What public policies are most effective in encouraging the growth of a venture economy? Before turning to general principles, these can be illustrated by considering two success stories.
In June 1992, the Israeli government established Yozma Venture Capital Ltd., a US $100 million fund wholly owned by the public sector. At the time, there was a single venture fund active in the nation, Athena Venture Partners. While there were certainly well-trained engineers in the nation working on promising technologies, entrepreneurs (and would-be company founders) were suspicious of venture investors. This reluctance was based in part on their interactions with the pioneering venture capitalists in the nation, as well as their general skepticism about selling equity to unaffiliated parties. Instead, they preferred to rely on bank debt for financing. The only problem, of course, was that such financing was rarely available for young, risky ventures.
The key goal of Yozma was to bring foreign venture capitalists’ investment expertise and network of contacts to Israel. The need for this assistance was highlighted by the failure of the nation’s earlier efforts to promote high-technology entrepreneurship. One assessment concluded that fully 60% of the entrepreneurs in prior programs had been successful in meeting their technical goals but nonetheless failed because the entrepreneurs were unable to market their products or raise capital for further development (Jerusalem Institute of Management 1987). Foreign expertise was seen as key to overcoming this problem.
Accordingly, Yozma actively discouraged Israeli financiers from participating in its programs. Rather, the focus was on getting foreign venture investors to commit capital for Israeli entrepreneurs. The government provided matching funds to investors, typically US $8 million of a US $20 million fund. The venture fund was given the right to buy back the government stake within the first 5 years for the initial value plus a preset interest rate of roughly 5–7%. Thus the incentives of Yozma meant that the government provided an added incentive to the venture fund if the investments proved successful. Moreover, learning from the nation’s misadventures during earlier programs to stimulate the venture industry—when cumbersome application procedures and burdensome reporting requirements discouraged participation—the administration of the program was deliberately made simple.
In addition to the financial incentives, the project adopted a legal structure for the venture funds that foreign investors would be comfortable with. Included were features such as a 10-year fund life, limited partnerships modeled after the Delaware partnerships that are standard practice in the USA and elsewhere, and “flow-through” tax status. Had the government not adopted these features—and the Israeli Treasury department resisted them before acquiescing under pressure—it is unlikely that the program would have succeeded in attracting foreign investors.
The Yozma program delivered beyond the wildest dreams of the founders. Ten groups took advantage of this offer, mostly from the USA, Western Europe, and Japan. Many of the original Yozma funds, including Gemini and Walden Ventures, earned spectacular returns and served as precursors to larger, follow-on funds. Moreover, many of the local partners recruited by the overseas venture capitalists were able to spin off and establish their own firms, which global venture capitalists were eager to fund because of their impressive track records. (A Yozma “alumni club” allows groups to learn from each others’ experiences while making these transitions.) One decade after the program’s inception, the ten original Yozma groups were managing Israeli funds totaling US $2.9 billion, and the Israeli venture market had expanded to include 60 groups managing approximately US $10 billion (Erlich 2003). In most tabulations, Tel Aviv has surpassed Boston as the urban area with the most venture activity after San Francisco.
Another, albeit younger and less conclusive, success is the New Zealand Venture Investment Fund (NZVIF).Footnote 4 In late 1999 the newly elected Prime Minister, Helen Clark, realized that New Zealand faced a fundamental problem and needed to change. In particular, she was concerned that New Zealand’s economy depended critically on production and exporting of commodities. The nation’s position in the knowledge-based industries was weak, and its living standards were steadily falling relative to the other major developed nations.
A critical area that her government targeted was enhancing innovation, and encouraging venture capital was a critical aspect of this goal. In light of limited activity in the local market, the government sought to accelerate the growth of the New Zealand venture capital market through co-investment with private investors and related market development activities. After a careful review of other models, the government adopted a so-called fund-of-funds approach, whereby it made investments in private venture capital fund managers.
Prior to any investments being made, NZVIF was structured as a stand-alone company, which ensured that the government could distance itself from risk and liability for the investments made. This approach also ensured distance and independence from decisions about appointment of venture capital fund managers and from individual investment decisions.
These investments were structured as equity (to minimize possible distortions) and could be bought out by the investors. Government investments in the funds were on the same terms as those of private investors, except that each fund was provided with an option exercisable up to the end of the fifth year of the fund to buy out the NZVIF investment on the basis of capital plus interest only (that is, other investors would receive any upside above this amount).
Deliberately, the project’s designers asked for no special rights. The fund managers were given responsibility for making and managing investments without government interference. NZVIF leaders participated in investor governance decisions on the same terms as private investors, with the same voting rights. Investor governance arrangements reflected current market practice. The funds were geared toward investors in early-stage companies, and every dollar had to be matched with two dollars from the private sector.
NZVIF’s decision to invest in a fund is made following completion of an extensive selection and due diligence process, undertaken by the fund manager, to determine whether the fund proposal is “investment grade.” An important process is the establishment of the fund through a process of competitive selection. The initial screening is done by the staff, followed by an outside assessment by an independent specialist private equity advisor. A standard methodology and fixed criteria are used to assess and rank all applications. In many cases, the staff work actively with teams of would-be venture fund managers to help them make their proposals more attractive (for instance, helping them identify prospective additional individuals who can contribute needed experience). This is necessitated by the limited supply of New Zealand-based funds. Following the completion of external due diligence, the NZVIF board selects those applicants with whom it wishes to negotiate investment terms.
As part of the negotiations, a monitoring and reporting framework is agreed with each NZVIF seed fund manager. This enables NZVIF to collect the economic and financial data it needs for the required regular reports on the performance of each fund and the impact of the program. This also enables NZVIF to monitor each fund to ensure it is compliant with its investment agreement and investor governance requirements. Once fund agreements are finalized, investment activity commences. While the program is still young, its success to date has been very promising.
More generally, three principles in particular seem critical as guide-posts:
Remember that entrepreneurial activity does not exist in a vacuum. Entrepreneurs are tremendously dependent on their partners. Without experienced lawyers able to negotiate agreements, skilled marketing gurus and engineers who are willing to work for low wages and a handful of stock options, and customers who are willing to take a chance on a young firm, success is unlikely. However, despite the importance of the entrepreneurial environment, in many cases government officials hand out money without thinking about barriers other than money that entrepreneurs face. In some cases, crucial aspects of the entrepreneurial environment may seem tangential, for instance, the importance of robust public markets for young firms as a spur to venture investment. It is critical to take a broad view and address not just the availability of capital but also other components of a productive arena in which entrepreneurs could operate.
Let the market provide direction. The two successful efforts we have highlighted above, the Israeli Yozma program and the New Zealand Venture Investment Fund, differed in their details: the former was geared toward attracting foreign venture investors; the latter encouraged locally based, early-stage funds. However, they shared a central element: each used matching funds to determine where public subsidies should go. In using the market for guidance, policymakers should keep in mind that these initiatives should not compete with independent venture funds or finance substandard firms that cannot raise private capital. Emulating successful initiatives in the past, programs should require that a substantial amount of funds be raised from nonpublic sources. To be sure, 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. However, only through a market-based system are the critical flaws that have doomed so many earlier programs likely to be avoided.
Resist the temptation to overengineer. In many instances, government requirements that limit the flexibility of entrepreneurs and venture investors have been detrimental. It is tempting to add restrictions on several dimensions, for instance: the locations in which the firms can operate, the type of securities venture investors can use, and the evolution of the firms (e.g., restrictions on acquisitions or secondary sales of stock). Government programs should eschew such efforts to micromanage the entrepreneurial process. While it is natural to expect that firms and groups receiving subsidies will retain a local presence or continue to target the local region for investments, these requirements should be as minimal as possible.
We can also highlight a few other points that are important to success:
Leverage the local academic scientific and research base. One particular precondition to entrepreneurship deserves special mention: in many regions of the world, there is a mismatch between the low level of entrepreneurial activity and venture capital financing, on the one hand, and the strength of the scientific and research base, on the other. The role of technology transfer offices is absolutely critical here. Effective offices do not just license technologies but also educate nascent academic entrepreneurs and introduce them to venture investors. Building the capabilities of local technology transfer offices, and training both potential academic entrepreneurs and technology transfer personnel in the process of new firm formation, is essential. All too often, technology transfer offices are encouraged to maximize the short-run return from licensing transactions. This leads to an emphasis on transactions with established corporations that can make substantial up-front payments, even though licensing new technologies to start-ups can yield substantial returns in the long run, both to the institution and to the region as a whole. It is important that policymakers think seriously about the way in which technology transfer is being undertaken, the incentives being offered, and their consequences.
Respect the need for conformity to global standards. It is natural to want to hold onto long-standing approaches in matters such as securities regulation and taxes. In many cases, these approaches have evolved to address specific problems, and have proven to be effective. Nevertheless, there is a strong case for adopting the de facto global standards. Global institutional investors and venture funds are likely to be discouraged if customary partnership and preferred stock structures cannot be employed in a given nation. Even if a perfectly good alternative exists, they may be unwilling to devote the time and resources to explore it. Unless the nation is one such as China—where global investors feel compelled to master the system, no matter how complex, owing to the size of the market opportunity—policymakers should allow transactions that conform to the models widely accepted as best practice.
Recognize the long lead times associated with public venture initiatives. One of the common failings of public entrepreneurship and venture capital initiatives has been impatience. Building an entrepreneurial sector is a long-run endeavor, not an overnight accomplishment. Programs that have initial promise should be given time to prove their merits. Far too often, promising initiatives have been abandoned on the basis of partial (and often, not the most critical) indicators, for instance, low interim rates of return of initial participants. Impatience—or creating rules that force program participants to focus on short-run returns—is a recipe for failure.
Avoid initiatives that are too large or too small. Policymakers must walk a tightrope in finding the appropriate size for venture initiatives. Too small a program will do little to improve the environment for pioneering entrepreneurs and venture funds. Moreover, inflated expectations, out of proportion to the money invested, may create a backlash that impedes future efforts. However, programs that are too substantial can swamp local markets. The imbalance between plentiful capital and limited opportunities may introduce pathologies. Unsuccessful programs, such as the Canadian Labor Fund Program, not only backed incompetent groups that did little to spur entrepreneurship, but it crowded out some of the most knowledgeable local investors.
Understand the importance of global interconnections. Entrepreneurship and venture capital are emerging as global enterprises. This evolution has two important consequences. First, no matter how eager policymakers are to encourage activity in their own backyard, they must realize that, to be successful, firms must have a multinational presence. Efforts to restrict firms to hiring and manufacturing locally are likely to be self-defeating. Second, it is important to involve overseas investors as much as feasible. Local companies can benefit from relationships with funds based elsewhere but investing capital locally. Moreover, successful investments will attract more overseas capital. In addition, local affiliates of a fund based elsewhere—having a successful track record—will gain the credibility they need to raise their own funds. That being said, when public funds subsidize activities by overseas parties, officials should obtain commitments from these entrepreneurs and groups to recruit personnel to be resident locally, and to have partners based elsewhere be involved with the management of the local groups.
Institutionalize careful evaluations of initiatives. All too often, in the rush to boost entrepreneurship, policymakers make no provision for the evaluation of programs. The future of initiatives should be determined by their success or failure in meeting their goals, rather than other considerations (such as the vehemence with which supporters argue for their continuation). Careful program evaluations will help ensure better decisions. These evaluations should consider not just the individual funds and companies participating in the programs, but also the broader context.
Realize that programs need creativity and flexibility. Too often, public venturing initiatives are like the pock-faced villain in a horror film—as much as one tries, he cannot be killed off. Their seeming immortality reflects the capture problem discussed above: powerful vested interests coalesce behind initiatives, making them impossible to get rid of. The nations that have been most successful in public programs have been willing to end those that are not doing well, and to substitute other incentives. Even more powerfully, they have been willing to end programs on the grounds that they are too successful and hence no longer in need of public funding. Moreover, program rules may have to evolve, even if important classes of participants are thereby eliminated. If government is going to be in the business of promoting entrepreneurship, it needs some entrepreneurial qualities itself.
Recognize that “agency problems” are universal and take steps to minimize their danger. The “horror stories” above illustrate that the temptations to direct public subsidies in ways not intended are not confined to any region, political system or ethnicity. While we might wish that human beings everywhere would confine themselves to maximizing public welfare, selfish interest all too often rears its ugly head. In designing public programs to promote venture capital and entrepreneurship, such behavior should be limited as far as possible. Defining and adhering to clear strategies and procedures for venture initiatives, creating a firewall between elected officials and program administrators, and careful assessments of the program can help limit self-serving behavior.
Make education an important part of the mixture. The emphasis on education should have at least three dimensions:
The first is building the understanding of outsiders about the local market’s potential. One of the critical barriers to the willingness of venture investors to invest in a given nation is lack of information. If one visits a racetrack for the first time, it is always nice to know whether the track favors front-runners or late closers, and who the hot local jockeys are. In the same way, institutions feel more comfortable investing if they have information about the level of entrepreneurial activity in local markets, the outcomes of the investments, and so forth. An important role that government can play is gathering this information, or else encouraging (and perhaps funding) a local trade association to do so.
Second, educating entrepreneurs is a critical process. In many emerging venture markets, entrepreneurs may have a great deal of confidence, but relatively little understanding of the expectations of top-tier private investors, potential strategic partners, and investment bankers. The more that can be done to fill these gaps, the better.
Finally, a broad-based understanding in the public sector of the challenges of entrepreneurial and venture capital development is very helpful. As we have repeatedly highlighted, policymakers have made expensive errors out of a lack of understanding of how these markets really work.