The IPL newsletter: Volume 12, Issue 249

INTRODUCTION

This newsletter is published by The Innovation Policy Lab at the Munk School of Global Affairs, University of Toronto, and sponsored by the Ministry of Research and Innovation. The views and ideas expressed in this newsletter do not necessarily reflect the views and policies of the Ontario Government.

Innovation in Cities and Innovation by Cities

Robert D. Atkinson, ITIF
Innovation is in vogue. Companies want it. Places want it. Why? Because the success of companies and places depends more on innovation than ever before. Despite its luster, many public and private sector leaders cannot really define innovation and therefore, stumble when trying to encourage or harness it. This paper suggests four challenges sub-national places face when it comes to innovation: 1. Understanding the integral link between private sector innovation and public innovation policy in economic development; 2. Understanding that innovation comes in many forms and phases of production and development; 3. Focusing on not just innovation in places, but innovation by places, i.e. states and localities must themselves try new policy approaches; 4. And finally, creating partnerships between places, especially local places and the national government.

The Role of Different Funding Models in Stimulating the Creation of Innovative New Companies: What is the Most Appropriate Model?

Technopolis/European Research Area Board
This study argues that the issue facing Europe is not just a lack of firms that rapidly grow large, but also a wider problem related to a long tail of poor performance enterprises operating in fragmented uncompetitive markets. This leads to wide productivity differences across and within national states. For many European regions the more important issue is upgrading existing firms’ productivity, rather than seeking to advance the technological frontier. The relative lack of venture funding for European firms compared to the US may therefore simply reflect problems of demand. In the UK, for example, public policy that has increased the supply of VC without properly addressing the capability of either VC funds or firms has had a limited impact. That said, there may be a small number of high potential, high quality firms that are not being funded effectively. This is particularly a problem in relation to equity financing. Moreover, the high tech firms investing in R&D and other intangible forms of innovation are the firms most likely to be refused debt even though they are the least likely to fail. This ‘equity gap’ is one factor explaining why American firms have much higher post-entry growth (60% growth in employment compared to European firms 5-35%). These differences in growth rates indicate a more experimental approach to start-ups in the US. Smaller firms in the US get the resources to grow faster if the smaller scale initial experiments are deemed a success. The key issue for policy makers is therefore not generating more small firms, but focusing on the small proportion of exceptional young firms that grow rapidly to become large firms. In this context, the study explores and appraises the main financial mechanisms in the US, Europe, Canada, Israel and Australia for stimulating young leading innovative companies.

What is the most appropriate mix of finacial support for young innovation companies (Yollies) and what mix of finacial methods is optimal at the European level?

The EU faces a lack of strong growth amongs its firms and not a lack of start ups
European public policy in relation to entrepreneurship needs to shift its focus from quantity to quality and enhance the performance of the small minority of firms that drive economic growth and job creation. Public policies that encourage excessive market entry of low quality firms can be damaging to the economy if they drive up factor prices for high quality firms, dilute entrepreneurial and managerial talent and create a ‘market for lemons’ for investors.

Venture investing is part of a strongly interconnected system – business angels and VC funds do not exist in isloation
This system is comprised of institutional and government investors; a flow of high quality, investment ready firms; skilled, specialized and large professional investor funds; exit markets that allow investors to realise high returns; and a network of professional advisors able to advise growing firms. This system has to work effectively for long periods of time in order to develop the necessary human capital for it to sustain itself. Moreover, it has to allow firms to move up the funding ‘escalator’ as they grow and access increasingly large amounts of money. As firms grow they need different kinds of funding. For example, young technology firms often need cash flow which is often more appropriately funded through debt instruments than through equity. Credit (loan) guarantees generally work in a modest, but effective way (although guarantees over 80% reduces the risk to lenders too much and reduces their incentives to evaluate proposals diligently). Equity, and particularly ‘smart’ equity that provides professional support in combination with money, is also important. Developing a viable VC and venture investing sector is a long term project that has taken over 50 years in the USA. Europe seems to be learning faster, in part because the US provided a model to follow, but policy makers should be thinking in terms of decades rather than years as this gives firms the time to innovate and produce meaningful results.

Simplicity, clarity and the alignment of incentives
The review of the various policy instruments that have been tried around the world suggests that policy should be designed with simplicity of administration, delivery, and wider understanding in mind. Attempts to integrate social policy with economic policy and use VC funds for social objectives are rarely effective. Instead, policy that has clear objectives that are well articulated to private
sector and other intermediaries involved in delivery, and is strongly aligned with private sector intermediaries’ incentives is most effective at achieving policy objectives. Schemes with a small number of core parameters (e.g. investment size, sector, age target, investment term) can be the most adaptable and flexible way of reacting to changing economic circumstance or policy shifts. Schemes must be able to adapt quickly, with the minimum of bureaucracy, to respond to the rapidly changing environments that have characterised the 50 year history of venture capital.

Accumulated knowledge shows what types of funds are the most successful
For Business Angels the key initial issue is building up capability and addressing demand side ‘investment readiness’ problems;
once these are addressed, policies can move onto support and then co-invest with the professional networks that emerge. Such policies can be effective and are often very cost effective. With VC, the review of evaluations highlighted the importance of building up human capacity during the early years of the industry, and continuing to support capacity building as experienced investors move out of early stage investing into later stage investing. As human capacity is built up successful policies tended to move towards strongly incentivizing success. These incentives can involve penalizing VC intermediaries who ‘misbehave’ and pursue short-term, high risk investment strategies. The experience of the UK hybrid fund schemes suggests that the public sector can make significant indirect returns from its investment in supporting well incentivized private sector venture funds from the increased taxation and job creation
that follows. Governments, unlike other investors, can appropriate the benefits of their investments indirectly, and therefore have more to gain from supporting worldleading clusters of technology, firms and investors.

Reward success rather than subsidize failure
Build well-funded, long-term, professionally managed schemes that reward success rather than subsidize failure. It is vital to ensure schemes are large, as underfunded schemes guarantees failure. Good policy focuses on both direct and indirect effects (i.e. job creation from policies aimed at achieving commercial returns and technology spillovers) and learns from experience over long
periods and drops (improves) bad schemes.

Design VC hybrid schemes
These should be large (i.e. >€50m), never regionally focused (as this constrains deal flow and the benefits of specialization), and properly aligned with realistic commercial incentives. This latter point means that funds should be allowed to make commercial decisions and should not be constrained in their ability to make follow-on investments and avoid dilution. Policy should ensure the escalation of smart capital, as both debt and equity funding, seamlessly grows with firms’ expanding funding requirements. As a consequence, low caps on the upper limit on VC type investments (i.e. below €3m) should be avoided. Schemes should rely on co-funding from private sector investors to signal quality, and strongly incentivize success (ideally with the recognition that tax payer returns are likely to be larger through increased tax revenues from the additional jobs and economic activity that is generated). Protecting funds from the consequences of their poor quality investment decisions by providing downside protection should be
avoided. The experience of the USA and Israel highlights the need to continuously support success in areas of global competitive advantage.

Shut down ineffective instruments
In such a dynamic environment it is important to evaluate policy and shut down or change ineffective policy instruments. There is evidence that there are a number of highly ineffective schemes for supporting SMEs operating in Europe that if shut down, would free up enough funds to allow a significant shift towards a more effective venture investing system within Europe at no additional cost to the taxpayer. At the EU level, the main financing initiatives are: the Risk Sharing Finance Facility (RSFF), the High Growth and Innovative SME Facility (GIF) and the SME Guarantee Facility (SMEG). In addition, the Structural Funds, through the European Regional Development Fund (ERDF) and various supporting initiatives (JEREMIE) has led to a significant investment in national and regional early stage and venture capital funds (with mixed results). Evidence on the effectiveness of the EU level instruments is
mixed, at best, and there is an on-going debate on how to develop them in the next financial period (2014-20). The study findings suggest that there should be a significant reorientation from the current model, which simplistically could be described as “multiplying sub-critical regional funds aiming at supporting low growth potential firms”, towards a limited number of European level funds with sufficient flexibility to adapt strategies rapidly to investment trends (e.g. the EU Invest proposal that would operate outside of national regulatory regimes with funds at least 10 times bigger than current national schemes and fund management outsourced to best available private investors).

Similarly, proposals to syndicate, leverage and encourage business angels’ interventions by topping up their investment with co-financing from the public sector including potentially by establishing a dedicated pan-European fund are worth pursuing. Given the limited deal flow from even the largest research universities or centres, the potential for one or more European level co-investment funds working with groups of research-intensive universities to encourage follow-on investments in the most promising new-technology based ventures could be considered. Extending the role of the Government sector through European level instruments such as an equivalent of the US SBIR would potentially help to generate a larger deal flow for the venture capital sector and promote Yollies in key sectors of relevance for public policies (e.g. health, transport, security, etc.). Finally, expanding the supply of venture capital and the rate of creation of Yollies is not a panacea, rather, it is the structural barriers in Europe to growth that need to be solved: too few VCs of sufficient scale and quality; problems arising from a fragmented market with varying national regulations, and the lack of an exit route of sufficient scale (a European NASDAQ).