Erasing Our Innovation Deficit

Eric Schmidt, chairman and chief executive at Google, recently wrote a great article, Erasing Our Innovation Deficit, which highlights some of the major points we are making at Catalyst Capital Management and Ventana Innovation.

In response, Eric Schmidt is right on! The top national priority must be jobs; it’s the core issue.

The great job creation engine consists of 3 parts: entrepreneurs, innovation and equity capital. Creating significant jobs will only happen when entrepreneurs identify disruptive innovations and have the ability to attract capital.  Finding capital continues to be a major problem in most regions of the United States; with the exception of the Silicon Valley.

During the last decade, venture capital fund raising dropped from $70 billion per year to $15 billion, and IPOs dropped from 100s per year to 7 in 2008 and 12 in 2009. The sequential effect of this has had a major impact on innovation, and as a result, major negative impact on jobs.

I agree, we can climb out of this current morass. Entrepreneurs have not gone away, they continue to innovate. However, there is basically “no” capital for early stage innovators.

Catalyst “fund of funds” was established to bridge that gap. Within the 600-strong national network of venture capitalists, is an incredible delivery system of know-how to finance innovation.

We have proposed to Obama and his advisors that he set aside $5 billion of the $30 billion for the equity capital that’s necessary to build companies, which creates jobs. We can’t afford to let our innovation advantage be transferred to other countries! Innovation is our main asset.

Help! Get this message to the President and his advisors. Capital formation for small business has suffered because of the lack of venture capital and IPOs.

Lineman, Receivers, and the Innovation Paradox

Common sense and experience tell us that large businesses are quite different from small ones.   Large companies characteristically possess the market experience, operating scale, customer knowledge, skilled workforce, and financial resources necessary to access, penetrate, and defend global markets.  In football terms they might be the offensive linemen of business.  Strong, powerful, persistent and momentum is often their greatest ally.

Small companies on the other hand are altogether different.  Unencumbered by the weight of a large organization, they are quick, nibble innovators who operate most comfortably “outside the box” to address and solve emerging problems.  If large companies are the offensive linemen, small companies are the wide receivers weaving their way through a maze of opportunities in search of a soft spot.

So what does this have to do with innovation?  Quite a lot really.  As investors in innovation, we do not seek businesses built on a premise that some form of “power”, be it in market or technology, will bequeath certain success.  Rather, we favor fast, nimble, and passionate teams that react quickly to changing conditions, readily accept advice and insight, have a passion to quickly solve problems, and generally operate comfortably “outside the box”.    To be successful, we as venture capitalists must be expert in the identification, development, and coaching of “wide receivers”.

From our experience, many leaders of large businesses grapple with the Innovation Paradox.  Specifically, how does one manage a large corporation to embrace innovation and thus behave like a small business?  Effectively, how do you coach a lineman to be an excellent wide receiver?

Recent research by Wharton professor of management Felipe Monteiro sheds light on the paradox (see article).  Most noteworthy is the role of corporate culture and norming behavior on the selection and advancement of innovative, “out-of-the-box” ideas.  Monteiro defines “dissonant knowledge”, i.e. knowledge that challenges predominant (organization) logic, as a major hurdle.  When describing the decision-making processes surrounding new ideas, Monteiro says, “You’re more likely to act on opportunities that confirm what you’re doing than opportunities that challenge what you’re doing.”  In essence, the very strengths that sustain the company simultaneously create paradigms that thwart innovation.

So how might one overcome such a paradox?  By combining internal knowledge with established external experts to enrich the innovative possibilities. Put another way; execute a game plan that maximizes the unique skills of both lineman and wide receivers.

Ventana Innovation: Providing Access to Innovation

INNOVATION is the engine that drives the American economy. Accomplished CEOs and corporate leaders know from experience the great effort required to grow a business while managing short-term operating pressures.   Most all acknowledge, however, that the more daunting challenge is to visualize and create a corporate future in the face of uncertainty and risk.  The single word, INNOVATION, captures both this challenge and opportunity.

VENTANA INNOVATION has the resources to become your external innovation advisor.

VENTANA INNOVATION was organized to partner with entrepreneurs and corporate leaders by providing them with ACCESS and expertise necessary to expand their global innovative leadership.  

VENTANA INNOVATION couples the major multi-national company with the innovative technology of a small enterprise. Our professionals work hard to provide you with the strategic ADVANTAGE.

VENTANA INNOVATION PARTNERS are in a unique position with access to privileged deal flow.

VENTANA INNOVATION PARTNERS provide:

• Access to extensive research and expertise from around the globe  
• Experience in indentifying strong management teams and product fit to market
• Access to the privileged Venture Capital network and deal flow
• Access to Southern California’s Technology Coast, rich in university and laboratory research and global technology companies
• A successful proven track record

Having enjoyed successful growth, endured recessions and funded recoveries, VENTANA INNOVATION has developed a level of experience that can only be obtained through a long history (25 years) of investing as venture capitalists.

PROVIDING ACCESS TO INNOVATION

America’s Genius in Jeopardy

AMERICA’S GENIUS IN JEOPARDY

A Call To Action For The Support of Innovation and Job Growth

By Thomas O. Gephart

Revised, January 2010

Thomas O. Gephart has over 30 years of experience building entrepreneurial companies. As the founder of Ventana Capital Management, a Southern California Venture Capital firm, he has been involved in more than 100 companies and has affiliates, investors and friends in more than twenty countries across the globe. Mr. Gephart holds a Bachelor of Science in Engineering from the University of Southern California.

Foreword

The U.S. has been dubbed the “new economy” for a simple reason: no one has seen any other country parallel its success – a nation in which growth and innovation has created jobs that never existed, boosted productivity to new heights and driven the economy forward for decades on end.

For many decades, the U.S. economy has enjoyed an extended and prosperous period of uninterrupted growth – mostly due to rapid advances in technology that has completely altered the business landscape. This is America’s genius. Understanding the importance of continuing innovation is key to a avoiding the path of complacency.

What is different today, that we have not faced in the past as a nation, is a new & different challenge in the global marketplace. With advances in technology ad communications, entrepreneurship and innovation has no borders. In fact, the U.S. is now facing challenges from other countries in the global race for the development of emerging technologies. As advocates of free enterprise and free trade, the United States has educated the rest of the world on the creation of technology and biotech enterprises, creating a cadre of innovators that are spread throughout the globe. The “economic miracle” model, which is the integration of capital, smart and supportive government as well as innovation and entrepreneurship, has caught on quickly in other countries including Japan, Korea, China, Taiwan and India. In order for the U.S. to maintain its global technological and economic leadership, we must continue to challenge ourselves by investing in policies to spur innovation.

The purpose of this discussion is to shed light on the pending impact of global changes on innovation as well as to propose general policy ideas that will help create an environment for targeted pre-seed capital and the transfer of technological innovation into the marketplace. The U.S.’ public policy has allowed us the ability to create our own genius, but conditions have now changed that have caused a serious need to re-evaluate our policies. We need to increase the nourishment of an environment that spurs innovation and entrepreneurship in order to maintain our genius and productivity, one of our most valuable national assets.

Innovation’s Role in U.S. Job Growth

The U.S has a long history of nurturing innovation starting with the post-World War II strategy of investing public funds in research. This transformed the U.S. from an agricultural and natural resource-based economy into one of the world leaders in developing new technologies.

In today’s global economy, innovation is one of the most important factors behind economic growth. As the United States competes and trades with many countries that often have lower labor and manufacturing costs, innovation is a distinct advantage. Comparing the U.S. with Europe confirms the importance of entrepreneurial activity. Over the past 20 years, many companies have consolidated and restructured, costing U.S. and European start-up companies an estimated 16 million jobs. In the U.S. however, entrepreneurs formed companies that created over 10 million jobs in each decade. Europe, facing a similar entrepreneurial challenge, was unable to fill the void left by the loss of jobs, resulting in an unemployment rate three times that of the U.S.

According to the RAND Corporation, the U.S. entrepreneurial system “has emerged as one of our mot important national assets, as important a source for growth today and in the future as have been…the nation’s natural resources in the past.” The U.S.  is, in fact, here today because of the public policies that have supported innovation. Unfortunately, as global climates change, these policies have become cumbersome and ineffective.

This discussion is not a call to a specific action, but meant to provide a clear realization of the problem and suggest general policy changes and plant the seeds of change. The call to action that should result from this discussion is the start of serious discussion and dialogues, which will be necessary for such a complex issue. In order for the U.S. to maintain its global lead in innovation, the following policies should be discussed, updated, fine-tuned and/or implemented.

(1) Create federal and state initiatives that encourage the creation of Regional Innovation Clusters that foster the development of revolutionary technologies.

(2) Create an environment and a system to provide the currently lacking “pre-seed” capital to commercialize innovative new technologies.

(3) Encourage broad-based employee ownership by resisting efforts to mandate the expensing of employee stock options.

(4) Make science, math, engineering and technology education a national priority.

(5) Encourage and support global partnering through the collaboration and sharing of IP (intellectual property) while aggressively pursuing the eradication of cross border technology piracy.

Revolutionary vs. Evolutionary Technology Innovation

It is important to discuss the type of innovation that will maintain a competitive edge. “Innovation” as a concept is a simple answer to regional economic and job growth; however, it is a complex concept with many facets. What will propel job growth is known as revolutionary (disruptive) innovation rather than evolutionary innovation. To better define this concept, start-up companies can be divided into two broad categories: evolutionary and revolutionary. The evolutionary company for instance, takes an existing product and makes a newer, better version of it. For instance, the evolutionary company builds a better mousetrap. The revolutionary company builds an entirely new approach (often involving new technology) to taking care of the mouse problem itself.

Both companies face similar challenges, but there are some very important differences. Revolutionary companies look at the market for mousetraps and invent a while new technology to address the problem, they change the rules of the marketplace. In most technology-driven markets, fundamental market paradigm shifts are created by the small, entrepreneurial, revolutionary companies. This is the kind of innovation that sparks massive changes in culture, economy and job growth, and that will enable the U.S. to continue on its current path of economic success.

Regional Innovation Clusters: A Successful Model

Why do some regions within the United States have greater job growth than others? Why do some cities have so many breakout high technologies of life science companies? Clustering of successful innovation in geographic regions is a well-documented phenomenon, one that many cities, counties, and states want to emulate. Policy-makers have realized that regional economies need innovation in order to thrive and prosper. What is missing for many regional economies is two-fold: a friendly, supportive community infrastructure, as well as a working plan to attract innovation, entrepreneurship, and capital to the region.

Those regions that foster revolutionary technologies are likely to attract the most capital and experience higher rates of job growth. In these small, highly networked communities, the big ideas that are extremely early stage are far more likely to gain the attention they deserve. Regions that primarily focus on evolutionary technology will have success but will not see the entrepreneurial activity that a cluster of disruptive technology companies will bring.

In fact, it is imperative that a friendly and non-threatening support structure and culture be created to maintain the entrepreneurial community. Innovation must be allowed to fail without fear of resulting repercussions. Harvard Business School Professor Michael Porter summarizes, “The central economic goal…should be to attain and sustain a high and rising standard of living for…citizens. The ability to earn a high and rising standard of living depends on increasing education standards and productivity, which in turn depends on innovation. The central challenge, then, in enhancing prosperity is to create the conditions for sustained revolutionary innovation output.”

Attracting Capital: The Missing Link

There are many levels and kinds of venture capital, including seed, early-stage and secondary funding. What is extremely challenging to obtain in today’s marketplace is the first or pre-seed validation capital, which is desperately needed to validate the research and development behind emerging technologies. This is one of the most risky areas of capital investment and, in today’s IRR driven environment, investors such as Venture Capitalists are extremely hesitant to become developmental or validation investors. So, the issue of how to obtain pre-seed capital for these technology break-throughs needs to be investigated:

(1) Who would qualify to receive such capital?

(2) Who would manage the capital?

(3) Should the region or the state have governance over the capital?

(4) Should this be a State or Federal program?

(5) What are some viable solutions or where to obtain the money?

(6) Should venture capitalists be given a set-aside for validation capital?

Besides governmental funding, Venture Capital is one of the most common funding sources for entrepreneurial companies, after seed and validation capital. Results of an economic impact study[1] released by the National Venture Capital Association (NVCA) reveals that Venture Capital invested during the period 1970 – 2000 created 7.6 million U.S. jobs and more than $1.3 trillion in revenue as of the end of 2000.

Understanding what attracts Venture Capitalists and other funding sources is imperative for the successful development of a regional innovation economy. The United States spends $184 billion per year on research and development, yet the government sets aside a miniscule portion of these monies to commercialize the intellectual property (IP) that is created, except through the SBIR program. Currently, both the federally funded SBIR and SBIC programs, which direct capital into the commercialization of innovative technologies, are in jeopardy. The critical next step of reaching the commercial marketplace is basically left to the technology developer, who typically does not have the means to bring the technology to market.

Under today’s R&D programs, a scientist with a potentially major breakthrough technology is given different levels of guidance on how to approach the marketplace or find the capital necessary to bridge the gap from R&D to commercialization. This guidance varies considerably and depends on the commitment and priority of the community and/or university environment. In today’s current development structure, the technology developer would receive funding for the basic research necessary to initiate a new innovation, but, in most cases, is left to validate the commercialization of the technology himself.

Some may argue that angel investors and venture capitalists fill this pre-seed validation capital gap, however, in today’s results-driven financial, highly competitive IRR environment, very few research companies are funded at the pre-seed level. Most venture capitalists and even angels have exited the seed capital market because of the three-year drought in creating liquidity in early stage companies. Incubators were a potential solution, but have mostly failed to this point. Potentially, this pre-seed validation capital gap could be filled with companion clauses that accompany the “set-asides” from the $184 billion in federal research and development funds that are dispersed annually. In other words, build in validation capital clauses to existing federal R&D disbursements that will kick in when researchers have successful technology development and need to move to the next level.  The federal monies are there, we just need to make sure that they are allocated to the proper channels. Programs like the SBIR, which allocate funds for small businesses are a great start, but do not come close to meeting the need for supporting innovation on the scale that the U.S. needs to foster regional innovation clusters. Another solution could be to utilize various tax incentives (i.e. tax credits, etc.) to stimulate innovation R&D activity. Various states are also doing a variety of pension fund allocations and tax incentives for companies, which maintain operations within the state.

Education: An Economic Driver

Economists have long predicted that education will be the fuel that drives the global economy. While many nations have already begun to rev their engines, America’s is stalled. College enrollments may be booming here in the U.S. but comparatively, China graduates twice as may students with bachelor’s degrees and six times as many engineering majors. Additionally, India and Singapore are pumping out scientists through top-notch undergraduate programs. In 2001, India graduated almost a million more students from college than the U.S. did, including 100,000 more in the sciences and 60,000 more in engineering. Additionally, about 550,000 foreign students study in the U.S. – double the number from 15 years ago – and about half of U.S. engineering PhDs are foreign-born[2].

The result of high education emphasis and friendly incentives is going to create fierce competition. There are many highly educated and motivated individuals in other countries that are using the U.S. model for success.  The difference in their success is that they emphasize education, making them a serious threat for future innovation.

Ventana Global has been working with Europeans since its inception in 1984 and has actively been working with Japanese enterprises since 1987. With first-hand knowledge, the path is clear. Europeans and Asian businesses are thorough and patient in building their enterprises as well as dedicated to create and utilize the most cutting edge technologies that are available.  As a result, they are quickly catching up to the U.S. in terms of innovation output and will surpass us within near future if we do not prioritize domestic innovation. Ventana has observed this global trend and has made it our mission to support America’s genius in supporting innovation and entrepreneurship in the biotech and high tech sectors.

There is much more to say about the new Japan, China, India, and various other global players. This paper is only meant to highlight what we, as a nation, will be facing in the next two decades. It is a reality we must face and conquer in terms of markets and innovation. We can never become arrogant or forget the new global reality that innovations are no longer only a U.S. phenomenon. We now have competition and the only way to remain a player is to create a user-friendly innovation and environment and make education a higher priority in our country.

Stock Options: Driving Innovation

As the U.S. competes with countries that can innovate and produce technologies at a cheaper rate than we can, the goal should be to incentivize our workforce to innovate. One of the key factors behind incentivizing our workforce is providing bonuses such as stock options. Almost all entrepreneurial companies have a stock option program. This is one of the most common wealth creation tools for both the blue and white-collar employees.

Stock options attract and keep valuable innovators in our workforce. Unfortunately, policymakers are looking into mandatory expensing of broad-based stock option plans. Exercising this action would devastate innovation and entrepreneurship in U.S. companies and, in turn, cause them to limit their capacity to innovate. Starting this vicious cycle can only lead to lack of innovation and a decrease in job creation.

The U.S. has had a great talent in creating tools to increase innovation, including incentive stock options, so why stop or retract such a powerful tool? A good example is that China is now promoting the use of stock options as a part of their five-year economic plan. The reason behind this plan: attracting higher quality employees and growing their economy. China has seen tangible value that this has brought to the U.S. job marketplace. Why do U.S. policymakers not see the same thing?

Young, entrepreneurial companies have been and will always be strapped for operating capital. Stock options allow these companies to attract the best talent at affordable wages. Stock options only have value when companies are successful. By stripping this tool away from young companies, their talent pool will shrink and, accordingly they will not have the ability to succeed. Simply stated, stripping away stock options will stifle the chances of a young company’s ability to successfully bring revolutionary technology to market.

Global Partnering

Global Partnering is a relatively new concept for many companies. To date, companies have typically kept trade secrets and innovative technologies in house for fear another entity might make it to market first. However, in today’s global marketplace, there is no substitute for forming strategic global alliances and sharing ideas and resources.

Companies that are open to the idea of global partnering will not only benefit from intellectual capital but in many cases will have access to human capital and additional resources that would be out of reach for a single company on its own. In fact, global partnering only promotes the cause to share IP and prevents the common occurrence of IP piracy in a closed border scenario. After all, if you make a non-U.S. form your partner and stakeholder, they are much less likely to steal from you if they are already getting the benefits of your collaboration.

Ventana is one of the few venture capitalists that has partnered globally and has seen first hand the effort and capital other counties are devoting to innovation. In fact, Ventana recently met with the former Chairman of NIF. NIF’s former Chairman, now with the JVCA (Japan Venture Capital Association), conveyed that they expect over 170 IPOs from Japanese technology companies during the 2004 calendar year. Coupled with the hundreds of millions of dollars strictly devoted to developing technologies and innovation, Japan is poised to create hundreds of thousands of new jobs and in turn, strengthening their economy.

This is not an uncommon story. Countries are globally making innovation and job growth a priority, potentially leaving the U.S. significantly behind in the development of disruptive technology. Partnering with countries to share ideas, resources, education, etc. is a necessary part of survival in today’s global marketplace, and if the U.S. does not continue to place great importance on its quest for innovation, we could end up in second or third place in the global race for innovation.

Concluding Thoughts

This discussion was prepared to create awareness of the subtle changes that could quickly grow to place the U.S. into a second or third place position as an innovation leader. If we act quickly and effectively this scenario does not have to take place. If we prioritize innovation, we will not lose the benefit of our genius.

Individually, none of the ideas presented here are revolutionary, but when examined in a concentric, interlinked model, it becomes clear that innovation will only continue to occur when universities, community leaders, and the government work together to foster entrepreneurial companies. Specifically, the U.S. government needs to provide entrepreneurial companies as well as geographic regions the tools such as critical public and private inputs that will stimulate innovation. This is the human, technology, and investment capital, plus infrastructure that have to be in place in order to reap the benefits for people and business that will cause job growth, rising average wages, and the ability to export value.

We also need to create federal/state incentives and set-asides for young companies. We need to make it user friendly for the innovators. These programs need to be targeted towards R&D companies that are developing innovative and revolutionary technologies. For instance, the U.S. government could offer tax credits or Small Business Implementation grants. This would encourage companies to bring innovation to market as well as continue to develop revolutionary technologies.

When our government understands the link between innovation and job growth, young companies will be protected and our role in the global marketplace will be secured. After all, part of the genius of America is that we are the sponsors of free democratic trade and economy.

The U.S. needs to continue to foster learning, growth, and wealth creation in order to continue to participate effectively in the global marketplace. Simply stated, we need to help all of our U.S. companies to remain globally competitive.

America’s challenge is to keep its innovation in the forefront of our domestic policy. Our current presidential candidates have begun to touch on the subject of innovation and job growth. This should be one of the most prevalent topics of this year’s campaign as it is the most direct path to growth, jobs, income and wealth. We need a rainmaker as president to focus on innovation and place the human capital behind it to succeed. The U.S. is headed for a crises and we need to see our presidential and other political candidates address how they are going to nurture our transitioning economy with one of the best tools in their arsenal: innovation.

The full text of the article along with some charts, originally published in The Venture Capital Review, Winter 2004-2005, is available at:

http://www.ventanaglobal.com/gephart-innovation-white-paper.pdf

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[1] DRI-WEFA, formerly Wharton Econometrics, The Economic Impact of Venture Capital, 2001.

[2] Mark Clayton, “Academia becomes target for new security laws,” The Christian Science Monitor, 9/22/2002.