In recent months, the U.S. government has taken on a challenging and controversial new role: private sector investor. This development has raised a host of questions about the government’s role in the economy and a new book by Josh Lerner, Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed — and What to Do About It, is required reading for anyone hoping to understand the issues.
Lerner, the Jacob H. Schiff Professor of Investment Banking at Harvard Business School, describes government interventions in countries as varied as the U.S., Singapore, and Israel, and explains the case for intervention. His analysis of successful and unsuccessful programs worldwide ultimately suggests a cautious approach to government intervention that bears little resemblance to the reality of today.
He has agreed to answer some of our questions about his book:
Silicon Valley is traditionally viewed as the epicenter of independent entrepreneurialism but you paint a different picture in the book. What role did the public sector play in Silicon Valley’s history?
It is received wisdom that the rugged individualism of entrepreneurs and venture capitalists established Silicon Valley as the high-tech hub it has become. But a review of the histories of the region suggests two facts that are little appreciated.
First, the justly celebrated culture of, and approach to, doing business in Silicon Valley was profoundly shaped in the early decades of the 20th century by the region’s firms. The first three decades of the 20th century saw a series of pioneering technology firms established in the Bay Area. While the level of activity was modest relative to contemporary ventures in the eastern United States, these entities established the template that other groups would follow in decades to come. Among the elements that would become commonplace in subsequent years were the active involvement of Stanford University as a source of technology and funding, the proliferation of spin-offs, and the reliance on local financiers for capital.
Second, the public sector, especially the U.S. Department of Defense, played a crucial role in accelerating the early growth of the region. Many of these pioneering firms and entrepreneurs relied on military contracts to get established and grow, such as Federal Telegraph and Magnavox during World War I and the years thereafter; Ralph Heinze‘s work on airplane-based power systems between the world wars; Dalmo-Victor, Hewlett-Packard, and Litton Engineering during World War II; and Varian Associates during the Korean War.
The impact of public funding, to be sure, was considerably less during the Valley’s years of spectacular growth, the late 1970’s and the 1980’s. But in many senses, federal money played a crucial role when it mattered most: during the period when the foundation for that spectacular growth was being built and key aspects of the Silicon Valley business culture were being developed and refined.
Your book focuses on policies to encourage both entrepreneurs and venture capital investors. Why is the venture capital industry so important?
The financing of young and restructuring firms is a risky business. Uncertainty and gaps in information often characterize these firms, particularly in high-technology industries. A lack of information makes it difficult to assess these firms, and permits opportunistic behavior by entrepreneurs after financing is received. To address these information problems, venture investors employ a variety of mechanisms that seem to be critical in boosting innovation. These include the screening process that venture capitalists use to select investment opportunities, the way in which the investments are structured, and the intensive oversight that is provided after the money arrives.
As a result of these tools, an extensive body of academic research suggests venture capital plays an important role in boosting innovation. This assistance has two dimensions: accelerating growth and ensuring long-run success. Venture capitalists not only provide the capital to speed the development of companies, but the evidence suggests that the early participation of venture firms helps innovators sustain their success long after their company goes public and the venture capitalists move on.
Involving venture capitalists has another benefit for public programs: it introduces a layer of “insulation” between the government officials and the entrepreneurs. In this way, the danger of distortions — for instance, those brought about by lobbying and political influence — is minimized, as the public sector is not directly deciding who receives funding.
Why should the government care about encouraging entrepreneurs and venture investors?
This question is timely because of two sets of circumstances.
First, there is a keen awareness on the part of many governments of the need for “green shoots,” high-potential firms that will lead to growth after the recession. The financial crisis opened the door to massive public interventions in the world’s economies in which the government served as venture capitalist, but one that focused on the most troubled and poorly managed firms in the economy, some of which may be beyond salvation. Many nations are now asking the question: if these extraordinary times call for massive public funds to be used for economic interventions, should they be entirely devoted to propping up troubled entities, or at least partially used to promote new enterprises?
Meanwhile, the venture industry in many nations is on “life support” and fighting for survival. The industry has struggled to realize good returns from investments since 2000. Many traditional investors are questioning whether they should continue to provide capital to these funds. Given the important role that venture capital has had in spurring innovation, it is natural to wonder whether there is a public role in ensuring the industry’s survival. Indeed, governments from London to New Delhi have announced venture initiatives in the past few months
Are government interventions to boost entrepreneurship always successful? Why do these programs fail?
Sadly, for every successful effort such as those in Israel and Singapore, there are numerous unsuccessful ones.
There are two well-documented problems that can derail government programs to boost new venture activity. First, they can simply get it wrong: allocating funds and support in an inept or, even worse, a counterproductive manner. Decisions that seem plausible within the halls of a legislative body or a government bureaucracy can be wildly at odds with what entrepreneurs and their backers really need. When Australia legalized the venture capital limited partnership structure earlier this decade, for instance, legislators worried that foreign funds or firms might exploit the favorable tax treatment these entities enjoyed. So they required that each company backed by a venture partnership have at least half its assets in Australia. The venture funds found that this restriction handicapped the companies in their portfolio. The entrepreneurs could not expand their software development activities in India or their manufacturing operations in China without putting the venture funds’ tax status in danger, even as they competed against American ventures that made heavy use of “off-shoring.”
Economists have also focused on a second problem, delineated in the theory of regulatory capture. These writings suggest that private and public sector entities will organize to capture direct and indirect subsidies that the public sector hands out. For instance, programs geared toward boosting nascent entrepreneurs may instead end up boosting cronies of the nation’s rulers or legislators. The annals of government venturing programs abound with examples of efforts that have been hijacked in such a manner.
You write about “The Neglected Art of Setting the Table” i.e. establishing a favorable environment for entrepreneurs. Tell us about the ideal place setting.
Often, in their eagerness to get to the “fun stuff” of handing out money, public leaders neglect the importance of setting the table, or creating a favorable environment. Such efforts to create the right climate for entrepreneurship are likely to have several dimensions. Ensuring that creative ideas can move easily from universities and government laboratories is critically important. However, many entrepreneurs come not from academia, but rather from corporate positions, and studies have documented that, for these individuals, the attractiveness of entrepreneurial activity is very sensitive to tax policy (particularly low capital gains tax rates). Also important is ensuring that the law allows firms to enter into the needed contracts — for instance, with a potential financier or a source of technology — and that these contracts can be enforced.
The government which has taken this imperative the most seriously is undoubtedly Singapore. In addition to creating a favorable business climate more generally, they have launched a wide variety of efforts, ranging from subsidies for leading researchers to move their laboratories to Singapore, efforts to mentor fledgling businesses, and even awards for failed entrepreneurs in the hopes of creating a culture of risk-taking.
The final chapter of your book outlines some guidelines for designing successful policy interventions. What are the most important “rules of thumb” for policymakers hoping to jump-start entrepreneurship and venture capitalism in their countries?
I would highlight five key principles:
- Remember that entrepreneurial activity does not exist in a vacuum: building an environment where new ventures can thrive is a critical first step.
- Be sure to let the market provide direction when distributing subsidies, rather than seeking to stimulate this activity on a “top down” basis.
- Recognize the long lead times these initiatives require.
- Realize that programs to promote entrepreneurship need creativity and flexibility; sometimes they must be refined or killed off.
- Recognize that “agency problems” — when individuals and organizations act to benefit themselves, rather than the broader social good — are universal, and take steps to minimize their danger.
These lessons are important not just for countries where venture activity is nascent, but also for policy-makers in more developed markets. For instance, efforts to boost “cleantech” by Federal and state governments here in the U.S. pose a number of concerns in light of the guidelines above.