Boulevard of Broken Dreams

Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed--and What to Do About It

Josh Lerner

• Publisher: Princeton University Press
• Year: 2009
• ISBN:
  9781400831630
• Topic: Business
• Subtopic: Entrepreneurship
• Index: Business

How governments can do a better job of supporting entrepreneurship and venture capital Silicon Valley, Singapore, Tel Aviv—the global hubs of entrepreneurial activity—all bear the marks of government investment. Yet, for every public intervention that spurs entrepreneurial activity, there are many failed efforts that waste untold billions in taxpayer dollars. When has governmental sponsorship succeeded in boosting growth, and when has it fallen terribly short? Should the government be involved in such undertakings at all? Boulevard of Broken Dreams is the first extensive look at the ways governments have supported entrepreneurs and venture capitalists across decades and continents. Josh Lerner, one of the foremost experts in the field, provides valuable insights into why some public initiatives work while others are hobbled by pitfalls, and he offers suggestions for how public ventures should be implemented in the future.Discussing the complex history of Silicon Valley and other pioneering centers of venture capital, Lerner uncovers the extent of government influence in prompting growth. He examines the public strategies used to advance new ventures, points to the challenges of these endeavors, and reveals the common flaws undermining far too many programs—poor design, a lack of understanding for the entrepreneurial process, and implementation problems. Lerner explains why governments cannot dictate how venture markets evolve, and why they must balance their positions as catalysts with an awareness of their limited ability to stimulate the entrepreneurial sector.As governments worldwide seek to spur economic growth in ever more aggressive ways, Boulevard of Broken Dreams offers an important caution. The book argues for a careful approach to government support of entrepreneurial activities, so that the mistakes of earlier efforts are not repeated.

CHAPTER 1

INTRODUCTION

The financial crisis of 2008 opened the door to massive public interventions in the Western economies. In many nations, governments responded to the threats of illiquidity and insolvency by making huge investments in troubled firms, frequently taking large ownership stakes.

The magnitude of these investments boggles the imagination. Consider, for instance, the over $150 billion invested by the U.S. government in AIG (American International Group) in September and November 2008 in exchange for 81 percent of the firm’s stock, without any assurances that the ailing insurer would not need more funds. Or the Swiss government’s infusion of $60 billion into UBS in exchange for just under 10 percent of the firm’s equity: this capital represented about 20 percent of the nation’s gross domestic product.¹ Moreover, the pressures in Western nations to rescue other failing sectors—beginning with their automakers—seem unrelenting and suggest that yet more transactions are to come.

Many concerns can be raised about these investments, from the hurried way in which they were designed by a few people behind closed doors to the design flaws that many experts anticipate will limit their effectiveness. But one question has been lost in the discussion. If these extraordinary times call for massive public funds to be used for economic interventions, should they be entirely devoted to propping up troubled entities, or at least partially designed to promote new enterprises? In some sense, 2008 saw the initiation of a massive Western experiment in the government as venture capitalist, but as a very peculiar type of venture capitalist: one that focuses on the most troubled and poorly managed firms in the economy, some of which may be beyond salvation.

Meanwhile, in a different part of the globe, in Dubai, the bittersweet fruits of a different type of public intervention can be seen. The emirate experienced truly extraordinary growth in its entrepreneurial environment for much of the past decade. This transformation could be seen through several metrics: new business creation rates, the inmigration of talented and creative individuals from around the region and the world, and the establishment of a regional hub of venture capital, growth equity, and investment banking activity. To cite one, albeit quite noisy, indicator, in the 2007 Global Entrepreneurship Monitor survey, the United Arab Emirates was ranked first among the forty-two countries rated for hosting start-ups geared primarily toward export markets.² Among the overall ranking in the number of start-up businesses begun in 2007, the nation moved up to the seventeenth position from the twenty-ninth spot the year before.

The role of the public sector in effecting this transformation in Dubai is unquestionable.³ The initial vision for the potential of the government’s capital and leadership in transforming the city can be traced back to the 1950s, when the late Sheikh Rashid bin Saeed Al Maktoum dredged the Dubai Creek. The waterway was crucial to Dubai’s trading and reexport businesses. (These activities had emerged as the city’s primary industries after the collapse of the pearl trade in the aftermath of the Great Depression and the invention of cultured pearls in Japan.) At the time a city of roughly 20,000 residents with few natural resources, Dubai was unable to afford the dredging and expansion project itself. To finance the effort, the sheikh essentially had to mortgage the emirate to the emir of Kuwait. Once the dredging work was complete, trading volume promptly increased and Dubai was able to rapidly repay the loan.

This successful project was only the first of a series of investments made by Sheikh Rashid. The most dramatic of these was undoubtedly the decision in 1972 to build a huge new port at Jebel Ali, massive enough to accommodate global shipping vessels, large cruise ships, and aircraft carriers. It was—and remains—the largest port in the region by far. The project, widely seen as hopelessly uneconomic at the time, created one of the world’s most successful ports and a key transshipment point for trade between the West and China. Numerous other investments followed, such as initiatives to catalyze development of a major airport and the flag carrier Emirates Airlines, hotel and resort projects, and major sporting arenas and events.

Another illustration of this aggressive policy can be seen in the creation of Dubai’s Internet City (DIC).⁴ This effort was announced in 1999. At the time, technology investment worldwide was booming, and the effort was seen as a way to diversify Dubai’s economy from its dependence on the emirate’s rapidly dwindling petroleum supply. In addition to developing office space, DIC offered a wide variety of incentives to companies that located there, including tax-free status for corporate earnings (guaranteed for fifty years), exemptions from customs duties, and the right to repatriate profits fully. DIC also offered tenants renewable, fifty-year leases on the land, enabling them to plan long-term projects.

A major focus was on providing amenities in addition to office space. These incentives included computer hardware, such as a world-class network built in collaboration with technology giant Cisco Systems. Many more intangible benefits were provided by DIC as well. These goodies included a three-day incor poration process (which allowed accelerated access to the many legal benefits that firms resident in the center obtained), a simplified immigration process for knowledge workers, help lines to answer any questions the new corporate residents had, and many opportunities for knowledge-sharing and networking among the resident firms. Certain services were geared to entrepreneurial firms, such as the availability of furnished one-room offices for rent on a month-to-month basis, with shared conference space. These services were initially provided by the management of the Internet City itself, and then spun off into an independent company. Throughout, the services were priced at a slight premium in comparison to like facilities, reflecting the particular desirability of this location.

Just as with the Jebel Ali port project, this venture attracted considerable skepticism. The catcalls intensified after the decline in technology and telecommunications stocks in the spring of 2000. But by the time the center opened, a year after being announced, it had attracted about 180 tenants, including major international players in the sector such as Cisco, Hewlett Packard, IBM, Microsoft, Oracle, and Siemens, as well as a variety of start-ups. The cluster continued to grow rapidly in the ensuing years, as many corporations chose the location as a regional hub for their business in the Middle East, Africa, and the Indian subcontinent, and new firms in the region gravitated to the facility.

But public intervention also has its dark side in Dubai, as recent events have revealed. While exact data are hard to come by, numerous analysts suggest that the Dubai government—and its government-linked corporations—is awash in a sea of red ink. In the last decade, public funds appear to have been used more and more indiscriminately for a wide array of highly levered real estate development projects, many of which were “me too” efforts with few broad social benefits or even the promise of attractive private returns.

The consequences of this excessive leverage were apparent in the aftermath of the financial crisis that began in 2008. As construction projects ground to a halt and employers contracted, many recent migrants drifted away in search of greener pastures. The debt incurred from the undisciplined pursuit of growth will be a drag on the emirate in the years to come.⁵

Moreover, in many other parts of the Middle East, governments are facing an even worse outcome: debts from large public expenditures with little new growth to show for their efforts. Numerous governments plowed their newfound oil riches into emulating the Dubai model. But in many cases, instead of seeking to copy the key principles behind Dubai’s success, they slavishly imitated the same distinct steps that the emirate took, regardless of whether their replication could pass a test of economic logic.

Consider, for instance, the efforts to emulate Dubai by creating regional transport and financial hubs. A plethora of economic analyses have suggested that these businesses have strong network effects, where the dominating position afforded an initial mover with a strong competitive position is very difficult to attack. But rather than identifying and exploiting underserved market opportunities—as Dubai’s neighboring emirate, Abu Dhabi, has done with its focus on cultural tourism—far too often the approach of neighboring governments has been to imitate what has worked for Dubai, no matter how modest the chance of repeated success. It is natural to wonder how many viable airport gateways, financial centers, and high-technology hubs can coexist within a few hundred miles of each other.

This two-sided picture of public investment represents the basic puzzle at work here. When we look at the regions of the world that are, or are emerging as, the great hubs of entrepreneurial activity—places such as Silicon Valley, Singapore, Tel Aviv, Bangalore, and Guangdong and Zhejiang provinces—the stamp of the public sector is unmistakable. Enlightened government intervention played a key role in creating each of these regions. But for each effective government intervention, there have been dozens, even hundreds, of failures, where substantial public expenditures bore no fruit.

This account of the results of public investment might lead the reader to conclude that the pursuit of entrepreneurial growth by the public sector is a massive casino. The public sector is simply making bets, with no guarantees of success. Perhaps there are no lessons to be garnered from the experiences of the successful and the failed efforts to create entrepreneurial hubs.

The truth, however, is very different. In many, many cases, the failure of efforts by governments to promote venture and entrepreneurial activity was completely predictable. These efforts have shared a set of flaws in their design, which doomed them virtually from the start. In many corners of the world, from Europe and the United States to the newest emerging economies, the same classes of problems have reappeared.

THE FOCUS OF THIS BOOK

Before we plunge into the substance of the book, it is worth highlighting the economic institutions on which we will focus, and mentioning those we won’t address.

Fast-growing entrepreneurs have attracted increasing attention both in the popular press and from policymakers. These business creators and the investors who fund them play a dramatic role in creating new industries and revitalizing economies. Many nations have launched efforts to encourage this activity. Such attention is only likely to intensify as nations seek to overcome the deleterious effects of the credit crunch and its recessionary aftereffects. This book is an effort to shed light on the process by which governments can avoid heading down an avenue of false hope, making all too common mistakes in an attempt to stimulate entrepreneurship.

One limitation is that we won’t be looking at all efforts to boost entrepreneurship. In recent decades, there has been an explosion in the number of efforts to provide financing and other forms of assistance to the poorest of the world’s poor, in order to facilitate their entry into entrepreneurship or the success of the small ventures they already have. Typically, these are “subsistence” businesses, offering services such as snack preparation or clothing repair. Such businesses typically allow the owner and his or her family to get by, but little else. The public policy literature—and indeed academic studies of new ventures—has not always made this distinction between the types of businesses that are being studied.

Our focus here will be exclusively on high-potential new ventures and the policies that enhance them. This choice is not intended to diminish the importance or relevance of efforts to boost microenterprises, but rather reflects the complexity of the field: the dynamics and issues involving micro-firms differ markedly from those associated with their high-potential counterparts. As we’ll see, a substantial literature suggests that promising entrepreneurial firms can have a powerful effect in transforming industries and promoting innovation.

It might be obvious to the reader why governments would want to promote entrepreneurship, but why also the frequent emphasis on venture funds as well? The answer lies in the challenges facing many start-up firms, which often require substantial capital. A firm’s founder may not have sufficient funds to finance projects alone, and therefore must seek outside financing. Entrepreneurial firms that are characterized by significant intangible assets, expect years of negative earnings, and have uncertain prospects are unlikely to receive bank loans or other debt financing. Venture capital—independently managed, dedicated pools of capital that focus on equity or equity-linked investments in privately held, high-growth companies—can help alleviate these problems.

Typically, venture capitalists do not primarily invest their own capital, but rather raise the bulk of their funds from institutions and individuals. Large institutional investors, such as pension funds and university endowments, want investments in their portfolio that have the potential to generate high yields, such as venture capital, and typically do not mind placing a substantial amount of capital in investments that cannot be liquidated for extended periods. Often, these groups have neither the staff nor the expertise to make such investments themselves. Thus, they invest in partnerships sponsored by venture capital funds, which in turn provide the funds to young firms.

In this book, we’ll explore efforts to promote the growth of high-potential entrepreneurial ventures, as well as the venture funds that capitalize them. While the public sector is important in stimulating these activities, I will note that far more often than not, public programs have been failures. Many of these failures could have been avoided, however, if leaders had taken some relatively simple steps in designing and implementing their efforts.

It is also important to note that this book focuses on new ventures, rather than restructurings, leveraged buyouts, and other later-stage private equity investments. Later-stage private equity resembles venture capital in a number of respects, sharing similar legal structures, incentive schemes, and investors. Such equity funds also invest in a type of enterprise that often finds external financing difficult to raise: troubled firms that need to restructure. Like venture capitalists, buyout funds protect the value of their equity stakes by undertaking due dilige...