Star-spangled startups

The recession has brought renewed attention to an ongoing problem: a steep decline in U.S. venture capital funding.

While this problem may appear relevant only for companies in need of VC dollars, the long-term consequences may reshape the global landscape of innovation. Unless U.S. VC funding picks up soon, we may see internationally based technology startups obtain financing faster than their U.S.-based counterparts, and U.S. startups may seek more of their funding internationally. To maintain its position at the forefront of technological development, the U.S. must take steps to help companies obtain funding and drive innovation.

The U.S. market has been the pioneer in driving technological innovation and currently makes up 79% of all venture capital investments, according to Dow Jones VentureSource. But as the economy continues to struggle and funding availability remains tight, it is unclear how long the U.S. will continue its dominance.

This is most noticeable in the clean technology industry. In 2008, venture capital investors in India, China and Hong Kong closed more than $5 billion of diversified funds that focused on the sector. Chinese VC funding in the sector was boosted by a policy that allows venture capital firms that provide equity capital to new small and medium-size high-tech companies to receive a bonus corporate tax deduction of 70% of their qualified investment.

Meanwhile, European funds seek to raise $7 billion in the clean-technology sector in 2009, according to Preqin Ltd.'s Private Equity Intelligence. Germany, often synonymous with solar-energy manufacturing by small to medium-sized, or "Mittelstand," companies, attracted $383 million for cleantech investment in 2008, an increase of 217% from 2007, making it the top European country in cleantech funding. Germany's strict pollution regulations may be partly responsible, as they force German companies to develop new technology faster than companies in countries with lax controls.

In the U.S., funds are seeking to raise up to $9 billion in cleantech investments in 2009. Given U.S. dominance in overall VC funding, one would expect to see a greater disparity between U.S. funding activity and Asian and European funding activity in the sector.

While these numbers do not suggest that the foreign VC markets are about to overrun the U.S. venture capital market, it does appear clear that steps are necessary to ensure the U.S. maintains its competitive advantage.

The U.S. markets need to encourage the emergence of smaller boutique banks that specifically focus on the smaller initial public offering market. One method of promoting the emergence and growth of boutique banks is to encourage greater "partnering" and fee sharing between boutique and major investment banks in the IPO process.

The U.S. government must expand tax incentives to stimulate the VC markets. The U.S. venture capital markets expanded rapidly during the 1980s, encouraged by tax incentives enacted late in the 1970s and early in the 1980s.

The American Recovery and Reinvestment Act passed earlier this year provides strategic initiatives, including significant funding by the Department of Energy to startups and early-stage companies for research, development and early deployment of new technologies in the renewable energy field. VC firms and companies in cleantech and alternative energy should be familiar with the incentives and act quickly to continue funding innovation amid the recession.

The U.S. government, through its tax policies, can significantly influence the flow of liquidity in our markets by providing more competitive capital-gains tax rates for investments in IPOs, lengthening the holding period for long-term capital gains, promoting tax incentives for certain types of investments and ensuring that the U.S. tax rates remain globally competitive.

Technology startups today know that funding is harder to obtain. VC firms continue to look for companies with a compelling idea, a strong management team and a solid business plan. Startup companies must meet these requirements to have a good chance of obtaining capital in the short term. For the future, however, and in the long term, the U.S. must realign its policies to do more to encourage innovation and maintain its leadership in global technology development.

Bob Strasser is a partner in the technology practice of BDO Seidman LLP.