Intended to provide our own search engines and external engines with highly rich, chapter-representative searchable text on the opening pages of each chapter. Because it is UNCORRECTED material, please consider the following text as a useful but insufficient proxy for the authoritative book pages.
Do not use for reproduction, copying, pasting, or reading; exclusively for search engines.
OCR for page 307
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE Evaluating the Small Business Innovation Research Program: A Literature Review Josh Lerner* and Colin Kegler** Harvard Business School* and Harvard University** EXECUTIVE SUMMARY Despite the proliferation of public efforts to finance small high-technology firms in recent years, there has been relatively little assessment of these programs’ economic impacts. This article first explores the underlying challenges that the financing of young firms poses, the ways that specialized financial intermediaries address them, and the rationales for and problems faced by public efforts to finance these companies. The final two sections review earlier efforts to assess these programs, and discuss the proposed evaluation of the Small Business Innovation Research program.
OCR for page 308
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE 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. Although these programs’ precise structures have differed, the efforts have been predicated on two shared assumptions: (1) that the private sector provides insufficient capital to new firms, and (2) that the government either can identify investments that ultimately will yield high social and/or private returns or can encourage effective financial intermediaries.1 In contrast to many forms of government intervention designed to boost economic growth, such as privatization programs, these claims have received little scrutiny by economists. The neglect of these questions is unfortunate. Although 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 contemporaneous private investments in new firms. Several examples, documented by Gompers and Lerner (1998b), underscore this point: The Small Business Investment Company (SBIC) program led to the provision 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, 1970). 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 percent of the amount disbursed by traditional venture funds in that year. Perhaps more significant, the bulk of the public funds went to earlystage firms, which in the past decade had accounted for only about 30 percent of the disbursements by independent venture capital funds (Venture Economics, 1996). Some of America’s most dynamic technology companies received support through the SBIC and the Small Business Innovation Research (SBIR) programs while the companies were still privately held entities, including Apple Computer, Chiron, Compaq, and Intel. Public venture capital programs also have had a significant impact overseas: For example, 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 (OECD, 1995). 1 It is striking to note the similar emphasis on these rationales in, for instance, the statement of Senator John Sparkman (1958) upon passage of the Small Business Investment Act and the recent testimony of Dr. Mary Good (1995), Under Secretary for Technology at the U.S. Department of Commerce. The rationales for such programs are discussed in depth in a report from the U.S. Congressional Budget Office (1985).
OCR for page 309
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE 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. Although these efforts have proliferated, a consensus as to how to evaluate these programs remains elusive. The gap between the approaches employed by academics and practitioners is substantial. Furthermore, there is a lack of consensus among economists as to what the proper approaches are. This article provides an overview of the motivations for these efforts to encourage individual investors. In the second section, 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 and common problems of public programs are explored in the third section. The fourth section discusses earlier efforts to assess these efforts, and the challenges that they have faced. VENTURE CAPITALISTS AND THE FINANCING CHALLENGE The initial reaction of a financial economist to the argument that the government needs to invest in young firms is likely to be skepticism. A lengthy literature has highlighted the role of financial intermediaries in alleviating moral hazard and information asymmetries. Young high-technology firms often are characterized by considerable uncertainty and informational asymmetries, which permit opportunistic behavior by entrepreneurs. Why one would want to encourage public officials instead of specialized financial intermediaries (venture capital 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 (1976) demonstrate that agency conflicts between managers 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, informational asymmetries may make raising external capital more expensive or even preclude it entirely. Myers and Majluf (1984) and Greenwald et al. (1984) demonstrate that equity offerings of firms may be associated with a “lemons” problem (first identified by Akerlof ). If the manager is better informed about the investment opportunities of his or her firm than the investors and acts in the
OCR for page 310
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE 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 also have been shown to exist in debt markets. Stiglitz and Weiss (1981) show that if banks find it difficult to discriminate among companies, raising interest rates can have perverse selection effects. In particular, 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 the investors. If the information asymmetries could be eliminated, financing constraints would disappear. Financial economists argue that specialized financial intermediaries can address these problems. By intensively scrutinizing firms before providing capital and then monitoring them afterward, 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-technology firms is the venture capital organization. The first modern venture capital firm, American Research and Development (ARD), was formed in 1946 by Massachusetts Institute of Technology 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 technology 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 Corporation (DEC) in 1957, which grew in value to $355 million. Because institutional investors were reluctant to invest, ARD was structured as a publicly traded closed-end fund and marketed mostly to individuals (Liles, 1977). The few other venture organizations begun in the decade after ARD’s formation also were 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 SBICs, federally guaranteed risk capital pools that proliferated during the 1960s. Although 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 decades never exceeded a few hundred million dollars and usually was substantially less.
OCR for page 311
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE The activity in the venture industry increased dramatically in the late 1970s and early 1980s. Industry observers attributed much of the shift to the U.S. Department of Labor’s clarification of the Employee Retirement Income Security Act’s (ERISA) “prudent man” rule in 1979. Prior to that year, ERISA regulations limited pension 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 venture 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 typically is 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 capitalists. On the one hand, venture capitalists had 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 substantial number of service firms (including Staples, Starbucks, and TCBY) 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 10 during the early 1980s, peaking at just under 6 billion 1996 dollars. From 1987 through 1991, however, fund-raising steadily declined. Over the past five years, the pattern has been reversed; 1997 represented a record fund-raising year, in which nearly $10 billion was raised by venture 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 variety of mechanisms. First, business plans are intensively scrutinized: Of those firms that submit business plans to venture capital organizations, historically fewer than 1 percent have been funded (Fenn et al., 1995). The decision to invest frequently is made conditional on the identification of a syndication partner who agrees that this is an attractive investment (Lerner, 1994). 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 disburse 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 capitalists intensively monitor managers, often contacting firms on a daily basis and 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-
OCR for page 312
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE ture capitalists are documented by Gompers and Lerner ; the theoretical literature is reviewed by Barry .) Note that, even with these many mechanisms, the most likely primary outcome of a venture-backed investment is failure or, at best, modest success. Gompers (1995) documents that, out of a sample of 794 venture capital investments made over three decades, only 22.5 percent ultimately succeeded in going public, the avenue through which venture capitalists typically exit their successful investments. (A Venture Economics  study finds that a $1 investment 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 (1980) analysis of the returns from 110 investments by three venture capital organizations. About one in six investments was a complete loss, while 45 percent were either losses or simply broke even. The elimination of the top-performing 9 percent of the investments was sufficient to turn a 19 percent gross rate of return into a negative return. In short, the environment in which venture organizations operate is extremely difficult. It is the mechanisms bundled with the venture capitalists’ funds that are critical in ensuring a satisfactory return. These circumstances have led to venture capital organizations emerging as the dominant form of equity financing for privately held technology-intensive businesses.2 RATIONALES FOR AND PROBLEMS OF PUBLIC VENTURE CAPITAL 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 programs. In this section, we assess these claims. We 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. We then highlight two classes of problems that can affect these programs. The Certification Hypothesis A growing body of empirical research suggests that new firms, especially technology-intensive ones, may receive insufficient capital because of the infor- 2 Although 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.
OCR for page 313
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE mation problems discussed in the preceding section.3 If public venture capital awards could certify that firms are of high quality, then these information problems could be overcome and investors could confidently invest in these firms. As discussed earlier, venture capitalists specialize in financing these types of firms. They address these information problems through a variety of mechanisms. 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, 1998a), 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 that 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, 1997); to put this in perspective, the Small Business Administration estimates that in recent years close to one million businesses have been started annually. Furthermore, these funds have been very concentrated: 49 percent of venture funding in 1996 went to companies based in either California or Massachusetts, and 82 percent went to firms specializing in information technology and the life sciences (VentureOne, 1997). 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 concentration 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.4 Case studies of the development of high-technology regions (e.g., Saxenian ) 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 venture investment in a start-up or early-stage business between 1961 and 1992 (ex- 3 The literature on capital constraints (reviewed by Hubbard ) 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 (R&D) expenditures, especially in smaller firms. 4 The theoretical rationales for such effects are summarized by Krugman (1991).
OCR for page 314
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE pressed in 1996 dollars) was $2.0 million (Gompers, 1995). The substantial size of these investments may be partially a consequence of the demands of institutional 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 institutions to limit the share of any fund that any one limited partner holds. 5 As a consequence, venture organizations typically raise substantial funds of $100 million or more. Because each firm in the venture capitalist ’s portfolio must be closely scrutinized, the typical venture capitalist is typically responsible for no more than a dozen investments. Consequently, venture organizations are unwilling to invest in very young firms that require only small capital infusions.6 This problem may be increasing in severity with the growth of the venture industry, as discussed earlier. As the number of dollars per venture fund and dollars per venture partner has grown, so too has the size of venture investments. 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, 1997). Again, it is not clear what lessons to draw from these financing patterns. Venture capitalists may have eschewed small investments because they were simply not profitable, because of either the high costs associated with these transactions or the poor prospects of the thinly capitalized firms.7 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 (1997) show that IPOs that had previously received equity financing from venture capitalists outperform other offerings. These findings underscore concerns about policies that 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 innovations to address the needs of early-stage entrepreneurs. These included the creation of incubators and “entrepreneur-in-residence ” programs by established ven- 5 The structure of venture partnerships is discussed at length by Gompers and Lerner (1996, 1998a). 6 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 experience. 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 percent and 3 percent of the capital under management. This motivates venture organizations to increase the capital that each partner manages. 7 For a theoretical discussion of why poorly capitalized firms are less likely to be successful, see Bolton and Scharfstein (1990).
OCR for page 315
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE ture 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 institutional 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 by Griliches  and Jaffe ) 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, however, 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 rates of return is substantial: The gap is probably equal to between 50 percent and 100 percent of the private rate of return. Although few studies have examined how these gaps vary with firm characteristics, a number of case-based analyses (Jewkes, 1958; Mansfield et al., 1977) suggest that spillover problems are particularly severe among small firms. These organizations may be particularly unlikely to effectively defend their intellectual property positions or to extract most of the rents in the product market. Distortions in the Award Process 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 (1965) and Stigler (1971), and formally modeled in works such as those of Peltzman (1976) and Becker (1983), the theory of regulatory capture suggests that direct and indirect subsidies will be captured by parties whose joint political activity is
OCR for page 316
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE not too difficult to arrange (i.e., when “free-riding” by coalition members is not too large a problem). These distortions may manifest themselves in several ways. One possibility (discussed, for instance, by Eisinger ), is that firms may seek transfer payments that directly increase their profits. Politicians may acquiesce in such transfers in the case of companies that are politically connected. Alternatively, past “public venture capital ” recipients may develop relationships with evaluators and managers that aid in the selection process. A more subtle distortion is discussed by Cohen and Noll (1991) and Wallsten (1996): 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. Inappropriate Program Design Even if “political capture” is not a problem, the programs’ effectiveness may be impaired because of poor design. In this section, we examine two classes of problems that affect the design of public venture capital programs. First, certain company characteristics —attributes that may not be adequately considered in the award selection process—appear to be highly correlated with a company’s ability to achieve its research and commercialization goals. Second, the structure of the financing may not match the needs of the entrepreneurial firm. The first of these problems has been highlighted in a variety of case study evidence, including Gompers and Lerner’s case studies of the Advanced Technology Program (1998b).8 Our field research indicates that a prevalent characteristic among underachieving companies is the existence of research grants from numerous government sources. Because a lack of results can easily be attributed to the high-risk nature of technology development, many of these companies can avoid accountability indefinitely. As a result, some of these government grant-oriented research organizations are able to drift from one federal contract to the next. Adding to the problem is the fact that companies with substantial government grant experience appear to have several advantages over other firms when applying for future public awards. Past grants, regardless of project outcomes, help a company to gain legitimacy in a particular area of research as well as to acquire the equipment and personnel needed to do future work. There is also a tendency for some government programs to try to “piggyback” on other government programs, hoping to leverage the impact of their grant dollars. In addition, 8 These findings are also corroborated by surveys of SBIR awardees by the U.S. General Accounting Office and the Lerner (1996) study discussed later.
OCR for page 317
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE firms gain considerable insight into the grant application process with each proposal they submit. Because of all of these factors, these firms frequently have a greater chance of being awarded future government grants than other firms. The end result can be a stream of government funding being awarded to companies that consistently underachieve. In fact, we have encountered examples in which awardees frequently advise first-time applicants on how to write and structure award proposals. Another telltale characteristic of underachieving firms was the existence of factors outside the scope of “public venture capital” projects that undermined their ability to successfully complete and later commercialize technology. Legal troubles, for instance, can divert substantial amounts of human and financial resources away from a company’s R&D projects. For early-stage firms, legal problems may even cause dramatic changes in the size and structure of the company. And when a firm is ready to commercialize its technology, the liability concerns associated with pending legal battles will often drastically impair the company’s ability to attract venture capital investment dollars. The existence of resource-draining auxiliary research projects also may undermine a company’s performance. One company in the sample of Advanced Technology Program awardees, for instance, was involved in a project that was only distantly related to the company’s core technology. Although the public funds were not used to fund this auxiliary project, it appeared that a substantial amount of the company ’s time, energy, and capital was diverted toward this tangential research. This, in turn, diluted the company’s focus on its publicly funded research project, and thus slowed the development of its core technology. 9 The existence of unrelated R&D projects, especially for smaller companies, can cause a company ’s resources to be spread too thin. tion plans. For early-stage companies, additional limiting factors frequently involve managers who lack experience in running small companies. Although some of these managers may have accumulated business experience as consultants or as members of large organizations, the successful operation of early-stage companies can demand very different management skills. It thus comes as no surprise that when venture capitalists sink substantial funds in a company, they often place their own hand-picked manager at the helm—typically an individual who has already been successful in managing an early-stage company in a similar industry. Because much of the skills needed for managing start-up companies comes through experience, the existence of managers who do not have this background can significantly undermine a company’s ability to carry out its commercializa- 9 Part of the problem in this instance is the lack of corporate discipline. If a venture capital firm had invested in this company, it likely would have provided this discipline by closely monitoring the company, and limiting the company’s R&D activities to areas that are directly related to its core technology.
OCR for page 318
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE In a broader context, each of these performance-undermining factors emphasizes the need for program managers to critically evaluate whether a particular company is, in fact, a viable vehicle for actually accomplishing its commercialization goals. This goes far beyond a simple assessment of the feasibility of a business plan. In fact, many of these potentially limiting factors will not even be discussed in a company’s proposal. It is tempting, of course, to attribute the failures resulting from such factors to the high-risk nature of the technology. However, to a large extent, companies exhibiting a high potential for under-achievement could be more thoroughly weeded out by placing a greater emphasis on these factors during the selection process. The R&D project itself may be high risk, but the risks of turning the technology into a product should be minimized. Regardless of how innovative or enabling a technology may be—or how well a business plan is constructed—if these undermining factors are substantial, a company will be hard pressed to overcome such roadblocks. A second example of inappropriate program design involves the structure of the financing provided. Before considering the example of the SBIR program, it is worth highlighting the typical attributes of the early-stage, technology-driven firms that are the typical recipients of public venture capital funds. First, a great deal of uncertainty always accompanies these types of firms. Because such companies are in their formative stages and have little or no track record, it is extremely difficult for their managers to predict the optimal magnitude and duration of R&D expenditures at the onset of a project. Regardless of the time and energy devoted to such forecasts, it is likely that initial estimates will have to be revised over time. Second, R&D and management resources are typically very scarce in these firms. If a project is delayed because of a lack of financing, talented researchers and managers are unlikely to be left “on hold ”; rather, they are likely to be drawn into other projects. Finally, the firms have a tremendous need to enter the marketplace rapidly. Rapid market entry is critical in the technology-driven industries targeted by public venture capital programs, particularly for small firms without the large marketing budgets that major corporations enjoy. The primary strength of small firms is their ability to get products into the market quickly. Through such early entry, the small firm may be able to build up a defensible market position, even against larger competitors. This may be accomplished through the establishment of a dominant industry standard, the creation of “network externalities ” that encourage later adapters to choose the same product as that selected by early users, or product improvements gleaned from early interactions with customers. Several public venture capital programs have structured their financing in ways that appear to be at odds with these conditions. With respect to SBIR, although it is a multiagency program, the structure of the awards is constrained to be similar across agencies. Promising proposals are granted Phase I awards (originally no more than $50,000, today $100,000 or smaller), which are intended to allow firms to conduct research to determine the feasibility of their ideas. Ap-
OCR for page 319
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE proximately one-half of the Phase I awardees are then selected for the more substantial Phase II grants. Phase II awards of at most $750,000 (originally, one-half million dollars) are designed to support two years of development work. This structure was designed to provide many of the same benefits as a staged venture capital financing. Information generated in the first phase of the project would be useful in assessing the application for a Phase II award. In theory, the program managers would be able to make small investments in a wide variety of projects, providing the bulk of the SBIR funds to the most promising of these projects. Survey findings, however, suggest that firms have serious concerns about the delays between Phase I and Phase II awards (GAO, 1987,1992). Firms believed that the long delays—sometimes two years or more—between the original application and the receipt of the Phase II funds often had a detrimental effect on their ability to commercialize technologies. Because of the characteristics of high-technology firms discussed earlier, these delays often made it difficult for the firm to sustain its innovative effort or to commercialize its findings. THE CHALLENGE OF EVALUATION As public venture capital programs have increased in number, policy makers and economists increasingly are 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 section, we review some of the most frequently encountered approaches and discuss their strengths and limitations. 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.10 Another approach has been to survey firms that have been funded under the SBIR program, asking such questions as whether the technologies funded were ever commercialized, the extent to which their development would have occurred without the public award, and how firms assessed their experiences with the program more generally.11 These approaches have important limitations. First, many awardees may have a stake in the programs that have funded them, and consequently feel inclined 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 10 In the context of the SBIR program, see SBA (1994), and many agency publications. 11 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).
OCR for page 320
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE because 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 from participating in public programs, lest they attract unwelcome attention. This is especially likely to be a problem in the life sciences, because periodic press and congressional investigations have highlighted “give-aways” of research funded by the National Institutes of Health (NIH) to biotechnology and pharmaceutical companies. Third, in many cases, it may simply be very difficult to identify the marginal 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. Finally, as argued by Wallsten (1996), these evaluation criteria may have a distorting 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 marginal impact of public funding on private research spending. Studies of federal technology programs by academic economists, beginning with Levy and Terleckyj (1983), 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 (1996) show that semiconductor 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. An analysis along these lines is undertaken by Wallsten (1996). He examines whether the SBIR program managers may select firms with too high a probability of success. In keeping with the earlier literature on “crowding out,” he seeks to distinguish between marginal funding (i.e., cases in which investments in firms would yield a high social return, yet are commercially unprofitable) and inframarginal funding (i.e., companies that would still be successful in the absence of federal assistance). Wallsten’s analysis concludes that the SBIR program is more inclined to fund inframarginal projects rather than support firms on the margins of commercial profitability. Every dollar of SBIR funding awards is likely to lead to a reduction of about one dollar of private research spending by the awardee firm. To remain true to its original purpose, Wallsten therefore recommends a restructuring of SBIR policy to fund marginal firms whose commercial success is less certain. However valuable a framework it may be when examining the macroeconomic 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 development team. It
OCR for page 321
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE may not be possible to accelerate the project’s progress by “scaling up” the project through the addition of researchers or technicians. 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 participation 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 program was associated with ultimate success, although disentangling the two effects, as discussed later, is challenging. In the context of the SBIR program, Lerner (1996) analyzes the growth of 1,435 SBIR awardees and matching firms over a 10-year period and documents that the awardees appear to have superior employment growth. This approach also has some important limitations. Most fundamentally, policy makers should seek to maximize social, not private, returns. If the growth of the SBIR awardees 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 percent 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 correlated with firm value, employment and sales. Finally, it is difficult to disentangle whether the superior performance of the awardees is due to the selection of better firms or the positive impact of the awards.12 12 Lerner (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-technology 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.
OCR for page 322
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE 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. Bolton, P., and D. Scharfstein. 1990. “A theory of predation based on agency problems in financial contracting, ” American Economic Review 80:93–106. Brav, A., and P. A. Gompers. 1997. “Myth or reality? Long-run underperformance of initial public offerings; Evidence from venture capital and nonventure capital-backed IPOs, ” Journal of Finance 52:1791–1821. Cohen, L. R., and R. G. Noll, eds. 1991. The Technology Pork Barrel. Washington, D.C.: Brookings Institution. Eisinger, P. K. 1988. The Rise of the Entrepreneurial State: State and Local Economic Development Policy in the United States. Madison: University of Wisconsin Press. Fenn, G. W., N. Liang, and S. Prowse. 1995. The Economics of the Private Equity Market. Washington, D.C.: Board of Governors of the Federal Reserve System. Freear, J., and W. E. Wetzel, Jr. 1990. “Who bankrolls high-tech entrepreneurs?” Journal of Business Venturing 5:77–89. Gompers, P. A. 1995. “Optimal investment, monitoring, and the staging of venture capital, ” Journal of Finance 50:1461–1489. Gompers, P. A., and J. Lerner. 1996. “The use of covenants: An empirical analysis of venture partnership agreements,” Journal of Law and Economics 39:463–498. Gompers, P. A., and J. Lerner. 1998a. “An analysis of compensation in the U.S. venture capital partnership, ” Journal of Financial Economics. Vol. 51, no. 1, pp. 7-51. Gompers, P. A., and J. Lerner. 1998b. Capital formation and investment in venture markets: A report to the National Bureau of Economic Research and the Advanced Technology Program. Working Paper, Harvard University, Cambridge, Mass. Gompers, P. A., and J. Lerner. 1999. The Venture Cycle. Cambridge, Mass.: MIT Press. Good, M. L. 1995. Prepared testimony before the Senate Commerce, Science, and Transportation Committee of the Subcommittee on Science, Technology, and Space, Washington, D.C., June, 23. Photocopy, U.S. Department of Commerce. Greenwald, B. C., J. E. Stiglitz, and A. Weiss. 1984. “Information imperfections in the capital market and macroeconomic fluctuations,” American Economic Review Papers and Proceedings 74:194–199. Griliches, Z. 1992. “The search for R&D spillovers,” Scandinavian Journal of Economics 94:S29-S47. Hall, B. H. 1992. Investment and research and development: Does the source of financing matter? Working Paper No. 92-194, Department of Economics, University of California at Berkeley. Hao, K. Y., and A. B. Jaffe. 1993. “Effect of liquidity on firms’ R&D spending,” Economics of Innovation and New Technology 2:275–282. Himmelberg, C. P., and B. C. Petersen. 1994. “R&D and internal finance: A panel study of small firms in high-tech industries,” Review of Economics and Statistics 76:38–51. Hubbard, R. G. 1998. “Capital-market imperfections and investment,” Journal of Economic Literature 36:193–225. Huntsman, B., and J. P. Hoban, Jr. 1980. “Investment in new enterprise: Some empirical observations on risk, return, and market structure,” Financial Management 9 (Summer):44–51. Irwin, D. A., and P. J. Klenow. 1996. “High tech R&D subsidies: Estimating the effects of Sematech,” Journal of International Economics 40:323–344.
OCR for page 323
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE Jaffe, A. B. 1996. Economic analysis of research spillovers—Implications for the Advanced Technology Program. Washington, D.C. National Institute of Standards and Technology. Jensen, M. C., and W. H. Meckling. 1976. “Theory of the firm: Managerial behavior, agency costs and ownership structure,” Journal of Financial Economics 3:305–360. Jewkes, J., D. Sawers, and R. Stillerman. 1958. The Sources of Invention. New York: St. Martin’s Press. Krugman, P. R. 1991. Geography and Trade. Cambridge, MA: MIT Press. Lerner, J. 1994. “The syndication of venture capital investments,” Financial Management 23(Autumn):16–27. Lerner, J. 1996. The government as venture capitalist: The long-run effects of the SBIR program. Working Paper 5753, National Bureau of Economic Research. Lerner, Josh. 1999. “The government as venture capitalist: The long-run effects of the SBIR program,” Journal of Business. July, v. 72 (3), pp. 285-297. Levy, D. M., and N. Terleckyj. 1983. “Effects of government R&D on private R&D investment and productivity: A macroeconomic analysis,” Bell Journal of Economics 14:551–561. Liles, P. 1977. Sustaining the Venture Capital Firm. Cambridge, MA: Management Analysis Center. Mansfield, E., J. Rapoport, A. Romeo, S. Wagner, and G. Beardsley. 1977. “Social and private rates of return from industrial innovations,” Quarterly Journal of Economics 91:221–240. Myers, S. C., and N. Majluf. 1984. “Corporate financing and investment decisions when firms have information that investors do not have,” Journal of Financial Economics 13:187–221. Myers, S., R.L. Stern, and M.L. Rorke, 1983, A study of the Small Business Innovation Research program (Lake Forest, Illinois, Mohawk Research Corporation). Nelson, C. W. 1996. “From free money to free market,” International Journal of Technology Management 12:748–759. Noone, C. M., and S. M. Rubel. 1970. SBICs: Pioneers in Organized Venture Capital. Chicago: Capital Publishing. OECD (Organization for Economic Cooperation and Development). 1995. Venture Capital in OECD Countries. Paris: OECD. Olson, M. 1965. The Logic of Collective Action. Cambridge, MA: Harvard University Press. Peltzman, S. 1976. “Towards a more general theory of regulation,” Journal of Law and Economics 19:211–240. Price Waterhouse. 1985. Survey of small high-tech businesses shows Federal SBIR awards spurring job growth, commercial sales. Washington, DC: Small Business High Technology Institute. Saxenian, A. 1994. Regional Advantage: Culture and Competition in Silicon Valley and Route 128. Cambridge, MA: Harvard University Press. SBA (Small Business Administration). 1994. Small Business Innovation Development Act: Tenth-Year Results. Washington, D.C.: U.S. Government Printing Office (and earlier years). Sparkman, J., 1958. “Introduction”. in U.S. Congress, Senate, Small Business Committee, Small Business Investment Act of 1958. Washington, D.C.: U.S. Government Printing Office. Stigler, G. 1971. “The economic theory of regulation,” Bell Journal of Economics 2:3–21. Stiglitz, J. E., and A. Weiss. 1981. “Credit rationing in markets with incomplete information,” American Economic Review 71:393–409. U.S. Congressional Budget Office. 1985. Federal Financial Support for High-Technology Industries. Washington, D.C.: U.S. Congressional Budget Office. U.S. General Accounting Office. 1989. Federal research: Assessment of Small Business Innovation Research program. Washington, DC: U.S. General Accounting Office. U.S. General Accounting Office. 1992. Federal Research: Small Business Innovation Research Shows Success But Can Be Strengthened. Washington,D.C.: General Accounting Office. U.S. General Accounting Office. 1998. Federal Research: Observations on the Small Innovation Research Program . Washington, D.C.: General Accounting Office.
OCR for page 324
The Small Business Innovation Research Program: AN ASSESSMENT OF THE DEPARTMENT OF DEFENSE FAST TRACK INITIATIVE U.S. General Accounting Office. 1987. Federal Research: Small Business Innovation Research Participants Give Program High Marks. Washington, D.C.: General Accounting Office. Venture Economics. 1988. Existing Venture Capital Investments. Wellesley, MA: Venture Economics. Venture Economics. 1996. “Special report: Rose-colored asset class,” Venture Capital Journal 36(July):32–34 (and earlier years). VentureOne. 1997. National Venture Capital Association 1996 Annual Report. San Francisco: VentureOne. Wallsten, S. J., 1996. The Small Business Innovation Research program: Encouraging technological innovation and commercialization in small firms? Working paper, Stanford University, Stanford, Calif.
Representative terms from entire chapter: