Mariana Mazzucato - The Value of Everything - Making and Taking in the Global Economy

The collective role of innovation can be seen not only in the cooperation between public and private but also in the role that workers play. Countries that have a more ‘stakeholder’ approach to corporate governance, many of which are to be found in Northern Europe, tend to involve workers more directly in the innovation process and to train them through well-developed vocational programmes: worker skills are most heavily invested in; they contribute more, and thereby are more able to share in the rewards that their work generates. When trade union representatives sit on the boards of companies, they are more likely to demand that any sacrifices in wages are compensated by higher investments in areas that eventually create more and better jobs. And countries with a more stakeholder-driven economy are more likely to embrace the kinds of public and private collaborations that are required for value creation: the strength of German manufacturing, for instance, is closely related to the strong links between science and industry fostered by public-private organizations like the German Fraunhofer Institutes. 6

An understanding of the uncertain, collective and cumulative characteristics of innovation is helpful to understand both value creation, as indicated above, but also value extraction. There are four key ways in which value extraction occurs in the innovation economy. The first is to be found in the economy’s interaction with the financial markets.

FINANCING INNOVATION

Given the lengthy and cumulative process of innovation, understanding which actors enter the innovation process, how they do it and at what point is key. In Figure 30 we can see how financial returns to innovation evolve through the innovation process. In the early days returns are low due to the very high risks; then, if the innovation proves successful, returns increase, often exponentially, before flattening out. This cumulative process is shown through a cumulative distribution curve. But it’s also true that who is doing what changes over that time period. In the very early days it is often public R&D agencies or universities that fund the science base, and only when innovation is close to having a commercial application do private actors enter. Public R&D agencies include organizations like DARPA and ARPA-E and even public sources of early seed money for innovative firms often tend to precede private venture capital. These include public venture capital funds (like Yozma in the Israeli government); the funding of small enterprises linked to public procurement programmes (such as the Small Business Innovation Research Programme in the USA); or through innovation funds inside public banks like the European Investment Bank, the KfW in Germany or the Chinese Development Bank. Evidence shows that it is only after these high-risk patient funds have been invested that the more risk-averse private financial funds enter, for example private VC. 7

Figure 30.Cumulative returns for innovation

In the case of venture capitalists, their real genius appears to lie in their timing: their ability to enter a sector late, after the highest development risks had already been taken, but at an optimum moment to make a killing. While many such investments fail, the few that succeed can make the investment fund in question a fortune, as exemplified by the success of the VC company Kleiner Perkins. In 1976, Kleiner Perkins invested $100,000 in the biotechnology company Genentech, which four years later, during its initial public offering on the stock market, was valued at $300 million. In 2009, Genentech was acquired by a Swiss-based healthcare company, Roche, for $47 billion, making a fortune for the investors. Similarly, Peter Theil’s $500,000 investment in Facebook back in 2004, which bought him a 10.2 per cent stake in the company, made him £1 billion when he sold the majority of his shares in 2012. These early investors are doubtless crucial to the innovation process. The critical question here is: are their rewards proportionate to the risks they take?

You might imagine, in the instances where public funds have made the initial risky investments – the private VC only entering at the point where investment looks more of a sure bet – that these funds would receive appropriate remuneration for their boldness. But in fact, the opposite is true. In these cases, the private VC industry’s share of the rewards tends to be about 20 per cent, excluding other fees and charges; by contrast, the public sector’s direct share is close to nil. The public sector is generally deemed to reap its rewards in other, more indirect ways: through taxation or from the benefits of products with high quality and low cost. Not only is this a way of thinking that all but ignores the crucial and risky early investments made by public funds in innovation; it disproportionally privileges the later, private investors in terms of rewards.

Let’s look at this a bit more closely.

VC – Timing is All

The VC industry began in the USA in 1946 when the American Research and Development Corporation (ARD) was set up to raise funds from wealthy people and college endowments to invest in entrepreneurial start-ups in technology-based manufacturing. It was soon making eye-catching investments. In 1957, ARD invested a total of $70,000 in DEC, a computer company; nine years later, this same investment was already valued at $37 million. Nevertheless, the VC industry’s growth was sedate until the 1980s, when it boomed, the role of pension funds upboosting its capital.

From the start of the VC industry, entrepreneurs and venture capitalists had often surfed on a wave created by decades of government investment. Starting after the Second World War, government investment in high-tech ventures grew significantly in the 1950s as part of the military-industrial complex, largely due to the Cold War. 8Before becoming famous around the world as ‘Silicon Valley’, a name coined in 1971, the San Francisco Bay area was producing technology for military use or, from the 1960s, spin-offs of military technology for commercial purposes. 9The first formal VC firm in Silicon Valley – Draper, Gaither and Anderson – was headed by two former US Army generals and the author of a secret report to President Eisenhower on how the US should respond to the USSR’s launching of Sputnik. 10

Much of the work to commercialize military technology was done in the research labs of established ICT companies like General Electric, Texas Instruments, AT&T, Xerox and IBM. Employees of these companies left to found their own start-ups. The Small Business Investment Company, set up in 1958 by the government’s Small Business Administration, itself founded in 1953, helped many of the start-ups to raise capital.

The establishment in 1971 of NASDAQ – a new stock market that did not have the stringent listing requirements of the New York Stock Exchange – complemented the government’s programmes. The creation of a highly liquid national market for more speculative corporate securities was important for attracting venture capitalists to invest in the IT industry, secure in the knowledge that there was now a feasible exit route from their investments. 11Venture capitalists typically look to exit from investments within three to five years, impatient to make a buck in one enterprise and start again elsewhere.

In 1972, the Silicon Valley VC industry began to coalesce at 3000 Sand Hill Road in Palo Alto; a year later the National Venture Capital Association (NVCA) was formed. The NVCA quickly became an influential lobby. By the early 1980s it persuaded Congress to halve capital gains tax rates, arguing that it would be an incentive to greater VC investment. Warren Buffett became a lead critic of this policy, admitting that he and most investors don’t look at tax, they look at opportunities. 12Indeed, the VC industry, from when it began, followed the opportunities created by direct ‘mission-oriented’ government investments in areas like the Internet, biotech, nanotech and cleantech.