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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

• 50%
• 25%

0% 25% 50% 75% 100% 125% 150% 175%

1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 Source: Author's analysis of Thomson/Reuters data

RETURNS BEFORE AND AFTER

Vintage Years: 1990-98 Vintage Years: 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.

Venture Capital Investment Worldwide 1992 ~ 2007

20 40 60 80 100 120 140 160 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year Investment Amount (in 2007 US$ billion) Israel Canada Asia Europe USA

Ratio of Venture Capital Investment to GDP, 2007

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 Greece Hong Kong Hungary India Indonesia Ireland Israel 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 Country Percentage

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…

18

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%

• f 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 100th 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

• pted 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

KEY VARIABLES

• Location – Defined as Combined Statistical Area (CSA)
• Main office – Location of first office of VC firm
• Outcome – success if company went public
• Macroeconomic variables

– GSP per capita, % of population with college degree, patents per capita – Capital gains tax rate, income tax rate

• Outcome controls

– VC firm quality – VC firm experience – Investment characteristics – Year, stage (round), location, industry

U.S. VCS ARE CONCENTRATED IN 3 CITIES

• San Francisco + NYC + Boston > 50%

1985 1995 2005 1985 1995 2005 San Jose-San Francisco, CA - Main Offices 65 97 230 15.0% 15.9% 21.6% San Jose-San Francisco, CA - Branch Offices 17 36 33 4.0% 6.7% 2.8% New York, NY -Main Offices 91 96 196 21.4% 15.7% 18.4% New York, NY - Branch Offices 4 13 14 0.4% 1.7% 1.2% Boston, MA -Main Offices 44 52 83 10.1% 9.3% 7.4% Boston, MA - Branch Offices 5 13 10 0.9% 2.1% 1.1% Washington, DC -Main Offices 12 17 51 3.1% 2.4% 4.8% Washington, DC - Branch Offices 5 7 0.0% 0.7% 0.5% Chicago, IL -Main Offices 13 26 35 2.9% 4.5% 3.3% Chicago, IL - Branch Offices 1 6 2 0.2% 1.2% 0.2% Dallas, TX -Main Offices 11 12 34 4.8% 2.8% 3.1% Dallas, TX - Branch Offices 6 5 5 0.2% 1.2% 0.3% Other - Main Offices 149 173 358 32.6% 27.5% 30.9% Other - Branch Offices 19 49 51 4.4% 8.1% 4.4% Total Main Offices 385 473 987 88.1% 78.8% 89.0% Total Branch Offices 52 127 122 11.9% 21.2% 11.0% CSA Year Share of Offices

VC-BACKED COMPANIES ARE SIMILARLY CONCENTRATED

• San Francisco + NYC + Boston ≈ 50%

CSA Number % Share of Total Main Office Branch Office Outside San Jose-San Francisco, CA 4,063 29.01 56.55 16.40 27.04 Boston, MA 1,634 11.67 42.34 8.07 49.59 New York, NY 1,224 8.74 47.94 2.37 49.69 Los Angeles, CA 851 6.08 11.93 2.53 85.54 Washington, DC 584 4.17 20.96 6.37 72.67 San Diego, CA 494 3.53 6.71 3.75 89.55 Dallas, TX 411 2.93 17.04 9.25 73.71 Seattle, WA 383 2.73 17.40 0.25 82.35 Denver, CO 369 2.63 22.68 0.55 76.78 Atlanta, GA 348 2.48 20.50 0.33 79.17 Chicago, IL 303 2.16 30.70 0.85 68.44 Philadelphia, PA 302 2.16 12.91 2.00 85.09 Other 3,040 21.70 16.41 1.19 82.40 Total 14,006 100.00 35.63 7.83 56.54 Portfolio Company Location VC firm office

SUMMARY STATISTICS

• Firms tend to invest locally

Measure N Mean Median S.D. P25 Unit of observation Opened a branch office in CSA 42,032 0.0042 0.0000 0.0648 0.0000 Firm-Year-CSA Local bias 42,032 5.7907 1.9320 18.5012 0.9783 Firm-Year-CSA Percentage of firm's deals in CSA, past five years 42,032 0.0894 0.0556 0.1076 0.0303 Firm-Year-CSA Percentage of all deals in CSA, past five years 42,032 0.0526 0.0259 0.0718 0.0128 Firm-Year-CSA VC's success rate in CSA, past five years 42,032 0.1857 0.0000 0.0760 0.0000 Firm-Year-CSA Success rate of all VCs in CSA, past five years 42,032 0.1452 0.1307 0.0760 0.0825 Firm-Year-CSA VC firm experience 7,328 48.7690 25.0000 68.6850 13.0000 Firm-Year Firm's industry diversification, past five years 7,328 0.4376 0.3750 0.2172 0.2800 Firm-Year Size of firm, number of partners, prior year 7,328 3.4425 3.0000 3.6964 1.0000 Firm-Year Firm based in San Francisco/Silicon Valley 7,328 0.2403 0.0000 0.4273 0.0000 Firm-Year Firm based in Boston 7,328 0.1288 0.0000 0.3350 0.0000 Firm-Year Firm based in New York City 7,328 0.0797 0.0000 0.2708 0.0000 Firm-Year Firm-Year-CSA controls Firm-Year controls

CHARACTERISTICS OF VC LOCATIONS (TABLE III)

• Areas with past-VC-backed success have the most
• ffices

[1] [3] [5] 3.7140 1.9440 0.6100 [5.52]*** [5.02]*** [3.57]*** 1.4820 0.7380 0.2070 [3.36]*** [2.61]*** [1.75]* 0.0170 0.0210 0.0140 [0.65] [1.53] [2.09]** 0.3390 0.1650 0.0540 [2.62]*** [2.23]** [1.71]* 0.1660 0.5140 0.5820 [0.06] [0.29] [0.61] Includes year dummies Yes Yes Yes Observations 2,256 2,256 2,256 R-squared 0.29 0.29 0.13 Log GSP per Capita OLS OLS OLS Percent of population with college degree or higher Log patents per capita State long-term capital gains tax rate Log Number of Offices in year Log Number of Main Offices in year Log Number of Branch Offices in year Success rate of all previous VC investments in CSA

CHARACTERISTICS OF VC BACKED COMPANY LOCATIONS (TABLE VII)

• Number of VC firms is significant

1.8 additional companies [1] [3] [5] [7] 0.7400 0.6960 [14.43]*** [18.90]*** 1.1100 1.1480 3.4170 3.1570 [6.85]*** [7.21]*** [6.89]*** [7.01]***

• 0.3060
• 0.2810

0.7760 0.6730 [2.02]** [1.84]* [2.14]** [1.91]* 0.0380 0.0390 0.0500 0.0520 [3.98]*** [3.98]*** [2.04]** [2.08]**

• 0.0250
• 0.0280

0.2320 0.1850 [0.58] [0.64] [2.08]** [1.78]* 0.3440

• 0.4010

0.5900

• 1.3800

[0.23] [0.29] [0.19] [0.55] 1.2420 3.2170 [7.31]*** [16.05]*** Year fixed effects Yes Yes Yes Yes Observations 2,256 2,256 2,256 2,256 R-squared 0.74 0.75 0.32 0.42 Percent of population with college degree or higher Log patents per capita State long-term capital gains tax rate CSA is San Francisco/San Jose Log Number of Portfolio Companies receiving initial investment in year OLS Log Number of VC firms in CSA Success rate of all VCs in CSA, past five years Log GSP per Capita

DOES LOCATION AFFECT OUTCOME? (TABLE VIII)

• Elite city-based VCs outperform

Companies outside Elite Cities: Main Office Investment Success Rate 0.154 0.115 *** 0.154

• 0.115

% Deals 41.31 21.55 64.92

• 33.04

Branch Office Investment Success Rate 0.212 0.152 *** 0.225 0.160 *** 0.151 0.124 % Deals 10.20 17.41 13.11 38.13 5.11 6.36 Outside Investment Success Rate 0.193 0.137 *** 0.197 0.131 *** 0.192 0.140 *** % Deals 48.50 61.04 21.98 61.87 94.89 60.60 All Deals Success Rate 0.179 0.135 *** 0.173 0.142 *** 0.190 0.131 *** Number 18,888 9,546 12,018 3,320 6,870 6,226 All Other Elite city based VC Companies in Elite Cities: Elite city based VC All Other Elite city based VC All Other All investments:

SUMMARY STATISTICS II (TABLE IX)

• Outside investments outperform

Variable mean s.d. mean s.d. mean s.d. mean s.d. Success Rates Success 0.145 0.352 0.176 0.381 0.175 0.380 0.164 0.370 Firm Characteristics Adjusted VC firm experience 0.475 1.106 0.938 0.972 0.418 1.113 0.484 1.112 Venture Capital Firm based in Elite City 0.793 0.405 0.575 0.494 0.604 0.489 0.664 0.472 Investment Characteristics Stage Initial investment in first round 0.566 0.496 0.445 0.497 0.479 0.500 0.507 0.500 Initial investment in second round 0.186 0.389 0.211 0.408 0.189 0.392 0.190 0.392 Initial investment in third round 0.099 0.298 0.147 0.354 0.119 0.324 0.114 0.318 Initial investment in fourth round or later 0.131 0.337 0.180 0.384 0.188 0.390 0.167 0.373 Industry Computers and Internet 0.504 0.500 0.466 0.499 0.420 0.493 0.453 0.498 Communications 0.184 0.387 0.235 0.424 0.162 0.369 0.176 0.380 Business and Industrial 0.018 0.132 0.016 0.126 0.021 0.144 0.020 0.139 Consumer 0.047 0.211 0.031 0.173 0.059 0.236 0.053 0.223 Energy 0.038 0.191 0.036 0.187 0.043 0.204 0.041 0.198 Biotech and Health Care 0.170 0.376 0.176 0.381 0.244 0.429 0.213 0.409 Financial Services 0.018 0.134 0.021 0.142 0.024 0.153 0.022 0.146 Business Services 0.012 0.109 0.011 0.103 0.015 0.122 0.014 0.116 Other 0.009 0.097 0.009 0.092 0.011 0.106 0.010 0.102 Number of Observations 28,434 Investment Type Overall mean [1] Main Office [2] Branch Office [3] Outside 9,948 2,227 16,076

WHAT DRIVES SUCCESS I? (TABLE X)

• Outside investments outperform

[1] [2] 0.0221 0.0222 [4.44]*** [4.44]*** 0.0231 0.0232 [2.74]*** [2.75]*** 0.0099 0.0091 [4.99]*** [2.52]** 0.0313 0.0311 [6.80]*** [6.66]*** 0.0012 [0.29] Includes year controls Yes Yes Includes round controls Yes Yes Includes portfolio company location controls Yes Yes Includes industry controls Yes Yes Observations 28,434 28,434 VC based in Elite City VC based in Elite City * Adjusted VC Firm Experience Success, IPO Probit Portfolio company outside VC's office CSAs Portfolio company in CSA of VC's branch office Adjusted VC firm experience

CONCLUSIONS

• VC firms and VC-backed companies are highly

concentrated

– Consistent with agglomeration economies in high-technology clusters

• Elite city VC firms achieve higher returns on non-local

investments

– Wedge from personal costs of non-local travel?

• Suggests skepticism about the wisdom of trying to subsize

too many hubs.

GETTING DETAILS RIGHT

 Appropriate sizing:  Too small may not make a difference.  Too big may flood local investor.  Avoiding rules that go against what market

needs.

 Need to ensure incentives to ensure participants

do well if meet goals.

 Allowing to programs to evolve and adjust over

time.

 Evaluation of managers and program itself.

FINAL THOUGHTS

 The critical rationale…  And the many pitfalls.  Three key points:  More than money is needed: entrepreneurship is not

in a vacuum.

 The virtues of market guidance.  Getting details right important as well.  Need for patience!

Josh Lerner Rock Center for Entrepreneurship Harvard Business School Boston, MA 02163 USA 617-495-6065 josh@hbs.edu www.people.hbs.edu/jlerner