THE BOULEVARD OF BROKEN DREAMS: GOVERNMENT AND THE PROMOTION OF ENTREPRENEURSHIP AND VENTURE CAPITAL Josh Lerner Harvard Business School
LEGACY OF THE CRISIS Massive public intervention in failing firms. Fiscal pressures from commitments. Desperate need for economic growth. A global story.
DESPERATE NEED FOR “GREEN SHOOTS”
BUT ENTREPRENEURSHIP GROWTH ENGINES SPUTTERING Poor venture returns since 2000 boom. Even more pronounced drought elsewhere. Linked to difficulties in exiting investments. Downturn in venture activity world-wide since crisis. Concerns of wide-spread disillusionment of investors.
DISTRIBUTED/PAID-IN CAPITAL, BY VINTAGE YEAR, U.S. VC FUNDS 1997 is last year with >1 median and mean ratio Source: Thomson/Reuters. Data as of 9/30/08.
U.S. VENTURE CAPITAL RETURNS Source: Author's analysis of Thomson/Reuters data 175% 150% 125% 100% 75% 50% 25% 0% -25% -50% 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
RETURNS BEFORE AND AFTER Vintage Vintage Years: Years: 1990-98 1999-2005 U.S. 37% 0% Europe 8% -5% Source: Thomson/Reuters. Data as of 12/31/08. Numbers are capital-weighted average IRRs,
INVESTMENTS BY VENTURE FUNDS ($B) Source: Sand Hill Econometrics
EXITS BY VENTURE FUNDS ($B) Source: Sand Hill Econometrics
WHY SHOULD THE PUBLIC SECTOR CARE? Entrepreneurial firms unlikely to be “systematically important.” Venture capital is still very young: First fund in 1946. Venture capital is still very small: In largest market, U.S.: Only about 4000 professionals. Average of 1,500 companies funded for first time annually, 2000- 2008. Relative to 1 million businesses started annually. Considerably less elsewhere.
Investment Amount (in 2007 US$ billion) 100 120 140 160 20 40 60 80 0 Venture Capital Investment Worldwide 1992 ~ 2007 1992 1993 1994 1995 1996 1997 1998 1999 Year 2000 2001 2002 2003 2004 2005 2006 2007 USA Europe Asia Canada Israel
Percentage 0.00% 0.05% 0.10% 0.15% 0.20% 0.25% 0.30% 0.35% 0.40% 0.45% Australia Austria Belgium Canada China Czech Republic Denmark Finland France Germany Ratio of Venture Capital Investment to GDP, 2007 Greece Hong Kong Hungary India Indonesia Ireland Israel Country Italy Japan Malaysia New Zealand Norway Philippines Poland Portugal Romania Singapore South Korea Spain Sweden Switzerland Taiwan Thailand The Netherlands United Kingdom United States Vietnam
BUT IMPORTANCE FAR BEYOND ITS SIZE Young high-tech and restructuring firms pose many challenges: Uncertainty. Information gaps. The nature of the firm’s assets. Market conditions. Difficult for traditional financiers to fund these firms: Banks. Public markets.
“I realize, gen “I realize, gentlemen, that thirty millio lemen, that thirty million dollars is a lot of money n dollars is a lot of money to spend. to spend. However, However, it’s not it’s not real money and, of real money and, of course, it’s not our money either.” course, it’s not our money either.”
GENERAL DORIOT’S INSIGHT A new organization could address with three key mechanisms: Sorting: picking the right entrepreneurs. Controlling: limiting “agency” problems, through a mixture of incentives and monitoring. Certifying: developing a tradition of quality and fair dealings. Hard for banks and others to duplicate…
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VENTURE CAPITAL HAS HAD A PROFOUND IMPACT Between 1972 to 2007, ~2500 venture-backed firms went public in U.S.: 13% of all public firms at end of 2008. 8% of market capitalization ($2.0 trillion). 6% of total employees. Particularly true in high-technology industries.
MORE SYSTEMATIC EVIDENCE We explore frequent claim: Venture capital spurs technological innovation, among both the firms receiving the financing and entire sectors. Look at evidence across 20 industries, using patenting and other proxies for innovation: Also control for corporate R&D, etc. Kortum and Lerner, “Assessing the Impact of Venture Capital on Innovation,” Rand Journal of Economics , Winter 2000.
WHAT THE REGRESSIONS TELL US Venture capital appears ~3 to 4 times more powerful than corporate R&D. Even after control for causality concerns. From late 70s to mid-90s, VC was only 3% of corporate R&D, but responsible for ~10%-12% of privately funded innovations. Potentially even greater influence in more recent years. Similar evidence in parallel studies.
WHY A GOVERNMENT ROLE? Increasing returns to scale Much easier to do 100 th deal than the first: Knowledge and expectations of entrepreneurs. Familiarity of intermediaries. Sharing of information among peers. Comfort level of institutional investors. Economists term these “externalities.” In these cases, government can frequently play a catalytic role.
ILLUSTRATIONS FROM HISTORY In the U.S.: Critical role of SBIC program. Established in 1958. Many early VC firms started as SBIC awardees, then opted out. Building critical “infrastructure”: Lawyers, data providers, etc . Similar insights from Israel, Singapore, etc . Suggests that some of funding should be directed to growing industries!
MANY RECENT EXAMPLES
TWO FUNDAMENTAL PROBLEMS Incompetence: Often, relatively little familiarity with worlds of entrepreneurship and venture capital. Many well-intentioned efforts are poorly executed. “Capture”: Public efforts can be directed to well-connected parties, who seek to benefit themselves.
THE BRITTANY MISADVENTURE Building a high-technology cluster in Brittany: Response to decline in shipbuilding activity in 1990s. Sought to build local Silicon Valley in response… despite lack of high-tech tradition. Focus of public spending was building broad-band network, training programs. Spending benefited France Telecom, local universities, but little entrepreneurship,
THE IOWA MISADVENTURE Sought to encourage venture activity in early 1990s by earmarking part of state pension fund. Issued RFP for local fund and waited for responses: Ended up selecting lightly-regarded group with no experience in region. Despite hefty management fees, fund had hard time finding deals. State sought to terminate fund: VCs ended up suing state for fees and profits would have made, could they find deals!
U.S. PRIVATE EQUITY FUND RETURNS Returns of 1927 funds from inception to 12/31/08. Source: Venture Economics.
THE BITS MISADVENTURE Sought to promote incubators to help young entrepreneurs: Largely funded from government’s stake in Telstra privatization. But at typical incubator, >50% of funding went to incubator managers, not entrepreneurs. In fact, managers even hindered firm progress: Forcing them to use in-house service providers, even if less qualified. Charging above market rates. For basic services Deficiencies eventually remedied.
BUT Undoubted growth in entrepreneurship in many regions: China. Israel Singapore. Taiwan. Aggressive government policy in all these markets… And undoubtedly had much to do with growth.
THREE KEY PRINCIPLES Making sure table is set. Ensuring effective design by listening to the market. Avoiding self-defeating design errors.
“STAGE SETTING” Ensuring entrepreneurship is attractive: Tax regime: Studies suggest critical role of capital gains vs. income effective tax rate differential. Easing formal and informal sanctions on involvement in failed ventures. Singapore’s Phoenix award. Easing barriers to technology transfer. Entrepreneurship education for students and professionals alike.
UNDERSTANDING THE MARKET Need to listen to market’s dictates: “Field of dreams” danger. Universal temptation to “share the wealth”: Spreading funds out. Matching funds most appropriate way to ensure.
SIDEBAR: SOME SUPPORTING EVIDENCE VCs provide more than risk capital so need to visit their investments Monitoring, coaching and interaction benefit from personal interaction Claims of strong localization effects have led to numerous efforts to build VC hubs by policymakers. “Finding ways to nurture the culture of entrepreneurs and the capital that feeds them must be the top priority of states” - National Governors Association (2001)
DATA • Pratt’s Guide to Private Equity and Venture Capital Sources – Global information on focus, size, contact information of private equity firms collected through annual survey by Venture Economics (now part of Thomson) – Office locations of VC firms (we focus on US) starting in 1975 • Thomson’s VentureXpert – Dates of venture financings, investors, amounts and outcomes • Matched 2,039 VC firms (75% of VentureXpert firms with 5+ investments) – Unmatched firms are mostly foreign, corporate VCs and banks – 14,006 companies and 28,434 investments
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