Seeding Entrepreneurship: How to Build a Venture-Finance Ecosystem
[Editor’s note: Cross-posted from The Economist, 11/2/11]
New York Mayor-entrepreneur Michael Bloomberg, not known for shyness, recently proclaimed New York City as America’s new entrepreneurship capital, roaring past Boston in venture capital and soon to leave Silicon Valley in the dust as the “go to” destination for entrepreneurs. Indeed, the world media are awash with proposals to kick start entrepreneurship as a strategy for economic revival, with support for venture finance at the heart of many programs. Yet the title of Harvard’s Josh Lerner’s recent book, “Boulevard of Broken Dreams,” is no coincidence, because proclamations are one thing, actual success is quite another.
Fortunately, there is a lot of experience around the world about what works and what doesn’t. Here are some practical principles that the Babson Entrepreneurship Ecosystem Project have been identifying and developing for public leaders who have, correctly in my opinion, identified entrepreneurship as an essential plank in economic policy.
1. Be clear that the objective is to foster an entrepreneurial finance ecosystem, not to directly provide capital to entrepreneurs. Over time, a healthy entrepreneurship ecosystem makes available capital to ventures that deserve it, while denying it to ventures that do not. This does not mean that governments need to revert to selecting the deserving. This idea has regained currency recently, but we learn time and again (Solyndra anyone?) that it does not work. It does mean that the availability of capital, and other resources, needs to be part of a natural process in which the ecosystem elements—in this case, deal flow and capital—continually evolve and adjust to each other, a concept that is consistent with Smith’s “invisible hand.” But the concept goes further by suggesting that enlightened and skillful leadership can play a critical role in encouraging the evolution of a self-sustaining ecosystem, but leaders have to understand how and when to get in, and how and when to get out.
2. Stimulate financing, but stay off of ventures’ balance sheets. Presence of government and government-owned entities as direct debt or equity holders of ventures should be a red flag. The only reason government should be on a venture’s balance sheet is in the rare case when it is absolutely necessary to entice private, profit-oriented entities to get involved as the natural selector of investment targets, and in those cases, government should have a clear plan to get out. Governments can, as have Israel, Finland and some other countries, provide smart, off-balance sheet funding in the form of repayable grants, matching grants and so forth. But presence on ventures’ balance sheets ultimately leads to a conflict of interest between governments’ social priorities and obligations, and the need to provide a positive return to invested capital. Overall, there is evidence that a moderate amount of this kind of financing can be beneficial, but as it gets to be too great, the benefits rapidly turn into liabilities.
3. Make sunset clauses for financial support programs the rule, not the exception. Permanent, or evergreen programs of government-supported venture capital, loan guarantees, startup grants, angel tax credits and so on, risk becoming white elephants and/or political assets, not economic ones, and in the process risk squandering public funds. Sunset clauses, or “sell-by dates,” help focus policy-implementation programs on (a) achieving results, and (b) creating self-sustainability by building capacity and mutually reinforcing systems (for example, by showing private sector players that they can actually make profits.)
4. “Pulse” incentives to foster discovery. An implication of sunset clauses, in general, is that if providers and consumers of risky capital can “discover” that it is profitable to engage, then they will accelerate self-interested behavior when the “visible hand” is removed. Seeing if providers and consumers of entrepreneurial capital “discover” the correct pricing mechanisms to allow them to engage in a profit-seeking transaction is one test as to whether the problem is really a market failure or not, and is not just an excuse for hiding behind the “market failure” mantra to gain political power. If governments are serious in judiciously using public resources to address a market failure, they should welcome such discoveries.
5. Subject financial support programs to the market test. When Yozma, the successful 1990s Israeli venture fund of funds, gave the private managing partners the option to buy out government’s stake in each fund at an agreed upon annual return, Yozma not only recouped the government’s investment (with about a 50 percent gain); more importantly it proved that it had permanently stimulated something of demonstrable value. This was a powerful signal to other potential venture investors that there was money to be made. Requiring matching funds by equity providers, royalty-based grant paybacks, and outright sale of government’s stake, are all ways to responsibly use public funds by testing them in the market place of profit-seeking investors.
6. Regulate-in easy failure, the quicker the better. To risk using an analogy, one of the major recent biological discoveries is how essential protein death is to protein synthesis and life, because the protein components get recycled and reused. Similarly, venture failure allows people, ideas, and capital to be recycled and applied more productively, IF there is an ecosystem that fosters this natural selection. As I have written in the Harvard Business Review, bankruptcy laws, transferring unemployment protection to unemployment insurance as Denmark has done, and credit reform all make it easier for entrepreneurship ecosystems to naturally dispose of their own “toxic assets.”
7. Build venture “chimneys,” not silos. The regulatory support of failure makes it much easier for entrepreneurs to take risk: Paradoxically, easy exit actually is a powerful stimulant for easy entrance. This circulation of entrepreneurial assets, which I liken to that of a chimney, also helps create and sustain the blaze of entrepreneurship.
Of course, there is no panacea—constant stakeholder dialog is essential, experimentation is necessary, learning from mistakes is necessary. It is not necessary to get things perfect, and it is very possible that from time to time, conscious violation of one or more of these principles might work because of other mitigating factors. But there is no substitute for having an appropriate set of policy guidelines.