Harvard’s Lerner Talks VC

Cyril Demaria, a regular guest contributor here at peHUB, recently had a conversation with Harvard Business School’s Jacob H. Schiff Professor of Investment Banking Josh Lerner. He gave us a transcript of their chat, which we’re happy to provide you today.

Cyril Demaria – According to your book, corporate R&D and venture capital have a very distinct path that can maybe be combined. Corporate R&D seems to be described as the main road to innovation, and VC as a marginal actor. Is this perception correct?

Josh Lerner – Venture capital is small relative to corporate R&D, but significant. Recent studies have also highlighted the special advantage in innovation that belongs to entrepreneurs backed by venture capital firms. Considerable evidence shows that venture capitalists play an important role in encouraging innovation. The types of firms that they finance—whether young start-ups hungry for capital or growing firms that need to restructure—pose numerous risks and uncertainties that discourage other investors.

The financing of young and restructuring firms is a risky business. Uncertainty and gaps in information often characterize these firms, particularly in high-technology industries. A lack of information makes it difficult to assess these firms, and permits opportunistic behavior by entrepreneurs after financing is received. To address these information problems, venture investors employ a variety of mechanisms that seem to be critical in boosting innovation.

CD – Is Silicon Valley an accident? A template for your proposal of combination of R&D and VC financing?

JL – Many narratives of the history of Silicon Valley begin with 1955, when William Shockley founded Shockley Transistor in Palo Alto, which would soon in turn spawn Fairchild Semiconductor and much of the modern semiconductor industry. Other accounts extend back to 1938, when Frederick Terman, dean of Stanford’s Engineering School, encouraged (and indeed, directly assisted in financing) his students William Hewlett and David Packard to found Hewlett-Packard. The powerful culture that drove Silicon Valley during its growth over the past few decades—with close ties between local universities and start-up firms, the absence of legal or social barriers to job-switching, an active venture community to finance new entities, and a willingness to work with young firms—has also been rightly celebrated by Annalee Saxenien and other authors.

At the same time, it is important to note that the story of Silicon Valley’s creation is more complex than many of these accounts often suggest. In particular, a review of the histories of Silicon Valley suggests two facts that are little appreciated. First, the culture of, and approach to, doing business in Silicon Valley was profoundly shaped by the pioneering firms in the early decades of the twentieth century. Second, the public sector, especially the U.S. Department of Defense, played a crucial role in accelerating the early growth of the region.

CD – You mention incentives as a major question in the success of R&D and venture capital. You do not mention externalities. They somehow seem to be rather crucial (SBA program, SBIC program, military programs in the US and Israel, etc.). What is your opinion on this? Is there enough (R&D) positive externalities today on the market to build on, notably as public financing for fundamental research looks rather poor compared to the after WWII?

JL – An extensive body of economic thought in public finance discusses the circumstances in which it is appropriate for the government to offer subsidies. These works emphasize that subsidies are an appropriate response in the case of activities that generate positive “externalities,” or benefits to others that are not captured by the firm or individual undertaking the activity. Thus, governments often provide subsidies to firms that invest in pollution control equipment or individuals who install solar power. Most of the benefits from their investment to reduce pollution and greenhouse gasses will benefit all of us, not the firm itself. To encourage investments that primarily benefit other firms and all of society, public subsidies are often an appropriate response.

In a similar manner, pioneering entrepreneurs and venture capitalists generate positive externalities that benefit others. It is precisely when such externalities are present that public interventions–whether tax incentives, regulatory shifts, or more direct measures—are justified. These spillovers to other firms are likely to be particularly important in the youngest days of the entrepreneurial sector or the venture capital industry, when pioneering new ventures and investment groups are just getting established. These relationships suggest that government may have an important role in priming the pump for additional entrepreneurial and venture activity during the industry’s inception.

CD – How does your current book fit with the previous “Boulevard of Broken Dreams”? In particular, you state that there is a need of pre-existing industries to build on R&D. What if there is no pre-existing industry (in certain African countries or poor Asian countries)? Is there no hope for innovation there? How to solve the equation?

JL – This book very much focuses on developed markets. I agree that there are many extremely interesting issues associated with boosting innovation in emerging economies, but I needed to focus this work.

CD – Is corporate R&D incremental and VC financing disruptive? This would explain that VC’s dollars have a fourfold impact compared to the corporate R&D dollars…

JL – Part of the added impact of venture capital is the selection of high-impact technologies and projects to focus on. But this higher impact effect still is present, even after controlling for the mixture of technologies funded.

CD – Corporate venturing is a landmark of the Swiss venture capital community. What can we learn from this experience? Any room for improvements?

One of the key problems with corporate venturing has to do with lack of staying power. The commitment that an institutional investor makes to a venture fund is a binding one: even if the limited partner contributes a small amount of the total capital promised at the time of closing, there is an expectation that the total amount promised will be provided. Even during the depths of the financial crisis, it was rare for investors to walk away from these commitments (a step which would have led to various sanctions, such as the forfeiture of the amount invested to date, as well as a damaged reputation). Instead, limited partners tended to sell stakes in these funds to other investors who were more liquid. In some cases, the limited partners even paid other groups to assume their commitments.

Now contrast this experience with that of corporate venturing funds. Companies have been all too fickle in their commitment to corporate venturing. Often, simply the accession of a new senior officer has been enough to trigger the abandonment of earlier efforts. This historical lack of commitment has real consequences. Employees are less likely to join a corporate venturing group they fund, entrepreneurs are reluctant to accept their funds, independent venture funds are hesitant to syndicate investments with these groups, and corporate funded start-ups find collaborations harder to arrange.

CD – You mention the fund size inflation as a problem for venture capital. Isn’t the 10-year lifespan also to blame?

JL – I very much agree. As I mention in the book, one natural reform would be to better link venture fund life to the nature of the investments being pursued. In this way, funds addressing more challenging areas, where profitable firms and successful exits are hard to achieve, could have longer to work with their firms. Such flexibility would limit the likelihood that venture funds would be driven by excessively short-run considerations, while still maintaining the critical protection that investors enjoy in limited partnerships: the fact the groups cannot hold onto their funds forever, but must ultimately return the capital to their investors and persuade them to reinvest or others to contribute capital.

CD – Is a solution to the VC woes the emergence of a viable and resilient secondary market for the early-stage stakes (notably as the timeframe from seed to IPO is 9.1 years in the US now, on average)?

JL – While a secondary market has some impact, it seems the extent of information problems make a liquid and efficient market in early-stage firms very difficult.

Cyril Demaria is a Professor at HEIG-VD and the author of “Introduction to private equity.” Opinions expressed here are entirely his own. He blogs here.

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Josh Lerner will give a keynote presentation on his PE return research at Thomson Reuters’ Alternative Investment Management Symposium in Boston on April 3. The following morning, Lerner will interview Eric Upin, Managing Partner of Makena Capital Management, Katie Hall of Hall Capital and Marina Mavrakis, Managing Director of TIAA-CREF. Interested parties may register for the AIM conference here.