Government's Positive Role in Kick-Starting Entrepreneurship

Silicon Valley is the poster child for capitalism, the synergistic geography where smart private money supports cool ideas, creates jobs, boosts national productivity, and provides a handsome return for investors.

Less well understood about the area's development was the role played by the U.S. government in making it a success. "Particularly during the early years, the government played a critical role in shaping Silicon Valley," especially spending and funding from the U.S. Department of Defense, writes HBS professor Josh Lerner in his new book, Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed—and What to Do about It.

Government has played similar catalytic roles in creating hubs of innovation is places such as Tel Aviv and Singapore. Such success stories often get lost against the common perception that government just bungles things when it wades into the private sector.

Lerner's book studies where public efforts to spur entrepreneurial activity have gone right and wrong—there are many more of the latter, the author acknowledges—and offers policy prescriptions to guide government actions in the future.

Sean Silverthorne: Why is this book right for the times?
Josh Lerner: There are two sets of events that make this book particularly timely.

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 these efforts focused on the most troubled and poorly managed firms in the economy, some of which may be beyond salvation. Since many nations believe that these extraordinary times call for massive public funds to be used for economic interventions, shouldn't these efforts be at least partially designed to promote new enterprises?

Second, in many nations the venture industry is on life support, fighting for survival. The industry has struggled to realize good returns from investments since the year 2000. Many traditional investors are questioning whether they should continue to provide capital to these funds. But 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.

Q: Why is there a need for government encouragement of entrepreneurship and VC? Should bureaucrats just get out of the way?
A: Entrepreneurship is a business in which there are increasing returns. To put the point another way, it is far easier to found a start-up if there are 10 other entrepreneurs nearby. In many respects, founders and venture capitalists benefit from their peers.

For instance, if entrepreneurs are already active in the market, then investors, employees, intermediaries such as law firms and data providers, and the wider capital markets are likely to be knowledgeable about the venturing process and the strategies, financing, support, and exit mechanisms that are required. In the activities associated with entrepreneurship and venture capital, the actions of any one group are likely to have positive spillovers—or, in the language of economics, "externalities"—for their peers. It is in these types of settings that the government can often play a very positive role as a catalyst.

This observation is supported by numerous examples of government intervention that has triggered the growth of a venture capital sector. For instance, the Small Business Investment Company [SBIC] program in the United States led to the formation of the infrastructure for much of the modern venture capital industry. Many of the early venture capital funds and leading intermediaries in the industry—such as law firms and data providers—began as organizations oriented to the SBIC funds, and then gradually shifted their focus to independent venture capitalists. Similarly, public programs played an important role in triggering the explosive growth of virtually every other major venture market around the globe.

Yet for every successful public intervention spurring entrepreneurial activity there are many failed efforts, wasting untold billions in taxpayer dollars.

Q: Specifically, what can government add to the potting soil that encourages entrepreneurial growth? Tax breaks? Research? Access? Protection?
A: Policies that governments employ to encourage venture capital and entrepreneurial activity take two broad forms: those that ensure that the economic environment is conducive to entrepreneurial activity and venture capital investments, and those that directly invest in companies and funds.

First, it is necessary to ensure that entrepreneurship itself is an attractive option. 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 from corporate positions, not from academia. Studies have documented that, for these individuals, the attractiveness of entrepreneurial activity is very sensitive to tax policy. 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.

A second important—though very challenging—role for government is to intervene directly in the entrepreneurial process. But these programs must be executed carefully to be effective. Among the key avenues to success are
• Being sure to let the market provide direction when offering subsidies to stimulate entrepreneurial and venture activity.
• Understanding the need for, and active encouragement of, strong interconnections with entrepreneurs and investors overseas, rather than solely focusing on domestic activity.
• Recognizing that the temptation for individuals and organizations to take steps that benefit themselves, rather than the broader social good, is universal and minimizing that danger.

Q: When governments do attempt to spur venture capital and entrepreneurial growth, where are they most likely to get it wrong?
A: Two well-documented problems 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, 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.
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.

Q: You devote a chapter to sovereign wealth funds, which I know are a research interest of yours. Are these a promising source of public support for entrepreneurial efforts?
A: In the book I consider a special, but highly visible, manifestation of the government as entrepreneur: the sovereign wealth fund. A sovereign fund can be defined as a state-owned fund that invests in various financial assets. These institutions have been experiencing remarkable growth, and an even greater increase in scrutiny from business and political leaders worldwide.

Sovereign funds can spur entrepreneurial activity due to their abundant capital resources and long-term outlook. To be sure, this is not easy: Many of the challenges facing sovereign wealth funds are similar to those encountered in the other public venture capital and entrepreneurial promotion schemes that I've summarized above. But these organizations must struggle as well with added issues, which make the effective leadership of sovereign funds especially challenging.

First, these organizations face political scrutiny, particularly in Europe and the United States. One might assume that sovereign funds, which have been part of the economic landscape for more than half a century, are too familiar to cause worry. But the rapid growth of these funds in recent years and their role in a few high-profile transactions have called attention to them and inflamed public anxieties.
Careful scrutiny suggests that many of the criticisms of sovereign funds have been misleading, but even these problematic perceptions can make performing their roles difficult.

The second major challenge relates to the need to generate good returns on investments. Groups, particularly the larger ones, must struggle with the cruel mathematics of size. Strategies that may be attractive for a small capital pool become much more difficult to implement with more capital under management. This problem is most acute when investing in entrepreneurial projects and private equity, on which many sovereign funds have increasingly focused.

Q: Let's put you on the spot. How is the Obama administration doing in boosting entrepreneurship?
A: The administration appears to have a keen understanding of the importance of research and innovation. To the extent that it follows through on the promise to create a more favorable environment for entrepreneurship—by using steps such as increased public funding for basic research, eased restrictions on immigration by high-skilled scientists and engineers, and a streamlined patent system—it is likely to translate into a better environment for high-potential entrepreneurs.

In other respects, the track record is not so good. As we've discussed, one of the most common fates of programs to stimulate high-technology ventures is capture. Funds end up getting distributed in ways that have little to do with the needs of high-potential ventures or society more generally, but rather by the whims of the powerful and well-connected. From the empty BioValley complex in Malaysia to the repeated U.S. Small Business Innovation Research grants to Beltway "mills" that produce few real innovations, this pattern is depressingly familiar.

Successful programs, by way of contrast, have clear, well-defined investment processes. They limit the danger of political influence by establishing independent bodies to oversee the programs. In many cases, they have further reduced capture problems by passing the funds onto intermediaries such as venture capital funds that make the real investment decisions. By keeping individual awards relatively modest, they limit efforts to misdirect these funds.

Unfortunately, the funding of clean tech innovation under the stimulus program has been characterized by a lack of clarity and consistency. In this uncertain environment, it is not surprising that entrepreneurs have responded in the old-fashioned Washington way: by hiring lobbyists. The big winner of the Department of Energy's battery funding orgy, A123 Systems (with $249 million in awards), spent about $1 million on Washington representatives between 2007 and early 2009. A partner at leading venture capitalist New Enterprise Associates suggests that at least half of the 25 clean tech firms in its portfolio have hired lobbyists. This does not seem like the ideal way to boost entrepreneurial innovation.

Q: Is there more research to be done in this area?
A: Sadly, the academic literature in this area is comparatively sparse. Economists have turned only recently to the question of how to boost entrepreneurship. In contrast to other government interventions designed to boost economic growth, such as privatization, programs to promote entrepreneurship have received little scrutiny by economists. Not only are the theoretical foundations much less well developed, but empirical studies are much fewer in number and generally less sophisticated. While related issues—such as the impact of research and development subsidies—have attracted more attention, definitive answers are scarce even among these better-researched topics.

Thus there is a substantial opportunity for further research into these questions that work over the next few years will hopefully begin to address. At the same time, these problems are complex and unlikely to yield easy answers. Policymakers face the challenge of having to consider many different options. It is often unclear how proposed changes will interact with each other. Furthermore, there is no clear "instruction manual" that explains which changes will have the desired effects, and academic research is unlikely to quickly develop one.

Q: What are you working on now?
A: I am working on a variety of related questions. First, venture capital's "big brother"—private equity or buyout funds—are attracting increasing scrutiny as regulators seek to prevent another potential economic meltdown. We are trying to understand the extent to which private equity contributes to the economic volatility, or "systemic risk," in the economy.

Another project is looking at the very smallest of investors in young firms: angels or individual investors. These investors are frequently hailed as a crucial component of the innovation system, but the choices behind and consequences of angel investments are poorly understood.

 

[This article was provided with permission from Harvard Business School Working Knowledge.]