Early Stage Funding Growing in Tennessee, Middle Market Access More Difficult: An Interview with Commissioner Hagerty

Commissioner Bill Hagerty leads the Tennessee Department of Economic and Community Development, Nashville, TN.

Key Takeaways:

  • It is more difficult than it should be for middle market businesses to access growth capital, but early stage capital is becoming more available, especially in Tennessee. In addition to providing funding, early stage investors help entrepreneurs create a logical and disciplined capital structure that makes it easier to attract follow-on funding.
  • Obstacles to greater access to capital in Tennessee include the need for stronger links between research institutions and entrepreneurs, loss of major banks and a growing appetite for more direct flights from capital centers.
  • At the same time, Tennessee and the South benefit from the current low interest rate environment nationwide, which drives the current frothiness of corporate debt markets. This easy money environment has driven valuations higher as investors seek equity returns. With valuation multiples more reasonably valued in the South, disciplined investors are becoming increasingly interested in the area
  • Capital deployed in the South is made more efficient via a more business-friendly tax and regulatory environment that keeps more capital in the business working toward future growth.
  • Tennessee is benefiting from the states’ efforts to increase entrepreneurial activity and attract capital, including helping out-of-state private equity groups partner with local investors, which is key.

Q: How easy is it for middle-market companies to access capital, particularly in the South?

A: It’s harder than it should be. That’s something I’ve known well before taking this job, and it’s been a great motivating factor in trying to move things forward for entrepreneurs. The good news is that our early stage capital statistics have been on the rise, which makes sense given Tennessee’s entrepreneurial DNA. I’d like to see Tennessee among the top ten states for early stage capital in the country, and we have embarked on the long-term process to get us there.

But, in general, capital availability is not where I would like to see it for companies in our state and in this region. This is true, I believe, to an even greater extent in the South broadly than it is in Tennessee.

I think there are multiple reasons for this. For example, early stage capital has historically been concentrated in San Francisco/Silicon Valley, Boston, Chicago and New York City. Silicon Valley and Boston have very close linkages with schools and university systems that are advanced in tech transfer. New York and Chicago have sophisticated capital markets and deep pools of capital. Early stage capital is abundant in these markets, as well as in Los Angeles. As you look across the country, the opportunities to invest are less concentrated and there is a disproportionate fall off in early stage capital availability.

The connections between educational and government research institutions and early stage capital players, which have played a key role in the success of major capital centers, is in process in the South. We are focusing on accelerating this in Tennessee, but it has not had as much time to evolve as in markets like Boston and Silicon Valley.

In terms of debt, banking in the South has concentrated in states outside of ours. We have some great banks here in Tennessee, but Tennessee has been caught in the wave of consolidation long underway in the banking sector. Consequently, the number of Tennessee banks headquartered here has dwindled. This is important because capital markets are interrelated. Senior debt availability supports mezzanine debt availability, which supports various flavors of equity capital. Having the migration outward of banking assets and decision makers has had an effect on the overall picture here.

Another frustrating issue, but a real factor, is the number of direct flights to Tennessee. Tennessee’s growth momentum is highlighting the need for easier air access to our market from money centers. We are working very hard to increase flights to Tennessee, but it is difficult in the current airline environment. For example, Delta acquired the Northwest operations and pulled out of Memphis. That hurts the affected local economy, and it also hurts our ability to bring out-of-state capital to Tennessee

There are hurdles, but there are also many positive things happening. At the macro level, we’ve had a low interest rate environment for an extended period. This has caused many institutional investors to be more sharply focused on rates of return moving their investments deeper into the capital structure in search of higher returns. As a result, capital markets are frothy, and higher valuations in the private equity space follow. Plus, debt terms are as generous as I’ve seen in my career, with EBITDA multiples as high as the pre-recession days. That is overall frothiness drives up valuations. It forces investors to be more creative and go to markets that are beyond where they historically focused their attention.

There exists a real valuation disparity and multiples have tended to be higher in areas near Silicon Valley, New York, Chicago and Los Angeles. A disciplined investor knows that a critical element to success is to not overpay for an asset. An easy remedy to that is to go to markets where assets are fairly priced. That is the case in Tennessee and across the South. For example, we’ve received inquiries from out-of-state managers of large funds who have confirmed that they are going beyond their normal geographic footprint to seek better deals because they’ve become uncomfortable with valuations in their home markets.

Specific to Tennessee, we have a very clear viewpoint that entrepreneurs are the lifeblood of our economy. My background, our Governor’s background, and governors who preceded him lead all of us to agree that the entrepreneurial spirit of Tennessee has been a real key to the success of our economy. Just look at FedEx or HCA. When we saw that inherent strength versus a big gap of capital availability, we wanted to do something to address the situation. However, we don’t see the state’s role as an investor – the private markets do a much better job. The private sector needs to drive the process, but the government can help entrepreneurs from an educational standpoint. We help with our unique statewide accelerator network, which provides access to mentors and programs that help smaller companies move forward. One good example is our export program called TN Trade. It helps companies that wouldn’t otherwise have access to the international markets they need to diversify their customer base and scale up, which makes them more competitive – and more attractive to investors.

Additionally, having a tax policy that allows business investors to retain more of their hard-earned money and reinvest it in business growth initiatives is a positive, and Tennessee has an attractive tax policy compared to states where capital is concentrated, like New York, Massachusetts and California. We also have a regulatory environment that is more conducive to business than in other states.

We are making private equity groups aware of these advantages, and they are interested. Conferences and Demo Days provide the acceleration to bring in out-of-state private equity groups, and organizations like Launch Tennessee do a great job of helping out-of-state groups partner with local investors. Those out-of-state investors want a deep enough pool of local partners so that they don’t have to feel like they’re going at it alone. They value local knowledge and want those boots on the ground. The longer they are in the market and the more experience they have, the more comfort investors in New York, Chicago, Boston or Silicon Valley will have in partnering up with their counterparts in Tennessee. I believe that this same scenario holds true throughout the rest of the South – partnerships between out-of-state and local investors have become a key factor to making capital more available in our region.

Q: What can be what can be done to make a business more attractive to investors?

One of the things unappealing to an investor is to find a business with naïve, overly-complex capital structures. This is not atypical of a founder who might seek multiple sources of capital in the beginning and, as a result, winds up with a scrambled and confusing cap table and a sub-optimal balance sheet. The benefit of having a robust network of early stage capital players, which Tennessee now has, is the discipline they bring to creating a logical and scalable capital structure that an entrepreneur can build upon. Every investor is looking for scalability in potential business investments, and entrepreneurs need not only the ability to scale operations, but to scale the capital necessary to fuel those operations.

Q: You mentioned Tennessee has ample early stage capital. Where do we need more?

We need more in the typical A and B Rounds. Once a company is ready for later stage equity capital, the markets are fairly efficient. You can get the folks you need from across the country and across the globe to invest large amounts of money in well-established, fast-growing companies. Geography presents a greater hurdle at series A and B Rounds, where the raises are smaller. It may seem counter-intuitive that it is easier to raise a large amount of money than a relatively small one, but that’s the way it is.

Q: Outside of a cleaner balance sheet, what else can companies do to make themselves more attractive to investors?

A diversified revenue stream is something that always makes companies more attractive because investors are looking for a competitive business that isn’t overly reliant on one customer or on one sector. In Tennessee, companies can make themselves more attractive by participating in one of our state’s business development programs, such as our TN Trade program, which is focused on opening up new geographic areas, and our early stage entrepreneur programs, which are oriented toward fundamental building blocks. Another program worth discussing is The TENN business plan competition, where the founders of ten early stage companies are selected to receive advanced mentoring and participate in a statewide tour that connects them with leaders of large corporations. The TENN is just one way we are connecting young companies with much larger strategic partners in the state, acting as matchmaker to help entrepreneurs diversify their revenue base and access significant potential customers. It is also helpful to the large company that doesn’t perhaps have the time to weed through all the possibilities, but cares enough about Tennessee to want to help local entrepreneurs who have cleared the hurdle of The TENN.

Q: In general, what types of businesses tend to be most attractive to investors?

Those that have scale and provide unique solutions to big problems. Growth capital investors like to find markets that are in a state of disruption or transition. That immediately brings to mind health care in middle and west Tennessee. The automotive space is booming, which includes suppliers to the automotive space providing unique new technologies. We are also great at logistics – look at Chattanooga and University of Tennessee, which has the best supply chain management program in the country. Our central location provides an advantage in the logistics realm, as well as our strong interstate highway systems, rail and waterways. As oil prices go up, logistics become an increasingly greater pain point, and we have a huge advantage and a great knowledge base to help drive competitive advantage. Software solutions and services are seeing a lot of activity as well.

Q: Why do you think Tennessee has such an entrepreneurial spirit?

It goes all the way back to the foundation of our state. We’ve had a strong history of early pioneers coming here to find opportunity. They settled this state and have grown it with a real sense of pride and ownership, and that has translated to successful multi-generational family businesses. People came here to find opportunities for their families and stayed here because they loved the environment. Tennessee is a welcoming place, and our ability to digest and support newcomers is renowned. We also have a great educational infrastructure that attracts good people and great thinking. A lot of people come here to be educated and don’t leave.

Q: How successful is institutional research at attracting capital?

Commercialization through any type of academic environment holds great potential. The Governor and I have met with chancellors, presidents and directors of many of the research institutions across the state and we have uniformly found an appetite to support greater commercialization activities. However, it requires a mindset and cultural shift that doesn’t change overnight. The culture in academic institutions has been oriented toward basic research, and we need to put in place a reward system and build success stories so more and more researchers can see the benefit of translating that research into commercial viability. We need to build momentum and will then see a cascading effect. We are still in the early stage of that momentum building process.

Brought to you by the team at FourBridges

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