing
are not as readily available. The J-curve is now a barrier to
your entry as opposed to simply a hurdle in becoming a going
concern.
Why is it harder today to finance your startup? Well, there
are three reasons:
First, venture capital and other forms of private equity
have largely abandoned early-stage investing, opting instead to
pursue more reliable returns in later-stage ventures.
Second, while angel and friends and family investors have
entered to fill the gap, they are not as adept in connecting to
later-stage capital partners that will fuel the firms' growth,
and angel capital availability is a fraction of the equity that
we have enjoyed in the past.
Third, the consolidation of the banking institutions and
their current conservative posture toward risk precipitated by
the Wall Street crisis has choked off needed debt financing. If
you cannot access equity financing, you can no longer start a
business today without collateralizing the debt against your
personal assets, and the line of credit that you need to smooth
your cash-flows now comes with higher interest rates, more
punitive terms, and generally not at the limits needed to
finance your firm. So I am sorry to say today large banks are
simply no longer a partner to small business. This is a bleak
picture that we all face as entrepreneurs.
While we have seen a clear resurgence of angel investors
and are hopeful by innovation occurring in the community and
commercial banking sector, our early-stage pipeline is under
unprecedented stress. This has staggering implications on our
economic future. Since the recession in 2008, Kauffman data
indicate that more firms than ever are being formed. That is
the good news. The bad news is that this result is hollow--as
the new firms that are largely being formed today are sole
proprietorships as opposed to job-creating firms. New firms
with employees during this same period, in fact, have been
dropping--a troubling indicator suggesting a slowdown in the
formation of potential scale companies.
Contrast this fact to another study published by our
foundation that up until the financial crisis, U.S. job and
output growth was driven by the formation of new firms and
startups, and firms younger than 5 years old were responsible
for virtually all the net new job creation. We have concluded
from our research that if the U.S. were to consistently
generate between 30 and 60 new companies whose annual revenues
eventually reach $1 billion, our country would enjoy
permanently a 1-percentage-point increase in its growth rate.
So guess what? This promises a solution to our fiscal future.
So if our goal is to motivate our economy and create new
jobs, we have to focus on job-creating, early-stage firms--
especially focus on those firms that have the potential to
achieve high growth and scale.
Yesterday, the president of the Kauffman Foundation, Carl
Schramm, presented a solution we are calling the Startup Act.
This proposal speaks to many of the dilemmas faced in my
testimony providing access to capital, by:
First, modifying the tax code to facilitate the financing
of small business, with a permanent capital gains exemption on
investments in startups held for at least 5 years. This is an
idea supported by the National Advisory Council on Innovation
and Entrepreneurship.
Second, reducing corporate tax burdens for new companies in
the first 3 years they have taxable income with a phased
exclusion on taxable profits. Again, an idea supported by the
National Council.
Third, making it easier for growing private companies to go
public, by allowing shareholders who invest in firms with a
market cap of $1 billion or less to decide whether to comply
with the requirements of Sarbanes-Oxley. If the IPO window is
opened, investors will be a lot more willing to finance early-
stage companies when they have at least the option of going
public after they have reached scale, rather than simply
selling out to larger firms.
So these proposals, among others, are needed to undertake
the course correction required to make the United States once
again the best place to found, grow, and scale an
entrepreneurial venture in the United States. Putting us back
on course will require the creativity of our Government and
business leaders and, of course, our entrepreneurs. I am
confident we will achieve these aims and look from to the
leadership in making America's entrepreneurial future again
possible.
Thank you very much for the opportunity.
Chairman Tester. Thank you, Dr. Zoller, for your testimony,
and thank you. I did not point out the 5-minute time limit, but
you were almost right on the money.
Mr. Zoller. Thank you very much.
Chairman Tester. Liz Marchi, you are up next.
STATEMENT OF ELIZABETH MARCHI, FOUNDER AND FUND COORDINATOR,
FRONTIER ANGEL FUND, LLC
Ms. Marchi. Thank you. Mr. Chairman, distinguished Members
of the Subcommittee, Ranking Member Vitter, my name is Liz
Conner Marchi. I am the coordinator of the Frontier Angel Fund,
Montana's first angel investment fund; a former economic
development executive in Flathead County, which I might say is
about the size of the State of Connecticut; the coordinator for
Innovate Montana; and a business consultant with Northfork
Strategies. I live on a working cattle ranch in the Mission
Valley of northwest Montana near Glacier National Park.
I am honored to have the opportunity to speak before you
today with a voice informed by 10 years of work in economic and
business development in Montana. I want to thank my great
fellow Montanan, Senator Jon Tester, for offering this
privilege to me today. Prior to moving to Montana, I worked in
business and economic development in North Carolina where I was
a constituent of Senator Hagan's.
The most interesting people I have ever met in my life live
in rural America. Most of them are innovators and entrepreneurs
because they have had to be to survive. As my business partner
at Northfork Strategies, Diane Smith, author of TheNewRural.Com
says, ``When I worked in Washington, DC, I knew a hundred
patent lawyers and not one innovator. Within months of moving
to Montana, I knew dozens of inventors and only one patent
lawyer.'' That speaks volumes about the challenges and
opportunities we face in America to retool an economy deeply
impacted by globalization and technology.
I want to speak today to three issues that I think merit
your attention as we focus on new job creation: financial
capital must be available to entrepreneurs; innovation and
discovery are everywhere; and telecommunications infrastructure
and regulatory policy are critical to this effort.
Today's capital environment is incredibly difficult for
entrepreneurs. Before the recession, many entrepreneurs
bootstrapped startups with personal credit cards. Banks would
just ask you to mortgage your house for a business loan, and,
frankly, that was a pretty significant barrier to
entrepreneurship even before the economy went south. In today's
climate, it is hard to know what your house is worth, so
lending on an asset is pretty rare. Most bankers will tell you
today that they are working for regulators, not for customers.
So bank lending today is driven by cash-flow, and most startups
have no cash-flow, and some do not have any liquid assets.
Banks look at history. As a result, bank debt is a very
unlikely source of capital for entrepreneurial ventures which
rely on a forward-looking opportunity.
Angel investors look forward at opportunities. In 2005, we
initiated a conversation with a number of high-net-worth
individuals who were living in Montana. In addition to
investment capital, they had deep skill sets in starting and
building successful businesses. So in 2006, the Frontier Angel
Fund closed with 33 investors who put in $50,000--and some put
in $100,000--each to invest in early-stage businesses located
in our region. So what is an angel investor? It is an
accredited investor, according to the SEC definition, that is
generally the first professional money in a business after
family, friends, and fools. I want to thank all of you
responsible for the compromise on the accredited investor
definition in the Dodd-Frank bill. Without the compromise, more
than two-thirds of the potential angel investors in Montana
would no longer have been accredited.
Angel investors differ from venture capitalists in that
they are investing their own money, not other people's money.
And most angels have a double bottom line: they want to make
money, but they also want to see their communities and regions
prosper. Many angels are successful entrepreneurs, and they
share a real affinity for mentoring and coaching others. The
estimated size of the angel and VC markets in the U.S. are
roughly the same amount, $20 to $30 billion annually. But in
2009, venture capital went to 3,800 companies in the entire
United States while angels funded almost 56,000 new startups.
Two-thirds of all VC investments were in California, Boston,
and New York, and half of all States had only one or no VC
deals. Angel investments happen in every State in America.
The Frontier Fund is easy to find. We have an online
application process. We screen deals every other month; we meet
every other month. We have looked at over 300 companies since
inception and have investments in 10 regional startups, most of
which have a proprietary product or service.
Government policy and investment play a critical role in
enabling the kind of telecommunications infrastructure required
for businesses to operate today. In last-mile locations like
Livingston, Montana, companies like Printing for Less have
developed sophisticated business platforms for serving global
markets, telecommunication infrastructure is critical.
Bandwidth and speed are their lifelines.
Bandwidth supports many new enterprises throughout Montana.
TeleTech has 900 employees in the Flathead. Bandwidth and a
trainable workforce brought them there. Profitability keeps
them there.
Innovation and discovery are everywhere, but we must find
better ways to connect capital to ideas and to entrepreneurs.
This is the recipe for new jobs in all of America.
We need Federal policy that does all it can to minimize
regulations, provide essential telecommunications
infrastructure, encourage angels, provide real-world business
education and strategy to entrepreneurs, and does not lose site
of the incredible talent and ambition we find today all over
America.
I have never regretted bringing my children to Montana to
be educated there in public schools. In addition to a great
education, they have learned values like thrift and self-
reliance that are part of the fabric of life in rural America.
We cherish our landscape, and with your continued vigilance,
rural America will be an important part of the path to economic
prosperity and national renewal.
Thank you very much.
Chairman Tester. Thank you, Liz.
Dr. Bargatze, I will need you to turn on your microphone,
if you can, or bring it closer to your mouth.
STATEMENT OF ROBERT F. BARGATZE, EXECUTIVE VICE PRESIDENT,
CHIEF SCIENTIFIC OFFICER, LIGOCYTE PHARMACEUTICALS, INC.
Mr. Bargatze. Good morning, Chairman Tester, Ranking Member
Vitter, and Members of the Committee. My name is Rob Bargatze,
and I am the founder and vice president and chief scientific
officer of LigoCyte Pharmaceuticals and chairman of the Montana
Bioscience Alliance. I want to thank you for the opportunity to
speak with you today about the unique hurdles to accessing
capital that innovative biotech startups face today.
Biotechnology has an incredible potential to unlock the
secrets to curing devastating disease and helping people to
live longer, healthier, and more productive lives, but barriers
that small biotech companies encounter on a daily basis raise
some important questions: Would we rather see the next
generation of breakthrough cures discovered by researchers in
Bozeman or Beijing? Do we want the jobs associated with this
groundbreaking science to go to workers in Missoula or
Malaysia? If we want more scientific breakthroughs that allow
us to enjoy a high quality of life, then shouldn't we be
putting in place policies that encourage innovation through
private investment?
While the biotech industry faces significant challenges, we
nonetheless are uniquely positioned to deliver the next
generation of cures and treatments to the bedsides of patients
who desperately need them, at the same time creating a
healthier American economy.
The leash that holds our industry back from helping more
people is, in large part, the devastating effect that a lack of
access to necessary capital that can help grow our biotech
companies. Today Congress has the opportunity to help speed
lifesaving cures and treatments to patients by bolstering
capital formation in our industry.
My company, LigoCyte, is a private biopharmaceutical
company based in Bozeman, Montana, with 38 employees. When I
cofounded LigoCyte in 1998, we were the quintessential small
business. My four cofounders and I each gave the new company
$5,000 to get things off the ground--our first round of
financing. With our startup funds, we bought kitchen cabinets
from the local home improvement store down the street and
installed them ourselves, giving ourselves our first laboratory
in the Montana State University Technology Park. Our first
contracts for service were with large pharmaceutical companies
which gave us enough income to cover overhead while we wrote
SBIR grant proposals. We were able to use the SBIR funds to
advance our research enough to be awarded a contract with the
Department of Defense for our vaccine pipeline. Our success
there led to venture capital financing, the true lifeblood of
the biotech industry.
We currently are entirely privately funded with the
exception of ongoing contracts with DOD. Getting to this point
was not easy. There is no ``beaten path'' for small companies
like ours to follow. Instead, we have to break new ground, both
in our science and in our search for funding.
Biotechnology R&D is a long and difficult road. It takes
more than a decade and upwards to $1 billion to bring a new
medicine from discovery through clinical trials and on to FDA
for approval. Due to this capital-intensive process, companies
lacking research and development funds turn to private sector
investors to finance the early stages of development.
Montana startups are at a particular disadvantage due to
the dearth of venture capital firms in and around our State.
Venture fundraising continues to be on the decline, and small
companies have borne the brunt of the investors' reluctance.
The shift in the economy has also harmed companies like
mine that already have venture financing. Historically, venture
capitalists receive a return on their investment when a company
goes public through an IPO. However, IPO markets are closed.
Investors are not able to exit and companies do not have access
to large public markets necessary to fund late-stage clinical
trials. This hampers critical research, forces companies to
stay private for longer, and depresses values of later-stage
venture rounds.
The breadth of the financing problem in the biotech
industry calls for comprehensive solutions to ease capital
formation. In addition to the difficult financing landscape and
struggling public markets, growing biotech companies also face
regulatory burdens which further hinder capital formation in
our industry. One such burden is the financial reporting
standards of Sarbanes-Oxley Section 404(b). Dodd-Frank made
permanent exemptions for small businesses with market caps
under $75 million do not have to comply, but most biotechs are
valued much higher than that due to successive rounds of
financing. Because we have no product revenue, we do not have
the resources needed to focus on complex reporting. By raising
the exemption ceiling to $700 million and adding a revenue test
to Section 404(b) and SEC Rule 12b-2, Congress could allow
cash-poor companies, small, innovative biotechs, to focus on
speeding cures and treatments to patients rather than Sarbanes-
Oxley compliance.
There is already an avenue for these small companies to
raise funds and avoid unnecessary burdens in the form of SEC
Regulation A, which allows for companies to undergo a direct
public offering valued at less than $5 million without
observing traditional disclosures requirements. However, the $5
million limit was set in 1980 and no longer provides a real
view of small companies looking for access to public markets. I
believe Regulation A could have a positive impact for biotech
companies if its eligibility threshold was increased from $5
million to $50 million while maintaining the same disclosures.
This a result of the increased company valuations and higher
levels of capital needed all driven by the impact of inflation
on the cost of development.
Although SEC policies like Rule 12b-2 and Regulation A are
designed to monitor public companies and offerings, the agency
also keeps tabs on private companies when they reach a certain
size. Currently the limit is 500 shareholders. However, most
biotech companies provide employees with stock options during
that decade that it takes to develop a single treatment.
Employee turnover pushes the shareholder number to over 500.
Increasing the shareholder limit from 500 to 1,000 and
exempting employees from the count would relieve a small
biotech company from unnecessary costs and burdens to grow.
These measures I recommend have no burden on the taxpayer,
but would have a substantial impact on the viability of our
biotech industry.
The U.S. biotech industry remains committed to developing a
healthier American economy, creating high-quality jobs in every
State, and improving the lives of Americans. While there is no
single solution to the challenges facing our industry, the
portfolio of options I have presented will help biotech
companies in Montana and across the Nation weather the current
economic storm and continue working toward delivering the next
generation of medical breakthroughs--and, one day, cures--to
patients who need them.
Thank you.
Chairman Tester. Thank you for your testimony. I am going
to kick it over to Senator Vitter for his comments and
questions at this point in time. Could you put 7 minutes on the
clock, please.
Senator Vitter. Thank you, Mr. Chairman. I do have another
hearing, as you know, and I appreciate the courtesy. And thank
you all for your testimony and, more importantly, thank you all
for your work.
Dr. Bargatze, let me start with you on one of the topics
you mentioned near the end, which is the mandate under
Sarbanes-Oxley. As you mentioned, the SEC Small Business
Advisory Board suggested an exemption of $700 million, but
Congress instead, through Dodd-Frank, passed an exemption of
$75 million--obviously a big difference.
I take it from your testimony you support more reasonable
robust exemption like $700 million. Why don't you put a little
bit more meat on the bone of what that would mean and what
burden that would lift?
Mr. Bargatze. Sure, certainly. Where we are as a company in
our stage of development, we are only entering into Phase II
clinical trials now, and we have a long way to go. We have
already raised in excess of $80 million in that process, so we
actually are approaching that point where Sarbanes-Oxley is
going to be a major issue for us. Our valuation is not yet that
high, but I feel that, you know, as we move forward, we begin
to talk with pharma companies, and we are valued, I think we
are going to be dealing with Sarbanes-Oxley, and this could
make a significant difference in the cash resources that we
have to actually move forward our products rather than putting
that into essential accounting.
Senator Vitter. And how major a burden and a drain would
that requirement be?
Mr. Bargatze. It makes the difference between being able to
hire a critical person who is necessary for our vaccine
development to move forward. Not being able to hire that
person, having to meet these SEC regulations is something that
essentially is an incredible burden in terms of us getting the
job done.
Senator Vitter. Right. Would you all also like to comment
on that Sarbanes-Oxley issue?
Ms. Marchi. I would. I know I have had another Montana
company, not in the biotechnology space, say it cost them
between half a million and a million dollars a year to comply.
You know, I do not know if the number is $700 million or the
number is $250 million, but it is higher than $70 million.
Senator Vitter. OK. Thank you.
Mr. Zoller. I would also argue that in the case of
Sarbanes-Oxley it represents more or less a new barrier for
mid-cap companies that are on their way up. I think that more
attention should be placed on that transition. So if you were
to look at the life cycle of a firm as it grows, Sarbanes-Oxley
is designed ultimately for a company that is quite established.
I do not think we were thinking at the time when we did
Sarbanes-Oxley about the implications on growth companies, what
we are calling ``gazelles.'' And what we have found is that
gazelles are our employers; whereas, as large companies, more
mature companies, actually become so productive that they
destroy jobs. Emerging companies, young companies, small-cap
companies, mid-cap companies grow jobs. So if we are looking to
grow jobs, we should not be selling the golden cow that is
ultimately the great tool we have.
Senator Vitter. Great. Thank you.
Ms. Marchi, in your testimony you say, ``We need Federal
policy that does all it can to minimize regulations.'' How
would you grade Washington the last few years on that central
core statement?
Ms. Marchi. With all due respect, I think you need to go
back to school.
[Laughter.]
Senator Vitter. Good. I agree. I appreciate that. And,
specifically, how do you think Dodd-Frank addresses that issue?
Ms. Marchi. Well, certainly, on the accredited investor
definition, I submitted, in addition to my written testimony,
the net worths of individuals who tend to be angels, and,
frankly, the preponderance of them are in the $2 to $3 million
category. And I will submit to you that somebody in Polson,
Montana, who has got a $2 or $3 million net worth is doing
pretty well and is not real excited about the U.S. Congress
telling them that they cannot make an investment in their local
technology company that is trying to create jobs. So in that
respect, we appreciate the compromise, but we were not happy
about any change, frankly, in the accredited definition. And
the same thing with Regulation D, we appreciate your help on
that. That had some very unintended consequences for small
startups.
Senator Vitter. Right. Mr. Zoller, I would invite your
reaction with regard to Dodd-Frank generally.
Mr. Zoller. Well, as a matter of fact, there is a trend
occurring now that I am not sure we are totally recognizing in
the policy arena, and that is, you know, we are seeing a
democratization of capital and equity, and we are seeing that a
number of small investors can be crowd-sourced to actually
accomplish things that would have otherwise been only in the
domain of people with high net worth. And what we are seeing in
the case of even someone with $1 million net worth is the
capability to actually fund extraordinarily high growing
companies given the advances we have had and the scale of new
businesses and the development of cloud computing, things of
that nature that have lowered the barrier to entry.
So the fit of capital to firm has changed fundamentally,
and we should be encouraging everything we can do to bring
private net worth into capital investment, especially when it
comes to building new growing concerns that will grow jobs. So
the Kauffman Foundation would advocate for, you know, policy to
actually focus on the democratization of equity.
Senator Vitter. OK. And, Mr. Zoller, also to follow up on
that, you make a major point about bank consolidation and other
trends hurting traditional bank financing. In your opinion, has
that in recent months, in the last year or so, been getting
better or worse?
Mr. Zoller. Hard to say. I do not have any data that would
reflect it, but I will give you a personal anecdote that I
think will bring some illumination to it.
I own a small business myself, and I recently called one of
the three largest banks that will remain nameless for the sake
of this testimony, and they could not even find my account, and
I have been doing business there for over 3 years. This is a
good example of how, you know, scale I think affects the
performance of our banking institutions, and I am quite excited
about the innovations I have seen in the community banking
environment where, you know, folks are recognizing the
relevance in regional banking settings. But we need to focus
very carefully on how large banks are working with our small
business sector because right now I would argue that it is
completely broken.
Senator Vitter. Well, I share that gut feel. Let me say in
closing I share the gut feel. I am very concerned that what
Washington has done in this sector recently not only enshrines,
does not dismantled too big to fail. I think it simply adds a
new category on the other end of the spectrum, which is too
small to cope, and it is creating more consolidation and moving
the trend in the wrong direction, not the opposite direction in
terms of size and consolidation.
Thank you all very much.
Chairman Tester. Thank you, Senator Vitter.
I am going to kick it over to Senator Toomey from
Pennsylvania for his comments and questions, and 7 minutes on
the clock again, please.
Senator Toomey. Thank you very much, Mr. Chairman and
Ranking Member Vitter. I also want to thank you for allowing me
to kind of crash this party. Since I am not on your
Subcommittee, it is kind----
Chairman Tester. We appreciate you being here.
Senator Toomey. Well, it is kind of you to do this, and I
just want to assure you that I have a great interest in this
topic generally. I am somewhat of a serial entrepreneur myself.
I have been through the process of raising capital. I have been
an investor. And I have seen how difficult it is for small,
growing firms to access the capital that they need. And so I
really want to give you all the credit I can for raising this
very, very important issue.
This is about economic growth and job creation, and the way
I look at it is there are two categories that I really hope
that this Congress will make some progress on, and I know you
are both interested in doing that. One is making it easier to
raise capital privately because that is how things get started
and how that initial growth occurs.
And the other part that is equally important to me is
accessing capital in public markets. We can lower the burdens
and obstacles in both of these categories, and if we do, we are
going to have more startups. We are going to have more growth.
We are going to have more jobs. And it is very, very
encouraging to me that you are addressing this.
One of the things that I wanted to invite anybody to
comment on is in the life cycle, the early life cycle of
startup companies, we often have a, often, a fairly predictable
sequence of capital raises for a growing company. It often
starts with maybe angel investors, moves on to venture
capitalists, then maybe an expanded private offering before
ultimately a public offering. If we made substantial progress
in facilitating capital raises at any point along that
sequence, does that not help all along the sequence?
Even, for instance, the liquidity event of an IPO. The mere
fact that that becomes more achievable, more doable, less
costly, does that encourage the earlier scale investment? Does
that do something to encourage angel investors or venture
capitalists because they see a more realistic exit strategy?
Would each of you comment on that.
Mr. Bargatze. Yes, I would be pleased to comment on that.
Essentially, our company has raised capital a variety of ways,
actually. A critical part of that is in addition to the
traditional private markets, certainly SBIR is a very important
aspect. It is our seed capital in Montana. We really do not
have a significant number of other sources. I think Liz's angel
efforts fairly recently have made a huge difference in
providing some early-stage capital, but when we look at what
can be provided through SBIR, where you have phases of
funding--for example, one of the programs that we funded, we
have raised over $8 million in SBIR funds to develop a product,
and that is significant in terms of resources that help you
move forward to the point where you have proof of concept.
I think the other aspect you asked about, with regard to
IPO, I think this is really critical for our investors now that
we have venture investors on board. They are looking for an
exit in which they get a multiplier, and right now in biotech,
it is very difficult to do, simply because of the long time for
development, and actually, at this point, very low returns on
investment that we are seeing in terms of what investors are
getting. The deals that are happening seem to be driven down
right now by the Pharma industry. They are trying to get cheap
products. Essentially, they are bidding low on what these
products are in terms of what it has cost to develop them. And
so that is really driving down the deals and driving down the
multiple investment that the investors are getting as a
consequence of being in for 8 or 10 years before they actually
see a return on their investment.
Ms. Marchi. And I would like to speak to that. Angels very
rarely invest in life science or biotechnology, simply because
of the amount of capital required to product development--even
though we did invest in Bob's company, because we think it is
an awesome company.
But we encourage ``bootstrapping'' to begin with, without a
doubt, and as angels, we are looking more and more at companies
that do not ever need venture capital because it is such
expensive money right now. But the IPO markets are critical for
exits and I think our whole notion of scale is changing. When
we look at a company like Facebook, with the kind of market cap
it has, it is still a small company.
Senator Toomey. Yes.
Ms. Marchi. You know, it is a very different world we live
in in terms of adding value.
Mr. Zoller. Mr. Toomey, I think it is an outstanding
question in a lot of ways because it occurs to me that when a
new firm begins, it begets another new firm, right. There is a
champion effect. And I would argue that when a firm goes
through an M and A or an IPO, that would beget a new trade sale
or IPO.
But to a certain extent, getting it right will involve kind
of solving on a quadratic equation. What I mean by that is you
have to solve at every level for it to occur, and I would
submit to you right now, as we speak, while we have new starts,
improving our capitalization engine at the early stage is
broken so that any chain in the link, at some point, if it is
broken, will actually have an effect throughout the entire life
cycle, as you suggest.
So a focus on each of the life cycles is going to be
critical to maintain kind of critical mass and ultimately the
momentum that will keep our economy surging forward. And at
this moment, we have got two of the four key stages, I think,
in distress.
Senator Toomey. Right. And one other question, Mr.
Chairman. You know, Pennsylvania is a home to a very large
number of very, very successful bio companies. The life
sciences are a booming sector in various parts of Pennsylvania
and it is a very, very encouraging area for us for job growth,
for quality of health care.
Dr. Bargatze made a very interesting observation in your
suggestions about the cost of compliance with Sarbanes-Oxley.
You are suggesting that, in many cases, not only is it very
costly to comply, but it is not very useful information because
the nature of the business, there are other activities that are
more interesting and more useful to investors than the items
that are demanded by Sarbanes-Oxley. I was wondering if you
could elaborate on that a little bit and share with us the
importance of diminishing this burden.
Mr. Bargatze. Yes. Certainly, I think, in limiting this
activity, it certainly frees us up to do a lot of activities
that are much more important in terms of generating clinical
data, providing that data in a context where we can take it out
to investors to raise more capital. It is also important to be
able to generate this kind of data to partners that we
potentially could bring online that brings more resources as a
consequence of their interest in codevelopment that may
associate with this data.
And so it is really a distraction from our main focus. In a
company, in a biotech, I mean, you are not profitable until you
actually have a product that reaches the market. And now we are
looking at a life cycle of, in our case, it is something in
excess of 14 years, and this is not atypical from the time you
start on a particular product until the time it either makes it
or fails.
And so I think that just simply because it is a capital-
intensive activity, anything that distracts us from being able
to focus on the activity that is providing the value, is of no
value to us.
Senator Toomey. And also, as you point out in your
testimony, it is not very useful to investors to have the reams
of data about Sarbanes-Oxley for a firm that has no revenue
yet. What is much more important is the actual--the tests, the
trials, the development of the science, and the application----
Mr. Bargatze. Precisely. That is where the interest is. We
do accounting at a level that is sufficient for our investors
to be quite happy with how their investment is being managed.
Accounting is certainly something that we put in place and have
had in place for a number of years as a consequence of our DOD
contracts. And so we can certainly pass a DOD audit. There is
no reason why that should not be sufficient for investors.
Senator Toomey. Thank you. Thanks very much, Mr. Chairman.
Chairman Tester. Absolutely, Senator Toomey. There will be
another round. If you have got one more, I would let you do it,
but otherwise, I am going to continue with more.
Senator Toomey. I have got to run, but I appreciate your
having me.
Chairman Tester. Absolutely. I appreciate you being here
and I appreciate your line of questions.
And with that, I want to thank the panel for being here.
The first question I have, you have all three addressed it in
one way or another, but I would like you to address it again,
and that is from your perspective, is the biggest challenge out
there for startups in rural and urban areas, and some of you
have had experience in both, is it capital alone? Is it
expertise? Is it infrastructure? And could you kind of give me
an idea, if you could rank them, and it is probably going to be
pretty tough to do that, but we will start with you, Dr.
Zoller.
Mr. Zoller. So a lot has been said about the concept of
champions. Serial entrepreneurs are a critical element to
creating an ecosystem that ultimately is going to be high-
performance, people who have done it, who have been there, who
have had experience and are facile in developing their
understanding of the market, being able to bring their ideas to
the market in the form of a venture.
You know, I am very bullish on what I am seeing now because
I think many people are now understanding the impact of
entrepreneurship and now entering as founders into the market.
We have a very healthy kind of culture that is evolving now,
especially among our young people. I see a young generation
that gets it and are really driving into entrepreneurship.
Unfortunately, enthusiasm is not enough. It might be a
necessary but not sufficient condition, because you need to
solve on several parts of the equation. The other part would
ultimately be the environment in which they operate. Are the
barriers high? And I would submit to you that under the current
economic climate, there is tough sledding now. So as a
consequence, it is harder to build your venture into a going
concern in today's environment.
All that being said, there are some natural opportunities
that are coming about as a consequence of technology
development that are dropping the barriers at the same time to
certain aspects of building your firm from a technical
standpoint.
Then the pieces that I have outlined in my testimony
regarding capital. I think that, unfortunately, debt partners
are not as readily available today. I think it is harder to
access debt capitalization. And, frankly, debt capitalization
in particular, when you are talking about line of credit, is
really critical to an early-stage company because you are
trying to smooth out and use your assets as carefully as you
possibly can.
One of the challenges you have in accessing a credit
facility easily is that you lose control of your own resources,
and as a consequence, it becomes inefficient. What we found is
that this equity scenario has turned out to be the only
solution, but equity is very, very precious, and in order to
use your equity efficiently, you need to understand how to use
debt. So banking has got to be a critical element to solving
this challenge.
And then we have all outlined the challenges in accessing
early-stage equity. You know, fortunately, we have got angels
coming to the rescue now and I think it is becoming a little
bit more systematic, which is exciting. But that also takes the
same leadership that I mentioned at the very beginning. The
serial entrepreneurs become the angel investors. So it is a
virtual cycle and you have to have health at every level of
that cycle for ultimately us to maintain that critical mass.
Chairman Tester. Thank you, Dr. Zoller.
Liz, do you want to address this.
Ms. Marchi. And I certainly echo, and I think the key word
is ``ecosystem'' here. I just want to give the example of Avail
TVN, a company that was born in Kalispell, Montana, with a
native Montanan who had put $50,000 on his credit card. Married
him with an experienced corporate executive who had done a
couple of startups, some angel investors, and we have a company
today in Montana that had $150 million in revenue. One of their
employees from Belt, Montana, has actually probably become kind
of a rich kid when the company exits.
But it is all of those things. It is the expertise. It is
the ecosystem. It is the entrepreneur. It is the enthusiasm.
But the guidance--building a company is not easy and we
confuse--we have not embraced that business development is
economic development. We get distracted by a lot of other
things. But if you want jobs, you have got to have new
companies.
Chairman Tester. Rob.
Mr. Bargatze. To address the issues you brought up, I think
certainly what we find is there is really an incredible amount
of expertise in Montana. Our schools are graduating kids with
incredible experience and biotechnology capabilities. So we
really are well stocked in terms of that.
The thing we have learned is that location in Montana is
just outstanding. I mean, we have all the resources that we
need to run the facility from the standpoint of the connection
with information. The University provides us with the necessary
expertise and facilities that we do not have within the company
that are very expensive that we can get through contracting
through them and working with them closely.
I think that one of the things that we are missing, is a
business infrastructure that really helps us to provide the
necessary expertise to provide our entrepreneurs with the
ability to navigate the business world. We have a lot of
scientists at the universities that would really like to spin
out companies, but in fact, with few sources of this type of
schooling, so to speak, it is very difficult for these folks to
move forward.
One of the things that truly is limiting is capital,
because in the State of Montana, getting VCs from the coasts to
come and see what we are doing there is very difficult. Once we
get them there, they are really excited because they actually
see that we have great things going on and we have great
technologies coming out of the universities and there is a lot
of opportunity for startups within the State. So getting our
round of VC funding is a consequence of a summit a couple of
years ago. As a consequence we have more people that are now
looking at opportunities in the State. But because of the
economic climate, it has been a lot more difficult to get the
deals done there, but they are slowly happening and we are
getting help in starting.
Chairman Tester. I want to follow up on that just a little
bit. As far as access to capital in rural America, is the issue
distance from available capital, or is it knowing where to look
for the available capital? Which is the bigger impediment?
Mr. Bargatze. Well, OK. It is sort of a two-step problem.
One, we traveled to all these sites for 10 years to try to
raise venture capital, and it really was not until the sixth or
seventh year of this effort that we were able to bring in
capital from outside of the State. Part of that was the fact
that these guys do not want to travel. They have got deals
going on right in their local areas and if they do not have to
get on an airplane to go somewhere, that is a much better deal
for them. However, once you get them to Montana and they see
the fly fishing, they see the skiing, all the opportunities
there, they think it is a really good place to visit and so we
actually have a bunch of really dedicated investors that are
now strongly supporting us.
So that plus the fact that we found that you really need to
get into the clinic with the biotech company. You have to have
human clinical data at this point to get an investment in
Montana. This is not the case on the coasts, where people can
be at earlier stages to get VC investment. So we have a hurdle
to overcome there, but I think we are getting there, and if we
continue to be successful with the companies that we have been
able to start, I think we are going to get more folks to the
State that are going to be looking at deals.
Chairman Tester. Thank you.
We have been joined by Senator Hagan from North Carolina.
You can go ahead, Kay. Seven minutes on the clock.
Senator Hagan. Thank you, Mr. Chairman, and I really do
appreciate you holding this hearing today because I think that
small businesses, new firms, are really the job creators in our
Nation today, and it certainly is proof positive in my State in
North Carolina.
And I do want to welcome Dr. Zoller here today, Vice
President of Entrepreneurship of the Ewing Marion Kaufmann
Foundation. I have looked at a lot of your work and I actually
cite it, so I do appreciate the great work you are doing. Also
the Executive Director for the Center for Entrepreneurial
Studies at the Kenan-Flagler Business School at UNC-Chapel
Hill, which has definitely spun off a number of thriving
companies from the University.
One of my children graduated from Chapel Hill about 2 years
ago under the business school and Chinese and got a great
education there, and I know, Ms. Marchi, you, too, have North
Carolina connections. Although you are in a great State in
Montana, come to the beaches in North Carolina. Fly fishing is
great in both places.
[Laughter.]
Senator Hagan. But, Dr. Zoller, you mentioned that certain
changes to the tax code would be useful in facilitating the
financing of small businesses, and you suggested that
exemptions from capital gains taxes for small businesses could
have a beneficial impact on growth. And I have heard that other
tax changes suggested for this purpose, such as allowing
partnership structures to pass through tax assets or providing
credits for angel investors. Can you discuss the effectiveness
of these types of tax changes and the associated risk.
Mr. Zoller. Well, first off, I am glad to have you here,
Senator Hagan. We were outnumbered by Montanans three to two
now----
[Laughter.]
Mr. Zoller. ----and we are Tarheels, so I think we can make
up for the difference----
Senator Hagan. Right.
Mr. Zoller. ----but it is a tough act. These are tough
people. Good people.
Senator Hagan. I agree.
Mr. Zoller. I have got to admit, we were having this
conversation right before the hearing, and it is not altogether
clear, frankly, that incentives on the investment side or the
equity side have as much effect as perhaps tax relief on the
founder side or the entrepreneur side.
I have been involved in a number of investments, for
instance, where the investors were not aware that tax credits
might be available both at the State and Federal level, are
available to them. So it is an untested question as to whether
or not a tax credit on the equity side would, in fact, have an
impact.
I think part of it is because Government really has a hard
time marketing those opportunities. What investor would not
take advantage of that credit if they knew about it? So I think
it is worthwhile to present as an experiment, and I think that
experiment is something that I think would be critical to
investors.
But I honestly think the most important solution would be
reducing corporate tax burdens on the entrepreneur side, and
the idea that we are proposing is a phased exclusion of taxable
profits. So the problem is the investment period of an early-
stage company, negative cash-flow period. That is one of the
key challenges in getting a company started, and survival rates
are a key problem. Companies fail during that negative cash-
flow period. So if we can give tax relief during the building
of a firm to the founding team and entrepreneurial venture, I
think it will pay huge dividends. So I think you should solve
on both sides, not just on the investor side, but on the
entrepreneur side. We are suggesting both.
Senator Hagan. Can you discuss why you would target the
investors and small businesses rather than changing tax
policies for the businesses themselves? And also, I have heard
it suggested that we could change the way the net operating
losses are calculated or how intangibles are amortized to
achieve a similar effect for small firms.
Mr. Zoller. I think that those would be outstanding
solutions, because there are differences in the ways companies
scale. Some companies are very capital-intense. Others can be
brought to high growth without a lot of capital investment. So
solutions that would help use, for instance, a capitalization
or amortization of investments that are made both in tangibles
and in intangibles, I think, would have a pretty substantial
benefit as you are building a company.
You know, Dr. Bargatze was talking a little bit about the
notion of bootstrapping and how you bring valuation to a
certain point so it is attractive to an equity investor. These
tools would allow the entrepreneur to actually build a stronger
case for their valuation prior to going out to the market for
equity, and that would actually put them in a much stronger
position to actually be able to lead the firm through time and
maybe even retain more of the equity as time goes on. And,
frankly, I would rather have the equity in the form of the
founder and the entrepreneur than in the form of professional
investors.
Senator Hagan. You know, I talk with a lot of different
companies and some of the new, I think, some of the biotech,
biomedical companies that I was speaking to recently said they
were actually going to Ireland to start some of their
businesses. And I was just curious if any of you have seen the
fact that we are not doing this type of taxation policy here,
that we are, in fact, losing companies that either had started
here or would have planned to start here and then we have lost
them to other companies.
Mr. Zoller. One thing I will mention just briefly, and cede
the time to the rest of my panel, is that we have been working
with the Start-Up Peru Group. This is a group that just has put
out a simple proposal. In order to bring companies to Peru, we
will give you $25,000 and provide a space. And Americans are
flocking in hoards there.
I have been shocked by the differences in early-stage
capital available in Europe relative to the U.S. It is easier
to form a $5 million premoney evaluation type of equity
investment for a venture that is started in Denmark than it is
in the United States. So this is something we need to really
focus on. The money is not getting to where it is needed most,
and that is among early-stage companies that can actually take
this opportunity to market and to growth.
Mr. Bargatze. Although I do not have any direct experience,
I do have anecdotal experience in terms of knowing that there
are a number of Asian companies that are creating biotech
centers and then offering the opportunity for companies to move
there with incentives. So there are certainly deals there that
are providing companies with less cost in terms of
infrastructure and incentives in terms of investment to help
move the firm and establish the firm, and then most likely, I
would think, providing them capital for operations. So that is
something that certainly I have seen. I have been approached,
but we have not had any details in terms of discussions,
because we want to stay in Montana.
Senator Hagan. Well, I will tell you, with unemployment
rates where they are around the Nation, and in North Carolina,
about 9.7 percent, we have got to be forward-thinking in our
policies to be sure that small niche companies can grow and
create jobs, have access to capital, and, in my case, employ
more people in North Carolina and around the country, certainly
without losing these companies overseas.
Thank you, Mr. Chairman.
Chairman Tester. Thank you, Senator Hagan. I appreciate
your comments.
It is interesting, what you said about Peru and potentially
Ireland. It would be great to sit down and figure out what we
could do that could actually make a difference, and I think
back to when I first got in the State legislature. I went to a
farm convention and there was an economic developer there that
said--now, this was in 1998--that said, it is evident to me
that with the incentives that are out there--this is the other
end of the spectrum--that you could make a good living just
fleecing the Government and not do one doggone thing when it
comes to economic development. So there must be some middle
ground there, where we can stop the fleecers but yet allow the
bona fide companies to really grow, and we could have another
hearing on that at some point in time.
But I want to talk about community banks, because community
banks are something you talked about, Dr. Zoller, with your
experience with the big guys, and I have always looked at them
as being a supporter of established businesses, particularly in
rural America, for operating loans and those kind of things.
Can they play a role, or would they play a role, or do you see
even a possibility of them playing a role when it comes to
startups?
Mr. Zoller. You know, as a matter of fact, I am quite
enthusiastic about what I am seeing in community banks. You
know, that simple relationship between the founder and the
banker is the relationship that helped build our country and we
have to go back to that simple concept. Because of the Internet
and because of the scale of our enterprises and the scale,
frankly, of banks today, it is difficult for that relationship
between the regional banker or the local banker and the
business owner to actually be established, and community banks
offer the opportunity to reduce the scale so that the bankers
understand the business impact of capital to the growth of that
business.
A banker can understand the risk that is being placed on
the part of the founder, can understand the promise of that
business, and actually can position debt in such a way to help
fuel the dreams of that individual. I honestly think that that
is risk taking that we cannot afford not to be doing. That is
exactly the kind of risk taking that built our country to what
it is today.
I think back even to the very first days of Standard Oil.
When John D. Rockefeller outlined the opportunity, he turned to
the banks to actually open up the opportunity. Without that
partnership between the banks and John D. Rockefeller, Exxon
would not exist today. Now, that is a very strange example to
bring up, but in the day, it was an entrepreneurial company,
right? That dyad of the banker with the founder is something we
have to come back to, and by going through a five-level CRM
system through a telephone-based menu is not the way to get
there.
Chairman Tester. I appreciate that. Would anybody else like
to comment? Liz.
Ms. Marchi. I would. We have watched in Montana our banks
literally live in fear of regulators. They are completely risk
averse. And one of the big issues that we have, as you well
know, is we do not do comps very well. The nearest comp is 100
miles away, and that just does not work in this system today.
So I could not agree with you more, and the sad thing in
Montana is that we still have that relationship, but hands are
tied. They are just tied.
Chairman Tester. Yes. Rob.
Mr. Bargatze. Actually, we have had some very good
experiences with local banks in Bozeman. It has really been a
result of a track record we developed locally as a consequence
of federally guaranteed loans that we got from the city. We
were able to borrow over $600,000 over a number of years. As a
result of us being able to pay those back, we developed
relationships with local banks that have given us lines of
credit of up to a million dollars, and so that has been very
instrumental in us being able to make it through gap periods
where we have needed to borrow and then repay when we had
additional funds we were able to bring in to move the company
forward.
Chairman Tester. That is good.
I would like to start with Dr. Zoller again, but I would
like you to talk broadly about the shift away from IPOs to
mergers and acquisitions and its impact upon jobs.
Mr. Zoller. It is a very troubling type of barrier that has
been placed. You know, there are only two exit windows, and
when you look at it from the investor's standpoint, they are
looking ultimately to return capital for their investment and
they look, quite frankly, at the exit opportunities. The only
two exit opportunities that are available to a firm--well, I
guess there are three exit opportunities--one is M and A, or a
trade sale. The second one would be an IPO. And the third would
be failure, which is not an exit opportunity that people look
for.
For all intents and purposes, the last several years, the
IPO window has been closed, and while we have seen some,
perhaps, recent examples of things that make us optimistic, I
am just as nervous about those opportunities because I think we
are dealing with an inflated valuation scenario in most cases.
We really need to think about build-to-last companies, not
build-to-sell companies. Entrepreneurs can build companies that
will employ millions, and if you think about the companies just
after the bubble, for instance, that have really made our
economy--I am talking about the Ciscos and the NetApps and the
Genentechs and different sectors--these were build-to-last
companies, not build-to-sell companies. And, frankly, an IPO is
the best way to deliver on a build-to-last opportunity.
Chairman Tester. Would either of you want to comment? It is
up to you.
Ms. Marchi. And what we have seen in Montana, actually, is
a couple of companies go into Canada and doing sort of the
reverse shell market, and the real reticence on the part of a
lot of companies to pursue the IPO market is just the expense
is just enormous. It is absolutely enormous to be a public
company today.
Chairman Tester. OK. You talked about firms that were ready
to go public, and Dr. Bargatze, you have a firm like LigoCyte
who has been, I would say, reasonably successful, if not very
successful. How does a firm know when it is ready to go public?
I can start with you, Rob, or I can start with Dr. Zoller. It
does not matter. Go ahead, Rob.
Mr. Bargatze. Yes, I think that there are some critical
elements in terms of, at least in biotech, what stage you are
at with regard to your clinical development. Have you got a
proof of concept? Have you gotten to the point where you have
shown that your product is actually working and it is safe? We
actually have reached that point, and I think if we were
looking at earlier times, you know, before the economic
downturn, there is a very high likelihood with the IPO markets
open, with additional things that we have had in our pipeline
that we have had to shelve as a result of difficult access to
capital, we would have been in a position to actually move to
potentially go to an IPO. But because of the current
conditions, you know, that IPO window is not open, and
certainly mergers and acquisitions are not as attractive as an
IPO in terms of both the founders and VC investment group,
because frequently these mergers/acquisitions are staged
events, and they pay out over a long period of time. There is
essentially no return on investment that comes back to our
investors.
Chairman Tester. OK. All right.
Mr. Zoller. One thing I would add is that there is an
interesting psychology when you are preparing a firm for an
IPO, and usually it is the run-up in understanding how to
position it for that event. The investment bankers will signal,
you know, what is the best outcome for the firm, both from the
standpoint of its future market takedown as well as its
valuation, and will literally shop the opportunity among
potential acquirers at the time when they are preparing an IPO.
I would submit to you, however, that in most cases when the
first is acquired, fundamentally the structures are upset
because the acquirer will integrate the company into its own,
you know, identity, its own body. In many cases there is
radical downsizing. In most cases there are innovations that
are left on the table because they do not synchronize with the
acquirer's goals; whereas, in the case of the IPO, the founding
team can maintain its strategy, preserve its employees, and
ultimately develop the capacities to actually take it to the
next level. There is no question in my mind, if you are looking
for employment growth, IPO is definitely the way to preserve
it.
Chairman Tester. OK.
Ms. Marchi. And, frankly, at the level--we are usually the
first money in. What we are finding is we are having to start
working with our companies much earlier in order to coach them
to exit so that we retain our investment value.
Chairman Tester. I got you. In parting, I would like to
have you share with me what you see out there that is very
exciting that gives you hope and that we should know about. Who
wants to go first? I hope there is an answer. Liz, do you want
to go first?
Ms. Marchi. Never a problem.
Chairman Tester. I did not think so.
Ms. Marchi. I actually think that it is an incredibly
exciting time in Montana and across the United States. I love
that this audience today has so many young people in it. We
have smart kids. They have a global perspective. They have
grown up with technology. And, frankly, I think the opportunity
that technology gives us is amazing.
We are going to soon be in a business world where it is not
about your resumes or your referrals. It is going to be about
the product that you have produced because everybody can see
it. I love in Montana, I am watching software developers work
from Yemen and Estonia and Arlee and Bigfork. And we talk about
clusters. It is not clusters geographically anymore. It is
communities of interest, and they are building them online.
So I see the opportunity to create value and discovery and
solve problems within this country unprecedented because of our
ability to connect and communicate. And I want to thank you
very much for holding this hearing.
Chairman Tester. Thank you for being here, Liz.
Rob.
Mr. Bargatze. I think there are two factors that I think
are very promising. One is that Montana is ripe, actually for
development of industries like biotechnology. One of the things
that I have not talked about that is really critical is the
cost of doing business there is far lower than doing business
on the coast. So our venture capitalists have actually made
note of the fact that it takes a third more money to get to the
same place in a clinical development plan on the coast than it
does in Montana. So we really offer a great economic equation
in terms of efficiency of what we do with that dollar and how
far we can go with it.
The other thing that collides with that and provides a
great opportunity is the big pharma companies are downsizing
their research and development groups. Those groups are no
longer producing the products internally. Biotech is really the
source of innovation. And so when you look at those two things
together, it is basically saying if we bolster the biotech
community in Montana, we potentially are going to be providing
the solutions that the big pharma companies need to build their
pipelines to continue to make products. And with that we will
actually be able to have a huge impact on health, and
particularly with vaccines, because the best preventative way
to lower costs and prevent disease is really to create vaccines
that prevent diseases that can otherwise be quite devastating
and quite costly for the health care system.
Thanks for the opportunity.
Chairman Tester. Thank you, Rob.
Dr. Zoller.
Mr. Zoller. Senator Tester, I really appreciate you putting
together this panel today. This is one of the most critical
issues, I think, facing our country, and we have got one heck
of an opportunity, and it is because of the people that are
behind you and the people that are behind us on the panel, the
young people that are here. They really get it. Fundamentally
why I am bullish is the young people are taking charge of the
situation, and they see the opportunity, I think, to leverage
entrepreneurship as a tool to really make progress in our
society. They realize that the promise of a large enterprise is
in the future. They know that they are going to try to solve a
problem and they are not going to take no for an answer. So I
am very bullish on the opportunity.
To a certain extent, clusters have been an abstraction. I
think now we have to talk about networks, and ultimately what
the young people do not realize and what I would kind of
suggest they should be focused on today is that they will need
some of us gray hairs to kind of help unlock some of the
potential. My hope is that we are seeing a democratization
among our entrepreneurs, and that democratization is also
flowing on the equity side. If we can bring the two communities
together, investors and entrepreneurs, I think we are going to
unlock a potential that will be a great opportunity for the
United States.
Chairman Tester. Well, thank you, and I thank all three of
you for being here. Just to kind of give you my perspective on
this, I could not agree with you all three more. I get the
opportunity to meet with a lot of young people in this job, and
it gives me incredible hope for the future. They do have it
figured out very, very well. They understand this world in a
way that gives me hope for the future in a very positive way.
I want to thank you all for testifying today. I very much
appreciate your insight and your knowledge about how to create
jobs and how to grow the economy. I think you are right. The
companies that you folks work with every day, the startups, the
entrepreneurs, is really how we are going to get out of the
economic downturn that we are in, and I look forward to working
with all of you into the future on the issues we discussed here
today.
For the record, the record will remain open for 7 days, and
any additional comments and any questions that might be
submitted will be in that record for the next 7 days.
With that, I once again thank the panelists, and this
hearing is adjourned.
[Whereupon, at 11:09 a.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
supplied for the record follow:]
PREPARED STATEMENT OF TED D. ZOLLER
Vice President of Entrepreneurship, Ewing Marion Kauffman Foundation
July 20, 2011
Chairman Johnson, Ranking Member Shelby, and other Members of the
Committee, my name is Ted Zoller, and I serve as Vice President of
Entrepreneurship at the Ewing Marion Kauffman Foundation, am a faculty
member in the business school at the University of North Carolina at
Chapel Hill, and an entrepreneur. I appreciate the opportunity to share
some perspectives on capital access to start-up and scale businesses in
the United States.
The Entrepreneur's Dilemma
I would invite Members of the Subcommittee this morning to put
yourself in the shoes of a founder of a new firm in the United States--
this is perhaps one job more exciting than being a United States
Senator. As a promising entrepreneur, your business concept solves a
problem, fills a customer need, and fulfills what the market demands.
However, starting any new enterprise requires capital. The investment
period every business experiences until it reaches cash flow break
even--a concept termed the ``J-curve''--is a perennial issue to any
start-up. This natural need for investment is precipitated by capital
requirements, labor costs, and the negative cash flow you will
experience until your business is established in its market and has
gained a loyal set of customers. The ``J-curve'' can only be remedied
by access to capital, and when capital is not forthcoming, represents a
substantial barrier to new firm starts. While a small percentage of
firms can be ``bootstrapped'' or self-financed and can achieve break
even through their own cash flows, the vast majority of all new
enterprises--and in particular high-growth firms that rely on
innovation and capital investment--require outside funding in the form
of equity and debt to shoulder the J-curve.
Pressure on Early-Stage Capital Access
The picture I will paint for you this morning is that your job is
harder today than it has been prior to the financial crisis and
recession in the United States, because both equity and debt financing
are not as readily available. The J-curve is now a barrier to your
entry as opposed to simply a hurdle in becoming a going concern. Why is
it harder today to finance the start-up? Three reasons:
First, venture capital and other forms of private equity have
largely vacated early-stage investing, opting instead to form
syndicates to pursue more reliable returns in later-stage ventures,
largely abandoning early-stage concerns.
Second, while angel and friends and family investors have entered
the early-stage financing market to fill the gap, these angels are not
as adept in connecting to later-stage capital partners to continue the
financing needs of the venture over its lifecycle to fuel the firms'
growth, and angel capital availability is a fraction of equity
investment that was available in the past.
Third, the consolidation of banking institutions and their current
conservative posture toward risk precipitated by the Wall Street
financial crisis has choked off needed debt financing. If you cannot
access equity financing, you no longer can start a business without
collateralizing the debt against your personal assets and signing a
``personal guarantee,'' and the line of credit that you need to smooth
your cash flows now comes with higher interest rates, more punitive
terms, and generally not at the limits needed to finance your firm. The
large banks are no longer a partner to small business. Indeed, I have
personally operated a family business now for 3 years and recently
contacted my bank for service--one of the three largest banks in the
United States that for the sake of my testimony will remain nameless--
and they could not even find my account, claiming on the phone that I
was not their customer. This is a bleak picture that we all face as
entrepreneurs.
Macroeconomic Relevance of the Start-Up
While we have seen a clear resurgence of angel investors and the
trend toward democratization of equity investing and are hopeful by
innovation occurring in our community and commerce banks, our early-
stage pipeline is under unprecedented stress. This has staggering
implications on our economic future. Since the recession began in 2008,
Kauffman data indicate that more firms than ever are being formed each
year. Unfortunately our research reveals that this result is hollow--as
the new firms are largely sole proprietorships and ``consultancies'' as
opposed to job-creating firms. New firms with employees during this
same period in fact have been dropping--a troubling indicator
suggesting a slowdown in the formation of potential scale companies.
Contrast this fact to another series of studies published by the
Foundation--that up until the financial crisis and subsequent
recession, United States job and output growth was driven by the
formation of new firms or start-ups, and firms younger than 5 years old
were responsible for all net new job creation. Moreover, we have
concluded from our research that if the United States economy could
consistently generate 30-60 new companies whose annual revenues
eventually reach $1 billion, the United States would enjoy permanently
a 1-percentage-point increase in its growth rate. This promises a
solution to our fiscal future. So if our goal is to motivate our
economy and create new jobs, then we must focus on job-creating, early-
stage firms--especially those firms that will achieve high-growth and
scale and require long-range financing. Achieving this goal will
require a continuous stream of new, bold entrepreneurs, fewer
roadblocks to the formation of new enterprises, and low-cost capital
available to finance startup and growth.
A Solution to Our Entrepreneurial Future
How can we do this in light of the looming budget austerity at all
levels of government? We must do this, as our fiscal future is at
stake. Yesterday, the President of the Kauffman Foundation, Carl
Schramm, presented a solution we are calling the Startup Act. This
proposal speaks to many of the dilemmas faced by the entrepreneur that
I have framed in my testimony and are the subject of this hearing--
providing access to capital, by:
First, modifying the tax code to facilitate the financing
of small business, with a permanent capital gains exemption on
investments in start-ups held for at least 5 years. There is a
strong case, given the job creation and innovation benefits of
start-ups, for exempting from any capital gains tax patient
investing in early-stage companies--an idea supported by the
National Advisory Council on Innovation and Entrepreneurship.
Second, reducing corporate tax burdens for new companies in
the first 3 years they have taxable income. To ease the
pressure on start-ups precipitated by the J-curve and initial
cash flow, the National Advisory Council has also suggested a
full exclusion on corporate taxable income earned by qualified
small business on the first year of taxable profit, followed by
a 50-percent exclusion in the subsequent 2 years--an idea our
research would support.
Third, making it easier for growing private companies to go
public, allow shareholders who invest in firms with a market
cap of $1 billion or less and are in the best position to judge
the cost-benefit of financial auditing mandates to decide
whether to comply with the requirements of the Sarbanes-Oxley
Act. If the IPO window is opened, investors will be a lot more
willing to finance early-stage companies and their continued
growth when those companies have at least the option of going
public after they have reached scale, rather than simply
selling out to a large firm, thereby retaining the
entrepreneurial energy of the scale enterprise as a long-term
business venture and employer.
Fourth, reforming Federal regulation by sunsetting all
major rules after 10 years, requiring all new major rules to
pass a benefit-cost test, and collecting data on regulation at
the State and local levels to allow for the objective
evaluation of how regions can promote business-friendly
climates.
These proposals, among others, are needed to undertake the course
correction required to make the United States once again the best place
to found, grow, and scale an entrepreneurial venture. The economic
shocks of the financial crisis coupled with the challenges of our debt
have fundamentally changed our direction. Putting us back on course
will require the creativity of our Government policy makers and
business leadership and, of course, our entrepreneurs. I am confident
we will achieve these aims and look to your leadership in making our
entrepreneurial future again possible.
Thank you.
______
PREPARED STATEMENT OF ELIZABETH MARCHI
Founder and Fund Coordinator, Frontier Angel Fund, LLC
July 20, 2011
Mr. Chairman, Distinguished Members of the Subcommittee, my name is
Liz Conner Marchi and I am the Coordinator of the Frontier Angel Fund,
Montana's first angel investment fund, a former economic development
executive for Flathead County, the Coordinator for Innovate Montana and
a business consultant with Northfork Strategies. I live on a working
cattle ranch in the Mission Valley of Northwest Montana near Glacier
National Park.
I am honored to have the opportunity to speak before you today with
a voice informed by 10 years of economic and business development work
in Montana. I want to thank my fellow Montanan, Senator Jon Tester for
extending this privilege to me. Prior to moving to Montana, I worked in
economic development in North Carolina where I was a constituent of
Senator Hagan.
The most interesting people I have ever met live in rural America.
Most of them are innovators and entrepreneurs, because they have had to
be to survive. As my business partner at Northfork Strategies, Diane
Smith, author of TheNewRural.Com says, ``When I worked in Washington,
DC, I knew plenty of patent lawyers but not a single inventor. Within
months of moving to Montana, I knew dozens of inventors but only one
patent lawyer.'' This speaks volumes about the challenges and
opportunities we face in America to retool an economy deeply impacted
by globalization and technology.
I want to speak to three issues that merit your attention if new
jobs are to be created:
Financial capital must be made available to entrepreneurs
Innovation and discovery is everywhere
Telecommunications infrastructure and regulatory policy are
critical to this effort
Today's capital environment is very difficult for entrepreneurs.
Before the recession, many entrepreneurs bootstrapped startups with
personal credit cards. Banks once would just ask you to mortgage your
house for a business loan. This, frankly, was a significant obstacle to
entrepreneurship when the economy was good. In today's climate, it's
hard to know what a house is worth, so lending on an existing asset is
rare. Most bankers will tell you they are working for regulators today,
not customers. Bank lending today is driven by cash flow. Most startups
have no cash flow, and some don't have many liquid assets. Banks look
at history. As a result, bank debt is a very unlikely source of capital
for entrepreneurial ventures which rely on a forward looking
opportunity.
Angel investors look forward at the opportunity. In 2005, we
initiated a conversation with a number of high net worth individuals
who were living in Montana. In addition to investment capital, they had
deep skills sets in starting and building successful businesses. In
2006, the Frontier Angel Fund, LLC closed with 33 investors who put in
$50,000 each to invest in early-stage businesses located in the region.
What is an angel investor? An ``Accredited Investor'' that is the first
``professional'' money in a business after family, friends and fools. I
want to thank all of you responsible for the compromise on the
Accredited Investor definition in the Dodd-Frank bill. Without the
compromise, more than two thirds of potential angel investors in
Montana could no longer be ``accredited.'' Angel investors differ from
Venture Capitalists in that they are investing their own money, not
other people's money. Most angels have a double bottom line: they want
to make money but they also want to see their community or region
prosper. Many angels are successful entrepreneurs and they share a real
affinity for mentoring and coaching others. The estimated size of the
angel and VC markets are roughly the same, $20-$30 billion annually. In
2009 Venture Capital money went to 3,800 companies in the United States
while angels invested in almost 56,000 companies. Two thirds of all VC
investments were in California, Boston and New York and half of all
States had only one or no VC deals. Angel investments happen in every
State in America. \1\
---------------------------------------------------------------------------
\1\ PricewaterhouseCoopers Money Tree Survey, 2006-2009 and
Jeffrey Sohl, Center for Venture Research, University of New Hampshire,
``The Angel Investor Market in 2007: Mixed Signs of Growth'', 2008.
---------------------------------------------------------------------------
The Frontier Fund is easy to find--we have an online application
process, we screen deal submissions every other month, and we meet in
person every other month. We have looked at over 300 companies since
inception and have investments in 10 regional startups, most of which
have a proprietary product or service. Frontier Fund conducts a monthly
call with 18 other groups in the inland Pacific Northwest to share
investment opportunities and to learn from each other. Angels are very
important, and we need more of them. In that regard, I would encourage
your support of a Federal angel tax credit. And as you consider capital
gains, think about the importance of that capital for angel investing.
Included in my submission today is a map of angel groups in the
U.S. provided by the Angel Capital Association of which the Frontier
Angel Fund is a founding member. They are now in every State in the
union. Compare that to Venture Capital which is concentrated on the
east and west coasts. I would encourage your focus on ways to support
the growth of angel networks and funds.
Government policy and investment plays a critical role in enabling
the kind of telecommunications infrastructure required for businesses
to operate today. In last mile locations like Livingston, Montana
(population 7,300), where entrepreneurs like Andrew Field with Printing
for Less.com have developed sophisticated businesses printing platforms
serving a global market, telecommunication infrastructure is critical.
For his company, bandwidth and speed are lifelines. And in the case of
PrintingforLess, which employs 160 highly trained workers, initial
funding came from a Montana based early-stage seed fund, Glacier
Venture Fund, and other local angels. Debt sources allowed the business
to grow, but equity got it off the ground.
Bandwidth supports scores of new enterprises throughout rural
America. TeleTech, a customer contact center, located in Northwest
Montana employs 900 people. Bandwidth and a trainable workforce
attracted this company. Profitability keeps it in Montana. You can
build and scale a technology based enterprise from anywhere if you have
the right business model, employees, and pipes. Avail TVN, the largest
provider of digital media services in North America, was born in
Kalispell, Montana, in 2005. A team of technologists, guided by an
experienced former corporate executive, built a company that last year
had $150 million in revenue, employs over 100 with 20 in Kalispell. As
an employee of Avail-TVN, a former University of Montana student from
Belt, Montana (population 589), has a real chance at becoming wealthy
through stock options if the company is sold or goes public. The
initial seed funding for Avail came from local angels and a local rural
telco. The local talent is as good as it gets, they just need the
teaching and sophistication that comes from experience.
Many of the programs designed here in Washington, DC, are built for
clusters of industries. This doesn't translate well to rural
innovators. A team in Montana is likely to include someone using open
source software in Estonia working with software developers in Bozeman,
Bigfork, and Arlee. It's a virtual community of interest, not
necessarily a geographic one. We often get a one-size-fits-all
approach, and it often doesn't fit for rural areas.
Innovation and discovery are everywhere. But we must find better
ways to connect capital to ideas and to entrepreneurs. This is the
recipe for new jobs in all of America. Innovate Montana is a new
initiative to not only tell our growing number of entrepreneurial
success stories, but to build a virtual community of interest around
businesses in IT, Cleantech, and Life Science. It's a low overhead
collaboration led by CEO's in the private sector, Governor Schweitzer's
Office of Economic Development, Tech Link, and the Tech Transfer
offices of our Montana universities. Too much money, time, and energy
is spent trying to create jobs without a business perspective in the
mix.
We need Federal policy that does all it can to minimize
regulations, provide essential telecommunications infrastructure,
encourage angels, provide real world business education and strategy to
entrepreneurs, and doesn't lose site of the incredible talent and
ambition that you find in rural America. Federal policy is often made
in Washington, DC, where you have 11,000 residents per square mile. It
doesn't always translate effectively to a place like Montana where we
have 6.8 people per square mile.
I have never regretted bringing my children to Montana to be
educated there in public schools. In addition to a fine education, they
have learned values like self-reliance, being thrifty and being
innovative--all a part of the fabric of life in rural communities. We
cherish our landscape and with your continued vigilance, rural America
will be an important part of the path to economic prosperity and
national renewal.
Thank you.
ADDENDUM 1
ADDENDUM 2
ADDENDUM 3
ADDENDUM 4
PREPARED STATEMENT OF ROBERT F. BARGATZE
Executive Vice President, Chief Scientific Officer, LigoCyte
Pharmaceuticals, Inc.
July 20, 2011
Good morning Chairman Tester, Ranking Member Vitter, Members of the
Committee, ladies, and gentlemen. My name is Robert Bargatze, and I am
Executive Vice President and Chief Scientific Officer of LigoCyte
Pharmaceuticals, Inc. I want to thank you for the opportunity to speak
with you today about the unique hurdles to accessing capital that
innovative biotech startups face. Make no mistake, biotechnology has
incredible potential to unlock the secrets to curing devastating
disease and helping people to live longer, healthier, and more
productive lives, but the barriers that small biotech companies
encounter on a daily basis raise some important questions: Would we
rather see the next generation of breakthrough cures discovered by
researchers in Bozeman or Beijing? Do we want the jobs associated with
this groundbreaking science to go to workers in Missoula or Malaysia?
If we want more scientific breakthroughs that allow us to enjoy a high
quality of life--indeed, breakthroughs that save the lives of our loved
ones--then shouldn't we put in place policies that encourage innovation
through private investment?
While the biotechnology industry faces significant challenges, we
nonetheless have the ability to deliver the next generation of cures
and treatments to the bedsides of patients who desperately need them
while at the same time creating a healthier American economy. The 1.42
million Americans directly employed by biotech are driven to treat and
heal the world, but in order for them to be able to do that, Congress
must remove the barriers to innovation that we face. Innovation in
biotechnology leads to the medical breakthroughs that cure and treat
devastating diseases like cancer and Alzheimer's and allow real people
to see their grandkids graduate from college or walk their daughters
down the aisle.
The leash that holds our industry back from helping more people is,
in large part, the devastating effect that a lack of access to
necessary capital can have on growing biotech companies. Today,
Congress has the opportunity to help speed lifesaving cures and
treatments to patients by bolstering capital formation in our industry.
My company, LigoCyte, is a private biopharmaceutical company based
in Bozeman, Montana, that is developing innovative vaccine products
based on our virus-like particle (VLP) platform. VLP technology
provides antiviral protection without the complexity associated with
live viruses. Our lead product candidate, a VLP-based vaccine designed
to prevent gastroenteritis caused by norovirus, just completed a Phase
I/II study which showed proof-of-principle in humans. I cofounded
LigoCyte in 1998, and we currently have 38 employees.
I am also the Chairman of the Montana BioScience Alliance, which
fosters partnerships among the various biotech stakeholders in Montana
in order to grow and sustain a globally competitive bioscience industry
in our State. Our relationships with entrepreneurs, laboratories,
hospitals, clinics, and universities allow Montana biotechnology
companies to create high-quality jobs and economic opportunity for the
people of Montana.
When I cofounded LigoCyte in 1998, we were the quintessential small
business. My four cofounders and I each gave the new company $5,000 to
get things off the ground--our very first round of financing. With our
startup funds, we bought kitchen cabinets from the home improvement
store down the street and installed them ourselves, giving us our first
laboratory shelves in our new workspace. Our location in the Advanced
Technology Park near Montana State University put us in prime position
to succeed, but we had no cash on hand past our initial personal
investment. Our first contracts were for high content screening with
large pharmaceutical companies like Merck and SmithKline to facilitate
selection of lead product candidate anti-inflammatory drugs. These
small revenue streams generated income to cover our overhead while we
wrote our Small Business Innovation Research (SBIR) grant proposals.
SBIR gave us the jumpstart we needed to move forward with our own
projects. SBIR is targeted specifically at small, innovative companies
like ours, and it was a key foundation of LigoCyte's success in
Montana. Because of our SBIR grants, we could focus on our vaccines and
make important progress in our research. We were able to leverage this
progress into a contract to do biodefense vaccine development work for
the Department of Defense (DoD). With our success on our DoD contract,
we were finally able to get our first round of venture financing.
Venture capital is the lifeblood of the biotechnology industry around
the country, and our early partnerships with two small venture firms in
the Rockies allowed us to fund Phase I clinical trials in our vaccine
pipeline. The data from those trials was instrumental in getting buy-in
from larger investors, which has pushed our research to where it is
today. Four years ago, we attended the Montana Economic Development
Summit, hosted by Montana Senator Max Baucus. We successfully presented
our Phase I data there to Forward Ventures and subsequently met with
several interested venture capital funds, including Fidelity
BioVentures and those affiliated with the large biopharmaceutical
companies MedImmune and Novartis. These relationships led to a $28
million round of venture financing.
We are currently entirely privately funded, with the exception of
our ongoing contracts with the Department of Defense. As you can see,
getting to this point was no easy task. Even as the Chief Scientific
Officer, I always had to keep one eye open for financing opportunities
to further our research. There is no ``beaten path'' for small
companies like ours to follow. Instead, we have to break new ground,
both in our science and in our search for funding. It is not a simple
undertaking, and many companies are not as successful as LigoCyte has
been. Their science might be just as groundbreaking as ours, but if the
funding cards do not fall the right way the science hardly matters.
As Chairman of the Montana BioScience Alliance, I have heard
numerous stories of other biotech startups going through the same
process that LigoCyte did. The first years of a private biotech consist
of cobbling together funding from any source possible until a larger
revenue stream opens up. LigoCyte was lucky enough to be researching
vaccines, as our biodefense contract with the Department of Defense was
an important financing milestone in our early development as a company.
However, most startups do not have a pipeline that lends itself quite
so easily to large biodefense contracts. Companies researching
treatments for cardiovascular disease, the leading cause of death in
the United States; diabetes, one of the fastest-growing ailments in the
population; or cancer, the largest biotechnology research space, would
get no interest from DoD, leaving them in an even weaker position when
seeking venture capital financing.
There are thousands of companies facing similar funding struggles
throughout the United States, each one with molecules and product
candidates that could change the face of modern medicine. Biotechnology
may hold the answers to the medical problems that America faces, from
the devastation of cancer and HIV/AIDS to the personal losses of
Alzheimer's and Parkinson's to the spiraling costs of health care
associated with diseases of epic proportions, such as Type 2 diabetes.
Of the 118 scientifically novel drugs approved from 1998 to 2007, 48
percent were discovered and/or developed by biotech companies. These
revolutionary cures and treatments save lives, provide a higher quality
of life, and reduce long-term health care costs. As Congress continues
to look for ways to reduce our Nation's deficit, it is important that
we remember the impact that innovative medicines can have on increasing
overall health, especially by combating costly chronic diseases. These
advances will save taxpayers money by decreasing the outlays necessary
to care for our aging population.
Additionally, the biotech industry is a thriving economic growth
engine, directly employing 1.42 million Americans in high-quality jobs
and indirectly supporting an additional 6.6 million workers. The
average biotechnology employee makes $77,595 annually, far above the
national average salary. President Obama has called for the United
States to lead in the 21st century innovation economy, and
biotechnology can be a key facet of our Nation's economic growth.
Montana is among the leaders of this growth--the bioscience sector in
our State spends more on R&D per capita than the bioscience sectors in
all but 13 States.
Despite these windows of opportunity, biotechnology research and
development is often a difficult process. Bringing groundbreaking cures
and treatments from bench to bedside is a long and arduous road, and
small biotechnology companies are at the forefront of the effort. It
takes an estimated 8 to 12 years for one of these breakthrough
companies to bring a new medicine from discovery through Phase I, Phase
II, and Phase III clinical trials and on to FDA approval of a product.
The entire endeavor costs between $800 million and $1.2 billion. Due to
this capital-intensive process, biotechnology companies lacking
research and development funds turn to private sector investors and
collaborative agreements to finance the early stages of development.
However, the current economic climate has made private investment
dollars extremely elusive. In 2010, venture capital fundraising endured
its fourth straight year of decline and its worst since 2003.
Biotechnology received just $2 billion in venture funding, a 27 percent
drop from its share in 2009. Even worse, the biggest fall was seen in
initial venture rounds, which are the most critical for early-stage
companies. Series A deals last year brought in just over half of what
they did in 2009. Decreasing up-front investment could mean cures and
treatments being shelved in labs across the Nation and ultimately not
reaching patients. Generally, venture capitalists are challenged by
significantly reduced capital flowing into their funds on the front end
and are having to hold their investments longer before exiting due to
the weakness of the public markets. This has led to venture funds
deploying capital differently than in the past, to biotech's
disadvantage.
Montana startups are at a particular disadvantage due to the dearth
of venture capital firms in and around our State. Although the Montana
BioScience Alliance has taken steps to increase university
partnerships, find firms that specialize in biotech construction and
intellectual property protection, and propel scientific and management
expertise to Montana companies, it remains the case that funding
sources are few and far between among the Rocky Mountains. In fact,
Senator Baucus's Economic Development Summit is one of the only
efficient ways for startup biotechnology companies in our State to
connect with venture capitalists. Small biotech companies in Montana
are almost all private and are largely reliant on SBIR and other
Government programs like the Therapeutic Discovery Project (TDP).
However, Government funding combined with investment from a company's
founders is not enough to pilot a clinical study or investigate
potential new treatments. The high cost and long development period
associated with bringing a new medicine to market make private capital
necessary, often in the form of angel investors and venture
capitalists. LigoCyte has been fortunate thus far, but the high-risk
nature of biotech development and the gloomy economic climate have made
investors reluctant.
The shift in the economy has also harmed companies like mine that
already have venture financing. Historically, venture capitalists
receive a return on their investment when a company goes public through
an initial public offering (IPO). The cash raised through the IPO would
provide an exit for these early investors as well as provide the
capital to fund expensive Phase II and Phase III trials at the company.
However, the IPO market is essentially closed at the moment. From 2004
to 2007, the United States had an average of 34 IPOs in biotechnology
per year. In 2010, there were only seventeen. Although the funding
level of biotech IPOs is increasing from its recession-induced nadir,
this progress has been made almost entirely by larger, more mature
companies. The two largest transactions in the industry last year were
completed by a company in Phase III trials and a next-generation
sequencing company that was already generating revenue. The weak demand
for these public offerings for smaller companies is restricting access
to capital. This then hampers critical research, forces companies to
stay private for longer, and depresses valuations of later-stage
venture rounds.
As U.S. biotech companies face financial uncertainty, other
countries are increasing their investments and enacting intellectual
property protections to encourage their own biotech growth. The United
States still holds its place as the leader in global biotechnology
patents thanks to our large head start, but China and India rank first
and second in biotech patent growth. These emerging powers are heavily
investing in science, and particularly in biotechnology. Meanwhile, the
U.S. has fallen to 20th out of 23 countries in new biotech patent
applications. A recent survey conducted by BIO found that nearly a
third of small biotech companies have been approached to move their R&D
operations offshore, and CEOs named China and India as two prime
destinations. Furthermore, since 2008, trouble in the IPO market has
decreased the number of public biotech companies in the U.S. from 394
to just 302, a 23 percent drop. Meanwhile, China's biotech IPO market
continues to grow--in 2010, thirty-three bioscience IPOs in China
raised $5.9 billion, an increase of 47 percent over 2009. The venture
capital and private equity market is thriving in China as well,
increasing funding levels by over 200 percent in the past 2 years.
Meanwhile, companies here in the United States struggle to find funding
from any number of sources, not all of which prove fruitful. In
Montana, we have found that novel financing sources are few and far
between, and innovation capital is dwindling. It is imperative that
financing is robust and available to encourage continued biotech
innovation in the U.S., enhance American competitiveness on the global
stage, and ensure that the United States maintains a healthy and
growing innovation economy.
Modifications to Current Federal Programs Impacting Innovative Biotech
Companies
Congress and the Administration have taken some notable steps to
help companies facing these financial struggles. By providing funding
to innovative companies and incentivizing investment in small
businesses, certain programs have proven invaluable to companies like
mine. However, Congress can increase the impact of these important
programs by making modifications to ensure that they have the largest
possible effect on innovation.
Small Business Innovation Research (SBIR) Program
As I have already mentioned, SBIR was a potent lifeline for
LigoCyte during our early stages of development. The SBIR program is
structured so that 2.5 percent of all Federal R&D grant monies are
reserved for small business applicants. These funds provide critical
seed money to new business innovators like the biotech startups in
Montana. However, the eligibility rules for small businesses to qualify
for SBIR have excluded biotech companies since 2003. In particular, the
size standard limits eligibility to companies that are majority owned
and controlled by individuals who are U.S. citizens (or resident
aliens). While the congressional intent of this definition was to keep
funding in the United States, the Small Business Administration (SBA)
has interpreted it differently. In 2001, after LigoCyte had already
received our SBIR grants, the SBA Office of Hearings and Appeals ruled
that the definition of ``individuals'' only applied to ``natural
persons,'' and not to entities such as venture capitals funds, pension
funds, or corporations. In 2003, SBA specifically applied this ruling
to biotechnology companies funded by venture capitalists. This
effectively barred venture-backed companies from receiving SBIR funds,
a drastic change from the program's implementation since 1982.
In order for biotechnology companies to be successful, they must
tap into venture capital funding. LigoCyte, for instance, meets
virtually every definition of the ``small, high-tech, innovative''
businesses that SBIR purports to help; however, we are not currently
eligible for SBIR grants because we are majority owned by venture
capital companies. Other companies like LigoCyte that are not as far
along the development pathway have been similarly barred from the
program. I have seen the impact the SBIR program has had on the
biotechnology industry, not only by fostering the growth of fledgling
companies during some of the most challenging times in their business
cycles, but also by enhancing the advancement of important cures and
treatments to the marketplace. However, the current rules have
inhibited the growth and survival of small private biotechnology
companies due to the inability of venture-backed companies to
participate in the SBIR program. I believe that Congress should restore
SBIR eligibility to majority venture-backed companies in order to truly
incentivize breakthrough innovation.
Therapeutic Discovery Project (TDP)
Another program which has helped LigoCyte and other small
biotechnology companies is the Therapeutic Discovery Project (TDP).
Last March, Congress enacted this important tax credit program designed
to stimulate investment in biotechnology research and development.
Under this program, small biotech companies received a much-needed
infusion of capital to advance their innovative therapeutic projects
while creating and sustaining high-paying, high-quality American jobs.
In total, the Therapeutic Discovery Project awarded $1 billion in
grants and tax credits to nearly 3,000 companies with fewer than 250
employees each. These small companies were eligible to be reimbursed
for up to 50 percent of their qualified investment in activities like
hiring researchers and conducting clinical trials. The impact of this
funding was felt across the American biotech industry, as companies in
47 States received awards. The average company received just over
$200,000, an important shot in the arm in these rough economic times.
LigoCyte received two awards under TDP, both for the maximum amount
of $244,479. Our nearly $500,000 TDP allotment has been a valuable
resource to our company. As a result of this funding, we were able to
hire one new researcher and keep the rest of our 44 workers employed at
salaries that reflects the hard work they put in. The cash influx that
TDP provided also helped us advance our research. One of our grants was
for our VLP-based norovirus vaccine which, as I have mentioned,
recently showed proof-of-principle in a Phase I/II trial. Additionally,
we received a grant for another candidate in our pipeline, a VLP-based
vaccine to prevent respiratory disease.
The infusion of capital for small biotech companies provided by the
Therapeutic Discovery Project is an essential incentive for companies
to keep their research and development, manufacturing, and operations
here in the United States. The critical funding will also accelerate
the movement of cures and treatments to patients who need them. This
program was a step in the right direction by Congress to invest in
growing the U.S. biotech industry to keep pace with our global
competitors. Given the imbalance between the extraordinarily high
demand by small biotech companies and the limited pool of funds, I hope
that Congress will extend and expand this oversubscribed program and
assist more American companies in pursuing life-saving scientific
breakthroughs and supporting American jobs.
Financial Services Capital Formation Proposals
The breadth of the financing problem in the biotechnology industry
calls for comprehensive solutions to ease capital formation, involving
both tax and financial services policy. In addition to the difficult
financing landscape and struggling public markets, growing biotech
companies also face regulatory burdens which further hinder capital
formation in our industry. Making changes to regulations which
unintentionally harm the biotech industry would free companies to focus
their efforts on their innovative scientific research rather than
complex reporting and compliance. I believe that changes to Sarbanes-
Oxley Section 404(b), SEC Rule 12b-2, SEC Regulation A, and the SEC
reporting standard could provide great benefit to groundbreaking
biotechnology companies.
Sarbanes-Oxley Section 404(b) (Financial Reporting)
The Sarbanes-Oxley Act (SOX) was enacted to protect investors by
bringing greater transparency to public companies. While the financial
reporting requirements in SOX continue to provide this important
service, Section 404(b) imposes a disproportionately negative cost
burden on smaller public companies.
The biotechnology sector is especially disadvantaged by the
compliance burden of Section 404(b) due to the unique nature of our
industry. The long, capital-intensive development period intrinsic to
biotechnology often causes companies to have a relatively high market
capitalization (caused by multiple rounds of venture financing prior to
going public) but little-to-no revenue. Therefore, many biotech
companies facing their first few years on the public market are forced
to divert funds from scientific research and development to Section
404(b) compliance. The opportunity cost of this compliance can prove
damaging, resulting in already limited resources being driven away from
a company's search for cures and treatments.
Further, the true value of biotech companies is found in
nonfinancial disclosures such as clinical trial milestone results, FDA
approvals, and patent status. Investors often make decisions based on
these development milestones rather than the financial statements
mandated by Section 404(b). Thus, the financial statements required do
not provide much insight for potential investors, meaning that the high
costs of compliance far outweigh its benefits.
Section 989G of the Dodd-Frank Wall Street Reform and Consumer
Protection Act is an important acknowledgment by Congress that Section
404(b) of Sarbanes-Oxley is not an appropriate requirement for many
small reporting companies. Dodd-Frank sets a permanent exemption from
Section 404(b) for companies with a public float below $75 million;
however, this is too narrow in practicality and must be raised. In
2006, the SEC Small Business Advisory Board recommended that the
permanent exemption be extended to companies with public floats less
than $700 million. The Advisory Board's proposed ceiling would allow
small innovative companies to focus on speeding cures and treatments to
patients rather than SOX compliance.
The Advisory Board also realized that public float alone does not
fully portray the complexity and risk associated with a reporting
company, and suggested a revenue test to paint a fuller picture.
Revenue should be a critical consideration when determining the
appropriateness of Section 404(b) compliance, along with public float.
The addition of a revenue test would better serve the congressional
intent behind Sarbanes-Oxley by reflecting the truly small nature of
companies with little or no product revenue. Public companies with a
public float below $700 million and with product revenue below $100
million should be permanently exempt from Section 404(b), allowing them
to focus on their critical research and development.
SEC Rule 12b-2 (Filing Status Definitions)
Amending the filing status definitions found in SEC Rule 12b-2
would be another way to reduce the 404(b) compliance burden on small
innovative companies.
SEC Rule 12b-2 establishes three distinct classifications by which
companies determine their filing status: large accelerated filers--
companies with a public float of more than $700 million; accelerated
filers--those with a public float of more than $75 million but less
than $700 million; and nonaccelerated filers--companies with a public
float of less than $75 million (known as smaller reporting companies).
Because a particular filing status carries with it onerous
regulatory duties and compliance costs (such as compliance with SOX
Section 404(b)), finding a method of designation that fairly captures a
company's profile is essential. While using public float as a primary
metric for determining filing status is a good first step, it fails to
take into account other relevant factors that more accurately measure
the size and complexity of certain industries or categories of
companies. The biotechnology industry provides a telling example.
Biotech companies often have a relatively large public float
because of the potential of the groundbreaking cures and treatments
they are developing. However, as I have discussed, the extended R&D
timeline that we face calls for a long-term commitment and considerable
private funding. During the long development period, small biotech
companies commonly have no revenue or operate at a loss. If revenue was
taken into account in determining filing status, then companies with
little to no revenue but a high public float could avoid the financial
burdens of certain auditing requirements with which larger, more
established companies must comply. Revising the definition of smaller
reporting companies to include a revenue component would reflect the
true nature of startup biotechnology companies and allow them to focus
on their groundbreaking science.
Additionally, the current quantitative metrics for determining
filer status under Rule 12b-2 also need revision. The definitions of
filer status were created to offer unique classifications based on
filer characteristics and determine the breadth of regulatory
compliance to which filers must adhere. As I have mentioned, the
markers are currently set at $75 million and $700 million, dividing
filers into three groups. When these definitions were set, they
provided an accurate depiction of the groups above and below the
markers. Since then, however, the market has continued to evolve and
these markers have become outdated. In particular, the $75 million
public float cap for smaller reporting companies does not match current
market conditions. I believe that a $250 million cap for nonaccelerated
filers would group companies with common characteristics together, as
the rule originally intended to do, rather than split them at the
outdated $75 million point.
SEC Regulation A (Direct Public Offerings)
Regulation A, adopted by the SEC pursuant to Section 3(b) of the
Securities Act of 1933, was created to provide smaller companies with a
mechanism for capital formation with streamlined offering and
disclosure requirements. Updating it to match today's market conditions
could provide an important funding source for small biotechnology
companies.
Regulation A allows companies to conduct a direct public offering
valued at less than $5 million while not burdening them with the
disclosure requirements traditionally associated with public offerings.
The idea behind Regulation A was to give companies which would benefit
from a $5 million influx (i.e., small companies in need of capital
formation) an opportunity to access the public markets without weighing
them down through onerous reporting requirements.
However, the $5 million offering amount has not been adjusted to
fit the realities of the current market and Regulation A is not used by
small companies today. The current threshold was set in 1980 and is not
indexed to inflation, pushing Regulation A into virtual obsolescence.
As it stands, a direct public offering of just $5 million does not
allow for a large enough capital influx for companies to justify the
time and expense necessary to satisfy even the relaxed offering and
disclosure requirements.
I believe that Regulation A could have a positive impact for small
biotechnology companies if its eligibility threshold was increased from
$5 million to $50 million while maintaining the same disclosure
requirements. This increase would allow companies to raise more capital
from their direct public offering while still restricting the relaxed
disclosure requirements to small, emerging companies. Regulation A
reform could provide a valuable funding alternative for small biotech
startups, giving them access to the public markets at an earlier stage
in their growth cycle and allowing them to raise valuable innovation
capital.
SEC Reporting Standard (Shareholder Limit)
Although SEC policies like Rule 12b-2 and Regulation A are designed
to monitor public companies, the agency also keeps tabs on private
companies when they reach a certain size. Modifying the SEC's public
reporting standard would prevent small private biotechnology companies
from getting unnecessarily burdened by shareholder regulations.
Once a private company has 500 shareholders, it must begin to
disclose its financial statements publicly. Biotechnology companies are
particularly affected by this 500 shareholder rule due to our
industry's growth cycle trends and compensation practices. As I have
mentioned, the IPO market is essentially closed to biotechnology,
leading many companies to choose to remain private for at least 10
years before going onto the public market. This long time frame can
easily result in a company having more than 500 current and former
employees, most of whom have received stock options as part of their
compensation package. Under the SEC's shareholder limit, a company with
over 500 former employees holding stock, even if it had relatively few
current employees, would trigger the public reporting requirements.
Exempting employees from any shareholder limit is a minimum necessary
measure to ensure growth-stage biotech companies are able to hire the
best available employees and compensate them with equity interests,
allowing them to realize the financial upside of a company's success.
Also, including accredited investors in the private company
shareholder count does not serve the intended purpose of protecting
retail investors. The SEC recognizes that accredited investors are a
unique class that does not require the same level of protection as
other investors. By including them in the 500 shareholder limit,
growth-stage private companies are forced to rely primarily on
institutional investors because they need to maximize funding without
triggering the limit. This excludes retail investors, who the SEC was
originally trying to protect, from taking part in this process.
Additionally, increasing the shareholder limit from 500 to 1,000
would relieve small biotech companies from unnecessary costs and
burdens as they continue to grow. As it stands, the limit encumbers
capital formation by forcing companies to focus their investor base on
large institutional investors at the expense of smaller ones that have
been the backbone of our industry. Further, it hinders a company's
ability to compensate its employees with equity interests and
negatively affects the liquidity of its shares. Increasing the
shareholder limit and exempting employees and accredited investors from
the count are measures that, together, would remove significant
financing burdens from small, growing companies.
New Tax Proposals Encouraging Private Biotech Company Investment
While modifications to onerous regulations would provide key
improvements to the biotechnology investment environment, Congress has
the opportunity to enact new incentives that could open new sources of
capital for small biotechs. Though this Subcommittee does not have
jurisdiction over tax issues, I would like to take this opportunity to
highlight a few tax policies that could be valuable in incentivizing
private investment. There are a number of new proposals, including the
modifications to IRC Section 1202, the House-passed Small Business
Early Stage Investment Program, an angel investor tax credit, and
partnership structures to support high-risk innovative industries,
which could incentivize biotechnology investment.
Reduced Capital Gains Rate for Sale of Qualified Small Business Stock
(IRC Section 1202)
Congress has striven to aid startup companies by providing
investors in qualified small businesses preferential capital gains tax
treatment on the return on their investments. Section 1202 of the
Internal Revenue Code covers this reduced capital gains tax and defines
the small businesses that are eligible for preferential treatment.
Congress's original intent in enacting Section 1202 was to
stimulate investment in small businesses. President Obama and the 111th
Congress further emphasized the importance of small business investment
by enacting a law temporarily allowing 100 percent of gains from the
sale of qualified small business stock to be excluded from capital
gains taxation. Thus, investors in qualified small businesses are
eligible for a zero percent capital gains rate on their sale of certain
qualified stock through the end of 2011. However, despite Congress's
support for stimulating investment in small and start-up businesses,
Section 1202, which defines the qualified small business stock eligible
for an exclusion from capital gains taxation, is too limited and
presents technical challenges which investors in small innovative
companies are unable to overcome. Among other challenges, Section 1202
employs a test in which a corporation's gross assets must be less than
$50 million immediately before and after the stock is issued in order
to be eligible for preferred capital gains treatment. When intellectual
property (IP) is incorporated as an asset, small biotech companies are
almost always over the $50 million limit. The high value of our IP
belies the fact that our emerging companies are small businesses that
need support if they are going to continue to work toward important
medical breakthroughs.
As I have mentioned, venture capital funding is very limited in
Montana, so incentives for further investment in our industry are much
needed. Modifications to the small business stock rules under Section
1202 so that they more accurately represent the State of innovative
small businesses in America could provide a critical capital infusion
for small biotechs.
Small Business Early-Stage Investment Program
Last year, the House of Representatives took action to assist
early-stage venture-backed businesses like those in the biotechnology
industry. In June, it passed the Small Business Early-Stage Investment
Program as a part of the Small Business Lending Fund Act of 2010. This
program would provide $1 billion in matching funds for venture capital
investments in certain industries, including life sciences. These funds
would serve as matching dollars for venture capitalists that have
already raised an equivalent amount of capital from private sector
sources. The Government would essentially double the seed financing for
venture capitalists who are investing in biotech startups.
In order to participate, an investment company like a venture fund
would have to submit a business plan describing its investment strategy
in early-stage small businesses in targeted industries, information
about the expertise of the management team, and the likelihood of
success and profitability. A participating investment company would
have to make all of its investments in small business concerns, 50
percent of which would have to be early-stage small businesses, defined
as domestic businesses with less than $15 million in gross annual sales
revenues for the previous 3 years. If a venture group qualified, it
would use its grant from the SBA to double its investment in an early-
stage small business.
Under the program, the SBA's grants would be treated the same as
investments by other limited partners in an investment fund, except
that the SBA would not receive any control or voting rights with
respect to the early-stage small business. Ideally, over time, the
SBA's investment program would become self-sustaining as funds from
successful small businesses were repaid into a revolving fund. This
would allow the SBA to continue to provide matching grants for venture
capitalists to extend lifelines to even more early-stage high tech
companies.
This legislation has the potential to significantly increase the
flow of capital into small, early-stage biotechnology companies. In
turn, it would give biotech startups the opportunity to conduct their
groundbreaking research to find cures and treatments for patients while
providing high-paying jobs for American workers.
Angel Investor Tax Credit
Congress could look to the States for examples of how to spur
biotech innovation. Over 20 States have implemented angel investor tax
credit programs, in which individual taxpayers are incentivized to
invest in small innovative businesses like mine. While Montana does not
have an angel investor tax credit program, angel investors continue to
play a significant role in early-stage financing of our small
biotechnology companies. A Federal angel tax credit program would
encourage additional financing from these valuable investors during a
biotech's seed stage of development.
Angel investors are the main source of capital for about 50,000
companies each year in the United States, but that number could
decrease significantly unless action is taken to promote investment and
minimize risk. Many States have recognized the importance of angel
investors and implemented tax credit programs reimbursing angels for 25
percent to 50 percent of their qualified investments in biotechnology
startups and other small businesses. This investment by the States
makes clear the important impact that innovation can have on the
national level. It is imperative that Congress look at measures the
Federal Government could take that would spur seed investing vital to
the beginning of the research and development process.
R&D Partnership Structures
Congress's support for biotechnology is critical in this uncertain
economic climate. Historically, Congress has provided tax incentives to
high-risk industries as a means of encouraging investment in new
endeavors which it deems important. Research and development in the
biotechnology industry is an extremely high-risk undertaking with
substantial start-up costs, a lengthy time period, and the possibility
that the technology will not be commercially viable. Biotech companies
face hurdles in finding and developing new resources and diversifying
risk while also expending substantial financial resources on research
and development before successful FDA approval.
Allowing investors in high-risk biotech startups to take advantage
of tax benefits accumulated during the long development process would
create a powerful incentive structure for private investment in this
often uncertain industry. By permitting biotech companies to drop their
R&D projects into joint ventures with investors to pass through their
tax benefits, R&D partnership structures would provide key early
funding for startup biotechs while also keeping investors engaged. As
Congress looks to maintain U.S. competitiveness in the global economy
and lead the effort to cure and treat diseases, it should look to tax
incentives that encourage investment despite the high-risk nature of
the biotechnology industry.
Closing Remarks
The U.S. biotechnology industry remains committed to developing a
healthier American economy, creating high-quality jobs in every State,
and improving the lives of all Americans. Additionally, the medical
breakthroughs happening in labs across the country could unlock the
secrets to curing the devastating diseases that affect all of our
families. While I am appreciative of the steps Congress has taken to
support and inspire biotechnology breakthroughs, further investment is
needed if the United States is to hold its place as a leader in
creating new medicines and cures. While there is no single solution to
the challenges facing our industry, the portfolio of options I have
presented will help startup biotech companies in Montana and across the
Nation weather the current economic storm and continue working toward
delivering the next generation of medical breakthroughs--and, one day,
cures--to patients who need them.
RESPONSES TO WRITTEN QUESTIONS OF SENATOR HAGAN
FROM ROBERT F. BARGATZE
Q.1. Dr. Bargatze, your testimony discussed the rounds of
financing that your firm undertook as it grew.
Is it common for early-stage firms like yours to seek
financing from investors such as angel networks, venture funds,
and high-net worth individuals?
A.1. Yes, from my experience here in Montana this is a commonly
shared path to early-stage company financing for raising
private capital. For the majority of biotechnology companies
that are without any product revenue, the significant capital
requirements necessitate fundraising through a combination of
angel investors and venture capital firms. Additionally, we and
other Montana start-ups have taken significant advantage of
SBIR/STTR and DOD contracts to advance our research and
development efforts. Being nondilute these funds have allowed
for founders and early-stage investors to suffer less dilution
of ownership. Additionally, these Government sources of
nondilutive capital made up the lion's share of financing that
enabled LigoCyte's acquisition of a large $28M round of venture
funding that has facilitated our later Phase human clinical
trials.
Q.2. If so, do these types of investors typically make up the
majority of shareholders in an early-stage firm?
A.2. In addition to founders and employees--yes, this would
represent a typical majority of early and midstage firms.
Q.3. I understand that proposals have been advanced that would
increase the 500 shareholder cap under Section 12(g) of the
Securities and Exchange Act to 1,000 shareholders. I am aware
of at least one such proposal that should also exempt
accredited investors and employees from the shareholder count.
If the shareholders in an early-stage firms are typically
accredited investors and employees, couldn't this exemption
result in a substantial ``phantom increase'' in the 12(g)
requirement?
A.3. While it is true that exempting employees and accredited
investors from the proposed 1,000 private shareholder limit
effectually redefines the limit to 1,000 retail shareholders,
exempting employees from any shareholder limit is critical.
Including employees in the count does not serve the intended
goal to protect investors in privately held companies, but
rather it limits a privately held company's ability to seek
investor financing of any kind due to employee compensation
practices.
Because many such companies are emerging, growth-stage
entities, the full financial success has yet to be realized.
Without large (or any) revenues, companies often reward
valuable talent with stock options so that employees can
realize the financial upside of the company, versus doling out
hefty salaries at a time when the company has little to no
product revenue.
Companies within industries with long growth cycles--such
as biotech--are particularly burdened. They see many employees
come and go in the 10-plus years it often takes to ready for
the public markets. One can see how quickly and easily a
company could hit the shareholder cap with employees, alone.
These restrictions prevent companies from hiring and
compensating the best talent, prevent companies from raising
the outside capital they need from private investors, and shut
out the retail investors that would otherwise choose to
participate in the growth of exciting private companies.
Including accredited investors in the shareholder count has
a similar effect: companies are forced to focus only on the
largest and most qualified investors, due to the cap.
Therefore, once again, retail investors are crowded out.
Excluding retail investors altogether was not the original
intention behind the private company shareholder limit.