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IV ANNEXES

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Annex A "Public Venture Capital": Rationales and Evaluation Joshua L`erner* Within the past few years, public efforts to finance small high-technology firms have proliferated. This article reviews the motivations for and the assessment of these efforts. It explores the underlying challenges that the financing of young growth firms poses, the ways that specialized financial intermediaries address them, and the rationales for public efforts to finance these companies. The final section raises a set of questions about the assessment of these efforts. INTRODUCTION The federal government has played an active role in financing new firms, particularly in high-technology industries, since the Soviet Union's launch of the Sputnik satellite. In recent years, European and Asian nations and many U.S. states have adopted similar initiatives. While these programs' precise structures have differed, the efforts have been predicated on two shared assumptions: (i) that the private sector provides insufficient capital to new firms, and (ii) that the government either can identify investments which will ultimately yield high so *Harvard University and National Bureau of Economic Research. This is based on comments at the "Symposium on the SBIR Program" at the National Academy of Sciences, as well as on conver- sations with Zoltan Acs, Ken Flamm, Paul Gompers, Adam Jaffe, Bill Sahlman, Greg Udell, and Chuck Wessner. Parts of this article are adapted from Lerner [1996] and Lerner [1998]. Financial support was provided by Harvard Business School's Division of Research. All errors are my own. 115

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116 THE SMALL BUSINESS INNOVATION AND RESEARCH PROGRAM cial and/or private returns or can encourage effective financial intermediaries.) In contrast to many forms of government intervention designed to boost eco- nomic growth, such as privatization programs, these claims have received little scrutiny by economists. The neglect of these questions is unfortunate. While the sums of money involved are modest relative to public expenditures on defense procurement or retiree benefits, these programs are very substantial when compared to contem- poraneous private investments in new firms. Several examples, documented in Gompers and Lerner [1998bi, underscore this point: the Small Business Investment Company (SBIC) program led to the pro- vision of more than $3 billion to young firms between 1958 and 1969, more than three times the total private venture capital investment during these years (Noone and Rubel [19701~. in 1995, the sum of the equity financing provided through and guaranteed by public small business financing programs was $2.4 billion, more than 60% of the amount disbursed by traditional venture funds in that year. Perhaps more significantly, the bulk of the public funds went to early-stage firms, which in the past decade had accounted for only about 30% of the disbursements by indepen- dent venture capital funds (Venture Economics [19961~. some of America's most dynamic technology companies received support through the SBIC and Small Business Innovation Research (SBIR) programs while still privately held entities, including Apple Computer, Chiron, Compaq, and Intel. public venture capital programs have also had a significant impact over- seas: e.g., Germany has created about 800 federal and state government financing programs for new firms over the past two decades, which provide the bulk of the financing for technology-intensive start-ups (Organization for Economic Coop- eration and Development ~ 1995 ~ ). Government programs in this arena have been divided between those efforts that directly fund entrepreneurial firms and those that encourage or subsidize the development of outside investors. While these efforts have proliferated, a consensus as to how to evaluate these programs remains elusive. The gap between the approaches employed by aca- demics and practitioners is substantial. Furthermore, there is a lack of consensus among economists as to what the proper approaches are. ~ It is striking to note the similar emphasis on these rationales in, for instance, the statement of Senator John Sparkman [1958] upon the passage of the Small Business Investment Act and the recent testimony of Dr. Mary Good, Under Secretary for Technology at the U.S. Department of Commerce [1995]. The rationales for such programs are discussed in depth in U.S. Congressional Budget Office [1985].

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ANNEX A 117 This article will provide an overview of the motivations for these efforts to encourage individual investors. In Section 2, the underlying challenges that the financing of young growth firms poses are discussed, as well as the ways that specialized financial intermediaries address them. The rationales for public pro- grams are explored in Section 3. Section 4 concludes the paper and raises a set of questions about the assessment of these efforts. VENTURE CAPITALISTS AND THE FINANCING CHALLENGE The initial reaction of a financial economist to the argument that the govern- ment needs to invest in young firms is likely to be skepticism. A lengthy litera- ture has highlighted the role of financial intermediaries in alleviating moral haz- ard and information asymmetries.2 Young high-technology firms are often characterized by considerable uncertainty and informational asymmetries, which permit opportunistic behavior by entrepreneurs. Why one would want to encour- age public officials instead of specialized financial intermediaries (venture capi- tal organizations) as a source of capital in this setting is not immediately obvious. The Challenge of Financing Young High-Technology Firms To briefly review the types of conflicts that can emerge in these settings, Jensen and Meckling [19761 demonstrate that agency conflicts between manag- ers and investors can affect the willingness of both debt and equity holders to provide capital. If the firm raises equity from outside investors, the manager has an incentive to engage in wasteful expenditures (e.g., lavish offices) because he does not bear their entire cost. Similarly, if the firm raises debt, the manager may increase risk to undesirable levels. Because providers of capital recognize these problems, outside investors demand a higher rate of return than would be the case if the funds were internally generated. Even if the manager is motivated to maximize shareholder value, informa- tional asymmetries may make raising external capital more expensive or even preclude it entirely. Myers and Majluf [19841 and Greenwald, Stiglitz, and Weiss [19841 demonstrate that equity offerings of firms may be associated with a "lemons" problem (first identified by Akerlof [19701~. If the manager is better informed about the investment opportunities of their firms than the investors and 2 Editors Note: Moral hazard refers to inefficient behavior by one actor in a transaction brought on by differences in information available to parties in the transaction. A classic example is insurance. An individual who purchases insurance has an incentive to engage in risky behavior, because insur- ance will compensate for negative consequences of the behavior. The insurance company might address the problem by collecting information and closely monitoring the individual. However, it is likely to be costly, and in some cases impossible, to collect sufficient information to adequately monitor the individual's behavior. See Dennis Carlton and Jeffrey Perloff, Industrial Organization, New York: Prentice, 1992, pp. 716-717.

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118 THE SMALL BUSINESS INNOVATION AND RESEARCH PROGRAM acts in the interest of current shareholders, then the manager issues new shares only when the company's stock is overvalued. Indeed, numerous studies have documented that stock prices decline upon the announcement of equity issues, largely because of the negative signal sent to the market. These information problems have also been shown to exist in debt markets. Stiglitz and Weiss [19811 show that if banks find it difficult to discriminate among companies, raising interest rates can have perverse selection effects. In particu- lar, the high interest rates discourage all but the highest-risk borrowers, so the quality of the loan pool declines markedly. To address this problem, banks may restrict the amount of lending rather than increasing interest rates. These problems in the debt and equity markets are a consequence of the information gaps between the entrepreneurs and investors. If the information asymmetries could be eliminated, financing constraints would disappear. Finan- cial economists argue that specialized financial intermediaries can address these problems. By intensively scrutinizing firms before providing capital and then monitoring them afterwards, they can alleviate some of the information gaps and reduce capital constraints. Responses by Venture Capitalists The financial intermediary that specializes in funding young high-technol- ogy firms is the venture capital organization. The first modern venture capital firm, American Research and Development (ARD), was formed in 1946 by MIT President Karl Compton, Harvard Business School Professor Georges F. Doriot, and local business leaders. A small group of venture capitalists made high-risk investments in emerging companies that were formed to commercialize technol- ogy developed for World War II. The success of the investments ranged widely: almost half of ARD' s profits during its 26-year existence as an independent entity came from its $70,000 investment in Digital Equipment Company (DEC) in 1957, which grew in value to $355 million. Because institutional investors were reluc- tant to invest, ARD was structured as a publicly traded closed-end fund and mar- keted mostly to individuals (Liles [19771~. The few other venture organizations begun in the decade after ARD's formation were also structured as closed-end funds. The first venture capital limited partnership, Draper, Gaither, and Anderson, was formed in 1958. Imitators soon followed, but limited partnerships accounted for a minority of the venture pool during the 1960s and 1970s. Most venture organizations raised money either through closed-end funds or small business investment companies (SBICs), federally guaranteed risk capital pools that pro- liferated during the 1960s. While investor demand for SBICs in the late 1960s and early 1970s was strong, incentive problems ultimately led to the collapse of the sector. The annual flow of money into venture capital during its first three

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ANNEX A 119 decades never exceeded a few hundred million dollars and usually was substan- tially less. The activity in the venture industry increased dramatically in late 1970s and early 1980s. Industry observers attributed much of the shift to the U.S. Depart- ment of Labor's clarification of ERISA's "prudent man" rule in 1979. Prior to that year, the Employee Retirement Income Security Act (ERISA) limited pen- sion funds from investing substantial amounts of money in venture capital or other high-risk asset classes. The Department of Labor's clarification of the rule explicitly allowed pension managers to invest in high-risk assets, including ven- ture capital. In 1978, when $424 million was invested in new venture capital funds, individuals accounted for the largest share (32 percent). Pension funds supplied just 15 percent. Eight years later, when more than $4 billion was raised, pension funds accounted for more than half of all contributions. (These annual commitments represent pledges of capital to venture funds raised in a given year. This money is typically invested over three to five years starting in the year the fund is formed.) The subsequent years saw both very good and trying times for venture capi- talists. On the one hand, venture capitalists have backed during the 1980s and 1990s many of the most successful high-technology companies, including Apple Computer, Cisco Systems, Genentech, Netscape, and Sun Microsystems. A sub- stantial number of service firms (including Staples, Starbucks, and TCBY) have also received venture financing. At the same time, commitments to the venture capital industry were very uneven. The annual flow of money into venture funds increased by a factor of ten during the early 1980s, peaking at just under six billion 1996 dollars. From 1987 through 1991, however, fund-raising steadily declined. Over the past five years, the pattern has been reversed; 1997 repre- sented a record fund-raising year, in which nearly $10 billion was raised by ven- ture capitalists. This process of rapid growth and decline has created a great deal of instability in the industry. To address the information problems that preclude other investors in small high-technology firms, the partners at venture capital organizations employ a va- riety of mechanisms. First, business plans are intensively scrutinized: of those firms that submit business plans to venture capital organizations, historically only 1% has been funded (Fenn, Liang, and Prowse [19951~. The decision to invest is frequently made conditional on the identification of a syndication partner who agrees that this is an attractive investment (Lerner [19941~. In exchange for their capital, the venture capital investors demand preferred stock with numerous restrictive covenants and representation on the board of directors. Once the decision to invest is made, the venture capitalists frequently dis- burse funds in stages. Managers of these venture-backed firms are forced to return repeatedly to their financiers for additional capital in order to ensure that the money is not squandered on unprofitable projects. In addition, venture capi- talists intensively monitor managers, often contacting firms on a daily basis and

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120 THE SMALL BUSINESS INNOVATION AND RESEARCH PROGRAM holding monthly board meetings during which extensive reviews of every aspect of the firm are conducted. (Various aspects of the oversight role played by ven- ture capitalists are documented in Gompers [1995i, Lerner [1995i, and Sahlman [19901; the theoretical literature is reviewed in Barry [19941.) It is important to note that, even with these many mechanisms, the most likely primary outcome of a venture-backed investment is failure, or at best mod- est success. Gompers [19951 documents that out of a sample of 794 venture capital investments made over three decades, only 22.5% ultimately succeeded in going public, the avenue through which venture capitalists typically exit their successful investments. (A Venture Economics study [19881 finds that a $1 in- vestment in a firm that goes public provides an average cash return to venture capitalists of $1.95 in excess of the initial investment, with an average holding period of 4.2 years. The next best alternative, a similar investment in an acquired firm, yields a cash return of only 40 cents over a 3.7-year mean holding period.) Similar results emerge from Huntsman and Hoban's [19801 analysis of the re- turns from 110 investments by three venture capital organizations. About one in six investments was a complete loss, while 45% were either losses or simply broke even. The elimination of the top-performing 9% of the investments was sufficient to turn a 19% gross rate of return into a negative return. In short, the environment in which venture organizations operate is extremely difficult. It is the mechanisms that are bundled with the venture capitalists' funds that are critical in assuring that they receive a satisfactory return. These circum- stances have led to venture capital organizations emerging as the dominant form of equity financing for privately held technology-intensive businesses.3 RATIONALES FOR PUBLIC PROGRAMS At the same time, there are reasons to believe that despite the presence of venture capital funds, there still might be a role for public venture capital pro- grams. In this section, I assess these claims. I highlight two arguments: that public venture capital programs may play an important role by certifying firms to outside investors, and that these programs may encourage technological spillovers. The Certification Hypothesis A growing body of empirical research suggests that new firms, especially technology-intensive ones, may receive insufficient capital due to the informa 3 While evidence regarding the financing of these firms is imprecise, Freear and Wetzel's [1990] survey suggests that venture capital accounts for about two-thirds of the external equity financing raised by privately held technology-intensive businesses from private-sector sources.

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ANNEX A 121 lion problems discussed in the previous section.4 If public venture capital awards could certify that firms are of high quality, these information problems could be overcome and investors could confidently invest in these firms. As discussed above, venture capitalists specialize in financing these types of firms. They address these information problems through a variety of mecha- nisms. Many of the studies that document capital-raising problems examine firms during the 1970s and early 1980s, when the venture capital pool was relatively modest in size. Since the pool of venture capital funds has grown dramatically in recent years (Gompers and Lerner [1996, 1998b]), even if small high-technology firms had numerous value-creating projects that they could not finance in the past, one might argue that it is not clear this problem remains today. A response to this argument emphasizes the limitations of the venture capital industry. Venture capitalists back only a tiny fraction of the technology-oriented businesses begun each year. In 1996, a record year for venture disbursements, 628 companies received venture financing for the first time (VentureOne [19971~; to put this in perspective, the Small Business Administration estimates that in recent years close to one million businesses have been started annually. Further- more, these funds have been very concentrated: 49% of venture funding in 1996 went to companies based in either California or Massachusetts, and 82% went to firms specializing in information technology and the life sciences (VentureOne [19971~. It is not clear, however, what lessons to draw from these funding patterns. Concentrating investments in such a manner may well be an appropriate response to the nature of opportunities. Consider, for instance, the geographic concentra- tion of awards. Recent models of economic growth building on earlier works by economic geographers have emphasized powerful reasons why successful high-technology firms may be very concentrated. The literature highlights several factors that lead similar firms to cluster in particular regions, including knowledge spillovers, specialized labor markets, and the presence of critical intermediate goods producers.5 Case studies of the development of high-technology regions (e.g., Saxenian [19941) have emphasized the importance of such intermediaries as venture capitalists, lawyers, and accountants in facilitating this clustering. A related argument for public investments is that the structure of venture investments may make them inappropriate for many young firms. Venture funds tend to make quite substantial investments, even in young firms; the mean ven- ture investment in a start-up or early-stage business between 1961 and 1992 (expressed in 1996 dollars) was $2.0 million (Gompers [19951~. The substantial 4 The literature on capital constraints (reviewed in Hubbard [1998]) documents that an inability to obtain external financing limits many forms of business investment. Particularly relevant are works by Hall [1992], Hao and Jaffe [1993], and Himmelberg and Petersen [1994]. These show that capital constraints appear to limit research-and-development expenditures, especially in smaller firms. 5 The theoretical rationales for such effects are summarized in Krugman [1991].

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22 THE SMALL BUSINESS INNOVATION AND RESEARCH PROGRAM size of these investments may be partially a consequence of the demands of insti- tutional investors. The typical venture organization raises a fund (structured as a limited partnership) every few years. Because investments in partnerships are often time-consuming to negotiate and monitor, institutions (limited partners) prefer making relatively large investments in venture funds, typically $10 million or more. Furthermore, governance and regulatory considerations lead institu- tions to limit the share of any fund that any one limited partner holds.6 As a consequence, venture organizations typically raise substantial funds of $100 mil- lion or more. Because each firm in his portfolio must be closely scrutinized, the typical venture capitalist is typically responsible for no more than a dozen invest- ments. Venture organizations are consequently unwilling to invest in very young firms that require only small capital infusions.7 This problem may be increasing in severity with the growth of the venture industry, as discussed above. As the number of dollars per venture fund and dollars per venture partner have grown, so too has the size of venture invest- ments. For instance, the mean financing round for a start-up firm has climbed (in 1996 dollars) from $1.6 million in 1991 to $3.2 million in 1996 (VentureOne [19971~. Again, it is not clear what lessons to draw from these financing patterns. Venture capitalists may have eschewed small investments because they were sim- ply not profitable, because of either the high costs associated with these trans- actions or the poor prospects of the thinly capitalized firms.8 Encouraging public investments in small firms may be counter-productive and socially wasteful if the financial returns are unsatisfactory and the companies financed are not viable. Support for these claims is found in recent work on the long-run performance of initial public offerings (IPOs). Brav and Gompers [19971 show that IPOs that had previously received equity financing from venture capitalists outperform other offerings. These findings underscore concerns about policies which seek to encourage public investments in companies that are rejected by professional investors. Furthermore, it appears that there were in 1997 a number of financial innova- tions to address the needs of early-stage entrepreneurs. These included the 6 The structure of venture partnerships is discussed at length in Gompers and Lerner [1996, 1998]. 7 There are two primary reasons that venture funds do not simply hire more partners if they raise additional capital. First, the supply of venture capitalists is quite inelastic. The effective oversight of young companies requires highly specialized skills that can only be developed with years of experi- ence. A second important factor is the economics of venture partnerships. The typical venture fund receives a substantial share of its compensation from the annual fee, which is typically between 2% and 3% of the capital under management. This motivates venture organizations to increase the capital that each partner manages. ~ For a theoretical discussion of why poorly capitalized firms are less likely to be successful, see Bolton and Scharfstein [1990].

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ANNEX A 123 creation of incubators and "entrepreneur-in-residence" programs by established venture organizations such as Mayfield and Mohr Davidow. Other examples are innovative efforts to direct the resources of individual investors to small venture capital funds (an example is Next Generation Partners, a "fund-of-funds" for wealthy families developed by FLAG Venture Partners). Finally, some institu- tional investors are displaying an increased willingness to provide capital to first time and seed venture funds. Thus, market forces may be addressing whatever problem has existed. The Presence of R&D Spillovers A second rationale emerges from the literature on R&D spillovers. Public finance theory emphasizes that subsidies are an appropriate response in the case of activities that generate positive externalities. Such investments as R&D expenditures and pollution control equipment purchases may have positive spillovers that help other firms or society as a whole. Because the firms making the investments are unlikely to capture all the benefits, public subsidies may be appropriate. An extensive literature (reviewed in Griliches [19921 and Jaffe [19961) has documented the presence of R&D spillovers. These spillovers take several forms. For instance, the rents associated with innovations may accrue to competitors who rapidly introduce imitations, developers of complementary products, or to the consumers of these products. Whatever the mechanism of the spillover, how- ever, the consequence is the same: the firm invests below the social optimum in R&D. After reviewing a wide variety of studies, Griliches estimates that the gap between the private and social rate of return is substantial: the gap is probably equal to between 50% and 100% of the private rate of return. While few studies have examined how these gaps vary with firm characteristics, a number of case- based analyses (Jewkes et al. [1958i, Mansfield et al. [19771) suggest that spillover problems are particularly severe among small firms. These organiza- tions may be particularly unlikely to effectively defend their intellectual property positions or to extract most of the rents in the product market. Even if these problems are substantial, however, the government may not be able to address them dispassionately. An extensive political economy and public finance literature has emphasized the possible distortion that may result from government subsidies as particular interest groups or politicians seek to direct subsidies in a manner that benefits themselves. As articulated by Olson [19651 and Stigler [1971i, and formally modeled in works such as Peltzman [19761 and Becker [1983i, the theory of regulatory capture suggests that direct and indirect subsidies will be captured by parties whose joint political activity is not too diffi- cult to arrange (i.e., when "free-riding" by coalition members is not too large a problem).

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24 THE SMALL BUSINESS INNOVATION AND RESEARCH PROGRAM These distortions may manifest themselves in several ways. One possibility (discussed, for instance, in Eisinger [19881), is that firms may seek transfer pay- ments that directly increase their profits. Politicians may acquiesce in such trans- fers in the case of companies that are politically connected. A more subtle distor- tion is discussed by Cohen and Noll [19911 and Wallsten [19961: officials may seek to select firms based on their likely success, and fund them regardless of whether the government funds are needed. In this case, they can claim credit for the firms' ultimate success even if the marginal contribution of the public funds was very low. THE CHALLENGE OF EVALUATION As public venture capital programs have increased in number, policymakers and economists are increasingly grappling with the question of how to assess these programs. Not only do substantial divisions exist between the approaches employed by academics and practitioners, but there is little consensus within the academic community itself about the best evaluation methodologies. In this final section, I will review some of the most frequently encountered approaches and discuss their strengths and limitations. I will discuss their implementation in the context of the program that is the subject of this symposium, the Small Business Innovation Research (SBIR) program. The approaches most frequently employed by practitioners have the virtue of being relatively straightforward to implement and communicate. One approach- utilized by many agencies when examining their SBIR programs has been to highlight successful firms.9 Another approach has been to survey firms that have been funded under the SBIR program, asking such questions as whether the tech- nologies funded were ever commercialized, the extent to which their develop- ment would have occurred without the public award, and how firms assessed their experiences with the program more generally.~ These approaches have important limitations. First, many awarders may have a stake in the programs that have funded them, and consequently feel in- clined to give favorable answers (i.e., that they have received benefits from the program and that commercialization would not have taken place without the awards). This may be a particular problem in the case of the SBIR initiative, since many small high-technology company executives have organized to lobby for its renewal. Second, in other cases, the results may be biased the other way: firms may be unwilling to acknowledge that they received important benefits 9 In the context of the SBIR program, see U.S. Small Business Administration [1994], and many agency publications. in Examples of evaluations of the SBIR program include Myers, Stern, and Rorke [1983], Price, Waterhouse [1985], and U.S. General Accounting Office [1987, 1989, 1992].

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ANNEX A 125 from participating in public programs, lest they attract unwelcome attention. This is especially likely to be a problem in the life sciences, since periodic press and Congressional investigations have highlighted "give-aways" of research funded by the National Institutes of Health to biotechnology and pharmaceutical compa- nies. Third, in many cases, it may simply be very difficult to identify the mar- ginal contribution of a public venture capital award, which may be one of many sources of financing that a firm employed to develop a given technology. Fi- nally, as argued by Wallsten [1996i, these evaluation criteria may have a distort- ing effect on which firms are selected for participation in these programs, leading to an emphasis on "safe" firms that would have succeeded anyway. The approaches employed by academics have important limitations as well. The most common approach is to examine in a regression framework the mar- ginal impact of public funding on private research spending. Studies of federal technology programs by academic economists, beginning with Levy and Terleckyj [1983i, have tended to focus on the short-run effects of these efforts. In particular, they often ask whether federal funds substitute for or stimulate private R&D spending. In another application, Irwin and Klenow [19961 show that semi- conductor manufacturers substantially reduced their own R&D spending while participating in the Sematech consortium. In theory, these frameworks should be applicable to the assessment of public venture capital programs. Indeed, Wallsten [19961 shows that the subset of SBIR awarders that were publicly traded reduced their own spending on R&D in the years immediately following the award. However valuable a framework it may be when examining the macro- economic impact of public expenditures, it is less clear that this econometric approach is appropriate when assessing public efforts to assist small high- technology firms. In many cases, small high-technology firms are organized around one key scientist or engineer and his research laboratory or product devel- opment team. It may not be possible to accelerate the project's progress by "scaling up" the project through the addition of additional researchers or techni- cians. It may well be rational for a firm not to increase its rate of spending, but rather to use the funds to prolong the time before it needs to seek additional capital. To interpret such a short-run reduction in other research spending as a negative signal is very problematic. A second academic approach is to examine the long-run impact of participa- tion in public venture capital programs on the growth of the firms themselves, relative to a matched set of firms. In this way, it is possible to assess whether either superior firms were selected for the program or participation in the pro- gram was associated with ultimate success, although disentangling the two effects, as discussed below, is challenging. In the context of the SBIR program, Lerner [19961 analyzes the growth of 1435 SBIR awarders and matching firms over a ten-year period and documents that the awarders appear to have superior employ- ment growth. This approach also has some important limitations. Most fundamentally,

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126 THE SMALL BUSINESS INNOVATION AND RESEARCH PROGRAM policymakers should seek to maximize social, not private, returns. If the growth of the SBIR awarders is merely at the expense of their rivals, the impact of the program on public welfare is likely to be minimal. Second, even the measures of private benefits that can be employed are imperfect. Ideally, the increase in firm value would be measured. Unfortunately, over 98% of the firms were privately held at the time of their first SBIR award. Consequently, assessing the valuation and profitability of these awards is very difficult. Thus, Lerner's examination is confined to two measures that are only imperfectly corrrelated with firm value, employment and sales. Finally, it is difficult to disentangle whether the superior performance of the awarders is due to the selection of better firms or the positive impact of the awards. Thus, the evaluation of public venture capital programs remains a subject of lively debate. The choice of appropriate valuation methodologies is likely to be of considerable interest for both academics and practitioners in the years to come. Efforts to encourage discussions of these issues between academics and practitio- ners, such as the ongoing joint venture between the U.S. Department of Commerce's Advanced Technology Program and the National Bureau of Eco- nomic Research, should be encouraged. This type of healthy dialog should lead to more effective programs. REFERENCES Akerlof, G.A., 1970, The market for 'lemons': Qualitative uncertainty and the market mechanism, Quarterly Journal of Economics 84, 488-500. Barry, C.B., 1994, New directions in research on venture capital finance, Financial Management 23 (Autumn), 3-15. Becker, G.S., 1983, A theory of competition among pressure groups for political influence, Quarterly Journal of Economics 98, 371-400. taverner [1996] tries to address this issue in a supplemental analysis using the following argument: firms whose key assets are intangible intellectual property are much harder for outside investors to evaluate using traditional financial measures. If SBIR awards are certifying firm quality to outside investors, then these signals may be particularly valuable in these industries. SBIR awards should then be more strongly associated with firm growth in high-technology industries. An alternative hypothesis is that Federal officials are selecting firms likely to grow rapidly, even without public subsidies. A potential motive would be that politicians could claim credit for the firms' ultimate success, even if the marginal contribution of the public funds was very low. Though the insights of Federal officials may give them a greater insight relative to that of other investors (and thus make a signal more valuable), it is by no means certain that it is easier to select successful firms in these industries. Empirical studies suggest that predicting success is much more difficult in high-technol- ogy industries. This suggests the reverse pattern: SBIR awards should be more correlated with firm growth in low-technology industries. Consistent with the certification hypothesis, he finds that the relationship between SBIR awards and growth is much stronger in high-technology industries.

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