For understandable reasons, the government’s flagship “levelling up’ agenda has not attracted much attention over the past few months. But as the debate shifts to recovery, policymakers will be on the hunt for ideas to close the UK’s large regional divides.
High growth entrepreneurship will be key to improving productivity in cities and towns outside the South East. To that end, I suspect we will see more proposals along the lines of Lord O’Neill’s ‘Good Bank’ (see Philip Salter’s assessment) to invest in growth capital outside London and the South East. And even if central government doesn’t bite, devolution and more financial freedom may prompt some Metro Mayors to try their hand.
The temptation to try and kick-start a venture capital industry is easy to understand. After all, venture-backed startups have a disproportionate impact on innovation, job growth, and productivity.
But for every success story like Israel’s famous Yozma programme, there are a dozen failed attempts where public money has been wasted with little to show for it. If we’re to avoid repeating those mistakes, it’s worth studying what’s worked and what hasn’t in the past. Thankfully, a pithy new paper from Harvard Business School’s Josh Lerner identifies the common factors that explain why most attempts to boost venture-backed entrepreneurship fail.
Incentives
First, it’s worth recognising the limits of public officials. Lerner’s assessment is tough, but fair.
“Government officials may have many valuable talents and play incredibly important roles; but the skill sets associated with successfully identifying and funding entrepreneurial businesses are very different from those encountered in their typical daily work. The ambiguity, complexity, and specialization associated with these ventures makes these tasks quite challenging.
In many instances, officials may be manifestly inadequate to the task of selecting and managing entrepreneurial or innovative firms. Many examples can be offered of government leaders who did not think carefully about realistic market opportunities, the nature of the entrepreneurs and intermediaries being financed, and how the subsidies they offered would affect behaviour. Whether they were rules that affect the ability of firms to accept outside financing, offshore routine coding work, or respond to shifts in customer demands, well-intentioned officials can make rules that prove to be very harmful to those they mean to help.
One potential solution is to bring in outside talent. But in order to get the best you need to be willing to pay high wages. The issue is that being part of the public sector brings additional scrutiny. Take the case of In-Q-Tel, a venture fund set up by the CIA to give them access to more cutting-edge tech. To get the right people, it was set up as an independent, not-for-profit entity. This allowed them to pay high salaries and offer performance related rewards. However, negative coverage in the New York Post led to intense scrutiny over compensation and pushed many investment staff to leave.
Regulatory Capture
A further issue faced by public-venture schemes is regulatory capture. Take the Department for Energy’s Clean Energy Initiative.
“…the Department of Energy had little transparency about the criteria used to select the awards to cleantech firms discussed in the introduction. Reflecting this lack of clarity, firms responded by hiring lobbyists to seek awards. For instance, more than half the cleantech companies in the portfolio of New Enterprise Associates, a large U.S. venture firm, hired lobbyists to seek to influence the rewards”
As well as leading to waste, there’s also a risk of missing out on the best ideas. Lerner notes “the most creative entrepreneurs are often outsiders”, so any process that ends-up favouring well-connected individuals will leave high-potential investments on the table.
Geography
But arguably the biggest concern for policymakers attempting to do regional policy through venture capital is the poor performance of public venture capital in areas without private venture capital.
Take the Small Business Innovation Research (SBIR) program. It’s the largest public venture programme in the US and spoken highly of by UK politicians such as Neil O’Brien MP. Its results are impressive – businesses that receive grants through SBIR grow faster than similar businesses who didn’t get SBIR funding. However, not all grants paid-off equally well. When Lerner looked at attempts to impose geographic fairness requirements on SBIR, he found that in high-tech regions the average recipient added 47 jobs (effectively doubling in size), while recipients in other regions only added 13 jobs.
Political pressure can force programmes to fund weaker companies. For instance, businesses in every one of the 435 congressional districts have received SBIR grants despite high-tech businesses typically clustering together.
This isn’t to say that some regions wouldn’t benefit from additional public support, but there needs to be some already existing demand for venture capital or else funds will be forced to invest in weaker businesses.
On a similar note, there’s a tendency for policymakers to decide to invest based on hype rather than investment fundamentals. For instance, 49 out of 50 US states have started programmes to promote biotech. Yet biotech requires a skilled scientific workforce and access to patent lawyers that only a few locations in the US possess. Ignoring this economic reality will often have unintended consequences. For instance, often when promising biotech firms were funded, they swiftly moved to a region with an established biotech sector.
Avoiding waste
The best way to avoid the pitfalls discussed above, while supporting a nascent venture sector, is to provide matching funds. Israel’s highly-praised Yozma programme provided foreign venture investors with matching funds (typically on 60% private, 40% public basis). This created discipline and ensured that public money wouldn’t be invested in businesses with poor prospects for political reasons. It also reduced the risk of capture and lobbying as private investors with skin-in-the-game have a strong incentive to only invest in viable prospects. The government’s Future Fund programme, which matched private venture investment 50:50 to provide a runway for startups struggling to raise investment due to coronavirus, is another good example of a well-designed intervention.
If politicians want to replicate London and Cambridge’s recent startup successes elsewhere in the UK, then they should proceed with caution and avoid the many pitfalls of past schemes by limiting their interventions to matching the private sector.