Lately, a few cities have taken on a new role: VC investor. New York City and Portland, Oregon, recently launched VC funds that provide seed capital to local start-ups. And this fall, Philadelphia announced plans to use $3 million of city money to create a VC fund in early 2013.

By investing in start-ups, cities hope to create hubs of high-growth companies that will boost their local economies and create jobs. It's the opposite of the classic urban economic-development model, in which cities offer tax breaks or loans to attract established companies that promise to employ local residents. Here, the cities are investing in tech start-ups that have few employees or profits to tax. The bet is that this will produce some home-grown big companies. "It's not just some feel-good way to get a lot of companies started," says Patrick Quinton, executive director of the Portland Development Commission, which oversees the city's $3.1 million fund. "Long term, we're looking for big wins." Portland, which contributed $700,000 to its VC fund, took a portion of that amount from a loan program originally set up for retail and service companies. Now, the money goes mainly to tech start-ups.

The cities partner with other investors to co-finance and manage the funds. In New York, FirstMark Capital, a local VC firm, vets start-ups for the NYC Entrepreneurial Fund and added $19 million to the city's $3 million seed investment. "We didn't want to just throw money at a bunch of start-ups," says Dmytro Pokhylko, a director of the New York City Economic Development Corporation, which created the fund. It works a lot like a traditional VC investment, with some differences: The companies must be based in New York, and the city has the right to veto any deal. The city's returns will be used to fund more start-ups.

Puneet Mehta says money from the NYC Entrepreneurial Fund allowed him to quit his job in finance and focus on his start-up, MyCityWay, which offers a mobile guide to New York City, including information on nearby restaurants, parking garages, ATMs, and public restrooms. Since Mehta received a $1 million investment in 2010 from an investor group that included the NYC Entrepreneurial Fund, MyCityWay has launched guides for another 74 cities, including San Francisco; Washington, D.C.; and London. And the company has raised an additional $5 million. Mehta, who now employs 16 people in New York and another 22 in India, expects to turn a profit in 2013.

It can be tricky for a city to pull off the role of venture capitalist. Some people have criticized the idea of investing government funds in private companies, especially after a few government-backed businesses, such as Solyndra, had highly publicized flops. If a company had promise, VCs would already be investing, argues Gary Kunkle, founder and CEO of Outlier and research fellow at the Edward Lowe Foundation's Institute for Exceptional Growth Companies. "The question is whether it's justifiable for government to be involved," he says. "Markets take care of themselves much more efficiently than governments want to give them credit for."

In Portland, some libertarian critics challenged the use of city money for high-risk private investments. It took time to build support for the fund, which launched in April 2011 and was co-financed by angel investors, the state of Oregon, and the local suburb of Hillsboro. Portland city officials do not see VC investments as a risk, says Quinton. "Seeding a lot of small businesses, even if some fail, is still a positive outcome compared to projects with cost overruns or misspent dollars," he says.

But many start-ups need more than just cash to grow. That's why Portland modeled its fund after TechStars and Y Combinator. The fund invests just $25,000 per company, but entrepreneurs receive coaching and mentoring, as well as trips to Silicon Valley and Seattle to meet with institutional investors and VCs. At the end of the three-month program, the start-ups pitch their plans to more than 100 investors and reporters.

So far, 17 companies have completed the program (another eight will graduate in December). After graduating, about half of the companies have raised additional capital--about $16 million in total. Entrepreneurs say the Portland Seed Fund has invigorated the local start-up scene. In 2011, VCs invested $82 million in Portland companies, double the amount invested in 2010. "The entire investment tone has changed here in Portland," says J.R. Storment, whose Portland start-up, Cloudability, makes a platform for managing the costs of cloud applications. After receiving an investment from the Portland Seed Fund this year, his company raised $8.7 million. "Things here have really taken off," he says.


Startup PHL Seed Fund

Size of the fund: $6 million, with $3 million from the city

Amount invested per company: $150,000 to $300,000

Number of companies funded: 0 (set to launch in 2013)

NYC Entrepreneurial Fund

Size of the fund: $22.5 million, including $3 million from the city

Amount invested per company: $200,000

Number of companies funded: 5

Portland Seed Fund

Size of the fund: $3.1 million, including $700,000 from the city

Amount invested per company: $25,000

Number of companies funded: 25