The Problem With Taxpayer Money in Startups

European Straits #151

Hi, it’s Nicolas from The Family. Today, I’m discussing the very specific context in which the state and private sector investors actually complement each other.

We’ve all seen the articles about US venture capital firms 🇺🇸 making inroads in Europe 🇪🇺: see here, here, and here for instance. Indeed, a lot has been written to inform a European audience about what it means for the continent. As for me, I wanted to compile some advice for those US investors if they want to make their way in the pan-European ecosystem. ⚠️ It’s my latest column in Sifted, and you can read it here: US Venture Capitalists: Here Are 10 Tips If You Want to Make It in Europe ⚠️

Another thing: last week’s issue, about Capitalism and the Future of Nation States, was the most read ever in the history of this newsletter 🎉. So thanks to Stefano Bernardi, who initiated the discussion; thanks to everyone who shared it, including FT Alphaville, Barry Ritholtz, and many others; and thanks to Substack, which makes it so much easier to gather a broader audience around written content!

This week I’d like to discuss the role of the state when it comes to supporting startups. Read along 👇

1/ Last week, FT Alphaville, the FT’s (excellent) daily news and commentary service for financial market professionals, discussed the idea of the state financing entrepreneurial ventures. A long-held assumption is that the state should refrain from deploying capital in such ventures because that taxpayer money risks “crowding out” private sector investments, thus triggering a vicious circle in which entrepreneurs end up with less money overall. Last week, however, three economists (Enrico Moretti, John Van Reenen, Claudia Steinwender) released a working paper that properly debunks this idea. Rather than crowding out private investment, the state deploying capital merely amplifies it:

[There are] three reasons as to why this “crowding-in effect” may be taking place. First, is that frontier technology projects have extremely high fixed costs — whether in the form of equipment or labour — so by letting the public sector fund the research, it allows the private sector to realise higher profits. Second is “spillover effects”, where new technologies find different applications in the private sector. GPS, for instance, was first developed to help missiles find their targets. It now helps FT Alphaville find lunch. Third are credit constraints on the private sector, where a project is difficult to fund without government support due to, say, an economic downturn.

2/ I have a problem, however, with such an explanation. Let me explain. I don’t doubt the three economists’ conclusions for one second. And I know enough about the history of innovation to realize that the state funding basic research is a key enabler of radical innovation at a large scale. But there’s one big problem. Although it’s important to acknowledge the correlation between the state deploying capital and more entrepreneurs succeeding, it also can give people the misleading idea that it’s all about a waterfall model—one in which the simple fact that the state funds more basic research is enough to inspire entrepreneurial efforts. This misunderstanding is especially present in my home country of France, but it also exists elsewhere—both in the governmental and the entrepreneurial spheres.

3/ There are typically three policy measures that the state needs to implement if it wants to enable innovative entrepreneurial ventures at scale. All are about hedging private sector investors against taking too many risks (yes: contrary to what you believe, even venture capitalists are risk-averse):

  • Basic upstream research is about the state providing entrepreneurs with cutting-edge technology without their having to take the risk of implementing that research themselves.

  • Then there are tax incentives for allocators to pick venture capital as an asset class. Once you provide entrepreneurs with technology, you need to invite investors to the dance. This requires lowering taxes on capital gains and enabling large institutional investors (such as pension funds) to allocate capital to venture capital funds.

  • Finally, there’s the possibility to exit investments so as to generate returns for LPs. It’s very hard to attract investors in innovative entrepreneurial ventures if you don’t provide them with an opportunity to exit their investment within 5-10 years. And so governments need to support companies going public and to create a favorable context for large companies acquiring startups.

4/ But merely enabling venture-backed entrepreneurship is not enough for the “crowding-in” to happen. An entire ecosystem takes off not because more money is thrown at it by the state, but rather due to the many interactions that happen at the small scale of what Brad Feld and Ian Hathaway call “startup communities”—that is, a small group of entrepreneurs, investors, and ecosystem builders that know each other, closely follow what everyone is doing, and frequently interact so as to make it easier to build startups. What brings these people together? It’s not only the geographic proximity. It’s also that all these people are specializing in the same field and pursue opportunities aiming in the same direction—to the point where they realize that they need to cooperate more, learn from each other, and pool resources. It’s part genuine inspiration, part fear of missing out, and part pay-it-forward.

5/ And so there must be a fourth contribution of the state to an entrepreneurial ecosystem taking off. The policy measures described above are mere enablers: they create a favorable context for building entrepreneurial ventures and turning the local startup community into an ecosystem. But the direction that the state provides is what really puts everyone on their toes. Usually that direction is phrased in terms of waging a war (whether an actual war or a figurative war against cancer or under-development, for instance). Consider everything that waging a war brings to a startup community:

  • A clear articulation of the goal, which makes everyone aware and spares entrepreneurs from having to explain too much about what they do and why they do it.

  • The guarantee that no special interest groups will dare stand in your way. When you’re at war, everyone who stands in the way of winning is literally an enemy of the nation.

  • Access to an infinite amount of resources, because when it’s about winning a war, what matters is less the cost than the actual outcome. Losing is simply not an option.

6/ All in all, the direction set by the state is a necessary complement to the policy enablers. Once the government sets the direction, entrepreneurs are all too happy to hack their way into profiting as much off these enablers as they can. They might not genuinely care about winning that particular war, but given their hunger for the resources you put at their disposal (basic research, money, exit opportunities), they’re happy to oblige and align their priorities with the general direction. In our experience at The Family, entrepreneurs are like junkies: they will say and do anything to get ahold of that cash they need to grow even faster.

7/ This is one way to look at the story of Silicon Valley. It was not planned by the government. Rather it was born out of the efforts of Frederick Terman, then the Provost at Stanford, to access the government’s money in the context of waging the Cold War. Terman had a very precise (and selfish) idea of what he wanted to do with that money: grow his beloved university and turn it into a vibrant ecosystem for research and entrepreneurship. He didn’t care that much about the Cold War. But he was ready to do what it took to grab as large a slice of that money as possible. Later, the US government put in place financing schemes, such as the Small Business Investment Company (SBIC), that were less than perfect. But upstart entrepreneurs and investors, junkies that they are, were willing to use them because they allowed them to access scarce resources, cut their teeth, and accumulate experience. Most of the first-generation VCs in Silicon Valley, like Franklin “Pitch” Johnson, used the ill-designed SBIC at the beginning before eventually moving away from it. For the state, though, it was mission-accomplished: it had applied pressure by providing a direction, enabling many people to get into the game by making it relatively easy to hack resources such as the SBIC program, however ill-designed they may have been.

8/ Then there’s one last thing: the psychology of government officials. As an entrepreneur, you will never meet someone more anxious and insecure than a politician. What they want to ask when they meet you is: “Have I done the right thing?” If you say “Yes”, they’ll put you on their white list and shower you with more praise and money. If you say “No”, they’ll make sure to avoid you in the future, because you can’t endure as a politician if you encounter too many people who criticize you.

9/ Hence the idea of entrepreneurs as courtiers—and the consequences when it comes to public sector investment in entrepreneurial ventures. There are two options. If the state sets a direction like “We must win the Cold War, otherwise we’ll all soon be dead”, the mission is so compelling that entrepreneurs are all too happy to tell you that you’re doing the right thing—and that they’re happy to contribute, provided you give them money. On the other hand, if you haven’t set a direction, all these courtier-entrepreneurs can do to win the favor of the state is to tell officials how great they’re doing in general—and this leads to a very different outcome. With a clear direction, you end up with Silicon Valley. But without a clear direction, it’s everyone for themselves rather than waging a war together—and the state isn’t leading, but is rather being drawn in myriad directions depending on who is the best at flattering the king. And you simply can’t build a healthy and thriving ecosystem like that.

10/ All in all, the problem these days is not a lack of means. Rather it’s a lack of direction. Supporting a given sector, such as healthcare or energy, is not a direction. Supporting a given research field, such as artificial intelligence, is not a direction, either. And supporting startups in general is definitely not a direction—because startups can lead you in so many directions you’ll end up lacking ecosystem density and any sense of alignment. I’m all for public sector investment crowding in, as FT Alphaville put it last week, but I worry about the inability of our current Western governments to wage a war with clear strategic goals. What problems are we trying to solve? And are those problems compelling enough so as to bring everyone, government and entrepreneurs, together?

In conclusion, entrepreneurs should be happy to play the role of courtiers, like Frederick Terman in his time, when it’s about bolstering the state as it tries to win a war. It becomes very dangerous, on the other hand, when nobody knows exactly what war is being waged at the moment. Is France at war? Is the UK? Germany? The European Union? I’m not sure. People are indeed busy, and elected officials love startups and are definitely willing to help and to shower a lot of money. But I don’t see the actual direction, and it’s the direction that maximizes the impact of public sector investment in an entrepreneurial ecosystem.

Please scroll down for a comprehensive reading list expanding on this discussion.

👩‍💻 Upwork has become one of the major players in the developing world of remote work, led these past years by Stephane Kasriel who just recently turned over the reins of the company. Stephane recently sat down with my colleague Erika Batista to talk about how to scale a company so that it satisfies the needs of many different stakeholders. Check it out.

🚀 At The Family, we’re proud to have hosted well over 1,000 events since our founding. And as the year comes to a close, it brings us to what will be our last events of the decade(!). I think the last two, both in Paris, are quite indicative of who we are: this Friday we’re hosting The Femme (in 🇫🇷) with several top women entrepreneurs on stage talking about how they’ve succeeded; then next Wednesday we’ve got 3 of our fastest growing startups talking (in 🇬🇧) about how to build a consumer brand that really touches people.

🧠 We are not rational beings capable of always putting emotion aside to process information and take the best decisions for our company.“Cognitive biases” refer to the distortions created by our cognitive system when we receive and process information. These biases have a tremendous impact on organizations. They hinder diversity and efficiency. My wife Laetitia Vitaud’s series for HR platform and media Welcome to the Jungle provides short and insightful articles to help  identify the biases, understand how they affect HR, and what to do to address them. 

💢 Finally, don’t miss this compelling article by former CIA analyst and author of The Revolt of the Public Martin Gurri about 2019: The year revolt went global.

Here are more readings about public sector investments in startup ecosystems:

From London, UK 🇬🇧