SSTI Review: Poorly Titled Boulevard Paves Road to Better Equity Programs

The fox pattern on his tie playfully conveyed Josh Lerner knew exactly where he stood as he looked out over the standing-room-only ballroom that served as the henhouse for SSTI’s annual conference two weeks ago. The audience, comprised mostly of practitioners from state, local, nonprofit and university-based TBED organizations, played its role as hens well – some nervous, some angry, all in fidgety anticipation of what the Harvard Professor was likely to say. SSTI fielded several questions before the conference as to why Lerner was invited as a plenary speaker based on apprehension from the title alone of his new book, Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed – and What to Do About It. As the book had just hit the streets the week before, we were all about to find out.

The resulting 90-minute session – with the sometimes-heated give and take among the audience, Lerner and ITIF Founder/CEO Rob Atkinson, who was invited to provide an oral review of the book following Lerner’s presentation – was one of several highlights from this year’s conference. More importantly, it was an unprecedented and critically timed event for charting the future of public equity initiatives.

It should be noted up front that Boulevard, whose poorly chosen subtitle is meant to be provocative but likely may drive away more sales than it generates, contains many nuggets that should be useful for public equity initiatives. Unfortunately, in a world where all discussion about policy is framed increasingly within the Twitter-delimited constraint of 140 characters, the subtitle announces a conclusion that isn’t supported by the 200 pages inside the book. More importantly it discourages meaningful discourse on the topic by its confrontational stance. The useful nuggets, as a result, could be forever separated from a significant portion of its intended market – state and regional policy makers and public equity program administrators.

The quickest solution is to lose the book jacket before even opening your hardcover copy of Boulevard (the title on the spine leaves off the unsupported subtitle). Barring that, this column is intended to point out some chosen morsels, either to help with the design or redesign of some activities or, as is more likely the case based on the public equity programs and policies with which SSTI is most familiar, to offer validation for your stakeholders that your initiatives are on the right course.

Note: all page numbers in parentheses below refer to quote locations within Boulevard. Also, bracketed inserts within quotes are added by SSTI, not the author.

Lessons for Legislators – the Argument for Public Involvement

• Public intervention to nurture and support new tech firms makes sense because (Chapter 3, pp 43-64):
  • “The link between innovation and growth is well established.” (p. 63)
  • “There is a powerful link between innovation and new firms.” (p. 63)
  • “Venture capital clearly serves as an important source industry for innovation.” (p. 64)

• Another argument for public intervention: “By its very nature, entrepreneurship is an activity that feeds on itself, which means that a public ‘jump start’ may well be helpful.” (p. 65)
  • Because of the beneficial spillovers to society from the success of innovation-based firms, “government may have an important role in priming the pump for additional entrepreneurial and venture capital activity during the industry’s inception.” (p. 68)

• A third argument for public intervention lies in government’s “ability to provide a stamp of approval”, or by providing a certifying effect. (pp. 69-70)
  • Because venture capital only invests in a tiny, but important, fraction of technology-oriented firms that are highly concentrated in certain sectors, “many promising firms in other industries are not attracting venture capitalists notice… If government programs can identify and support these neglected firms, they might provide the stamp of approval these high potential, underfunded firms need to succeed” (p. 70)
  • The stamp of approval “provided by government awards are likely to be particularly valuable in technology-intensive industries where traditional financial measures fall short.” (p. 71)

• The fourth rationale Lerner offers is the wide and significant types of knowledge spillovers associated with innovation. “In many instances, firms pursuing an innovation get fewer benefits than society as a whole. As a result, left to their own devices, companies will do less research than desirable. But with government subsidies, firms may be encouraged to invest the socially ideal amount of funds in R&D.” (p. 72)

But…
Lerner then lays out a case against government intervention. Sadly, this is where the book misses an important opportunity to be a standard bearer or manual for effective public equity policy.

The anti-argument boils down to a distrust of any government’s ability to enact and implement sound public policy to support entrepreneurship and venture capital. Not that the public sector shouldn’t be involved as Lerner laid out above, but that, based on a handful of anecdotal examples drawn from across the globe, the leap is made that no one can get it right. So the book’s subtitle is borne from the unsubstantiated generalizations made in Chapter 4 that all public equity programs will fail because some have suffered from incompetence or capture (an economist’s term for political cronyism and favoritism).

Despite this condemnation of government’s ability to do anything right, Lerner provides the reader with considerable passages elucidating the opposite stance – that public intervention can effectively support innovation and entrepreneurship if fashioned appropriately and implemented judiciously.

In fact, he goes so far as to advise politicians and public officials: “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.” (p. 112)

More Lessons for Legislators – Appropriate Public Involvement

• Create a favorable environment to support and sustain entrepreneurship first – innovation-based entrepreneurship “doesn’t happen in a vacuum” (p. 181):
  • “Ensuring that creative ideas can move easily from universities and government laboratories is critically important (p. 12, 182)
  • For entrepreneurs coming out of a corporate environment, “the attractiveness of entrepreneurial activity is very sensitive to tax policy.” (p. 12)
  • “Creating training opportunities in entrepreneurship for midcareer professionals is also likely to pay dividends.” (p. 12)

• Have patience. “Building a venture capital industry is a long-run investment, which takes many years until tangible effects are realized.” (p. 112)
  • “No matter how promising the returns of entrepreneurial activity ultimately are, in a venture market’s early years, low returns are likely.” (p. 69)
  • Building a vibrant entrepreneurial sector “is not a process that can be accomplished in a few years.” (p. 112)
  • “A short-term outlook is fundamentally at odds with what we know about the entrepreneurial process.” (p. 116) It’s a “kiss of death.” (p. 117)

• Set realistic expectations, recognizing returns on investments or monetary payback are not the best measure of success for a public program: “in many cases, government officials proceed under the assumption that [financial] success is the typical outcome.” (p. 78)

• Scale investments appropriately: “reasonable programs have been too tiny to have an impact” (p. 13) but avoid being “so large that they swamp” the existing local private equity market and replace private investment with public dollars. (p. 124)
  • “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” (p. 117) so either set expectation appropriately or strive to make a more significant investment in the effort.

• Do not over-legislate by defining too closely program activities and structure in enabling or authorizing legislation.
  • “Realize that the programs to promote entrepreneurship need creativity and flexibility” to adapt to the needs of individual firms and market fluctuations. (p. 17)
  • “In short, public venture capital initiatives should not be hobbled by excessive regulation.” (p. 128)

• Do not require funds to be spent within a certain time limit or certain geographic areas to discourage the need to invest in inferior opportunities out of necessity to draw down funding. (p. 120)

• Minimize opportunities for individuals, organizations, political parties, and industry sectors to use the program to benefit themselves, rather than supporting broader social goals. Build in transparency, accountability, and impartiality to program design, service delivery and evaluation. (p. 17)

• Do not require programs to become self-sustaining, evergreen or profitable as that is likely to distort or skew the program’s activities and interests away from the social goals and toward survival (leading to “capture” problems Lerner cites on pp 83-84). Instead reward performance along predefined societal goals. (p. 85)
  • If the goal is to address failures in early-stage VC markets, then requiring programs to become profitable or evergreen is “quite out of line with the fund’s ultimate objectives.” (p. 116) Early-stage investments are particularly vulnerable to intensely cyclical periods of boom and bust. (p. 117)

• Avoid “mandates to local institutional investors [such as public university endowments and public pension funds] to make larger allocations to venture capital, regardless of the nature of the opportunities.” (p. 17)

• Avoid substantial up-front tax incentives for investments [for example, most CAPCO models – p. 141], which can introduce distorted incentives.” (p. 17, 189)

• Avoid bringing “in hired guns with poor incentives… Several reasons this decision [to bring in outside investment firm to manage the initiative] will probably be unproductive:
  • These intermediaries frequently charge substantial fees…
  • The investments by the intermediary may not be driven by the local government’s priorities.” (p. 190)

Lessons for Program Designers

• For equity investment programs, require “credible private sector players provide matching funds.” (p. 13)
• “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.” (p. 184)
• Just as private investors do, build in performance incentives for public program participants [e.g., service deliverers, investment managers as well as portfolio companies] to access cash distributions so that they do not “do well [financially] even if the companies go belly-up.” (p. 14, 138)
• Allow program rules to evolve, “even if important classes of participants are thereby eliminated.” (p. 187)
• Stick to clearly articulately strategies and procedures for venture initiatives, “creating a firewall between elected officials and program administrators.” (p. 187)
• Foster and sustain connections between firms and funds: “Venture capital is a true ‘people business’ where personal connections are critical to overcoming the very substantial information gaps that surround these risky investments.” (p. 107)
• Evaluate program effectiveness at two levels: at the program level and at the individual fund manager and portfolio company level. (pp. 142-145, 186)
• Recognize the need to build a local entrepreneurial sector and venture capital industry with strong global ties.” Not having an international perspective “is a recipe for” irrelevance and failure. Encourage international participation. (p. 154-158)
• “Make education part of the initiative, including that of overseas investors, local entrepreneurs, and the public sector.” (p. 17)
• “Avoid a reliance on financial intermediaries to manage these programs, since they are likely to have different incentives.” (p. 17