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Not all innovation is alike

innovationJames Pethokoukis at AEI makes a distinction between “efficiency innovation” and “empowering innovation.”  The former can contribute to a polarized job market, while the latter is the necessary ingredient for a vibrant economy and improved living standards:

Not all innovation is alike.  Incumbent firms replacing man with machine is a kind of innovation that may lift corporate profits and boost stock prices without necessarily broadly raising prosperity.  Such technological advancement and efficiency is already contributing to polarized employment markets in advanced economies.  Jobs are created at the top for high-creative workers and at the bottom for high-touch workers.  But jobs in the middle— especially those involving routine, repetitive, and rules-based tasks—are automated away.  In other words, the executives and janitors at a bank keep their jobs, but tellers get replaced by ATMs.

But there is another kind of innovation, termed “empowering” innovation by business consultant Clayton Christensen.  This is the sort of innovation generated by fast-growing startups offering new products and services.  Empowering innovation is a job creator, not a job destroyer—though some jobs may shift from uncompetitive incumbents to these aggressive new challengers.

Both sorts of innovation have their place, of course. But right now efficiency innovation may be destroying jobs faster than empowering innovation creates them.  So what is the key to generating greater levels of empowering innovation? Competition—and the more the better.  As economist Joseph Berliner once put it:

(T)he effect of competition is not only to motivate profit-seeking entrepreneurs to seek yet more profit but to jolt conservative enterprises into the adoption of new technology and the search for improved processes and products.

Vibrant economies need plenty of fast-growing startups to generate empowering innovation and to also push incumbents themselves to become more innovative.

And if incumbents can’t compete, government needs to let them fail.  Free and frequent entry and exit of firms is critical.  Government has to make sure tax, regulatory, and spending policy is neither impeding the creation of new startups nor giving incumbents an unfair advantage.

Some politicians think “innovation policy” means spending taxpayer money on promising young firms favored by bureaucrats.  Rather, innovation policy means ensuring that the status quo is continuously challenged by upstart rivals and threat of failure.  Those are the keys to the Schumpeterian “gales of creative destruction” that drive innovation, which in turn drives long-term economic growth and improvement in living standards.

National prosperity is generated by the start-ups who innovate and challenge entrenched incumbents.  Anyone who’s worked for a large corporation – especially in an R&D department – would not rely primarily on that model for innovation.  Anyone who’s worked for a large corporation – especially in a dying industry – would not rely primarily on that model for job growth.  Yes, start-ups lack the economies of scale and R&D budgets of larger firms; but that’s the support venture capital provides. Those start-ups that do gain traction are able to raise capital, and, with hard work and a little luck, become large companies… and then face the next generation of innovators.


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CEOs are from Mars, VCs are from Venus – redux

mars venus

Borrow our title and we borrow your clever pic.

This article in Entrepreneur echoes (and borrows the title of) a post from our first month of blogging (November 2009):  CEOs are from Mars, VCs are from Venus?

Back then we cited a joint study conducted by the NVCA and Dow Jones which outlined several factors that contribute to a good long-term partnership for long-term growth, and highlighted two data that we found insightful band mildly humorous:

Do you respect me or my money?

  • 54% of VCs cite mentoring the CEO as a critical value-add; only 27% of CEOs see the value.

The money will always be important.  After all, entrepreneurs should pick a financial partner who can provide additional capital as needed as their companies grow.  But the best (sadly, not all) venture partners provide much more than money – valuable contacts, “been there, done that” experience when facing tough business issues and a sympathetic sounding board for entrepreneurs working under great pressure.

As was the case with another contributor at a different publication, the author of the Entrepreneur piece is either subconsciously thinking mostly about early-stage venture financing or is perhaps painting with too broad a brush.  But he still makes a few valuable points:

Ultimately, Gray’s [author of the 1992 book Men are from Mars, Women are from Venus - ed] advice for better relationships applies: If founders and capital providers invest the time to understand their objectives deeply, they will have a productive relationship.  The key is to find activities where they can make the other party better off.

Or, if you prefer, as we once put it in The fate of control (also from 2009):

It’s more about chemistry than control. How you react during the inevitable challenges of building a business together will define the relationship. Over time you learn to play to each other’s strengths and make the concessions and adjustments that a given situation demands.


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What California can learn from Texas

When a state’s manufacturing base is escaping, and its citizens are agitating to break up, that state is no stranger to bad news.  AEI’s Carpe Diem blog reports:  Texas has created one million more jobs than California since the end of the Great Recession.


What’s different about Texas and California that would explain why one state (Texas) has added more than one million net new jobs since 2007, while the other (California) has created almost no new net jobs over the last six and-a-half years? Let’s start by pointing out that one of those states — Texas — is pro-energy (i.e. fossil fuel energy), it’s a right-to-work state, it has no state income tax, its electricity prices are significantly lower because it doesn’t have a renewable energy mandate, and its regulatory burden on businesses is much lighter. In other words, Texas has created a pro-business and pro-growth environment that has helped to nurture the creation of more than one million jobs since December 2007. Meanwhile, California has created an increasingly anti-business climate with some of the highest state tax and regulatory burdens in the country, which along with sky-high industrial electricity prices (83% higher than in Texas), have stifled business and job creation, with almost no net job gains in more than six years.

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The Founding Fathers Were (Mostly) Entrepreneurs

Nearly all who signed the Declaration of Independence ran their own businesses.  The Big Names, the Renaissance Men, have familiar stories; yes.  But it is true of most of the less well known signatories as well.

founding_27397George Washington’s success as an entre- preneur recently earned him the moniker Founding CEO.  Born neither poor nor rich, with a father who died while he was just 11 years old, Washington transformed Mount Vernon “from a sleepy tobacco farm into an early industiral village.”

Ben Franklin ran several businesses and never patented a single of his many famous inventions, seeing them as gifts to the public.  An early open-source advocate?

Thomas Jefferson invented many small practical devices (e.g. the swivel chair) but, like Franklin, had no interest in commercialization.  Furthermore, if you count these sorts of things as entrepreneurial – and we do – he founded the University of Virginia and the middle part of the country known as The Louisiana Purchase.  Jefferson however (and unhelpfully) was not exactly a huge fan of finance:

The system of banking we have both equally and ever reprobated. I contemplate it as a blot left in all our constitutions, which, if not covered, will end in their destruction, which is already hit by the gamblers in corruption, and is sweeping away in its progress the fortunes and morals of our citizens.

Letter to John Taylor, 1816

Well, nobody’s perfect.  That kind of attitude is what lands you on the $2 bill.  More seriously, his view of banks seems to have reflected his distaste for public debt and inter-generational debt.  (He inherited his father-in-law’s estate and its debts, which took years to pay off and contributed to his own personal financial difficulties.)  We can imagine he would have felt differently about the type of financial backing that allowed yeoman entrepreneurs to pursue happiness.

This 2013 piece by Bill Murphy Jr. in Inc. magazine tells the stories of the less famous self-made men behind the Declaration of Independence:  “Doctors, lawyers, merchants (and a few ne’er do well heirs).”  The merchants were entrepreneurs, obviously, but even those doctors and lawyers would have had an entrepreneurial bent, typically arranging their own educations or apprenticeships, hustling up clients, and running the business end of their own practices.

We hope all our readers and their families enjoy a Happy Independence Day.


Lost: $1 trillion

Today’s Wall Street Journal reports:  since 2005 productivity has declined 8% off its long-run trend, which has meant $1 trillion less in business output.  The reason?  Fewer start-ups.  From Behind the Productivity Plunge:  Fewer Start-ups

Lagging productivity growth is an enormous problem because virtually all of the increase in Americans’ standard of living is made possible by rising worker productivity. In our view, an important factor contributing to declining productivity growth is the large decline in the creation of new businesses. The creation rate of new businesses, as well as new plants built by existing firms, was about 30% lower in 2011 (the most recent year of data) compared with the annual average rate for the 1980s. (The data is the Census Bureau’s Business Dynamic Statistics.) The decline affected nearly all business sectors.

Steven Malanga coined the term startupicide – “suffocating regulations, inflated business taxes and fees, a lawsuit-friendly legal environment, and a political class uninterested in business concerns” – which gets sprayed on every business, large and small.  At the margins those factors clearly affect the viability of new businesses and new projects.  Here’s how we once put it, discussing just one of the four ingredients:

For Costco (one example) to build a new store, a 40% tax rate on the income will require much higher sales expectations for the store than if taxes were 30%, or 20%, or 0%.  It’s the same analysis regardless of who is making the investment decision: rich angel investor, venture capitalist, Fortune 500 CFO.  When taxes are higher, fewer stores get built and fewer companies get started.

The WSJ piece continues:

New businesses are critical for the U.S. economy to grow because a small fraction of today’s startups will become tomorrow’s economic heavyweights. Most of today’s workers are employed at older, established businesses, but the country cannot rely on existing companies to boost the economy. Businesses have a life cycle, in which even the largest and most successful reach a stage at which they stop expanding.

If history is any indication, many of today’s economic heavyweights will ultimately decline as new businesses take their place. Research by the Kaufman Foundation shows that only about half of the 1995 Fortune 500 firms remained on the list in 2010.

That’s the funny thing about those large companies:  they all have birthdays, either as start-ups themselves or as spin-offs from other companies (who were once start-ups).  Many of them are born during very bad times – as long as the entrepreneurial incentives, and entrepreneurial optimism, remain intact.

Over half the companies on the Fortune 500 were started during a recession or bear market.  The patents for the Television, Jukebox, and Nylon were granted during the greatest period of job destruction in our history:  The Great Depression.  (Although we can’t confirm any patent information on the chocolate chip cookie, it too was invented at the same time.)  This is precisely the creative destruction that makes our economy an engine of innovation and wealth creation.

That $1 trillion in forfeited economic output demonstrates that a growing economy, with plenty of opportunity, and no shortage of entrepreneurial activity (at start-ups and within firms) should not be taken for granted.


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Conversations about valuations

This article on valuation from the Houston Business Journal is written from the point of view of middle-market investment banking, but it’s also relevant to term sheet negotiations between entrepreneur and venture capitalist.  Higher EBITDA doesn’t automatically lead to higher multiples (and higher valuations).

The reality is that valuations are much more complex and are primarily a function of the underlying fundamentals of a business. These fundamentals might include growth opportunities, recurring revenues, customer and product diversity, entry barriers, proprietary products and high levels of free cash flow.  Our experience tells us that different buyers can have widely divergent views of value based on their relative assessments of these underlying fundamentals

It is important for private business owners to understand valuation drivers and to develop the financial and operating data that will enable buyers to properly assess the underlying fundamentals of their business.  More clarity for a buyer leads to a higher level of confidence and a more attractive valuation for the seller.

It also leads to a higher level of confidence in the relationship.  The early conversations about valuation (and control) begin to shape the personal chemistry crucial to a successful long-term partnership.  Clarity and transparency, which make it easier for everyone involved to observe how decisions are being made, are much more important to hopeful-future-teammates than either side trying to squeeze maximum value out of a single transaction.

If a good tone is set early and maintained consistently, over time everyone on the team worries less about who’s in control and more about how to create the best scoring opportunity.



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Vintage Future VI

Here is the long-overdue “VIth” installment of our Vintage Future series, in which we take a tongue-in-cheek look back at the predictions of past generations of investors and futurists.

In our line of work it’s good to guard against the hubris inherent in projecting conventional wisdom too far out into the future, and to remind ourselves that today’s trend can be tomorrow’s punchline.

Courtesy of “The Forgotten Firsts: 10 Vintage Versions of Modern Technology.

Predicting technology trends is not for the weak at heart – and that’s before one tries to protect the IP and find a way to profit from it.

These are among the reasons we affectionately call the really early stage of investing adventure capital, and consider ourselves a “growth accelerator” for established, rapidly growing businesses with strong management teams. We prefer to focus our efforts on assessing competitive and execution risk rather than product or business model risk, and we want to see tangible evidence of the unique value offered by a company’s product or service.


N.B. – previously featured in Vintage Future:




How private entrepreneurs won WWII

Freedoms ForgeIn case you missed it late Friday (June 6) online at the WSJ:  How private entrepreneurs won WWII.

We appreciate the author’s (Freedom’s Forge) point that it was the entrepreneurial spirit of both the Titans of Industry and their smaller counterparts who made the Arsenal of Democracy possible.  “Big and small firms – all – stepped up.”

Easy to forget that in 1940 we had only the 18th largest military in the world, behind Argentina.


Appreciating the rich for how they got there, Part II

We once wrote that the hard-earned success of entrepreneurs is what gives them the inclination and the wherewithal to help support the next generation of high-growth companies.  The wealth created “yesterday” is not stuffed under plump mattresses, it’s used “today” to fund the businesses and innovations that enhance and enrich all our lives.  Most of those savings come from a relatively small fraction of individuals in the top income tax bracket, and to disparage them is to bite the hand that feeds long-run economic growth.

Intel's 4004: the first microprocessor

Intel’s 4004: the first microprocessor

John Steele Gordon, author of “An Empire of Wealth: The Epic History of American Economic Power,” advances the argument in the 6/4/14 Wall Street Journalextreme leaps in innovation, like the microprocessor, bring with them staggering fortunes – but also enrich and enhance all our lives.

(N)o one is poorer because Bill Gates, Larry Ellison, et al., are so much richer. These new fortunes came into existence only because the public wanted the products and services—and lower prices—that the microprocessor made possible. Anyone who has found his way home thanks to a GPS device or has contacted a child thanks to a cellphone appreciates the awesome power of the microprocessor. All of our lives have been enhanced and enriched by the technology.

This sort of social transformation has happened many times before. Whenever a new technology comes along that greatly reduces the cost of a fundamental input to the economy, or makes possible what had previously been impossible, there has always been a flowering of great new fortunes—often far larger than those that came before. The technology opens up many new economic niches, and entrepreneurs rush to take advantage of the new opportunities.

The full-rigged ship that Europeans developed in the 15th century, for instance, was capable of reaching the far corners of the globe. Soon gold and silver were pouring into Europe from the New World, and a brisk trade with India and the East Indies sprang up. The Dutch exploited the new trade so successfully that the historian Simon Schama entitled his 1987 book on this period of Dutch history “The Embarrassment of Riches.”

Steele mentions a few other notable examples:

  • James Watt’s rotary steam engine sparked the Industrial Revolution, causing growth – and thus wealth and job creation – to sharply accelerate.
  • Railroads made transportation cheap and created national markets.  Railroad owners and retailers made fortunes while everyone benefited from easier access to cheaper goods.
  • Edwin Drake’s drilling technique made oil abundant, the Bessemer converter made steel cheap, and both taken together made the automobile possible;  this in turn had spillover effects (and fortunes) in other industries (rubber, glass, road building, etc.)

The Little Miracle Spurring Inequality today is cheap computing power.  Software, hardware, the Internet, and precise inventory control have transformed the world and created huge new fortunes in the process.

To see how fundamental the microprocessor—a dirt-cheap computer on a chip—is, do a thought experiment. Imagine it’s 1970 and someone pushes a button causing every computer in the world to stop working. The average man on the street won’t have noticed anything amiss until his bank statement failed to come in at the end of the month. Push that button today and civilization collapses in seconds. Cars don’t run, phones don’t work, the lights go out, planes can’t land or take off. That is all because the microprocessor is now found in nearly everything more complex than a pencil.

Just as before, that wealth will not be stuffed into mattresses, it will go to work:

Any attempt to tax away new fortunes in the name of preventing inequality is certain to have adverse effects on further technology creation and niche exploitation by entrepreneurs—and harm job creation as a result. The reason is one of the laws of economics: Potential reward must equal the risk or the risk won’t be taken.

And the risks in any new technology are very real in the highly competitive game that is capitalism. In 1903, 57 automobile companies opened for business in this country, hoping to exploit the new technology. Only the Ford Motor Co. survived the Darwinian struggle to succeed. As Henry Ford’s fortune grew to dazzling levels, some might have decried it, but they also should have rejoiced as he made the automobile affordable for everyman.


Mt. Everest conquered but not tamed

hillarynorgay61 years ago, on May 29, 1953, New Zealander Edmund Hillary and Nepalese sherpa Tenzing Norgay became the first to reach the summit of Mount Everest, arriving just before noon after spending the night high on the mountain.

The anniversary brings to mind another May (1996) expedition on Everest which ended in deadly disaster.  The details of what went wrong in that May 43 years after Hillary and Norgay’s triumph are recounted by John Krakauer’s Into Thin Air (one of the recommended books on decision-making in The Library in St.Pete.)

air_In the author’s retelling, a series of events led to several climbers inexplicably ignoring the “Two O’Clock Rule,” which says:  if not at the summit by 2:00, turn back because “darkness is not your friend.”   Their descent occurred at night, in a blizzard, as they ran out of supplemental oxygen.  5 people died and others barely escaped with their lives after many hours wandering in the dark while braving subzero temperatures.

That series of events was analyzed by Professor Michael Roberto in a 2002 paper entitled “Lessons from Everest.”  It had struck Professor Roberto that “the disastrous consequences had more to do with individual cognition and group dynamics than with the tactics of mountain climbing.”  He found several factors that caused experienced people to violate their better judgment.

Cognitive biases

3 cognitive biases came into play:

  1. Sunk Cost Fallacy:  The magnitude of the personal investment – $70,000 and weeks of agony – made many reluctant to turn back once so close to the peak.  “Above 26,000 feet the line between appropriate zeal and reckless summit fever becomes grievously thin.”
  2. Overconfidence bias:  The lead guides had impressive track records of success and had overcome adverse conditions before.  One told his team, “We’ve got the Big E figured out.  We’ve got it totally wired.  These days, I’m telling you, we’ve built a Yellow Brick Road to the summit.”   He also “believe(d) 100% I’m coming back” because “I’m going to make all the right choices.”  The overconfidence extended to many other climbers as well.  Krakauer wonders if they weren’t “clinically delusional.”
  3. Recency Effect:  Paying too much attention to recent events.  Climbers had encountered good weather on the mountain in recent years so many of the climbers thought the storm was surprising but in fact it was rather typical.

Team Effectiveness

The team lacked the ‘robust social systems’ in which members’ informal  modus operandi ensure that the decision-making process functions properly.

  1. Climbers were almost strangers and had not had time to develop trusting relationships.
  2. Group members did not feel comfortable expressing dissenting views, in part because one expedition leader had stated, “I will tolerate no dissension up there… my word will be absolute law.”  (Sadly, to protect everyone via enforcement of the Two O’Clock Rule.)
  3. There was an absence of candid discussion due to (a) the deference in the “guide-client protocol” and (b) a pecking order amongst the guides that led “lesser” ones to keep their concerns to themselves.

Complex Interactions and Tight Coupling

Very briefly, “the team fell behind schedule and encountered the dangerous storm because of a complex set of interactions among a customs problem in Russia, Scott Fischer’s acclimatization routine in Nepal, a Montenegrin expedition’s use of rope, a failed negotiation with Outside magazine, and so on.”  There was also no slack in the system, so when there was a problem in one area it triggered failure in another.

The bottom line may be that they violated a sacrosanct rule, but the more interesting question is why?  The unwillingness to question team procedures and exchange ideas openly prevented the group from revising and improving their plans as conditions changed.

Though the stakes are (much) smaller in a high-growth company, an entrepreneur faces similar challenges:  he has a team and a plan, faces a fast-changing environment, and the odds might be long.  Success hinges on creating an environment of mutual accountability in which team members trust and challenge each other.



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