VENTURE CAPITAL AND PUBLIC POLICY: HOW TO DRIVE START-UP ACTIVITY, INVESTMENT, AND ECONOMIC GROWTH
Americans usually deny that government intervention is a good thing in the entrepreneurship and venture capital game. Most of them believe that the growth of the venture capital industry and the high growth technology start-up phenomenon was the result of some sort of pure capitalistic forces that were devoid of any sort of government intervention. That is simply not the case.
The growth of the venture capital industry in the United States was really a side effect of a policy intended to protect pensioners. The Employment Retirement Security Act (ERISA) http://en.wikipedia.org/wiki/Employee_Retirement_Income_Security_Act which was enacted in 1974 resulted in driving a large amount of capital into the venture capital industry. Essentially the reason was that pension funds managers were pressured to use sound portfolio allocation models that resulted in a portion of their investment portfolios being allocated to “alternatives” including venture capital. Also, these managers were forced to invest in 3rd party expert managers, or bear personal liability for backward-looking poor investment decisions. Thus the supply of institutional capital that became rapidly available to the venture capital industry was an unintended consequence of the Act. One can trace the growth of the venture capital industry right back to 1974, and before that, its birth around the time that the Small Business Investment Act of 1958 http://en.wikipedia.org/wiki/Small_Business_Investment_Act_of_1958. This programme was really responsible for launching the venture capital industry in the United States. (for more on this read Lerner and Gompers).
SUPPLY IS A GOOD THING – AND SO IS COMPETITION
Supply creates demand. The increased supply of risk (venture) capital in the Silicon Valley had a positive effect. New firms were formed and existing firms grew larger. The competition between venture capital firms caused them to aggressively seek out investments and offer as much help to these early stage start-ups as they could so that they could grow and form competitive advantage. This, in turn, caused more angels to enter the market in the early stages, for they were confident that the later stage venture capital funds could assist the firms in which they invested, and increased the odds of exit down the road. This increase supply of capital, in turn, lured entrepreneurs from not only the halls of the universities in Northern California such as Stanford and Berkeley, but also from the world at large. Entrepreneurs flocked to the Valley “like flys on sugar”. Entrepreneurs needed angels and venture capitalists and angels and venture capitalists needed entrepreneurs. It was a match made in heaven. And the snowball effect took hold. Fast forward 35 years and the Silicon Valley is now home to 50% of the planet’s venture capital supply.
WHY AREN’T THERE MORE START-UPS AND TECHNOLOGY COMPANIES OF SIZE IN SCOTLAND
There are not as many start-ups and technology companies of size in Scotland because of the lack of risk capital at all stages of the lifecycle of a high growth venture. Especially in early and mid-stage venture capital. Arguably, currently there are only two substantial players in the technology venture capital game here in the early stages, and another one that is playing in the later stage and is pan-European. The angels in the Country have all but shut down, especially in the financing of new early stage technology ventures. Three firms playing in Country of 5 million with 13 universities and a handful of inactive angels is the landscape that faces the entrepreneur in Scotland today.
People often correlate the lack of start-ups and growth companies to “lack of management talent” and “lack of marketing know how” or “lack of the spirit of selling”. However, what these people are forgetting is that these problems are easily solved with money. Its that simple.
Money can buy marketing and management talent, and attract good salespeople. Offered competitive salaries and share packages, talent will move wherever in the world to make things happen. It will come from Silicon Valley, Boston, Hong Kong, Paris, Stockholm, you name it. (Read Richard Florida’s “Flight of the Creative Class” for more on this). Its not about the weather, its about paying people what they are worth and compensating them for taking a risk on the upside. And the lifestyle benefits are here. But without money, entrepreneurs can’t buy in the talent they need. And without a competitive venture capital industry, entrepreneurs can’t get the money they need to buy in this talent.
There are a more than a few promising areas for Scotland (and the UK as a whole), including energy (cleantech), biotechnology and informatics. Just addressing the biotechnology industry, and its promise, it is obvious that without “big” venture capital, the potential of the industry will never materialize. Scotland needs firms that can start with investments of $5 million, follow-on with $20 million, and then come in with another $50 million in the “C” round. Sizable, expert venture capital is needed to bring this industry to fruition. What is needed is a step change in thinking, and in growing global companies. Without it, projects such as the BioQuarter http://www.scottish-enterprise.com/se/edinburghsciencetriangle/est-scienceparks/edinburghscienceparks/bioquarter.htm at the University of Edinburgh will never be leveraged to their full potentials and make a big dent on economic development.
Create the supply of risk capital and the entrepreneurs will sniff it out and get on the trail. They will emerge and come out to the light, out of the woodwork — from the halls of the universities, the bowels of large corporations, from the cramped offices of smaller firms, from the design studios and other creative spaces. They will travel over the waters to get here, from lands far away, and from parts unknown. They are a people driven by a dreams and visions, and will go where they must to receive the fuel they need to make these dreams and visions a reality. They will settle and build things of value.
INCREASING THE SUPPLY OF VENTURE CAPITAL THROUGH POLICY
Learning from the US example, the government can enact policies to increase the supply of risk capital in the Country (used interchangeably to mean either devolved Scotland or the UK, the issues are basically the same. While their powers are different, and a more detailed examination and policy recommendation will be made in a later paper).
Tax Policy is OK, but Not Enough:
Tax policy can help. Already this has happened in the angel market, with tax benefits for these investors who are part of VCTs. However, tax policy is but one option. It hasn’t yet been able to drive large flows of capital into the technology risk investment sector as of yet. Even at the angel level, most are not playing in the high growth technology firm game.
Other policies could drive money into the venture capital industry and should be pursued. For example, all public institutions with investment portfolios [most of them are in equities (stocks) and debt (bonds)] could be required to allocate a % of their portfolios to domestic venture capital managed by third parties. This % allocation might be around 2% at the beginning, rising to 10% over time. Something similar to the ERISA legislation could be enacted, but with the specific requirement of a minimal investment in venture capital.
What about the government just simply investing in venture capital itself? In the United Kingdom, the government now owns a large portion of a lot of big banks. I believe that the ownership share of the taxpayers is around 70% of the Bank of Scotland now. http://www.heraldscotland.com/business/markets-economy/taxpayer-loss-from-rbs-and-lloyds-bail-outs-1.925914 With that much exposure to financial institutions, which might fail anyway, why wouldn’t the government legislate policies to increase the supply of risk capital, especially venture capital, both early and later stage? Let’s ask the taxpayer: which would you rather invest your taxpounds in? a) Venture capital firms based in your Country that invest in exciting, early stage technology companies that could change the world, and create really cool new jobs or b) Big banks that create and sell shaky derivative things, buy and create bad mortgages, don’t lend money to the small business, don’t invest in the small business, and buy groups of banks (that you never heard of) in other countries?
By pursuing such policies and growing the venture capital supply base, the Country will effectively undertake a contrarian strategy that could reap great benefits in the long run. Its science and technology base will grow and be exploited. With the venture capital industry predicted to downsize 50% over the next 5 years in the US, the UK will grow its risk capital base here upwards of 500% over the same period, and harvest good venture capital talent from around the globe in the process. Dawn of a new day, perhaps.
WHAT ARE THE HISTORICAL RETURNS IN INVESTMENT IN VENTURE CAPITAL?
In my next writing I’ll address this question for it logically follows my argument above about turning on the faucets for venture capital through public policy. I’ll look at this question and the dynamics of the venture capital investment from the institutional point of view. An increased portion of public assets would be placed in riskier venture capital investments. Suffice to say for now that all classes of venture capital have historically beaten the public equity markets in the US context over the long haul. And let’s not forget what happened over the last year, when most public institutions lost 20 – 30% of their portfolio values because of the public equity markets. Supposedly these were “safe” investments.