LESSONS AND PITFALLS
The stories and studies discussed in earlier chapters have a variety of implications for those—whether government officials, local business leaders, or simply interested citizens—who seek to promote high-potential entrepreneurship and venture capital. While in many cases this evidence illustrates what not to do, it also offers many positive suggestions.
In this final chapter, I highlight a number of implications that emerge from the earlier discussions. I also discuss frequently offered suggestions and programs to boost entrepreneurial and venture capital activity that are less consistent with the principles outlined in this book, and explain why they do not make sense.
RECOMMENDED RULES OF THUMB
There are a number of important guidelines that, if followed, would facilitate the development of local entrepreneurial and venture capital activity:
• Remember that entrepreneurial activity does not exist in a vacuum. Entrepreneurs are tremendously dependent on their partners. Without experienced lawyers able to negotiate agreements, skilled marketing gurus and engineers who are willing to work for low wages and a handful of stock options, and customers who are willing to take a chance on a young firm, success is unlikely. But despite the importance of the entrepreneurial environment, in many cases government officials hand out money without thinking about barriers other than money that entrepreneurs face. In some cases, crucial aspects of the entrepreneurial environment may seem tangential: for instance, the importance of robust public markets for young firms as a spur to venture investment (as noted in chapter 5). Singapore provides a great example of a nation that took a broad view and addressed not just the availability of capital, but other components needed to create a productive arena in which entrepreneurs could operate.
• Leverage the local academic scientific and research base. One particular precondition to entrepreneurship deserves special mention: in many regions of the world, there is a mismatch between the low level of entrepreneurial activity and venture capital financing, on the one hand, and the strength of the scientific and research base, on the other. The role of technology transfer offices is absolutely critical here. Effective offices do not just license technologies, but also educate nascent academic entrepreneurs and introduce them to venture investors. Building the capabilities of local technology transfer offices, and training both potential academic entrepreneurs and technology transfer personnel in the process of new firm formation, is essential. All too often, technology transfer offices are encouraged to maximize the short-run return from licensing transactions. This leads to an emphasis on transactions with established corporations that can make substantial up-front payments, even though licensing new technologies to start-ups can yield substantial returns in the long run, both to the institution and to the region as a whole. It is important that policymakers think seriously about the way in which technology transfer is being undertaken, the incentives being offered, and their consequences.
• Respect the need for conformity to global standards. It is natural to want to hold onto long-standing approaches in matters such as securities regulation and taxes. In many cases, these approaches have evolved to address specific problems, and have proven to be effective. Nevertheless, there is a strong case for adopting the de facto global standards. Global institutional investors and venture funds are likely to be discouraged if customary partnership and preferred stock structures cannot be employed in a given nation. Even if a perfectly good alternative exists, they may be unwilling to devote the time and resources to explore it. Unless the nation is one such as China—where global investors feel compelled to master the system, no matter how complex, owing to the size of the market opportunity—policymakers should allow transactions that conform to the models widely accepted as best practice.
• Let the market provide direction. Two successful efforts have been the Israeli Yozma program and the New Zealand Seed Investment Fund. While these programs differed in their details—the former was geared toward attracting foreign venture investors; the latter encouraged locally based, early-stage funds—they shared a central element: each used matching funds to determine where public subsidies should go. In using the market for guidance, policymakers should keep certain points in mind:
• The identification of appropriate firms or funds is not likely to take place overnight. Rather than fund dozens of groups immediately, programs should first fund a handful of entities. As feedback comes in from the early participants, second and third batches of capital may be invested, or the capital of the pioneering firms and funds may be supplemented.
• These initiatives should not compete with independent venture funds or finance substandard firms that cannot raise private capital. Emulating successful initiatives in the past, programs should require that a substantial amount of funds be raised from nonpublic sources.
• In selecting venture funds to which to provide capital, it may be a challenge to interest top-tier venture groups. The expectation should be that a given region can attract solid groups with a particular interest in industries where there is already real local strength.
• In the same spirit, policymakers may wish to cast their net broadly to attract firms and funds of different types. In addition to traditional stand-alone start-up venture funds, they may wish to consider corporate spin-outs and venture funds as well.
• In encouraging seed companies and groups, leaders should be aware that extensive intervention may be needed before they are “fund-able.” Programs may need to work closely with the organizations to refine strategies, recruit additional partners (perhaps even from other regions), and identify potential investors. Moreover, firms and groups should retain enough “dry powder” so that they do not go belly-up once government subsidies run out. Having the right leader is critical if a program’s interventions are to be effective.
• Policymakers should publicize in advance their evaluation criteria for prospective firms and funds. These evaluation standards should be close to those employed in the private sector for assessing entrepreneurs and venture funds.
• Resist the temptation to overengineer. In many instances, government requirements that limit the flexibility of entrepreneurs and venture investors have been detrimental. It is tempting to add restrictions on several dimensions: for instance, the locations in which the firms can operate, the type of securities venture investors can use, and the evolution of the firms (e.g., restrictions on acquisitions or secondary sales of stock). Government programs should eschew such efforts to micromanage the entrepreneurial process. While it is natural to expect that firms and groups receiving subsidies will retain a local presence or continue to target the local region for investments, these requirements should be as minimal as possible.
• Recognize the long lead times associated with public venture initiatives. One of the common failings of public entrepreneurship and venture capital initiatives has been impatience. Building an entrepreneurial sector is a long-run endeavor, not an overnight accomplishment. Programs that have initial promise should be given time to prove their merits. Far too often, promising initiatives have been abandoned on the basis of partial (and often, not the most critical) indicators: for instance, low interim rates of return of initial participants. Impatience—or creating rules that force program participants to focus on short-run returns—is a recipe for failure.
• Avoid initiatives that are too large or too small. Policymakers must walk a tightrope in finding the appropriate size for venture initiatives. Too small a program will do little to improve the environment for pioneering entrepreneurs and venture funds. Moreover, inflated expectations, out of proportion to the money invested, may create a backlash that impedes future efforts. But programs that are too substantial can swamp local markets. The imbalance between plentiful capital and limited opportunities may introduce pathologies. Consider the Canadian Labor Fund Program discussed in chapter 6. Not only did it back incompetent groups that did little to spur entrepreneurship, but it crowded out some of the most knowledgeable local investors.
• Understand the importance of global interconnections. As this book has repeatedly emphasized, entrepreneurship and venture capital are emerging as global enterprises. This evolution has two important consequences. First, no matter how eager policymakers are to encourage activity in their own backyard, they must realize that to be successful, firms must have a multinational presence. Efforts to restrict firms to hiring and manufacturing locally are likely to be self-defeating. Second, it is important to involve overseas investors as much as feasible. Local companies can benefit from relationships with funds based elsewhere but investing capital locally. Moreover, successful investments will attract more overseas capital. In addition, local affiliates of a fund based elsewhere—having a successful track record—will gain the credibility they need to raise their own funds. That being said, when public funds subsidize activities by overseas parties, officials should obtain commitments from these entrepreneurs and groups to recruit personnel to be resident locally, and to have partners based elsewhere be involved with the management of the local groups.
• Institutionalize careful evaluations of initiatives. All too often, in the rush to boost entrepreneurship, policymakers make no provision for the evaluation of programs. The future of initiatives should be determined by their success or failure in meeting their goals, rather than other considerations (such as the vehemence with which supporters argue for their continuation). Careful program evaluations will help ensure better decisions. These evaluations should consider not just the individual funds and companies participating in the programs, but also the broader context. At the very least, these evaluations should:
• Gather and publicize accurate data on the extent of high-potential entrepreneurship and formal and informal venture capital activity. Some of this information can be collected immediately; other information can only be gathered after some activity. These data will be important not only for the program evaluations, but also to publicize the growing size and dynamism of the local venture market to prospective investors.
• Compare publicly supported firms and venture groups to their peers to infer the difference the program has made.
• Carefully track the performance of the companies that are and are not participating in the program, including not just financial returns but also such elements as sales and employment growth.
Evaluators may also wish to consider whether it would be feasible to randomize at least some awards, or explore the use of regression discontinuity analysis in the evaluations.
• Realize that programs need creativity and flexibility. Too often, public venturing initiatives are like the pock-faced villain in a horror film—as much as one tries, he cannot be killed off! Their seeming immortality reflects the capture problem discussed in chapter 4: powerful vested interests coalesce behind initiatives, making them impossible to get rid of. The nations that have been most successful in public programs have been willing to end those that are not doing well, and to substitute other incentives. Even more powerfully, they have been willing to end programs on the grounds that they are too successful and hence no longer in need of public funding. Moreover, program rules may have to evolve, even if important classes of participants are thereby eliminated. If government is going to be in the business of promoting entrepreneurship, it needs some entrepreneurial qualities itself.
• Recognize that “agency problems” are universal and take steps to minimize their danger. The stories in this volume illustrate that the temptations to direct public subsidies in ways not intended are not confined to any region, political system, or ethnicity. While we might wish that human beings everywhere would confine themselves to maximizing public welfare, selfish interest all too often rears its ugly head. In designing public programs to promote venture capital and entrepreneurship, such behavior should be limited as far as possible. Defining and adhering to clear strategies and procedures for venture initiatives, creating a firewall between elected officials and program administrators, and careful assessments of the program can help limit self-serving behavior.
• Make education an important part of the mixture. The emphasis on education should have at least three dimensions:
• The first is building the understanding of outsiders about the local market’s potential. One of the critical barriers to willingness of venture investors to invest in a given nation is a lack of information. If one visits a racetrack for the first time, it’s always nice to know whether the track favors frontrunners or late closers, and who the hot local jockeys are. In the same way, institutions feel more comfortable investing if they have information about the level of entrepreneurial activity in local markets, the outcomes of the investments, and so forth. An important role that government can play is gathering this information, or else encouraging (and perhaps funding) a local trade association to do so.
• Second, educating entrepreneurs is a critical process. In many emerging venture markets, entrepreneurs may have a great deal of confidence, but relatively little understanding of the expectations of top-tier private investors, potential strategic partners, and investment bankers. The more that can be done to fill these gaps, the better.
• Finally, a broad-based understanding in the public sector of the challenges of entrepreneurial and venture capital development is very helpful. As we have repeatedly highlighted, policymakers have made expensive errors out of a lack of understanding of how these markets really work.
APPROACHES SOMETIMES RECOMMENDED THAT SHOULD BE AVOIDED
Not all the suggestions that circulate in policy circles are good ones. In this section, we’ll consider some ideas that are frequently heard—indeed, often touted by consultants and intermediaries—but are inconsistent with the global evidence on appropriate steps to build a successful entrepreneurial sector or venture capital.
• Go domestic. Local entrepreneurs and venture investors frequently demand that government funds—whether sovereign funds owned by the states or pension funds for public employees—be mandated to devote their general investment pool to domestic entrepreneurs or venture funds. This suggestion, while initially plausible, is problematic for several reasons.
First, the success of dynamic markets is largely driven by the engagement of global private equity limited partners, rather than local players. Early-stage venture funds—assuming that they can develop a reasonable track record—are likely to attract considerable interest from institutional investors. By directing funds to local groups that cannot raise money, governments are likely to be rewarding precisely the groups that don’t deserve funds.
Moreover, a real danger with public programs is that they flood the market with far more capital than it can deploy. Such well-intentioned steps can actually hurt entrepreneurs and venture capitalists.
Finally, rules requiring local investment fly in the face of the principle that public venture capital funds should rely on the market to identify attractive opportunities, rather invent their own mandates. While it would be hoped that local pension and investment funds will eventually play an important role in local markets, it should be at a pace that they are comfortable with.
• Set up immediate tax breaks. A second bad idea is the commonly heard demand for provisions that give venture capital investors an immediate tax deduction. A frequently cited model is the CAPCO program pioneered in Louisiana and adopted by other states. Unfortunately, as discussed in chapter 7, these efforts have been largely unsuccessful.
This suggestion is problematic for two reasons. First, the primary way in which tax policy encourages venture capital is through the demand side: the incentive that the entrepreneur has to (typically) quit a salaried job and begin a new firm. Little evidence suggests that tax policy can dramatically affect the amount of venture capital supplied by the sophisticated institutional investors that provide capital to the world’s leading venture industries. (Indeed, many dominant venture capital investors—such as pension funds and endowments—are exempt from taxes in most nations.)
Second, one of the powerful features of the venture capital process is the alignment of incentives. No one—whether limited partner, venture capitalist, or entrepreneur—gets substantial gains until the company is sold or goes public. Economists argue that such an alignment keeps everyone focused and minimizes the danger of behavior that benefits one party but hurts the firm. Substantial tax incentives at the time of the investment can distort this alignment of incentives.
• Bring in hired guns with poor incentives. Another bad idea, tried in a number of American states, is to bring in an outside investment firm to manage the entrepreneurship promotion initiative. For several reasons this decision will probably be unproductive. First, these intermediaries frequently charge substantial fees. While they may appear small (only 1 percent of capital under management!), they can eat up a huge fraction of the returns.
Second, the investments by the intermediary may not be driven by the local government’s priorities. The intermediary’s fees can create incentives to do deals for their own sake, rather than to advance the mission of the fund. Thus, an outside financial institution may be tempted to put money to work quickly, so it can raise another fund (and generate more fees). Alternatively, the intermediary may have a special relationship with certain funds (for instance, an investment bank’s fund-raising group may be gathering capital for that group). Divided loyalties will come into play, and the best interests of the government may not be served. Thus, U.S. states such as Oklahoma that have hired outside managers to run their entrepreneurship programs have had limited success in growing their venture sectors.
• Imitation is the sincerest form of flattery. Another persistent theme—perhaps the hardest to resist—is the desirability of duplicating programs and incentives provided elsewhere. In chapter 1, we discussed the temptation of so many Persian Gulf states to borrow concepts from Dubai, even though the very fact that the strategies (such as the creation of a major air travel hub) were successful for Dubai means that they are less likely to work elsewhere.
Moreover, there has been a strong temptation to emulate even programs that have proved unsuccessful elsewhere. For instance, incentive schemes that give large tax benefits for those who invest in entrepreneurial firms have typically been unsuccessful in promoting entrepreneurship, yet have been widely emulated. Similarly, the widely adopted strategy of instructing local pension fund managers to make economically targeted investments with employees’ funds has a troubled legacy.
It is important to remember the adage “Two wrongs do not make a right.” Ill-considered steps to promote entrepreneurship and venture capital can be profoundly distorting, attracting inexperienced operators and leading to ill-fated investments. The poisonous legacy that results can discourage other legitimate investors from participating in the market for years to come and set back the creation of a healthy industry. Thus, tempting as it is to match investment incentives offered by others, if a strategy appears ill-considered, it is best avoided.
FINAL THOUGHTS
In this book we began by highlighting the extraordinary recent public expenditures devoted to rescuing troubled firms, and asked whether government should have a role in the promotion of newer, more promising firms as well. We then looked at the experiences in encouraging entrepreneurs and venture capitalists across many decades and continents. We have delved into theoretical models and empirical studies. We have seen the good, the bad, and the ugly.
As I acknowledged in the introduction, the quest to encourage venture activity can seem like a sideshow among the many responsibilities of government, from waging war to ensuring the stability of major financial institutions. Certainly, the dollars spent each year on entrepreneurship programs—while significant on an absolute basis—pale when compared to defense and health care expenditures. But the picture changes when we consider the long-run consequences of policies that facilitate or hinder the development of a venture sector: that is, the impact on national prosperity of a vital entrepreneurial climate. In the long run, the significance of entrepreneurial policies looms much larger.
Much of the discussion in the book has focused on specific policies and analyses. But throughout the discussion, five consistent themes have emerged:
• Governments around the world today seek to promote entrepreneurial and venture capital activity, employing a variety of “stage setting” and direct strategies.
• These steps are sensible, given the historical record and theoretical arguments regarding the importance of such interventions in the development of entrepreneurial regions and industries.
• But programs to promote entrepreneurship are challenging. Governments cannot dictate how a venture market will evolve, and top-down efforts are likely to be unsuccessful.
• The same common flaws doom far too many programs. These flaws reflect both poor design—indicating a lack of understanding of the entrepreneurial process—and poor implementation.
• Governments must do a careful balancing act, combining an understanding of the necessity of their catalytic role with an awareness of the limits of their ability to stimulate the entrepreneurial sector.
If policymakers apply these key lessons, many sagas of waste and disappointment can be avoided. Entrepreneurs will find a more hospitable climate, and we will all benefit from a healthier economic world.