Can private capital fund the gap between passion and profit necessary to create a sustainable entrepreneurial community? Or do governments need to invest non-returns-based capital to seed the ecosystem? A thought about seed funding, externalities, and the distribution of returns.

No, I didn’t win.

First, my response to Gary Whitehill, The Seed Funding Phenomenon Bubble of 2010:

Even if valuations don’t skyrocket, it’s hard to see the returns solely justifying the effort of these seed programs. But the need is there, and the returns to the community are there, even if the returns aren’t strictly ROI-based. Long-term, these seed programs will be funded as “entrepreneur community programs” by entrepreneurs (i.e. TechStars) or by smart local governments with economic development money and a hands-off approach. If the city / region’s entrepreneurial community isn’t vibrant enough, governments will need to fund these programs to seed the community until there’s a strong enough base of entrepreneurs with capital to provide viable alternatives.

I’m stoked that TechStars is launching in NYC in 2011. I’m interested to see how NYC Seed performs. Even if the returns are questionable so far, these pre-seed / seed funding programs create enormous value for entrepreneurial communities. However, much of the value is in the form of externalities to the locality and broader community that cannot be captured by a purely returns-based private investor. What kind of externalities? Experience and knowledge for budding entrepreneurs. Press and PR for burgeoning entrepreneurial communities. Attention that can help attract national talent and broaden the minds and views of local entrepreneurs. Education and exposure for local mentors and capital on how companies are built and funded outside of their region.

Pre-seed programs are a cheap way for communities to fund the early failures and haltering steps of individual entrepreneurs and entrepreneurial communities. At the early stages of an entrepreneurial community’s development, passion does not economically translate to profit. Too many externalities escape to the community; too much of the value created by the early leaders seeps into the community without financial returns. The gap between passion and profit isn’t closed until talent, capital and opportunities combine to create the scale necessary for entrepreneurial communities to grow.

Can private capital fund the gap between passion and profit necessary to build a sustainable entrepreneurial community? Maybe. It depends on the city, obviously, and the particular spikes of money, talent and interest in investing into entrepreneurialism and economic development resting in each city. In NYC, Silicon Valley, Boston, Austin and many other cities, the returns to supporting entrepreneurial ventures are apparent and profitable (directly and indirectly). In other cities such as New Orleans, it’s less apparent, and less profitable, and more difficult for private capital to fund that gap. Thus, who can fund that gap? Can governments create entrepreneurial hubs? Can governments be smart enough to invest (i.e. give) non-returns-based capital into pre-seed programs and step out of the way?

Should they? In some cities, yes. Can they? I hope.

Related: a blast from the past, my core conversation at SXSW in 2009, Venture Capital for Long Tail Entrepreneurs.