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With Organized Angels on Their Side, Can Start-ups Really Start Up Anywhere in the Country?

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Raise your hand if you realized the Midwest has become a hotbed of angel group activity -- and a well-respected resource of nationally respected investment knowledge. This spring, Tony Shipley represented the Angel Capital Association, a professional alliance of angel groups in the United States and Canada, in front of a Congressional subcommittee discussing equity finance as a catalyst for small business growth. The software entrepreneur, who founded the Cincinnati-based angel network, Queen City Angels= in 2000, testified about the financial and intellectual capital angel investors provide, while making suggestions on how Congress can use legislation and public policy to bolster the entrepreneurial ecosystem.

Shipley's presence at this meeting illustrates the growing national attention given to Midwest angels, who are making the region a hub for innovation. According to the 2011 HALO Report, 79 percent of angel group investments occurred outside of traditional funding mecca California. Of these investments, the Great Lakes region received the biggest proportion of them -- 15.9 percent, a percentage greater than the shares of innovation-rich regions such as New England and the Southeast.

What's helping the Midwest, a region not traditionally considered a force in the investing world, become a start-up hotspot? For starters, legislative support at the state level. Citing a 2012 study of Wisconsin's angel tax credit program and related initiatives, Shipley told the subcommittee that "the state's initiatives helped increase angel investments in Wisconsin small businesses by 22 percent in 2011 over 2010" and that since 2003, angel groups have invested $61.1 million in early stage companies. In Ohio, the Technology Investor Tax Credit enables angels to write off up to 30 percent of their investments from state taxes. And the Ohio Third Frontier program has provided direct financial incentives for those angels who choose to join an organized effort.

"I'm fond of saying if start-up entrepreneurs can't get funding in Ohio, they can't get it anywhere," said John O. Huston, founder of the Columbus, Ohio-based Ohio TechAngels. The nation's largest angel network, it was founded by Huston in 2004 and has quietly grown to include 280 members and three funds. Collectively, this group has invested in 35 companies in eight years.

This intricate support system has helped Ohio's angel networks grow in size and sophistication. "When I started Ohio TechAngels, I was participating in rounds of $300,000 or $400,000," said Huston. "Now, we have seven angel groups in Ohio. We syndicate our deals, which typically are in the $1.5 million-to-$2.5 million range."

Although Midwest early stage companies have attracted venture capital investments (i.e. B and C rounds), the risk capital pumped into the region still isn't proportional to the amount of the angel groups' increasingly savvy investments. Because the Midwest still lags behind other regions in follow-on funding, it has also lagged in terms of high-profile exits and, as such, the reputational boost which comes with them.

It's a catch-22: Angel group investments are likely to be more successful when the entrepreneurial ecosystem is fully balanced -- i.e., when there's a satisfactory amount of seed, angel and venture funding available to start-ups. Yet a balanced ecosystem isn't always easy to develop, especially in areas of the country that don't immediately come to mind (but I would argue should) when it comes to tech innovation.

However, here are three things governments can do to nurture this crucial facet of a region's economic progression:

1. Drawing out-of-state venture investors to the region.

Money goes further in the Midwest, which is good news for out-of-state investors used to deals on the notoriously expensive coasts. The Ohio Capital Fund ("OCF") was formed in 2005 to bring out-of-state venture investors to the region. But besides giving direct financial assistance to these VCs, OCF has helped them become aware of the region's startup talent. For instance, the Independence, Ohio-based Vox Mobile -- which provides software, services and support to the businesses -- just raised $7.5 million in venture capital; the deal was led by the Lawrenceville, N.J., firm Edison Ventures. A principal of the firm, Sever Totia, told Crain's Cleveland Business that Edison discovered Vox Mobile from the locally-based associate it was able to hire after an OCF investment.

VCs need to realize there's a golden opportunity to make some great investments (at great valuations) in the Midwest. Partnering with Midwest funds (or, as Edison Ventures did, hiring people to look out for deals in the region) could be a great way for these VCs to diversify their portfolios.

2. Creating financial incentives for investors

Encouraging investors involves reaching them where it matters: their wallets. Fort Wayne, Indiana's "Enterprise Zone" -- a nearly four-square-mile section in the central part of the city --rewards those who invest in businesses in this area. Entities purchasing an ownership interest may be eligible for an "investment credit" against their state tax liability -- in some cases, up to 30 percent of the purchase price.

This idea is catching on outside of the Midwest. In May, New York State Democratic Assembly member Micah Kellner proposed the Angel Investor Tax Credit to encourage investors to support New York City-based start-ups. Investors who contributed between $25,000 and $1 million of their own money to these start-ups would receive a 25-percent tax credit. Analogous initiatives in Connecticut and yes, Wisconsin, were reportedly his inspiration for this credit. Even President Obama is getting into the act, by "calling on Congress to extend a 30-percent investment tax credit for manufacturers that invest in equipment to make components for clean-energy projects."

3. Encouraging post-angel round investments

Sure, some companies -- even quite successful ones -- are only angel-funded. But many need a little extra financial bump to get them to the next level. For companies backed by angels, the state of Ohio has created several programs to help these companies access additional (follow-on) funding. For instance, the Ohio Innovation Loan Fund lends up to $2 million to early stage companies in targeted industries so they can buy, build and equip their facilities.

Having a complete continuum of capital -- seed, angel, venture and beyond -- is critical to the entrepreneurial success of a region. Governments that promote angel investing (but don't encourage the formation of Series B and C funds beyond that) are only creating a partial solution. A comprehensive support system, which takes into account all levels of funding, is necessary to enact the most change.

It's also important to remember this out-of-state financial enticement isn't meant to be a permanent crutch, but a way for regions like the Midwest to eventually become self-sufficient. This process won't happen overnight. However, as the region starts having successful exits -- such as Ohio-based, angel-backed company Diagnostic Hybrids Inc., a diagnostic test maker in Athens, Ohio, acquired for $130 million in 2010 by San Diego's Quidel Corp. -- it should cause a snowball effect: Out-of-state VCs will recognize the good deals and come here on their own volition, without the use of incentives.