While scientific research in other industrialized nations is centralized, hierarchical, and bureaucratic, in America it is competitive and entrepreneurial.  This is not to say that politics plays no role in deciding how American science is funded; far from it. But in America, governmental sources of funding are much more diffuse (half a dozen federal agencies and departments spend at least $1 billion a year on basic research), and private sources are much more numerous, than in most European or East Asian nations. It all adds up to strength through pluralism.

Schwarz cites a few specific American strengths:

• The profusion of funding sources makes it easier for researchers with good ideas to shop around and find a willing partner.
• Independent state universities compete for the best and brightest research.  “Americans can consider themselves fortunate that except for the service academies, there is no system of national universities.“
• All our competitive factors – within and between institutions, funding sources, states, federal agencies, and military branches – benefit from “…the absence of any federal Department of Science and Technology -  despite the assumption in many quarters that if something is important, it must have its own cabinet secretary.”

Schwarz adds a counterpoint: Europe and China may have an advantage for funding big-ticket items like the Superconducting Super Collider, because they’re “good at spending lots of money with little squawking from the citizens.”  However he then favorably quotes Professor William Happer of Princeton who called the SSC’s demise “a tragedy for science” but also cautioned: “I would rather accept mistakes made by the people or their elected representatives than live with mistakes made by scientific bureaucrats.”

Schwarz’s conclusion sums it up nicely:

America’s hodge-podge of scientists, institutions, and funding agencies – imperfect though it may be -  is the closest thing the world has to a free market in science, and the results can be seen in Nobel Prizes, citations, and the steady influx of researchers from abroad who know that the United States is the land of scientific opportunity.

The patents for the Television, Jukebox, and Nylon were granted during The Great Depression.  Although we can’t confirm any patent information on the chocolate chip cookie, it too was invented at the same time (1930 to be precise).

Joseph Schmupeter argued that this was an essential strength of the American economy:  economic destruction breeds creative success.  From The Library of Economics and Liberty:

Schumpeter was among the first to lay out a clear concept of entrepreneurship. He distinguished inventions from the entrepreneur’s innovations. Schumpeter pointed out that entrepreneurs innovate not just by figuring out how to use inventions, but also by introducing new means of production, new products, and new forms of organization. These innovations, he argued, take just as much skill and daring as does the process of invention.

Innovation by the entrepreneur, argued Schumpeter, leads to gales of “creative destruction” as innovations cause old inventories, ideas, technologies, skills, and equipment to become obsolete. The question is not “how capitalism administers existing structures, … [but] how it creates and destroys them.” This creative destruction, he believed, causes continuous progress and improves the standards of living for everyone.

To cite additional evidence in support of our position might have us justifiably accused of “selling past the close,” but this one we like because we found it off the beaten path, in The Weekly Standard.

In Lone Economic Star, Eli Lehrer reports that “in a nation looking for good economic news, Texas stands out as a bright spot.”   Although the success “defies easy explanation,” Lehrer maintains that it’s a mix of  good land/city planning, investing in research and the arts, and avoiding two mistakes that have an all-too-familiar ring to them:  excessive government spending and poorly conceived private lending.

In May alone, Texas, America’s second most populous state, added over 75,000 jobs—more than California (the biggest), New York (third biggest), and Florida (fourth biggest) combined. Texas has shown consistent gains in 10 of the 11 categories of private employment that the Bureau of Labor Statistics measures. The state is far more than cowboys and oil: It has several of the nation’s leading medical research centers (Baylor and UT hospitals among them), one of the biggest computer makers (Dell), and a financial industry that never took a turn for the worse. And, even though unemployment remains a tick over 8 percent (about a point and a half lower than the national average), the rapid growth is bringing this down quickly. During the last week in June, the job-hunt website Monster.com offered more new job openings in Texas than in California even though the Golden State has over 10 million more people.

But we don’t make “seed investments” which are at very earliest stage of the venture capital spectrum.  While seed investing isn’t a part of our investment strategy, we know that such investments are a key piece of the venture capital ecosystem and need to be encouraged.  Most of these investments are done by “angel investors”, and as we have discussed previously, there are a number of important initiatives that would help encourage seed investing.  However, while seed investing by institutional investors is rare, there are a small handful of firms that make such investments in the Southeast as part of their broader investment strategy.

One such firm that we respect and admire – we have known the principals there for a number of years dating back to their previous firms – is Valhalla Partners in Northern Virginia.  We recently received a newsletter from Valhalla with an interesting essay by Co-Founding Partner Hooks Johnston on seed investing.    We think it offers some valuable insight and wisdom on how to think about seed investing that should prove useful to angel investors and other firms throughout the Southeast that are considering investments at the earliest point in a company’s life cycle.

Partners’ Viewpoint: Hooks Johnston on Seed Investing

Valhalla Partners has now done a number of seed investments, and I would like to pass on some of the things we’ve learned about investing at this stage.

The two central facts of seed investments are 1) the opportunity to participate in a high-growth investment at the earliest possible stage and 2) a daunting set of risks. Investing wisely in seed-stage opportunities means understanding both sides of the equation.

The upside of seed-stage deals can be tremendous, both financially and in terms of making a difference. Prior to Valhalla I was one of a group of angels that invested in webMethods, which began as a husband-and-wife team meeting weekly at the Silver Diner and turned into a very successful public offering (and a great exit). The original idea of webMethods was just the sketch of a product. It had to be built, tested, brought to market, and sold in a repeatable, scalable way.

In addition to an untested product idea, seed-stage investments may involve significant team risk. The team is typically incomplete and frequently the “team” is just a founder or a couple of founders who themselves may not be experienced managers. You can’t assume that you can just define objectives and leave the team to execute; you need to invest a substantial amount of time working with the team as they execute on their objectives and encounter unexpected obstacles.

To mitigate these risks, we try, first of all, to invest in potentially very big ideas, since only a giant win can compensate for the level of risk in a seed investment. A second way to mitigate risk is to invest with a syndicate with experience in seed investments, whether angels or, if the right deal can be structured, with other institutational investors.

To succeed, we have found that the plan for a seed investment needs to involve objective, verifiable, and determinative proof points that can be observed in the very near-term. If the proof points are not objective and verifiable, there will be no clean way to find out if they have been met. If they are not determinative, the seed investment will not have proved enough about the product and the market to warrant a Series A investment.

Lastly, of course, you need to be willing to let go if the proof points are not testing out.

One advantage we have in the mid-Atlantic is being knowledgeable about government programs for seed-stage investing. In addition to the Small Business Innovation Research (SBIR) programs run by many Federal agencies, there are seed-level grants from state or quasi-governmental entities such as Virginia’s Center for Innovative Technology. And government entities can be customers as well as investors, or, with a group like In-Q-Tel (the venture capital arm of the intelligence community), both.

Scripps Florida – the first and sole satellite of the Scripps Research Institute, is one of only three national translational research high-throughput screening centers approved by the NIH and received the first NIH drug development grant.

Its presence has helped South Florida attract other impressive research organizations: the Max Planck Institute (Jupiter), Torrey Pines Institute for Molecular Studies and the Vaccine and Gene Therapy Instititute (Port St. Lucie), Sandford-Burnham Medical Research Institute (Orlando), and The University of Miami’s Life Science Park.

While biotech research is becoming more and more the province of research centers, the resulting technology spin-offs do tend to cluster around those research centers. Mark Mirkin of Carlton Fields writes:

“For better or worse, biotech innovation has largely been abandoned as a primary pursuit by pharmaceutical companies, becoming the pursuit of universities and research institutes, leaving pharma to focus on applied research. (Although) it is difficult to calculate with precision a rate of return on an investment in basic research because of the lenghty time period between discovery and application, it is hard not to notice that hundreds of biotech companies have arisen in the San Diego area, home of Scripps, and hundreds of others have arisen in Germany’s Bavaria region, home of Max Planck.”

Venture capitalists, angel investors, private equity investors and service providers from Florida and around the nation will gather to support and encourage early stage investing in Florida – a vital component of our flourishing venture ecosystem and economy.

Presenter application submissions will be accepted through August 31, and can be completed online here.  All other attendees can register here.

Two significant changes to the tax code are likely to occur in the next few years, both of which will directly affect entrepreneurs:

1. The tax cuts passed by Congress in 2001 and 2003 expire at the end of 2010.
2. The recently enacted health care reform initiates additional taxes on all investment gains starting in 2013, including the extension of Medicare taxes to all investment gains – effectively adding an additional 3.8% to the long term capital gains tax rate.

We have published a brief white paper which highlights how an entrepreneur could take taxes into consideration when contemplating a capital raise, and how he or she might maximize the value of the after-tax proceeds from a minority recapitalization.

No entrepreneur should make significant changes in the long term plans for his or her business based solely on likely changes in the tax code. However, if you or your shareholders are currently considering a capital raise and/or would like to consider realizing some liquidity on part of your investment over the next 12 months, it may well make sense to accelerate the timing to beat the December 31, 2010 and/or 2013 deadlines.

UPDATE 7/23/10:

A recent editorial in Investors Business Daily entitled The Tax Tsunami On The Horizon maintains that there are three upcoming “waves” of taxes, including those we mention above: (1) the expiration of various tax cuts enacted last decade, (2) new taxes designed to pay for health care reform, and (3) the alternative minimum tax’s widening net, upcoming tax hikes on employers, and the loss of deductions for tuition.

If you want to watch Rhys’s testimony, it can be seen from minute markers 107:16 to 113:30 of the hearing’s webcast at the Senate Committee’s site; and his Q&A session (where he really shines in our opinion) runs from 125:44 to 128:44.  A transcript of his testimony is also available at the site for those who prefer some enjoyable reading without the interruptions.  In addition to making compelling points, Rhys does an excellent job dealing with the standard difficulties of that environment:  having your thunder stolen by earlier witnesses and getting squeezed for time at the end so the Senators get enough of their own “air time”.

For those who want the “Rhys’s Points for Dummies” summary, he offered six specific recommendations which, from the perspective of angel investors and early-stage entrepreneurs, would improve both innovation and the nation’s overall economic performance:

1. FDA Reform. Fill vacancies more quickly, speed up regulatory review, and switch from the “zero defect” to the ”calculated risk” model.  In recent years, high profile drug safety incidents have hamstrung regulators – costing years of product development time and burning up precious capital.
2. Address the backlog of patents. The US Patent & Trademark Office has a backlog of up to 3.5 years – which lengthens time to market, increases legal costs and creates uncertainty.  In addition to working the backlog with additional resources, expedited reviews should be granted for strategic sectors and IP with greater risk of piracy.  Also push for reciprocity and enforcement of IP violations within foreign jurisdictions.
3. Tax reform.  The current federal tax framework dampens innovation and competitiveness.  In addition to lowering certain rates tied to investment activity (capital gains, carried interest), we ought to create tax credits for: innovative companies, angel investors, and certain specific business activities (capital attracted, employment growth, capital expenditures, etc) in order to promote a true, sustainable “growth agenda.”
4. Simplify federal and state securities regulations.  Early stage firms are forced to devote too much time and attention to regulations intended for much larger firms.
5. Promote the “Entrepreneurial Ecosystem”.    Develop and integrate the local and regional infrastructure for the commercialization of R&D, the growth of private angel investor networks, and the provision of matching grants to qualified SBIR/STTR grant recipients.
6. Preserve the missions of SBIR/STTR.  (Small Business Innovation Research and Small Business Technology Transfer)  Protect their funding from encroachment by larger firms.

Thank you to Rhys for traveling to D.C. on his own dime and making the case so succinctly.  Everyone involved in Florida’s early stage entrepreneurial culture would benefit from echoing these points to our state and national legislators and regulators as often as possible as we debate how to ignite renewed economic growth in America.

Dreaming big, innovating in processes/systems unrelated to the technology, spotting early trends for customers and vendors (or portfolio companies, present and future!) – these are the positive side effects from playing with not-yet-ready-for-our-business technologies.

Tom Glocer, CEO of Thomson Reuters, shares the story of giving his staff first-generation mp3 players (9 years ago) for Christmas and challenging them with a “Christmas assignment.”

The dominance of the list by Florida and Texas–the former has eight of the top 20 counties, the latter four– makes sense to Robert Shrum, manager of state affairs at the Tax Foundation in Washington, D.C., since neither state has an income tax. “If you’re a high-income earner, then that, from a tax perspective, is going to be a driving decider if you’re going to move to one of those two states,” Shrum says.

After accounting for property taxes, Shrum’s analysis shows that Texas has the fourth-lowest personal tax burden in the country, and Florida has the eighth lowest. Shrum also points to eight states that have targeted wealthy households with extra-high tax brackets: California, New York, New Jersey, Maryland, Hawaii, Oregon, Connecticut and Wisconsin. Six of the top 10 counties the rich are fleeing are located in those states.