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lerner

VIEWS: 5 PAGES: 49

									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)




              0
                  20
                       40
                            60
                                 80
                                      100
                                            120
                                                  140
                                                        160
       1992
       1993
       1994
       1995
       1996
       1997
       1998
       1999




Year
       2000
       2001
       2002
       2003
       2004
       2005
       2006
       2007
                                                              Venture Capital Investment Worldwide 1992 ~ 2007




                            Asia

                            USA
                            Israel



                            Europe
                            Canada
                                                             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
               Greece
           Hong Kong
              Hungary
                 India
             Indonesia
               Ireland
                Israel
                  Italy
                Japan




Country
             Malaysia
          New Zealand
              Norway
           Philippines
               Poland
                                                                                                          Ratio of Venture Capital Investment to GDP, 2007




              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, gentlemen, that thirty million dollars is a lot of money to spend.
  However, it’s not real money and, of 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
        capital appears ~3 to 4 times
 Venture
 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 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
      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
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%
 CSA                                                  Year                  Share of Offices
                                               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                  0         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%
VC-BACKED COMPANIES ARE SIMILARLY CONCENTRATED


  •         San Francisco + NYC + Boston ≈ 50%
                                   Portfolio Company                VC firm office
                                        Location
                                              % Share of   Main        Branch
      CSA                           Number         Total                             Outside
                                                           Office      Office
      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
SUMMARY STATISTICS


      •        Firms tend to invest locally
Measure                                                     N      Mean    Median       S.D.      P25 Unit of observation
Firm-Year-CSA controls
   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
Firm-Year controls
   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
CHARACTERISTICS OF VC LOCATIONS (TABLE III)


  •       Areas with past-VC-backed success have the most
          offices
                                           Log Number of     Log Number of Main Log Number of Branch
                                           Offices in year      Offices in year     Offices in year
                                                OLS                  OLS                 OLS
                                                 [1]                  [3]                 [5]
  Success rate of all previous VC              3.7140               1.9440              0.6100
  investments in CSA                          [5.52]***           [5.02]***           [3.57]***
  Log GSP per Capita                           1.4820              0.7380              0.2070
                                              [3.36]***           [2.61]***            [1.75]*
  Percent of population with college           0.0170              0.0210              0.0140
  degree or higher                             [0.65]              [1.53]             [2.09]**
  Log patents per capita                       0.3390              0.1650              0.0540
                                              [2.62]***           [2.23]**             [1.71]*
  State long-term capital gains tax rate       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
CHARACTERISTICS OF VC BACKED COMPANY LOCATIONS (TABLE
VII)

  •    Number of VC firms is significant
                                               Log Number of Portfolio Companies receiving initial
                                                              investment in year
                                                                      OLS
                                                  [1]           [3]          [5]           [7]
      Log Number of VC firms in CSA             0.7400        0.6960                         1.8 additional
                                               [14.43]***    [18.90]***                    companies
      Success rate of all VCs in CSA, past       1.1100        1.1480      3.4170       3.1570
      five years                               [6.85]***     [7.21]***    [6.89]***    [7.01]***
      Log GSP per Capita                        -0.3060       -0.2810      0.7760       0.6730
                                                [2.02]**      [1.84]*      [2.14]**     [1.91]*
      Percent of population with college         0.0380       0.0390        0.0500      0.0520
      degree or higher                         [3.98]***     [3.98]***     [2.04]**     [2.08]**
      Log patents per capita                    -0.0250       -0.0280      0.2320       0.1850
                                                [0.58]         [0.64]      [2.08]**     [1.78]*
      State long-term capital gains tax rate    0.3440        -0.4010       0.5900      -1.3800
                                                 [0.23]        [0.29]       [0.19]       [0.55]
      CSA is San Francisco/San Jose                           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
DOES LOCATION AFFECT OUTCOME? (TABLE VIII)

    •       Elite city-based VCs outperform

                           All investments:            Companies in Elite Cities:   Companies outside Elite Cities:
                            Elite city     All          Elite city   All             Elite city   All
                           based VC      Other         based VC     Other           based VC    Other
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
SUMMARY STATISTICS II (TABLE IX)

   •        Outside investments outperform
                                                                  Investment Type
                                                      [1]               [2]             [3]          Overall mean
                                                   Main Office     Branch Office       Outside
 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                               9,948            2,227            16,076           28,434
WHAT DRIVES SUCCESS I? (TABLE X)

  •     Outside investments outperform
                                                              Success, IPO
                                                                 Probit
                                                             [1]          [2]
   Portfolio company outside VC's office CSAs              0.0221       0.0222
                                                          [4.44]***   [4.44]***
   Portfolio company in CSA of VC's branch office          0.0231      0.0232
                                                          [2.74]***   [2.75]***
   Adjusted VC firm experience                             0.0099      0.0091
                                                          [4.99]***   [2.52]**
   VC based in Elite City                                  0.0313      0.0311
                                                          [6.80]***   [6.66]***
   VC based in Elite City * Adjusted VC Firm Experience                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
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

								
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