CHAPTER 6

HOW GOVERNMENTS GO WRONG: BAD DESIGNS

The frequent failures among public programs to stimulate entrepreneurship and venture capital suggest that many pitfalls face these efforts. The stark truth is that many more initiatives have been unsuccessful than successful. One benefit that policymakers today have, however, is that they can learn from the mistakes made in earlier years, and adjust their programs accordingly.

Readers may wonder how this book’s recommendations have been arrived at, given my cautions about the early stage of our knowledge. Indeed, not enough work has been done on how to structure entrepreneurship programs to ensure their greatest effectiveness and to avoid political distortions. But as I discuss later in this chapter, a number of previous programs appear to be predicated on premises that are fundamentally at odds with what is known about the process of financing entrepreneurial firms.

The next two chapters will highlight the critical challenges these initiatives face, drawing on research and history. In this chapter, we’ll look at conceptual problems. All too often, public programs incorporate fundamental errors that are a death sentence for a program before it even starts. These failings can be divided into designs that do not reflect what the entrepreneurial and venture process is all about, and those that seek to tell the market what to pursue, rather than listen to its needs. In the chapter 7, we will consider some of the key errors made when programs are implemented.

FAILING TO UNDERSTAND THE VENTURE MARKET

If public programs are indeed to create an environment in which new ventures can succeed, they must first understand the ways in which the market identifies and funds high-risk, high-potential entrepreneurs. All too often, programs have incorporated assumptions that may have sounded plausible when proposed within the halls of government but are utterly at odds with the manner in which venture markets really work.

In this section, I will highlight three common ways in which public efforts misunderstand the working of venture markets.

Timing

The first common mistake relates to the length of the programs. Democracies worldwide are shaped by the ebb and flow of election cycles. This inevitably leads to a short-run orientation. And even leaders in office for life are often anxious to display progress and look for quick fixes.

But building a venture capital industry is a long-run investment, which takes many years until tangible effects are realized. To cite one example, historians date the birth of the modern U.S. venture capital industry to 1978, a full twenty years after the enactment of the SBIC program. (The gestation period in the United Kingdom was even longer.) While it may be possible to build a vibrant entrepreneurial sector more quickly today (as we will discuss below, the globalization of the industry has some dramatic implications), this is not a process that can be accomplished in a few years.

As a result, an entrepreneurship or venture capital initiative requires a long-run commitment on the part of politicians and public officials. The one certainty is that there will be few immediate returns. If programs are abandoned after a few months or years, they are highly unlikely to bring any benefits. There has to be a commitment to be undaunted by initial failures—for example, the low rate of return that early publicly subsidized investments or funds garner—and instead to fine-tune programs in the face of early discouragements.

An illustration of the need for commitment is the experience of Malaysia. To their credit, Malay policy leaders recognized early on the importance of encouraging entrepreneurial activity. In the 1970s, Malaysia began its transition into a middle-income country by gradually broadening its economic activities and switching from the production of raw materials, such as rubber and palm oil, to the manufacture of electronics. By the early 1990s, the nation’s leaders recognized that Malaysia’s future growth depended on encouraging innovation.

In 1993, the Malaysian Industry-Government Group for High Technology (MIGHT) was launched. This independent, nonprofit organization aimed at facilitating partnerships between industry and government in high-technology industries. It became an active advocate for efforts to promote high-technology entrepreneurship: for instance, the Multimedia Super Corridor, encompassing an area of nearly 300 square miles, was started in 1995 and was explicitly modeled after Silicon Valley.¹ The importance of this effort was reflected in the comments of the most senior levels of the Malay government: for instance, in 1999, Tan Sri Dr. Omar Abdul Rahman, the joint chairman of MIGHT and president of the Malaysian Academy of Sciences, pointed to the success of Singapore in promoting high-technology entrepreneurship and argued that there was a “need for a paradigm shift.”² This vision was largely incorporated into Malaysia’s five-year plans in the late 1990s and 2000s.

However worthy the initial vision, its implementation was marked by inconsistency that largely defeated the government’s good intentions. Consider, for instance, the efforts in biotechnology.³ In 2001 the Malaysian prime minister, Mahathis Mohamad, set in place plans to boost Malaysia’s biotechnological capacities through the establishment of a BioValley: Malaysia targeted biotechnology (like almost everyone else!) as critical to the nation’s development. The BioValley itself was intended to nurture local research and medical discoveries and enhance commercialization. At the core of the 2,000-acre site would be three research institutes focusing on genomics and proteomics, agriculture, and pharmaceutical technologies, which would share resources. The valley was projected to be fully operational in 2009, and would also have commercial, education, recreation, and residential facilities, with a total public expenditure exceeding $150 million.

Inauspiciously, the BioValley was built on the site of Entertainment Village, Malaysia’s failed attempt to create a version of Hollywood. Reflecting the absence of advance planning or follow-through, this expensive real estate development lay empty. In an echo of the earlier failure, by April 2004 only three companies had signed contracts to locate in the BioValley, and by 2005 the empty halls of the BioValley and unused equipment had earned the place the nickname the “Valley of Bio-Ghosts.”

What went wrong with this effort? In part, it reflected the lack of planning highlighted above. Perhaps blinded by the success of Singapore’s Biopolis, the Malaysia effort’s leaders apparently did not ask whether biotechnology firms wanted to locate in the BioValley. The lack of properly trained talent to operate research facilities, the uncertain nature of intellectual property rights in Malaysia, and the absence of a national tradition of high-technology entrepreneurship all weighed heavily in the mind of private firms considering this facility. Rather than engage in dispassionate analysis of the likelihood of attracting tenants, the project’s leaders seemed to follow the mantra of the movie Field of Dreams: “If you build it, they will come.” As we have seen, in the realm of growing venture activity, this strategy is rarely enough.

The inconsistencies of Malaysian policies also led many biotechnology firms to turn elsewhere. For instance, not long after breaking ground on the center, the Science, Technology and Environment Ministry announced the establishment of biotechnology satellite hubs in all of the country’s states by 2006, with each state concentrating on a particular scientific field.⁴ These changes, as well as the shroud of secrecy under which the project was organized, led many to wonder about the government’s commitment to BioValley. (This kind of push to be “fair,” to ensure that every region gets a “piece of the action,” has defeated many similar efforts.) Then, in April 2005 the nation’s biotechnology policy was revisited. The plans for the BioValley were scaled down, in favor of institutes elsewhere and focused on other industries, tax breaks, and matching incentives.

Perhaps not surprisingly, firms participating in other Malay programs also saw dizzying changes of policy and inconsistencies, which reduced their effectiveness. For instance, the Advanced Microchip Design and Training Center project was launched in 1999, with a vision of establishing fifteen semiconductor design houses employing 5,000 designers by the end of 2003.⁵ An important element was to be intensive training of local students to prepare them for state-of-the-art work. The government enthusiastically supported this effort, pointing to its fit with the broader goal of promoting information technology. But by 2003, the government—apparently discouraged at the slow pace of progress—had largely abandoned the project, and ended up in litigation with its various foreign partners. Similarly, the Malaysian Technology Development Corporation underwent numerous shifts of strategy in the face of severe write-downs, continuous losses from 1999 to 2004, and corruption charges against its most senior executive.⁶

This experience is not unique to Malaysia. A recent evaluation by Scott Wallsten looked at counties in the United States that had been the site of publicly funded science parks, and compared them to similar counties that did not have such facilities.⁷ An initial comparison suggested that science parks had little impact: for every park such as the Center for Advanced Technology at Colorado State University, which saw a surge in venture funding in the years after its establishment, there is a Alturas Technology Park, in Moscow, Idaho, where the growth rate in high-technology employment and venture activity in the five years after it was built lagged behind that of peers without such a park.

It might be objected that this comparison isn’t really fair. After all, in many cases, a key reason that the government decides to spend precious public funds on these projects is that the area is in trouble economically to begin with. Not surprisingly, science parks tend to be located in counties that are losing jobs. But even after controlling for economic conditions, the basic pattern remains: these parks have no measurable impact, positive or negative, on venture activity or high-tech jobs more generally.

Much of the blame for the failures of these parks must be laid at the feet of the short-run orientation of many government leaders. All too often, leaders assume that a science park project, once completed, will solve problems immediately. One frustrated park director compared the state legislature—which cut off funding for his center after “not enough had happened” within two years of its opening—to a child who kept digging up the ground where he had planted seeds because he was frustrated that the flower was not yet blooming.⁸ A short-term outlook is fundamentally at odds with what we know about the entrepreneurial process.

Even if programs are given a long-run mandate, they are often structured in a way that makes it impossible for them to carry out their mission. Consider, for instance, the experience with promoting entrepreneurship and venture capital in Finland.⁹ The Finnish effort has relied on two institutions:

•  The Finnish Industry Investment Ltd (FII) was begun in 1995, with the objective of assisting venture funds investing in early-stage companies. It invests directly in these funds, frequently serving as the lead, or cornerstone, investor. It also directly finances entrepreneurs with promising business plans.

•  The Finnish National Fund for Research and Development (abbreviated Sitra) has been involved in making government investments in venture capital since 1967. While it originally focused on overseas funds, it also increasingly focused on early-stage funds and in giving money directly to early-stage domestic entrepreneurs.

The overlapping roles of these two agencies might well have given policymakers pause. But these two institutions also shared another, considerably more problematic feature: financial “ground rules” that were inconsistent with their basic missions. On the one hand, FII operated under the rule that its investments be undertaken profitably. This requirement has been interpreted by the bureaucracy as meaning that its returns each year were expected to be above the inflation rate. Sitra, on the other hand, was expected to be an “evergreen” fund, with the pace of new investments limited to whatever the fund gets from selling its proceeds.

These requirements seem quite out of line with the funds’ ultimate objectives of addressing failures in early-stage venture capital markets. As we have discussed in chapter 2, venture markets are intensely cyclical with booms and busts. This is particularly true of early-stage investing. To expect a steady flow of profits, as the government does from FII, is not realistic. This requirement appears to have led FII to emphasize later-stage investing, in the hope that a more steady profit flow would allow the fund to remain in compliance with its ground rules. Not only is this hope probably ill-founded, but the shift has meant the program has moved away from the mission that the legislators assigned it.

Sitra’s requirement of financial self-sustainability has also been counterproductive. In particular, the fund had ample capital to throw into the overheated market of 1999–2000, when the Finnish market was exploding and few entrepreneurs with a decent (or not so sensible) idea were languishing unfunded. By 2001 and 2002, by the time that the Finnish venture market was prostrate, Sitra had no outflows that would allow it to fund anyone.

When enacting these two programs, Finland’s parliamentarians realized they needed long-run investments to overcome market failures. But in the design of these programs, seemingly reasonable requirements—who can be against self-sufficiency?—ended up undoing their good intentions. As a result, the ability of these initiatives to address the societal problems that legislators had identified was profoundly compromised.

Given the long span involved in creating a vibrant entrepreneurial and venture capital culture, a short-term perspective (or rules that inadvertently introduce such a point of view) is likely to be a “kiss of death.” Political leaders need to appreciate that quick returns are unlikely to appear. If short-term fixes are the only kind of successes being sought, it is best not to undertake a pro-entrepreneurial program at all.

Sizing

The second common mistake relates to the sizing of the program. Either too small or too large an initiative can pose profound difficulties.

The problem with too small a program, of course, is that it won’t make much of a difference. For instance, some public programs have only invested a few million dollars. Such an effort is very unlikely to make an impact on a large and diverse economy. Few venture capitalists or other investors will learn about the program, and the possibility that such funding will serve as a “stamp of approval” to others will be remote. The companies or groups receiving the funds are unlikely to have enough capital to move on to the next level. (While the minimum size varies by country and sector, conversations with practitioners suggest $60 to $75 million is the smallest size for an effective venture fund.)

Yet in many cases, the public sector has created programs that are far smaller.¹⁰ In 1991 Peter Eisinger found that the average size of twenty-nine venture capital programs begun by twenty-three U.S. states was $6.5 million. By way of contrast, the typical venture fund begun that year was $31 million. In many cases, governors and legislators sought to promote the state’s economic development, but at the same time to have as little impact as possible on the meat and potatoes of government: funding schools, building roads, and so forth. With such limited money—and often inflated promises about the impact these funds would have—the odds that they would fulfill expectations were remarkably low. Indeed, when Eisinger returned twenty months later to check on the state funds’ status, over a third had already been dissolved.

Nor is the creation of too small funds a uniquely American phenomenon.¹¹ For instance, the European Union has launched numerous efforts to encourage the financing of new firms. Typically, they have followed a depressingly familiar pattern: even if the intention of the Eurocrats is to create reasonable-sized funds, by the time every country, or every region in each country, gets its “fair share” of the government’s money, the pie has been sliced in very thin pieces indeed. The European Seed Capital Fund Scheme is one telling example. As Gordon Murray points out, these funds (which typically had under two million euros in capital) were so undercapitalized that even if they did nothing beside pay for the salary of an investment professional and an administrative assistant, rent for a modest office, and travel, and never invested a single dollar, they would run out of capital long before their assigned ten-year life was up. Moreover, with so few euros to disperse, the investments they could make were tiny. Certainly, they were insufficient to get the typical entrepreneurial company to the point where it could go public, or even, in many cases, to the point where it would be interesting to a corporate acquirer. For a number of groups, their best hope of achieving any return from their investments was to sell the stakes back to the companies they had bought them from. This is hardly a way to achieve the European Commission’s goal of providing capital to needy entrepreneurs!

On the other hand, if public programs become too large, they can crowd out, or discourage, private funding. Public funds may become so extensive that they discourage venture capitalists from investing in a given market, because all attractive opportunities have been funded already by the public funds.

The experience of the Canadian Labor Fund Program in the 1990s provides a good illustration of this latter danger.¹² A number of provincial governments, seeking to encourage venture capital, established these funds in the 1980s and 1990s. But in doing so, they adopted some very peculiar elements:

•  Rather than encouraging institutional investors and sophisticated high-net-worth investors—who are the dominant investors in venture funds around the world—these funds were designed for the “little guy.” Individual investors received exceedingly generous tax credits—they received a credit of 20 percent of the amount they invested in these funds when paying their federal taxes, and another 20 percent credit in many provinces—but the benefits were capped after a few thousand dollars.

•  Reflecting the political horse-trading that is part and parcel of the democratic process, the Quebec parliament (which enacted the first of these funds and whose legislation was widely imitated in other provinces) decreed that these funds would be managed by labor unions. Predictably, unions were unfamiliar with the venture process, leading to a “rent-a-union” dynamic where outsiders curried favor with unions to get permission to run their funds. Not surprisingly, the unions often turned to cronies and fast-buck operators rather than experienced investors to manage the funds. There were no incentives for the unions to hire top-tier managers, or any provision for government program managers to step in if a problematic manager was hired.

•  The funds frequently had wide-ranging, somewhat muddled mandates, which ran from generating financial returns to providing labor education to promoting local economic development.

•  Tight limits were put on how long the funds could “sit” on the money they raised. For instance, in Ontario, one-half the funds had to be invested in the first year, and 70 percent within two years, whether there were attractive opportunities or not.

•  Numerous costly reporting requirements were imposed on the funds and were compounded by the presence of many individual investors.

Despite these design imperfections, the amount of capital investors put into labor funds grew spectacularly: the investment pool climbed from $800 million in 1992 to $7.2 billion in 2001, while private independent funds grew from $1.5 billion to $4.4 billion over the same period (all figures in billions of 1992 Canadian dollars).

But the funds that were established and raised capital were far from inspiring. For instance, the Canadian Football League Players’ Association sponsored the Sportsfund.¹³ Joel Albin, a former vice president of the Bank of Montreal, was the leading spirit behind the venture. He candidly described his motivations:

When I saw what the labor-sponsored vehicle offered with the tax breaks, I thought, “Geez, if I can structure it in a way that I could get my investors those tax breaks, then why not?” It would be sort of negligent not to as a corporate finance person.

This effort attracted so much interest it had to be closed off to new investors. Perhaps the investors were more swayed by the glitzy launch party, which featured the fund’s advisors—Canadian professional sports heroes and Olympians—than by Albin’s lack of investment experience. But after disappointing investments in such ventures as the World Pitch & Putt Corporation (which promoted an Irish variant of golf, where no hole is more than 300 feet from the tee) and a short-lived Broadway musical based on Jane Eyre, the fund lost more than half its value, and investors fled.

The consequences of this poor design are not surprising. The performance of labor funds lagged far behind both private and public equity indexes in the United States and Canada. The apparent disconnect between poor results and the large amount raised presumably reflected the power of the tax benefits the labor funds enjoyed, as well as uninformed investors.¹⁴

The effects of the labor fund initiative have been analyzed by Douglas Cumming and Jeffrey MacIntosh.¹⁵ They look at the level of venture capital funding in each province, and see whether the presence of the labor fund program enhanced or reduced the amount of funding. They show that the adoption of the federal legislation seems to be associated with a reduction, not an increase, in overall venture activity. But this analysis raises concerns: in particular, to what extent did the federal legislation coincide with some other change that made Canadian venture investing less attractive than that in the United States (for instance, the proliferation of pioneering Internet companies in California)?

In the second part of their analysis, Cummings and MacIntosh exploit the fact that the program was not begun or ended in all provinces at once: rather, it was phased in and out at various times, reflecting Canada’s decentralized government. In this way, they are able to control—at least roughly—for the changing investment climate, and look at the consequences of the adoption of the program specifically. Here the results are indecisive. Certainly there is no evidence that the program boosted the aggregate amount of venture spending in each province.

While this analysis is suggestive, by focusing on the aggregate amount of venture investments, the authors may be missing the larger picture. Conversations with independent Canadian venture funds indicate that they found themselves during these years competing against these uninformed investors, who were in many cases willing to commit capital at huge valuations. Many of the independent groups, convinced that they could not generate profitable returns in the Canadian market, shifted (at least temporarily) to investing in the United States instead. Thus, the problem may have been less with the aggregate amount of funding during these years, than with the quality of the groups providing the funding to the entrepreneurs.

Evidence consistent with this view is presented in a recent evaluation of the Canadian program by James Brander, Edward Egan, and Thomas Hellmann, which looks in depth at what happened to individual companies participating in it.¹⁶ The authors find that not only were the companies backed by the labor funds less financially successful, but they underperformed on other measures that might have also been goals of policymakers. The fund-backed firms were less likely to be issued patents or perform R&D, which suggests that they were less innovative than their peers. (The authors control for the fact the tendency of firms in different industries to file for patent protection varies.) Nor is there any evidence that these firms were any better at expanding employment or introducing more competition to Canadian industry, two other justifications that have been offered for the program. In short, by flooding the market with funds, the program appears to have accomplished neither its financial nor broader social goals.

In all fairness to the Canadians, the Labor Fund program was far from unique in having these design flaws. A similar picture emerges from studies of European initiatives. Dozens of national and Europewide initiatives in recent decades have sought to promote funding for entrepreneurs and venture capital funds. To cite just one of many examples, in 2001, the European Commission provided more than two billion euros to the European Investment Fund, making it overnight Europe’s largest venture investor. This amount is very significant relative to the roughly four billion euros that were invested by European venture funds in that year.

The motivation of these efforts was again laudable. Europe has seen a low level of venture activity for many decades. Figure 6.1 illustrates the ratio of venture investment to gross domestic product for leading industrialized nations, and highlights the low level of activity across Europe.¹⁷ These low levels reflect the miserable returns that European venture investments have yielded. Venture Economics’ calculations suggest that from the beginning of the industry through the end of 2007, the average European venture fund has had an annual return of minus 4 percent: hardly a number to warm the hearts of investors!¹⁸ (The comparable number for U.S.-based funds over the same period is 16 percent.) Thus, policymakers have argued, the low levels of fundraising and low historical returns create a need for public financing.

Figure 6.1. Ratio of venture capital investment to GDP, 2007

But just as in the Canadian case, the huge amount of funds provided at the European, national, and regional levels may be having a perverse effect. As Wim Borgdorff of the leading European fund-offunds AlpInvest has noted, “The unfair competition from public money might well have a disastrous unintended consequence by inducing many private funds with stricter financial criteria to leave the European venture capital industry altogether.”¹⁹

Support for this claim comes from a 2006 paper by Marco Da Rin, Giovanna Nicodano, and Alessandro Sembenelli, which examines the level of venture capital funding across fourteen European countries over the past two decades.²⁰ The authors look at the extent to which venture capital is an important source of financing for private firms. The analyses suggest that many factors determine the level of activity. Particularly harmful are high rates of taxation, the presence of legal hurdles to entrepreneurship, and the absence of stock markets geared toward entrepreneurial companies characteristic of many countries. The supply of funds from the government, however, has no significant impact. Once again, the data suggest that for every dollar being handed out by a government-sponsored program or fund, private investors put a dollar less into the sector. And if the most skilled and knowledgeable investors are on the private side, the quality of investment selection, advice, and oversight in this market may decline markedly as a result of public interventions. To put it another way, the low returns in the European venture markets may be as much a consequence as a cause of the massive public interventions in these markets.

This problem is not dissimilar from the difficulties facing the few pioneering venture funds operating in Africa over the last decade. There are so many governmental and quasi-governmental financing sources that would be satisfied with simply getting their capital back that it is next to impossible for private investors to put their funds to work. The relatively few promising entrepreneurs find the venture funds’ need for a 25 percent or 30 percent return on their investment unsatisfactory, preferring to take funds from public sources that do not demand a market rate of return. Once again, seemingly well-intentioned public programs can stymie the development of a crucial intermediary. Many other illustrations of this phenomenon, where a publicly subsidized competitor drives out private investment, can be found on other continents as well.²¹

Flexibility

A third point is that government officials must appreciate the need for the flexibility that is central to venture capital investment. Venture capitalists make investments in young firms facing tremendous uncertainties in technology, product market, and management. Rather than undertaking the (often impossible) task of addressing all the uncertainties in advance, they remain actively involved after the investment, using their contractually specified control rights to guide the firm. Changes of direction—which often involve shifts in product market strategy and the management team—are an integral part of the investment process. Far too often, public administrators view these shifts not as natural evolution, but as troubling indications that awardees are deviating from their plan.

The consequences of inflexibility can be seen in the two largest venture programs run in the United States over the past fifteen years. The U.S. Department of Commerce’s Advanced Technology Program (ATP) sought from 1990 to 2007 to support technology-based projects conducted by American companies and industry-led joint ventures. In its first eight years, 36 percent of ATP funding went to small businesses, with an additional 10 percent going to joint ventures led by small businesses.

The regulations governing ATP stated that the firms funded be “pre-commercial.” The rationale for this policy was easy to understand: the drafters of the law wanted to support young companies that would find it hard to raise funds elsewhere. But note, demanding that companies be precommercial is very different from encouraging early-stage investing. As numerous scholars of entrepreneurship have pointed out, successful early-stage companies are almost im me diately focused on interacting with customers and refining prototype products, despite their young age.²²

The consequences of the ATP’s regulations are not hard to anticipate. For instance, one very promising awardee, Torrent Systems, completed preproduct R&D ahead of schedule.²³ But instead of rewarding the firm, the ATP forced Torrent to choose between giving up the unused money and expanding its R&D into nonessential areas where it did not have commercial activity. Torrent decided to pursue a rapid-commercialization strategy, including an alliance with IBM. ATP promptly impounded the remaining funds. Torrent wasn’t anticipating another round of venture financing for a number of months, so its executives now had to scramble to replace the lost financing. All of the events—along with threats from ATP to shut down the company and subject it to an exhaustive audit—consumed immense amounts of Torrent’s limited time and money. As a result of the government’s lack of flexibility, Torrent paid a heavy penalty for its success.

Another example can be drawn from the Small Business Innovation Research (SBIR) program, which sets aside 2.5 percent of all federal external R&D expenditures (the research not directly undertaken by government scientists) to fund small, high-tech businesses. In recent years, the program has invested more than $1.5 billion annually in entrepreneurial technology-intensive firms.²⁴

When the SBIR program was enacted, a major concern was ensuring that the awardees would indeed be American-owned small businesses, and not foreign or large companies masquerading as eligible firms. As a result, the legislation required that (a) the firms and their affiliates receiving the awards have no more than 500 employees, and that (b) the business be 51 percent owned by individuals who were U.S. citizens or permanent residents. These rules governed the program for its first two decades.

In January 2001, however, an administrative law judge deep in the bowels of the Small Business Administration interpreted the law differently, essentially making up a new policy. Companies in which venture capitalists owned more than 50 percent of the equity, the judge ruled, should not be considered as complying with these rules. In particular, because venture capitalists owned a majority of CBR Laboratories of Boston, the firm was not able to receive a SBIR award.

This ruling was profoundly illogical. As we have seen in chapter 3, venture capitalists fund many of the most innovative start-up firms, the bulk of which would now be excluded from the program. Moreover, venture ownership is fundamentally different from the large corporations that the congressmen enacting the program feared would grab the lion’s share of the grants: it is a temporary state, as the venture fund is typically required by its operating agreement with investors to sell its stakes within a decade or less of the initial investment. Finally, in many industries, such as biotechnology, raising venture financing is not a choice: the substantial information gaps and intense financing needs mean that sophisticated investors are a necessity. About the only people satisfied with this ruling were hardcore small business lobbyists such as the American Small Business League, who characterized critics of the change as “well-heeled investors [attempting] to hijack billions of dollars in federal contracts earmarked for legitimate small businesses.”²⁵

As a result, many biotech companies have since been denied SBIR grants or have opted not to apply. We’ll never know what would have happened had they been able to pursue their research. In other cases, the effects were more evident, as with Intronn, a Maryland-based company developing a promising therapy for cystic fibrosis by “reprogramming” damaged genes. The firm, started by an unemployed pathologist in his living room, used a grant from the National Institutes of Health to go from three to sixteen employees, as well as to attract venture funding. But when the government learned the firm had sold a majority stake to venture capitalists, it pulled SBIR funding. As a result, the firm had to lay off employees and dramatically scale back its research efforts. It ended the cystic fibrosis project.

In response to the ensuing uproar, the Small Business Administration in 2005 issued a new ruling, which seemed (the language is incredibly opaque!) to allow companies with a majority stake held by venture investors to take part in the program once again, as long as the venture firm itself employs fewer than 500 employees. But the SBA’s staffers have continued to do all they can to frustrate the participation of venture-backed firms, apparently convinced that these firms are skirting the rules. One firm’s status as a small business was recently rejected, for instance, not because it had too many employees (it had seven), nor because the venture organization funding it did (it had a total of nine employees), but because the sum of the number of employees working for the venture firm and every firm in its portfolio exceeded 500!²⁶ This kind of madness reflects a deep failure in understanding how entrepreneurial finance works.

Inflexibility manifests itself in many ways. One of the international development banks adopted a mandate of trying to boost entrepreneurship in developing countries by investing in the most promising venture funds. As the program evolved, the bank’s senior management had a brainstorm: they could better put more money to work, and thus better fulfill their mission, if they co-invested alongside their venture funds in promising companies. This insight translated into a rule that all new investments in funds include a requirement that the bank be offered a chance to co-invest in each investment made.

While once again, the intentions of the policy’s drafters may have been innocent, an inflexible policy had troubling consequences. The most sophisticated developing world venture organizations took one look at the policy and decided not to ask the development bank to invest in their next fund. They had no interest in facing the delays, bureaucrat disruption, and loss of flexibility associated with the proposed co-investment mandate. Meanwhile, less successful groups, desperate to raise money at whatever the cost, acquiesced to the mandate. But these were not the funds that the bank was seeking to support! Thanks to an ill thought-through and inflexible mandate, the bank’s mission of encouraging the best developing-country-based venture funds was distorted.

In short, public venture capital initiatives should not be hobbled by excessive regulation. However well intentioned, it almost inevitably limits the freedom of venture capitalists and the entrepreneurs they fund to pursue the most attractive opportunities.

NOT LISTENING TO THE VENTURE MARKET

A second problem relates to the way in which public funds are allocated. Far too often, the decisions are distorted by a lack of understanding of how the market works or by political rather than economic considerations. By requiring that matching funds be raised from the private sector, the dangers of uninformed decisions and political interference can be greatly reduced.

We’ve already seen so many examples of well-intentioned but uninformed leaders making boneheaded decisions that we need not belabor the point! But it is worth saying a few more words about agency problems that can distort public efforts to help entrepreneurs and venture capitalists.

As we noted above, an extensive literature in political economy and public finance has emphasized the distortions that may result from government subsidies as particular interest groups or politicians seek to direct subsidies to benefit themselves. The theory of regulatory capture suggests that direct and indirect subsidies will be secured by parties whose joint political activity, such as lobbying, is not too difficult to arrange.

Figure 6.2. Change in employment among SBIR awardees and matching firms

These distortions may manifest themselves in several ways. One common impetus is the pressure to “spread the wealth”: to ensure that every region has its “fair” share of venture subsidies. But as we have seen earlier, entrepreneurship is an intensely unfair activity: there are powerful forces that lead firms to cluster in particular places. Thus, in many cases, much of the impact is diluted as funds that could be very helpful in a core area end up where they aren’t useful.

The SBIR program, the largest public venture program in the United States, provides an illustration of this problem. The effect of a fairness policy can be seen by comparing the performance of program recipients with that of matching firms; see figure 6.2, which compares the growth of SBIR awardees and matching firms.²⁷ The figure shows that the awardees grew considerably faster than companies in the same locations and industries that did not receive awards.

Unfortunately, underneath these positive results lie some intense political pressures and conflicting interests. For one thing, congressmen and their staffers have pressured program managers to award funding to companies in their states. As a result, in almost every recent fiscal year, firms in all fifty states (and indeed every one of the 435 congressional districts) have received at least one SBIR award.

Figure 6.2 also highlights the consequences of such political pressures. In particular, it contrasts what happened to the workforce size of SBIR awardees located in regions characterized by considerable high-tech activity (that is, a firm in the same ZIP code received at least one independent venture capital financing round in the three years before the SBIR award) and those elsewhere.

It reveals that in the ten years after receipt of SBIR funding, the workforce of the average award recipient in a high-tech region grew by forty-seven, a doubling in size. The workforces of other awardees—those located in regions not characterized by high-tech activity—grew by only thirteen employees. Though the recipients of SBIR awards grew considerably faster than a sample of matched firms, the superior performance, as measured by growth in employment (as well as sales and other measures), was confined to awardees in areas that already had private venture activity. In the name of geographic “diversity,” the program funded firms with inferior prospects.

In addition to the geographic pressures, particular companies have managed to capture a disproportionate number of awards. These “SBIR mills” often have staffs in Washington that focus only on identifying opportunities for subsidy applications. This problem has proven difficult to eliminate, as “mill” staffers tend to be active, wily lobbyists. Moreover, “mills” commercialize far fewer projects than those firms that receive just one SBIR grant. Though a single SBIR grant does seem to encourage performance in awardee firms, the program clearly still has some work to do in eradicating waste and distortions.

Yet another distortion is when policymakers make decisions based on “buzz,” or incomplete information. One study determined that forty-nine of the fifty U.S. states started major programs to promote the biotechnology industry, in hopes of creating a cluster of activity.²⁸ Realistically, only a handful of these states had the base of scientific resources and the supporting infrastructure (e.g., lawyers versed in biotechnology patent law and financing practice) to support a successful cluster, so the bulk of these funds were wasted. When these programs did support a promising firm, in many cases it rapidly moved to a region more conducive to biotechnology entrepreneurship.²⁹

But how, then, can governments be smarter about which sectors to back? This is an especially important goal given that in each new industry there are typically only a few “clusters,” or centers of activity. We might be skeptical about whether smart selection is a feasible task for governments, given how little success academics—who have been studying this question for decades—have had in predicting winners. The topic remains actively under research, with little clear consensus. (It is true that there are some clues in the literature: for instance, many observers agree with the conclusions of Lynne Zucker and coauthors, who attempt to disentangle the drivers of the growth of the U.S. biotechnology industry.³⁰ They argue that the critical element to jumpstart the industry in a given region was the presence of leading academic scientists. Venture funding and the formation of new firms seemed to follow from their presence.)

Certainly, in some instances, government officials have targeted the right sectors at the right time. To cite one example, in just fifteen years, Taiwan moved from having almost no experience in high-technology industries to being a leading producer of hardware for nearly every major computer vendor in the world.³¹ Taiwan’s success in the computer industry was largely due to a coordinated government strategy to support private entrepreneurship by a large number of small, flexible, innovative companies.

Taiwan’s industrial leaders saw that the island was well suited to the international personal computer industry. The open architecture created by IBM in the personal computer (PC) industry lowered the barriers to entry and created a market for standardized components and peripherals. In the earlier mainframe computer era, smaller companies were largely shut out of the market by IBM’s market dominance and its strategy of producing a large share of components and peripherals in-house. The PC revolution created a new industry structure, with opportunities for many companies to compete in niches in this fast-growing market. A company could build a better or cheaper component, based on openly available technical standards, and find a buyer for it. Taiwan’s leaders also saw that the island’s existing industrial infrastructure, which extended from basic parts and components into the plastics, metalworking, chemicals, and electronic industries, would greatly enhance the strength of firms.

Taiwan’s leaders put in place a government policy that has been aimed at complementing and supporting, rather than replacing, the efforts of the private sector. There has also been an effective flow of information between the public and private sectors. Information from the private sector has enabled government to make policies that address the needs of industry, such as facilitating technology transfer and funding research that the private sector could not afford. Government institutions have provided industry with information on new technologies and market opportunities. Government has also provided for the development of critical human resources needed by industry, emphasizing the production of engineers and computer professionals, the training and certification of existing staff, and the recruitment of high-level, experienced overseas Taiwanese to help develop its information industries.

But Taiwan is the exception rather than the rule. The vast majority of efforts by the public sector to target particular industries seem to have been far less successful. And the academic literature has been not much better in creating workable algorithms to identify which sector is likely to grow at which time. If dozens of Ph.D.s poring for years over econometrics models with mountains of historical data have been unable to show how to target industries, how can the typical government leader identify good prospects in a compressed time period and with limited information?

But there is a way to address this problem at least partially. The most direct way is to insist on matching funds. If venture funds or entrepreneurial firms need to raise money from outside sources, organizations that will ultimately not be commercially viable will be kept off the playing field. In order to ensure that these matching funds send a powerful signal, the matching requirement should involve a substantial amount of capital (ideally, one-half the funding or more should be from the private sector).

An illustration of this approach is the New Zealand Venture Investment Fund (NZVIF).³² In late 1999 the newly elected prime minister, Helen Clark, realized that New Zealand faced a fundamental problem and needed to change. In particular, she was concerned that New Zealand’s economy depended critically on the production and exporting of commodities. The nation’s position in the knowledge-based industries was weak, and its living standards were steadily falling relative to the other major developed nations.

A critical area that her government targeted was enhancing innovation, and encouraging venture capital was a critical aspect of this goal. In light of limited activity in the local market, the government sought to accelerate the growth of the New Zealand venture capital market through co-investment with private investors and related market development activities. After a careful review of other models, the government adopted a so-called fund-of-funds approach, whereby it made investments in private venture capital fund managers (see figure 6.3 for a schematic of a fund-of-funds approach).

Prior to any investments being made, NZVIF was structured as a stand-alone company, which ensured the government could distance itself from risk and liability for the investments made. This approach also ensured distance and independence from decisions about appointment of venture capital fund managers and from individual investment decisions.

These investments were structured as equity (to minimize possible distortions) and could be bought out by the investors. Government investments in the funds were on the same terms as those of private investors, except that each fund was provided with an option exercisable up to the end of the fifth year of the fund to buy out the NZVIF investment on the basis of capital plus interest only (that is, other investors would receive any upside above this amount).

Deliberately, the project’s designers asked for no special rights. The fund managers were given responsibility for making and managing investments without government interference. NZVIF leaders participated in investor governance decisions on the same terms as private investors, with the same voting rights. Investor governance arrangements reflected current market practice. The funds were geared toward investors in early-stage companies, and every dollar had to be matched with two dollars from the private sector.

NZVIF’s decision to invest in a fund is made following completion of an extensive selection and due diligence process, undertaken by the fund manager, to determine whether the fund proposal is “investment grade.” The initial screening is done by the staff, followed by an outside assessment by an independent specialist private equity advisor. A standard methodology and fixed criteria are used to assess and rank all applications. In many cases, the staff work actively with teams of would-be venture fund managers to help them make their proposals more attractive (for instance, helping them identify prospective additional individuals who can contribute needed experience). This is necessitated by the limited supply of New Zealand–based funds. Following the completion of external due diligence, the NZVIF board selects those applicants with whom it wishes to negotiate investment terms.

Figure 6.3. Schematic drawing of public fund-of-funds structure

As part of the negotiations, a monitoring and reporting framework is agreed with each NZVIF seed fund manager. This enables NZVIF to collect the economic and financial data it needs for the required regular reports on the performance of each fund and the impact of the program. This also enables NZVIF to monitor each fund to ensure it is compliant with its investment agreement and investor governance requirements. Once fund agreements are finalized, investment activity commences.

FINAL THOUGHTS

The provision of public funds to entrepreneurial companies and venture funds is a far trickier process than the “table setting” exercises described in the earlier chapters. Much can go wrong along the way.

But the experience of many programs across the globe suggests some common pitfalls that can be avoided with careful planning. In this chapter, we’ve highlighted two fundamental challenges that—unless properly addressed up-front—can doom a program before it begins.

The first pitfall is the failure to understand the entrepreneurial and venture capital markets. These markets are complex, and good intentions alone are not enough to overcome fundamental flaws. Any number of poor design decisions—from expecting the effort to bear fruit too quickly, to creating too large or too small a program, to inflexibility in design—can doom an effort.

The second danger is a top-down approach, in which bureaucrats mandate which sectors or locations are to be funded, without listening to what the market is saying. Whatever the motivations for such targeted funding, it is likely to be a road to disaster. Programs are more successful if the entrepreneurs or venture capitalists receiving public funds have to raise matching capital from private sector sources as well. In this way, the market can help sort out which players are likely to succeed, and who will probably be ineffective.

Good design is essential. But the successful implementation of a program also has tricky aspects. These challenges will be our focus in chapter 7.