Fred Schwarz, in The Uncertainty Principle, argues that an economy’s ability to generate innovative companies results not only from the availability of seed capital, but the structure of the early-stage investing ecosystem:
While scientific research in other industrialized nations is centralized, hierarchical, and bureaucratic, in America it is competitive and entrepreneurial. This is not to say that politics plays no role in deciding how American science is funded; far from it. But in America, governmental sources of funding are much more diffuse (half a dozen federal agencies and departments spend at least $1 billion a year on basic research), and private sources are much more numerous, than in most European or East Asian nations. It all adds up to strength through pluralism.
Schwarz cites a few specific American strengths:
The profusion of funding sources makes it easier for researchers with good ideas to shop around and find a willing partner.
Independent state universities compete for the best and brightest research. “Americans can consider themselves fortunate that except for the service academies, there is no system of national universities.“
All our competitive factors – within and between institutions, funding sources, states, federal agencies, and military branches – benefit from “…the absence of any federal Department of Science and Technology - despite the assumption in many quarters that if something is important, it must have its own cabinet secretary.”
Schwarz adds a counterpoint: Europe and China may have an advantage for funding big-ticket items like the Superconducting Super Collider, because they’re “good at spending lots of money with little squawking from the citizens.” However he then favorably quotes Professor William Happer of Princeton who called the SSC’s demise “a tragedy for science” but also cautioned: “I would rather accept mistakes made by the people or their elected representatives than live with mistakes made by scientific bureaucrats.”
Schwarz’s conclusion sums it up nicely:
America’s hodge-podge of scientists, institutions, and funding agencies – imperfect though it may be - is the closest thing the world has to a free market in science, and the results can be seen in Nobel Prizes, citations, and the steady influx of researchers from abroad who know that the United States is the land of scientific opportunity.
The economic future just happened. This study from the Kauffman Foundation finds that well over half of the companies on the 2009 Fortune 500 list, and just under half of the 2008 Inc. list, began during a recession or bear market.
The patents for the Television, Jukebox, and Nylon were granted during The Great Depression. Although we can’t confirm any patent information on the chocolate chip cookie, it too was invented at the same time (1930 to be precise).
Joseph Schmupeter argued that this was an essential strength of the American economy: economic destruction breeds creative success. From The Library of Economics and Liberty:
Schumpeter was among the first to lay out a clear concept of entrepreneurship. He distinguished inventions from the entrepreneur’s innovations. Schumpeter pointed out that entrepreneurs innovate not just by figuring out how to use inventions, but also by introducing new means of production, new products, and new forms of organization. These innovations, he argued, take just as much skill and daring as does the process of invention.
Innovation by the entrepreneur, argued Schumpeter, leads to gales of “creative destruction” as innovations cause old inventories, ideas, technologies, skills, and equipment to become obsolete. The question is not “how capitalism administers existing structures, … [but] how it creates and destroys them.” This creative destruction, he believed, causes continuous progress and improves the standards of living for everyone.
To cite additional evidence in support of our position might have us justifiably accused of “selling past the close,” but this one we like because we found it off the beaten path, in The Weekly Standard.
In Lone Economic Star, Eli Lehrer reports that “in a nation looking for good economic news, Texas stands out as a bright spot.” Although the success “defies easy explanation,” Lehrer maintains that it’s a mix of good land/city planning, investing in research and the arts, and avoiding two mistakes that have an all-too-familiar ring to them: excessive government spending and poorly conceived private lending.
In May alone, Texas, America’s second most populous state, added over 75,000 jobs—more than California (the biggest), New York (third biggest), and Florida (fourth biggest) combined. Texas has shown consistent gains in 10 of the 11 categories of private employment that the Bureau of Labor Statistics measures. The state is far more than cowboys and oil: It has several of the nation’s leading medical research centers (Baylor and UT hospitals among them), one of the biggest computer makers (Dell), and a financial industry that never took a turn for the worse. And, even though unemployment remains a tick over 8 percent (about a point and a half lower than the national average), the rapid growth is bringing this down quickly. During the last week in June, the job-hunt website Monster.com offered more new job openings in Texas than in California even though the Golden State has over 10 million more people.
Rhys Williams is an old friend of BPV and both a successful biotech entrepreneur and a founding member and President of one of the largest and most successful statewide angel investing groups in Florida (New World Angels). So we were delighted to hear that Rhys was recently invited by Senator George LeMieux (R-FL) to testify at the “Innovation in America: Opportunities and Obstacles” hearing before the U.S. Senate Committee Subcommittee on Competitiveness, Innovation, and Export Promotion. Florida’s entrepreneurial community could not have asked for a better spokesman on issues of importance to early stage entrepreneurs in Florida and throughout the country. And kudos to Senator LeMieux for inviting Rhys to speak.
If you want to watch Rhys’s testimony, it can be seen from minute markers 107:16 to 113:30 of the hearing’s webcast at the Senate Committee’s site; and his Q&A session (where he really shines in our opinion) runs from 125:44 to 128:44. A transcript of his testimony is also available at the site for those who prefer some enjoyable reading without the interruptions. In addition to making compelling points, Rhys does an excellent job dealing with the standard difficulties of that environment: having your thunder stolen by earlier witnesses and getting squeezed for time at the end so the Senators get enough of their own “air time”.
For those who want the “Rhys’s Points for Dummies” summary, he offered six specific recommendations which, from the perspective of angel investors and early-stage entrepreneurs, would improve both innovation and the nation’s overall economic performance:
FDA Reform. Fill vacancies more quickly, speed up regulatory review, and switch from the “zero defect” to the ”calculated risk” model. In recent years, high profile drug safety incidents have hamstrung regulators – costing years of product development time and burning up precious capital.
Address the backlog of patents. The US Patent & Trademark Office has a backlog of up to 3.5 years – which lengthens time to market, increases legal costs and creates uncertainty. In addition to working the backlog with additional resources, expedited reviews should be granted for strategic sectors and IP with greater risk of piracy. Also push for reciprocity and enforcement of IP violations within foreign jurisdictions.
Tax reform. The current federal tax framework dampens innovation and competitiveness. In addition to lowering certain rates tied to investment activity (capital gains, carried interest), we ought to create tax credits for: innovative companies, angel investors, and certain specific business activities (capital attracted, employment growth, capital expenditures, etc) in order to promote a true, sustainable “growth agenda.”
Simplify federal and state securities regulations. Early stage firms are forced to devote too much time and attention to regulations intended for much larger firms.
Promote the “Entrepreneurial Ecosystem”. Develop and integrate the local and regional infrastructure for the commercialization of R&D, the growth of private angel investor networks, and the provision of matching grants to qualified SBIR/STTR grant recipients.
Preserve the missions of SBIR/STTR. (Small Business Innovation Research and Small Business Technology Transfer) Protect their funding from encroachment by larger firms.
Thank you to Rhys for traveling to D.C. on his own dime and making the case so succinctly. Everyone involved in Florida’s early stage entrepreneurial culture would benefit from echoing these points to our state and national legislators and regulators as often as possible as we debate how to ignite renewed economic growth in America.
The dominance of the list by Florida and Texas–the former has eight of the top 20 counties, the latter four– makes sense to Robert Shrum, manager of state affairs at the Tax Foundation in Washington, D.C., since neither state has an income tax. “If you’re a high-income earner, then that, from a tax perspective, is going to be a driving decider if you’re going to move to one of those two states,” Shrum says.
After accounting for property taxes, Shrum’s analysis shows that Texas has the fourth-lowest personal tax burden in the country, and Florida has the eighth lowest. Shrum also points to eight states that have targeted wealthy households with extra-high tax brackets: California, New York, New Jersey, Maryland, Hawaii, Oregon, Connecticut and Wisconsin. Six of the top 10 counties the rich are fleeing are located in those states.
“Over the 25 year period between 1980 and 2005, without the contribution of start-up firms, net job creation would have been negative.”
This recession, like others, disproportionately affected small businesses. However, the nature of the downturn has been unlike others in ways especially challenging to SMBs:
The degree to which credit contracted was the highest ever recorded by the NFIB (National Federation of Independent Business). “Corporate bond spreads rose to unprecedented heights during the financial crisis in late 2008, but came down just as quickly as the crisis subsided. For small businesses, dependent on bank lending, the situation has been slower to improve.”
The downturn struck sectors in which small businesses are extremely vulnerable: construction, real estate services, professional, scientific and technical services, and other services.
When we’ve written on this subject, we’ve tried to emphasize the adverse impact this proposed tax hike will have on an already distressed economy. In short, we’ve argued that venture capital is critical to economic growth, new job creation, and innovation – and if you tax those things you are certain to get less of them. Furthermore, venture capital is a long-term investment that doesn’t ask for (or need) bail-outs.
Langeler worries that the heated political rhetoric about “punishing Wall Street” is interfering with basic consistency, and draws several parallels to the financing and profitable sale of a typical home: Continue reading ‘In Defense of Carried Interest’
In The Library in St.Pete you will find Amity Shlaes’ The Forgotten Man, in which Shlaes recounts how the TVA crowded out Wendell Wilkie’s Commonwealth & Southern, a private-equity-backed company ($400 million as reported in Wilkie’s testimony before a House committee) that was in the process of bringing electricity to the rural South.
Since the TVA could borrow unlimited funds at low interest, and did not have to turn a profit, C&S eventually had to sell its properties in the Tennessee Valley to the TVA in 1939 for $78.6 million. (Fwiw, those events led to Wilkie’s 1940 presidentialrun.) 71 years after that transaction comes a new study which explores government spending on economic development and its effects on private investment.
Harvard professors Lauren Cohen, Joshua Coval, and Christopher Malloy look at increases in local earmarks and other federal spending that flow to states after the senator or representative rose to the chairmanship of a powerful congressional committee. The surprising result: as a result of government spending in their states, companies actually retrenched by cutting payroll, R&D, and other expenses.
Some of the dollars directly supplant private-sector activity—they literally undertake projects the private sector was planning to do on its own. The Tennessee Valley Authority of 1933 is perhaps the most famous example of this.
Other dollars appear to indirectly crowd out private firms by hiring away employees and the like. For instance, our effects are strongest when unemployment is low and capacity utilization is high. But we suspect that a third and potentially quite strong effect is the uncertainty that is created by government involvement.
…Our findings suggest that they should revisit their belief that federal spending can stimulate private economic development. It is important to note that our research ignores all costs associated with paying for the spending such as higher taxes or increased borrowing. From the perspective of the target state, the funds are essentially free, but clearly at the national level someone has to pay for stimulus spending. And in the absence of a positive private-sector response, it seems even more difficult to justify federal spending than otherwise.
The implications of these findings for how best to nurture the growth of entrepreneurial companies are interesting. There will no doubt be private growth companies that benefit from government subsidies in areas such as cleantech and alternative energy, given the magnitude of the dollars being spent. But it would seem government could do far more to encourage sustainable entrepreneurial activity more broadly by insuring that the proper tax incentives are in place for new company formation and then also working to keep the regulatory burdens at a minimum. If government does that consistently over a long period of time, the right incentives plus greater certainty will encourage a surge in new entrepreneurial ventures.
Last Friday’s WSJ features an op-ed entitled Incentives vs. Government Waste in which John Steele Gordon argues that incentives could be better structured and used by bureaucracies.
While we have mixed feelings about the idea – we’re certainly believers in incentives, but it’s hard to believe any incentive plan could withstand the gamesmanship of a skilled bureaucrat (see: Fannie Mae) – we enjoyed the historical analogy the author employs:
But it is possible to incentivize public (and nonprofit) employees to find ways to save money rather than waste it, to find new and better ways of doing business. There is no better example of how to go about that than the British Royal Navy in the age of Admiral Lord Nelson (1758-1805).
The navy’s job in the endless wars of the 18th century was to capture enemy warships and to sweep enemy commerce from the seas. As the novels of Patrick O’Brian [see below] and C. S. Forrester so vividly bring to life, the Royal Navy was exceedingly good at doing exactly that. No small reason was that the navy gave its officers and men an enormous incentive to capture enemy warships and merchantmen: the whole value of the ships and cargoes they captured.
(NB: we also learned that this is why so many British warships of that era had french names.)
Gordon goes on to suggest that employees of bureaucracies be awarded bonuses equal to the first year’s cost savings on a dollar-for-dollar basis (the “prize” akin to the Royal Navy’s in the 18th century). Furthermore, best practices could be shared and healthy competition encouraged amongst bureaucracies to be the ones who capture the savings (and “prizes”).
Now, to be sure, bureaucracies can’t sally forth, capture an enemy bureaucracy, and sell it to the highest bidder. But they can certainly find new ways of doing their jobs that are cheaper and better than the old ways, especially if they are handsomely rewarded for doing so.
In any case, it occurs to us that as government grows larger and more and bigger bureaucracies (e.g. the delivery of health care) directly affect our businesses, it would make sense to start focusing on how we at least make these institutions as efficient as possible.
We’ve written before on a recurring thread found in Thomas Friedman’s recent columns: the importance of keeping the entrepreneurial spirit strong as a uniquely American source of economic prosperity. While finding ourselves in agreement, in broad terms, we’ve also noted that Friedman seemed to not connect the dots between increasing taxes on venture capital and hurting job growth.
In yesterday’s New York Times, he connects the first few dots in his conclusion. The “other taxes (to cut) to stimulate growth” ought to specifically include the carried interest.
“My takeaway is that U.S. and European politicians — please don’t laugh — are going to have to get a lot smarter and more honest.
To be the Regeneration, they’ll have to figure out how to raise some taxes to increase revenues, while cutting other taxes to stimulate growth; they’ll have to cut some services to save money, while investing in new infrastructure to grow economic capacity.”
Tax rates matter. And what matters about them is what activities get taxed, not who gets taxed. When you increase the tax rate on an activity, you get less of it. The only question is how much less of it you will get.
Congress should be asking one question: “Is long-term investment something we really want less of, especially now?” Unfortunately, in today’s political climate, tax policy discussions focus almost exclusively upon who, not what, gets taxed. This means singling out specific groups of people—bankers, Wall Street, “the rich,” the owners and executives of insurance, oil and drug companies—to punish for our economic difficulties. This may be politically popular but will have bad consequences for the economy.
