Michigan Budget Battle Pits Startups Against Road Infrastructure

On Oct. 7, the entire staff of the Michigan Economic Development Corporation (MEDC), the state office in charge of tourism and economic development, gathered for the first time in months. Big changes are coming to the department—it recently announced layoffs as well as a 27 percent cut in its overall operating budget—and its leadership wanted to meet with staff to outline some of what lies ahead.

The all-hands meeting capped a tumultuous year for the organization, one that saw lawmakers introduce bills that would pull money from the MEDC’s budget in order to fund desperately needed fixes to Michigan’s crumbling infrastructure of roads and bridges. The MEDC has been the subject of a political tug-of-war for years, as conservative lawmakers questioned the need for the myriad economic development programs it oversees. The threat of the department’s demise seems to bubble up whenever tough budget choices need to be made, but by this spring, the threat had turned into actual legislation wending its way through the committee process.

This was not happy news for Michigan’s tech startup community. Angst over the potential elimination or drastic reduction of the MEDC started to come up regularly over the summer when I would talk with sources from Michigan’s entrepreneurial ecosystem, even when our conversation was about something else entirely. (Disclosure: I worked in the MEDC’s communications department from 2008-2011, and MEDC has, in the past, been an underwriter of Xconomy.)

The organization was formed in 1999 and was spun out of the Michigan Jobs Commission. Its current $351.8 million annual budget comes from the state’s general fund, casino revenues, and settlement money from a national tobacco lawsuit. In 2005, as Michigan continued limping along in an economic slump that had begun early in the decade, the government under Governor Jennifer Granholm passed legislation that allocated $1 billion from Michigan’s share of the tobacco settlement to establish the 21st Century Jobs Fund, a 10-year initiative to diversify the state’s manufacturing-dominated economy. As a provision of the Jobs Fund, the $109 million 21st Century Investment Fund was also created to get capital flowing to early-stage Michigan startups and jumpstart the state’s entrepreneurial ecosystem.

The MEDC utilizes these funds to support many key programs that help early-stage startups in the state get off the ground, including the First Customer Program; the Michigan Translational Research and Commercialization program, which helps propel university research and technology into the marketplace; the Michigan Pre-Seed Fund, which supports the state’s venture capital continuum as well as early-stage startups; and the Michigan Emerging Technologies Fund, which matches federal Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) grants, often for life science startups. Venture funds supported by the MEDC often are the first to invest in a company, helping to de-risk it for other potential investors.

Though MEDC officials were hopeful the programs would succeed, what they probably didn’t anticipate was the startup boom that has begun to reshape cities across Michigan, sometimes to a remarkable degree—as anyone who has been to the Motor City lately can attest. If the programs were to go away or shrink beyond recognition, many sources say, it would have a chilling effect on Michigan’s growing entrepreneurial and venture capital ecosystems.

Governor Rick Snyder, a Republican, is well aware of the impact the MEDC’s programs have had on diversifying the state’s economy. Before entering politics in 2010, he served as chair of the board at Gateway, the Irvine, CA, computer company that was acquired by Acer in 2007, and co-founder of Ardesta, a now-defunct Ann Arbor-based VC firm. Yet his silence on the MEDC budget issue is troubling to many observers in the community, especially as Snyder continues to tout Michigan as a haven for young tech talent in trade missions both in the U.S. and overseas. (Numerous messages requesting comment from the governor’s office and state legislators were not returned.)

Adrian Fortino is one of those young tech talents who decided to stay in Michigan because of what was happening in the entrepreneurial community. After graduating from the University of Michigan, Fortino co-founded Shepherd Intelligent Systems, the company responsible for “Magic Bus” fleet management technology. He eventually co-founded SideCar, a ride-sharing service that matches drivers with people in need of transportation, and he spent a few years flying back and forth to San Francisco getting the company off the ground.

Today, Fortino is the Texas-based Mercury Fund’s man on the ground in Michigan; previously, he helped run the First Step Fund and Invest Detroit—venture funds that support early-stage tech startups—and throughout his career, he’s worked extensively with MEDC-supported programs. One of the Michigan-based companies he co-founded, Flocktag, received pre-seed microloan funding and a $250,000 matching grant from MEDC-supported initiatives, he said.

“Flocktag would have never gotten anywhere near where it is now without support from the MEDC,” Fortino said. “They come in before anyone else. It’s an incredible value. Here’s the issue: If a bunch of these programs are cut, you won’t see the rug pulled out instantly. But the poison seeds will be planted, and then, in a matter of months or a year, you’ll start seeing an exodus and we’ll be back to where we were a few years ago. A lot of these early-stage programs keep talented people in Michigan.”

Data on the results of the MEDC-supported programs have started to trickle in. Michigan’s ranking in the national startup scene has improved; according to the Michigan Venture Capital Association’s 2015 report, there has been a 70 percent increase in the number of venture-backed companies in Michigan over the past five years. In 2007, the MVCA counted 40 venture investment professionals in the state; in 2014, it identified 115. Nationally, Michigan ranks 21st in venture capital invested, and according to Kauffman Foundation figures, it’s third in the Midwest, after Illinois and Ohio, in terms of startup activity.

Investors from out of state are putting their money into Michigan companies at a rate previously unseen—the MVCA report says 65 percent of the capital invested in Michigan startups comes from out-of-state investors. Cities like Detroit and Grand Rapids have embraced their place in the emerging startup landscape, which in turn attracts young talent. According to these numbers and recent interviews with entrepreneurs and venture capitalists, the programs largely did what they were intended to do: help diversify and strengthen Michigan’s economy.

“There was a huge focus put on entrepreneurship in Michigan 10 years ago,” said Gerry Roston, CEO of Civionics and the executive-in-residence at TechTown, a startup incubator affiliated with Wayne State University in Detroit. “Investments were made. Early on, [the state] spent money inefficiently, but we were still learning. Lately, we’ve spent money very efficiently, and the metrics are good, but we’re still in junior high in terms of the ecosystem’s maturity. We’re trying to train a generation of people to think about starting a business, which is a long-term process.”

But the majority of Michigan’s residents aren’t involved in the entrepreneurial ecosystem, and they often have a hard time grasping the importance of the MEDC’s programs. Conservative voters in Michigan are allergic to taxes, and many seem to resent the idea of their tax dollars going to support small businesses that they don’t personally run or benefit from. Meanwhile, the state’s pothole-pocked roads continued to disintegrate as lawmakers spent Snyder’s entire term fighting over how to pay to fix them, and the idea of making huge cuts to the MEDC’s budget to solve the funding shortfall gained traction. Then, this past spring, a last-ditch proposal to raise the state’s sales tax to fix the roads went down in flames as 80 percent of voters rejected it. The current battle over the MEDC, its budget, and its priorities began in earnest.

Gerry Roston

Gerry Roston

The majority of the startup community has been squarely behind the department. “The issue is consistency,” Roston explained. “When an entrepreneur is starting a business, they look at the ecosystem to see what resources are available. Entrepreneurs know these programs are out there, and they plan around them because these things help them grow. The MEDC is not picking winners and losers, but supporting the ecosystem, which is what we’re trying to develop. We have to think about the whole process of state-supported entrepreneur training like we do K-12 education. The state doesn’t fund K-12 education and expect an immediate return. Silicon Valley didn’t happen overnight; it took decades of evolution and growth.”

Corporate Welfare?

Conservative activists have repeatedly attacked the MEDC and accused it of lavishing corporate welfare on favored companies and industries. Often leading the charge is the Mackinac Center for Public Policy based in Midland, MI. The Mackinac Center is a technically nonpartisan think tank that pushes policies favoring a free-market approach, though a 2014 article in Salon characterized it as a “Movement Conservative think tank” that is one of the largest and most influential state-level operations of its kind. (The Mackinac Center’s former vice president, Joseph Overton, is credited with coming up with the concept of the Overton Window, a political strategy that works by affecting public perception so that ideas previously thought of as radical begin to seem acceptable over time.)

Michael LaFaive is director of the Mackinac Center’s Morley Fiscal Policy Initiative, and he’s an outspoken critic of the MEDC. He said his research shows that state-directed economic development programs like the kind the MEDC supports are “ineffective at best, and counterproductive at worst.” Rather than fostering economic growth, he sees them as a hindrance. He doesn’t want to see a cut to the MEDC’s budget—he wants to see the department eliminated completely.

LaFaive interprets tax dollars going toward programs that assist entrepreneurs and startups as a transfer of wealth. “If you need to have politicians take money from your neighbors and give it to you, perhaps you shouldn’t be in business,” he said. “Whatever tools are created really have done nothing to improve Michigan’s well-being. The market created jobs and opportunities for millennia. The notion that you need a state department to create opportunity is simply fatuous nonsense. A fair field with no favors is the best way—Berry Gordy didn’t need a subsidy to start Motown.”

In a 2014 post on the Mackinac Center’s website titled “There is No Good Reason the MEDC Should Exist,” LaFaive wrote, “To put it bluntly, the Michigan Economic Development Corp. presided over what was arguably the most significant decline in the state’s economic fortunes in its history. From 2000 through 2009, when the MEDC and its programs were in full flower, Michigan was the only state in the union with a negative economic growth rate, as measured by state Gross Domestic Product.”

While that may be true, to pin it all on the MEDC seems questionable. For one, it ignores global economic forces and the decline of Michigan’s auto industry, which was itself brought on by a number of factors, including the passage of the North American Free Trade Agreement during the Clinton administration. Many of the MEDC’s programs were put in place because state leaders saw the auto-dependent economy tanking, and diversification was considered critical to getting Michigan back on track.

In response to LaFaive’s comments, Jen Nelson, the MEDC’s chief operating officer, wrote in an e-mail: “Since the 21st Century Job Fund started to provide entrepreneurship and innovation assistance either directly to companies or through [service providers], Michigan has assisted more than a thousand companies. We feel confident the programs have created thousands of direct jobs and generated significant direct wages and benefits.”

Others with experience at the organization weighed in, as well. Michael Psarouthakis served in various business acceleration roles at the MEDC until 2012, and he’s since gone on to be the assistant director of the University of Michigan’s Venture Center, which is housed in the university’s office of technology transfer. Psarouthakis said an obsession with return-on-investment figures is a short-sighted way to evaluate the effectiveness of the MEDC’s programs.

“It’s hard for a report to capture the benefits not tied directly to a specific program,” he said. For instance, when Google wanted to open up an office in Ann Arbor a few years ago, it received support from the MEDC in the form of tax credits tied to investment and job creation. What a report on that specific project or accompanying tax credits might miss, he suggested, are the trickle-down benefits to the community at large when an entity like Google moves in.

“Now, there are something like 2,000 companies in a two-block area instead of a few hundred,” he said. “Google is an anchor for what turned out to be tremendous growth in Ann Arbor’s IT sector. Did it happen because of the MEDC? It’s hard to directly attribute, but why else would it happen? It’s very nuanced, but if you want to create more IT jobs, Google as an anchor brings in more people, talent, traffic, and customers. It’s hard to define and measure that impact accurately.”

Battle in the House

The MEDC enjoyed relative periods of calm when the Democrats controlled the state House of Representatives from 2007-2010. But as the voice of the legislature’s Tea Party contingent came to the forefront over the past few years, the MEDC found itself in the crosshairs of the budget debate.

Meanwhile, there was trouble brewing with the state’s aging infrastructure. Everyone agrees we need to repair our roads, but nobody wants to pay for it. The legislature’s conservative leadership thwarted early attempts at modest gas tax increases, and in May, Proposal 1, which would have raised $1.3 billion for roads by increasing taxes, including raising the state sales tax to 7 percent from 6 percent, was shot down by voters—the Detroit Free Press called it the most one-sided loss ever for a proposed amendment to the state’s 1963 constitution. Voters sent a clear message to the state that increasing the sales tax to fund road repairs was off the table.

After the defeat of Proposal 1, Republican lawmakers almost immediately introduced House Bills 4607 and 4608, which would raise $1 billion for infrastructure projects in part by diverting $185 million from state economic development coffers, which amounts to roughly half of the MEDC’s budget. That loss would likely affect funding for some of the MEDC’s programs deemed most crucial by business and entrepreneurial leaders in Michigan.

Supporters from around the state traveled to the Capitol in May to testify on behalf of the MEDC’s programs for more than three hours before the House Committee on Roads and Economic Development. Frank Ervin, director of governmental affairs for tier-one auto supplier Magna International, told the committee that the bills threatened “to irreparably harm Michigan’s ability to compete for new manufacturing projects.” Business Leaders for Michigan, an advocacy group made up of C-level executives from the state’s largest companies and universities, said drastic cuts to the MEDC’s budget would be a step in the wrong direction. Steve Arwood, who took on the job of executive director of the MEDC in January, called the bills a “raid on our jobs and prosperity” in light of the fact that Michigan’s economy was better than it had been in 15 years, thanks to a healthier domestic auto industry, a friendlier corporate tax environment, and a revitalized Detroit that was partially the result of an influx of young entrepreneurs and tech professionals.

As the bills were being debated, Gov. Snyder remained fairly quiet. The general consensus was that he was licking his wounds after the sweeping rejection of Proposal 1, legislation he toured the state championing, and at odds with state GOP leaders about how to go forward. At a business conference in May, Snyder said he didn’t think it was a good idea to take money out of the MEDC’s budget to pay for road funding, but that was about all he said. Earlier in his administration, he eliminated the Michigan Economic Growth Authority, the state body tasked with awarding tax credits like the ones Google received, and gutted the program that granted tax credits to the film industry—but many believed he was still in support of the majority of the MEDC’s programs.

It had been tacitly assumed by many in the entrepreneurial ecosystem that Snyder—who arguably knows more about the importance of bolstering early-stage startups and getting them access to capital than most government officials—would veto any bills that called for dramatic reductions to the MEDC’s budget. But then, his silence on the issue started to make people nervous. Some wondered why he hadn’t met with leaders in the entrepreneurial community privately to reassure them.

That was the climate when the University of Michigan’s Office of Technology Transfer hosted an “unconference” in June. At an unconference, participants suggest and then vote on small-group discussion topics by writing down their thoughts on sticky notes and posting them on a gigantic white board at the front of the room. Someone wrote, “MEDC funding: Now what?” and slapped it up on the board.

The MEDC discussion group attracted a who’s who of entrepreneurial power players, including Chris Rizik, a VC and longtime friend and former business partner of Rick Snyder (and an Xconomist); David Brophy, a U-M finance professor and founder of the Michigan Growth Capital Symposium; Terry Cross, an investor and tireless mentor to Michigan’s tech startups (he’s also an Xconomist); and a host of others who work in various parts of the ecosystem. The group was divided; some wanted government to get out of the way of economic development or at least produce concrete return-on-investment figures, while others found the idea of trying to keep Michigan’s entrepreneurial and VC ecosystems afloat without the MEDC’s support unfathomable. Everybody in the group agreed that seeing the state’s emerging entrepreneurial ecosystem come to a screeching halt would be a bad thing.

Return on Investment: Now What?

Paula Sorrell runs her own management consultancy, but between 2011 and June 2015, she was the MEDC’s vice president of entrepreneurship, innovation, and venture capital. Economic developers in other states, she said, are envious of the kind of economic growth Michigan has been able to create through its programs supporting entrepreneurship. There are “enormous opportunities” for private investors in the state right now, she said—opportunities that likely wouldn’t be there if the MEDC hadn’t identified gaps in the ecosystem and created programs to address them. In particular, she said the programs that entice venture capitalists to invest in Michigan companies have been successful, and there continues to be a “serious need” for them.

“Most of the people who say early-stage funding isn’t necessary don’t have all the information,” she said, adding that her team at the MEDC started collecting data on program beneficiaries during her tenure. “It’s popular to say that government participation in economic development is bad. The pendulum has swung back and forth on this, but it’s a mistake to ignore the gains Michigan has made or to go back.”

Complicating the political fight over the future of the MEDC is the mechanism through which the department is funded. Part of its budget comes from gaming revenues generated by the state’s Native American tribes. Over the summer, the Gun Lake tribe announced it would stop making casino revenue payments to the state as a result of a dispute over Internet gaming, further affecting the MEDC’s bottom line.

For now, the MEDC’s key entrepreneurial programs are safe—sort of. The department’s spending plan for the current fiscal year has been resolved; for the 2016 budget that began on Oct. 1, the MEDC’s portion shrank from $481.7 million last year to $351.8 million, and the department laid off dozens of people, also effective Oct. 1.

According to the MEDC’s Nelson, $15 million has been allocated out of the department’s budget to support key entrepreneurial programs, down from $25 million the previous two years. (It’s a relatively small part of the department’s budget—in comparison, the MEDC has earmarked about $34 million toward the popular Pure Michigan tourism campaign.) The MEDC made the cuts because of the casino revenue shortfall; the question of where the state will find money to fix its infrastructure remains up in the air. According to my sources in the Michigan House of Representatives, HB 4607 and HB 4608, which would pull money from the MEDC’s budget and put it toward road repairs, have been sent to the Senate’s Government Operations committee, where they will likely die a quiet death.

What’s certain is that this issue isn’t going away, and whatever reprieves the 2016 budget granted are temporary. Michigan’s roads are no closer to being fixed, and sources say the state’s startup ecosystem is not yet sustainable through the private sector alone. The MEDC will have to keep convincing lawmakers—and thanks to term limits, there’s a new crop every two years—that the department deserves to continue its existence.

“The case most of us are making is, we’re not at the point of total private sustainability when it comes to the entrepreneurial ecosystem,” the Mercury Fund’s Fortino said. “We’ve made great progress, but we’re not there yet. If you pull the rug out now, you stand to lose all those gains along with our national credibility. I travel the country and see other ecosystems, and we’re close; we’re actually getting there.”

Fred Molnar took over Sorrell’s job at the MEDC this summer, and he said the MEDC’s current funding levels allow the department to pay for core entrepreneurial programs, at least for now. “It’s enough to keep the gears moving,” he said. “With road funding still out there, theoretically there can still be cuts to the general fund [where the MEDC’s budget is drawn from], so I’m not certain we’re out of the woods yet. We look solid now, but time will tell.”

He pointed to the MVCA’s data as an illustration of what Michigan’s entrepreneurial programs have done for the state. The MEDC’s leadership is committed to keeping programs like the Michigan Pre-Seed Fund intact, he said, as evidenced by the department’s 2016 strategic plan outlining eight key priorities, one of which is “entrepreneurial and economic gardening services.”

Michael Psarouthakis

Michael Psarouthakis

The MEDC has hired Ohio-based nonprofit research and development firm Battelle to analyze the data Sorrell and her colleagues collected for the past few years to illustrate the efficacy of its programs. The report was originally slated to be released over the summer, but Nelson said she now expects the results will be made public by November. She declined to comment on the report’s contents, saying she hadn’t seen it yet.

Molnar said the purpose of the Battelle report is have an independent third party analyze the entire entrepreneurial ecosystem to determine the return on investment for the MEDC programs. Those numbers will also be used to benchmark the MEDC’s performance compared to other states. Molnar said he’s seen some of the initial data, but he didn’t want to get into specifics. “My gut feeling is that, overall, it’s going to be complimentary,” he said.

While the startup community anxiously waits for the Battelle report, many wonder what will happen to new ventures that have come to see MEDC programs as a necessary component of business development in the state.

“I’m optimistic,” U-M’s Psarouthakis said. “In the startup world, we see so much activity. Ann Arbor is rocking right now, and there are great things going on in Detroit and Grand Rapids. People are starting to get it. Could it be better and faster? Sure. But no matter where the action is, the whole state benefits greatly even if it’s regional. The money paid in taxes alone benefits the entire state.”

Earlier this month, Gov. Snyder was in Silicon Valley with Doug Rothwell, who heads up Business Leaders for Michigan. They were there to sell Michigan expatriates living in the Bay Area on all the changes afoot in the Great Lakes State—the burgeoning startup scene, investment opportunities, and abundance of good-paying tech jobs. Some would argue that none of those selling points would exist if the MEDC and its programs supporting entrepreneurs and venture capitalists hadn’t bolstered the ecosystem. (And those supporters see a massive disconnect in having the governor of Michigan touting the state’s entrepreneurial and economic gains while some of his fellow Republican leaders are pushing measures that would yank funding from the programs.)

Ultimately, the fact that more Michigan entrepreneurs aren’t vocally touting their successes—whether individual or collective, and to lawmakers or the masses—is another issue in the fight to preserve the MEDC programs, Psarouthakis said.

“That’s a Midwestern challenge; we’re not very good at giving ourselves credit even when credit is due,” he added. “That’s a problem. Legislators who don’t see any direct benefit in these programs are going to say, ‘I don’t see any jobs.’ The entrepreneurial community really needs to get the word out about where we want to go and what we want to do. There are dramatic benefits to the entire state, and it would be a shame if the programs were eliminated.”

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