by Josh Lerner and William Sahlman http://hbr.org/2012/03/reviving-entrepreneurship/ar/
Photograph: Topical Press
Agency/Stringer/Getty Images: Orville Wright lands a glider, 1911
America’s economic culture has traditionally been distinguished by a willingness to pursue opportunities; a parallel willingness to adopt new products and services; social, legal, and economic tolerance for failure; and the ability to efficiently redeploy people and money. All this has led to a highly evolved system for allocating human and financial capital to entrepreneurial ventures, which has brought the U.S. enormous advantage.
But this entrepreneurial engine is showing serious signs of weakness. Considerably fewer new businesses are formed in the United States today than in the past, creating fewer new jobs. Venture capital funding has contracted in both amount and breadth, and initial public offerings of small-cap companies have sharply declined. In other markets, including China and Brazil, those indicators are moving in the opposite direction.
As U.S. policy makers wake up to the need to reinvigorate entrepreneurial ventures, they must recognize entrepreneurship as a process, not an act. Their decisions change the climate for new enterprises at each stage of that process, sometimes dramatically—whether or not those decisions are made with entrepreneurship in mind.
Spot an Opportunity
Basic and Translational Science
U.S. government funding of basic research has paid off handsomely in the past. Private capital has been able to leverage federally supported discoveries, allowing them to be translated into valuable commercial applications. But the level and nature of government research funding are problematic today. As resources tighten up, decisions about what to fund grow ever more conservative. Labs have difficulty obtaining capital for the projects with the greatest potential societal payback, because those projects tend to be highly speculative and to challenge conventional wisdom. The U.S. needs to find a way to facilitate the right kinds of “risky” research.
When government wants to change social behavior—say, to reduce the use of carbon-based fuels—it has various mechanisms at its disposal. It can simply forbid the behavior, or it can levy taxes to dissuade it. More positively, it can use subsidies to encourage better options (for example, by issuing loan guarantees or purchase contracts to producers of alternative fuels). It can even underwrite the development of new technologies that might help bring about the desired change. Government shouldn’t try to pick the winners but, rather, must recognize that society benefits most when diverse approaches are allowed to compete. Entrepreneurs can be relied on to relentlessly pursue opportunities; the key for government is to ensure the right mix of risks and rewards to elicit a broad-based response.
Social issues, from education to poverty alleviation, can be effectively addressed by current and would-be entrepreneurial actors. Consider the disruptive influence of the Knowledge Is Power Program, whose experimental charter schools often achieve better outcomes than traditional public schools, and at lower cost. Think of Youth Villages, which uses evidence-based treatment models to help at-risk children; over the past decade, in collaboration with state government, it has safely reduced the number of Tennessee children in foster care by 34%. Government has a responsibility to recognize how extraordinarily important such players can be in challenging the status quo and providing alternatives to government-administered programs and other models.
Quality and Supply of Human Capital
Policy decisions relating to the entire educational system, from K–12 on up, affect whether the U.S. will have the right people, with the right skills and attitudes, to build on its entrepreneurial advantage. Immigration policy is also crucial, especially in the realm of “high potential” entrepreneurial action—the kind that generates game-changing innovations—where studies have shown that educated immigrants play a disproportionately large role. Does it make sense to welcome millions of foreign students to U.S. colleges and universities, only to make it difficult later on for them to stay? Here’s a better idea: Staple a green card to every advanced diploma granted.
No question: Policy is needed to rein in taxpayer-funded financial market speculation. But if regulations make it harder for ventures in the real economy to raise capital for growth and investment, the cure will be worse than the disease. The IPO market is moribund, at least in part because of Reg FD, Sarbanes-Oxley, the decimalization of trading, and the separation of investment banking and research. Although greater financial regulation is helpful in some arenas, the U.S. must avoid policies that, however well-intentioned, reduce incentives for entrepreneurial action and cripple firms’ ability to access public capital.
Just as first-time visitors to a racetrack are at a disadvantage because they don’t know whether it favors front-runners or late closers or who the hot area jockeys are, financial institutions are handicapped in local markets where they can’t access information about the level of entrepreneurial activity, outcomes of past investments, and so forth—making them understandably leery of committing funds. For their part, entrepreneurs in emerging venture markets often lack insight into the expectations of top-tier private investors, potential strategic partners, and investment bankers. Government can help bridge these information gaps by publishing data and facilitating conversations. It can also encourage local trade associations to do so, perhaps by providing them with funding.
Go to Market
Competitive Playing Fields
For the valuable process of creative destruction to occur in the marketplace, new players with superior offerings and ingenious business models must be able to get into the game. Government needs to strike a balance, allowing companies to gain advantage but preventing them from making that advantage unassailable. This is, of course, the point of antitrust and anti-unfair-competition legislation, so the first order of business for the U.S. is to more strictly and swiftly enforce the laws that are already on the books.
Refine the Model
Workforce Health Care
When employers bear the costs of workers’ health care, any government action that affects those costs changes the prospects for entrepreneurial action. Health care costs amount to a tax on employment; a rise in them discourages entrepreneurship and, indeed, all domestic employment. Unfortunately, the recently enacted Affordable Care Act focused on reforming access to health insurance, not access to health. The best thing government could do in this sphere to encourage entrepreneurship is something it should do for the public regardless: drive large-scale innovations in technology (for example, to facilitate cures, not merely palliative treatments, and to improve cost and outcome tracking); in business models (for instance, by promoting the use of routine-care outpatient clinics staffed by nurse practitioners); and in systems that deliver superior outcomes at lower costs (by, say, changing patient behavior, reforming payments, and increasing transparency).
Succeed and Harvest…
Tax Treatment of Risks and Rewards
Tax policy has extraordinarily potent effects on entrepreneurial action. Capital gains taxation affects the share of profits retained and therefore influences the supply of risk capital. Limiting the deduction of investment losses depresses investment, especially given the steep mortality rate of new ventures. At the personal level, policies that tax income from exercised stock options at the same high rates as ordinary income discourage workers from supplying their labor to entrepreneurial ventures. At the corporate level, policies that provide tax credits during years of losses increase cash flows and encourage investment. To promote entrepreneurial action, policy needs to change the after-tax payoff structure for both human and financial capital, making gains more attractive and losses less painful.
Intellectual Property Rights
Few areas of public policy evoke more contentious debate than intellectual property rights, and with good cause. A world in which entrepreneurial actors could not protect their inventions would be a world of limited innovation. But too much protection of inventions might suppress innovation to an even greater extent. As it strives for the right balance at home, the U.S. must also champion measures to encourage and reward invention everywhere else in the world, mindful that a “one size fits all” approach is unlikely to work.
…Or Fail and Try Again
Mobility of Human and Financial Capital
For any new venture to gain traction, it needs infusions of capital and labor. The U.S. economy has benefited from its ability to redeploy both these resources quickly and productively. In other countries such redeployment is often hobbled by well-meant but flawed policies—for example, mandates that employees who have worked a certain length of time be given substantial notice and severance pay. Because many new ventures will inevitably fail, policies that punish failure suppress entrepreneurship. The U.S. must continue to skirt this pitfall.
In the U.S. the newest drag on entrepreneurship comes from policy uncertainty, as weak economic performance has produced political gridlock. Sensible policies are often not enacted, and when they are, they are apt to change as first one party and then the other gains the upper hand. Consider investment tax credits for solar panel installations, which the U.S. has approved multiple times. As the credits are put to repeated legislative tests, investors’ misgivings grow. Because entrepreneurial action is risky to begin with, any added uncertainty has a disproportionate negative impact.
Be PatientBuilding an entrepreneurial sector is a long-term endeavor. Too many promising initiatives have been abandoned on the basis of partial (and often not the most critical) indicators—for instance, low initial rates of return. Creating rules that force participants to focus on short-term results is a recipe for failure.
Get the Scale of the Program RightIf a public program is too small to have an impact, it is unlikely to succeed—and failure may discourage other efforts. If it is too big, it may swamp the local market, with too much capital chasing too few opportunities. An example of the latter is Canada’s Labour Sponsored Investment Funds program, which not only backed many incompetent groups that did little to spur entrepreneurship but also crowded out some of the most knowledgeable local investors.
Accept That Many Ventures Must Be GlobalPolicy makers naturally aim to encourage activity in their backyards, but many firms today need a multinational presence. Don’t restrict firms to hiring and manufacturing locally. Do help local companies connect with overseas investors. Successful investments will attract more overseas capital, and local affiliates of foreign-based funds with good track records will gain the credibility needed to raise their own funds. Be careful, of course, to ensure that public money translates into enhanced local activity. Reach an understanding as to how much activity will be managed by locally resident personnel and how much by partners based elsewhere.
Evaluate PerformancePolicy makers often neglect to spell out how an initiative’s performance will be measured. Its future should depend on its meeting clear goals, not on factors such as the vehemence of its supporters. Design evaluations to consider not just individual funds and companies but also a program’s broader context.
Avoid “Capture”Like zombies in a horror film, some public programs defy efforts to eliminate them and may keep rising from the dead. Economists call this problem “capture”: Vested interests coalesce behind a program and use their power to sustain it. Be willing to end programs that are not doing well; also end public funding for programs that have become so successful that they no longer need it. Regularly revisit program rules, knowing that changing the classes of participants who benefit may provoke an outcry.
Minimize Agency ProblemsWe might wish that public servants would work simply to maximize public welfare, but selfish interests often infect decision making. Establish clear procedures and erect firewalls between elected officials and program administrators.