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National Security Considerations and Entrepreneurship

Venture capital is critical for innovation, and young entrepreneurial firms tend to be key drivers of those innovations, even if many innovations are commercialized by larger firms, said Josh Lerner, Jacob H. Schiff Professor at Harvard Business School and codirector of the school’s Private Capital Project, in his keynote address at the workshop. A study of hundreds of key innovations in the second half of the 20th century found that small firms contributed a disproportionate share of major innovations.¹ The contribution of small firms was greatest in immature industries that were relatively unconcentrated, said Lerner, which is consistent with models of technological competition.²

Research also has shown, Lerner reported, that staying private for a long time can be good for companies and that private companies are more innovative.³

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¹ Zoltan J. Acs and David B. Audretsch. 1988. Innovation in large and small firms: An empirical analysis. American Economic Review 78(4):678–690.

² Jennifer F. Reinganum. 1989. The timing of innovation: Research, development, and diffusion. Handbook of industrial organization, vol. 1, pp. 849–908. Amsterdam: North-Holland Publishing Co.

³ Shai Bernstein. 2015. Does going public affect innovation? Journal of Finance 70(4):1365–1403; Sabrina T. Howell, Josh Lerner, Ramana Nanda, and Richard R. Townsend. 2023. How resilient is venture-backed innovation? Evidence from four decades of U.S. patenting. National Bureau of Economic Research. Working Paper 27150. https://www.nber.org/papers/w27150

Private companies generally have fewer reporting requirements and less quarter-to-quarter financial pressure. Also, relative to peers, the quality of innovation decreases after an initial public offering.

However, small firms face many challenges when accessing resources. They may find it difficult to secure bank financing given perceived levels of risk and a lack of tangible assets. Angel investors can be difficult to access and mercurial, public market capital can be likewise hard to acquire, and small firms may lack credibility with corporations and financial intermediaries.

Lerner described how, in the years around World War II, the French-American Georges Doriot became worried about the dangers of postwar stagnation in the United States. He saw innovations developed during the war, especially in the Boston area, as key potential drivers of economic growth. But he also recognized a need for new financial institutions that could play three roles: sorting, governing, and certifying. To fill this gap, he created the venture capital firm American Research and Development in 1946.⁴

Today, the role of venture capital is much greater than it was in the postwar period. In particular, venture capital investments along with other kinds of funds surged globally in the early 2020s. Furthermore, the shares of global venture capital investment from the developing world, including China, have risen dramatically.⁵ “Doriot was right!” said Lerner.

Venture capital returns have historically outperformed public markets, Lerner observed. In a study of the relationship between venture capital and innovation looking across 20 industries and using patenting and other proxies for innovation, venture capital appeared to be three to four times more powerful than corporate research and development (R&D), even after controlling for causality concerns.⁶ From the late 1970s to the mid-1990s, venture capital was only 3 percent of corporate R&D but was responsible for approximately 10–12 percent of privately funded innovations.

Firms backed by venture capital are particularly innovative. In an investigation of the relationship between venture capital and innovation using patent data, patents affiliated with venture capital were 2.6 times more likely than patents at large to be in the top 10 percent of subsequent citations, 4.6 times more likely to be in the top 1 percent of subsequent citations, 2.6 times more likely to be in the top 1 percent of intellectual breadth, and 3.9 times more likely to be in the top 1 percent of patents related to pathbreaking science.⁷ Furthermore, more

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⁴ Spencer E. Ante. 2008. Creative capital: Georges Doriot and the birth of venture capital. Boston: Harvard Business School Press.

⁵ Josh Lerner, Junxi Liu, Jacob Moscona, and David Y. Yang. 2023. Appropriate entrepreneurship? The rise of Chinese venture capital and the developing world. Unpublished working paper. https://scholar.harvard.edu/sites/scholar.harvard.edu/files/moscona/files/llmy_entrepreneurship.pdf

⁶ Samuel Kortum and Josh Lerner. 2000. Assessing the impact of venture capital on innovation. RAND Journal of Economics 31(4):674–692.

⁷ Sabrina T. Howell, Josh Lerner, Ramana Nanda, and Richard R. Townsend. 2023. How resilient is venture-backed innovation? Evidence from four decades of U.S. patenting. National Bureau of Economic Research. Working Paper 27150. https://www.nber.org/papers/w27150

venture capital engagement with companies leads to more innovation and better outcomes.⁸

As a result, venture capital has become a key funding source for growing firms.⁹ This is not surprising given the benefits of venture capital funding to entrepreneurs, such as mentorship, credentialing, and potential to scale quickly, Lerner said. Of the nonfinancial U.S. companies going public between 1995 and 2019, 45 percent were venture backed. Of those companies still publicly traded at the end of 2019, 51 percent were venture backed, representing 72 percent of the total market capitalization and 88 percent of total R&D expenditure.

But important questions linger, Lerner added. The kinds of innovation being supported raise concerns. Venture capital has focused on scalable technologies, including software and services firms, which can “crowd out” technological progress in other sectors. Innovation in general has become more focused, Lerner observed, and that is even more true for venture capital, even as many “tough technologies” languish unfunded. These technologies may have lower returns because of their capital intensity and the time required to de-risk deep technology ventures. They may also have lower relative returns due to industry and market structure. For example, energy, materials, and much of health care involves selling into highly regulated industries with low margins, where customers are also competitors.

Also, venture capital is subject to boom–bust cycles, Lerner pointed out. Venture investors achieve large returns and start to commit more capital. Then prices go up, “too much money is chasing too few deals,” and returns decline. Crises in public markets can cause limited partner investors to become overcommitted to illiquid assets such as venture capital, and they then reduce their commitments. As the macroeconomy improves and prices come down, returns start to improve. This pattern is seen around the world, Lerner said.¹⁰

IMPLICATIONS FOR SBIR/STTR PROGRAMS

These observations have several implications for the national security establishment, Lerner explained. It is critical to address design flaws and introduce experiments in entrepreneurial finance programs. An example of a flaw is the low rate of return from Phase II grants, he said, according to work by Sabrina Howell looking at the Department of Energy program.¹¹ Given the much higher rate of returns to Phase I awards compared with Phase II awards shown in her

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⁸ Shai Bernstein, Xavier Giroud, and Richard R. Townsend. 2016. The impact of venture capital monitoring. Journal of Finance 71(4):1591–1622.

⁹ Josh Lerner and Ramana Nanda. 2020. Venture capital’s role in financing innovation: What we know and how much we still need to learn. Journal of Economic Perspectives 34(Summer):237–261.

¹⁰ Ufuk Akcigit, Sina T. Ates, Josh Lerner, Richard R. Townsend, and Yulia Zhestkova. 2024. Fencing off Silicon Valley: Cross-border venture capital and technology spillovers. Journal of Monetary Economics 141:14–39.

¹¹ Sabrina T. Howell. 2017. Financing innovation: Evidence from R&D grants. American Economic Review 107(4):1136–1164.

work, why is the bulk of the money going to Phase II rather than to Phase I?, he asked. An example of an experiment is the advent of open topics competitions used, most notably by the Air Force. Nevertheless, he said, the entrepreneurial support programs in the United States remain a long way away from the policy flexibility seen in countries such as Israel or Singapore. “When’s the last time an entrepreneurial finance program has been killed in the U.S.?” Lerner asked. “Not very often.”

Lerner also pointed to the need for skill building on the part of technology entrepreneurs. “The leap from being a skilled technologist or scientist to being an entrepreneur is a long and hard one, and it’s a process that takes a lot of investment to get right.” A good example of such skill building is the work of InQTel Emerge (now NobleReach Emerge) with funders from the Defense Advanced Research Projects Agency. Outside mentors can be particularly important in fostering entrepreneurship.

Seemingly weak intelligence gathering on foreign venture investments and innovations is another shortcoming in the United States, Lerner said. For example, by examining the full text of Chinese patent data, Lerner and his colleagues have uncovered many interesting differences between innovation in the two countries. Is enough information gathering going on in other countries?, he asked.

According to Lerner, quantitative metrics that could promote commercialization within the program include patents generated, growth, and growth trajectories. “My sense is that a lot more could be done in terms of evaluation,” Lerner said. “Any evaluation scheme can be gamed in some shape or form, but doing more along those lines would be really helpful.”

FURTHERING COMMERCIALIZATION

In response to a question about how to provide program managers with incentives that would reward them for funding major commercial successes, Lerner pointed out that this is an issue within corporations as well. “Given the difficulties of doing financial incentives, I don’t think there is a simple solution here.” Companies have tried to develop corporate venture programs, but the programs have run into problems with such issues as the “not invented here” syndrome or simply the weight of day-to-day responsibilities. “This is often seen as outside [managers’] core responsibilities.”

Regarding a question about the complementarity of SBIR and private venture capital, Lerner pointed toward evidence suggesting that SBIR and other programs can “play a bridging role in getting people to the next level” of commercialization. However, there is an “impedance mismatch” between the world of contracting and venture capital. For example, if a contract is delayed, financing can suffer. Such issues “pose a big set of managerial challenges to the typical technology entrepreneur.”

Asked about the types of support that companies need to be successful in the market, Lerner responded that this is an area where more innovation is

needed. The models that exist are interesting but not perfect. One option would be to increase interaction between the financier and the entrepreneur “given the complexities and the challenges associated with the commercialization process.” A particular weakness of the market is helping companies get to the point where they can answer some of the questions that even an early-stage venture investor would have. “We could probably do more in terms of identifying the gaps.” More can also be done with mentoring beyond the typical 6-hour training class, which he deemed to have “limited efficacy.”

Finally, in response to a question, Lerner said that the average rates of return from programs like SBIR are small compared with the rates that would be needed to get venture capital interested. But policies that target particular sectors, such as those with a high social rate of return or particular returns to the government, could increase interest. “The challenge is to figure out how you do well-designed programs that address the market failures.”

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