The Smartest Places on Earth
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By contrast, Europe’s strengths are its Fraunhofer-type institutes, the largesse of the European community in its support of long-term projects like the Factory of the Future or the European Spallation Source, the helping hand offered by science-park incubators, and the subsidization of clean-energy initiatives.
The difference in attitudes toward start-ups in the two regions is particularly striking. In the United States, start-ups have not only caught the popular imagination but are the major driving force in innovation. Entrepreneurs who fail are still looked down on in Europe (although this is gradually changing), whereas American venture capitalists view a record of failing as a badge of honor and proof of prior experience that they want to see before they invest. In Europe, it is the midsized companies that are revered and even coddled.
“What we lack in Germany is a culture of start-ups,” Alec Rauschenbusch, a founder of Stuttgart-based venturecapital firm Grazia Equity, told us when we met him in his modern office overlooking Stuttgart. “We have so much car expertise that Tesla could have started here, but we don’t really have an ecosystem for young entrepreneurs in manufacturing. Banks don’t lend, there is no credit-rating system, and not enough venture capital money.”28 As a result, instead of starting their own business, young engineers in Europe find open doors not only at the Mittelstand companies but in global giants like Bosch, Daimler, and Porsche or the top American firms in Europe like IBM and Hewlett Packard (HP). For them, in-house R&D is still an important model and young engineers are still attracted to the advantages of working in large, stable organizations.
Venture Capital
Venture capital (VC) is financial capital invested in an early stage company, usually one with a cutting-edge technology or business model (hence the concentration of venture capital in high-tech industries like life sciences and IT),29 in exchange for equity in the company. Companies in which VC firms made investments are responsible for over 20 percent of all US business revenues,30 and without those investments, many well-known companies that together employ more than one out of eight Americans simply would not exist. Iconic tech companies such as Microsoft, Apple, Amazon, Google, Facebook, and Twitter as well as pioneering life-science companies like Boston Scientific, Intuitive Surgical, Amgen, Genentech, and Gemzyne can all (at least partially) credit venture capital with their enormous success.
All venture capital is invested with the same goal—to buy into a young company with disruptive technology, high profit potential, and a skilled management team—and it has both private and public sources. There are two private sources of venture capital, the first of which is dedicated venture-capital firms, whose sole focus is investing the pooled resources of the backers and funds they manage. The average investment made by a VC firm is about $4 million,31 and many specialize in specific industries. There are roughly 1,000 venture capital firms in the United States, most of which are clustered in Silicon Valley, the Boston-Cambridge area, and New York City.32 The second private funding source is the corporate venture-capital arms of large technology firms like Google, Intel, Cisco, Microsoft, and Qualcomm, and life-science companies like Johnson & Johnson, Medtronic, Biogen Idec, GSK, and Roche. Together, these companies have invested $61 billion over the past twenty years, accounting for 10 percent of total VC funding and 17 percent of all investments.33
Another source of venture capital comes from the public sector, particularly a little-known breed of government-backed funders that have become crucially important in the United States. One of the boldest, most innovative, and most important is the Defense Advanced Research Projects Agency, the $3 billion venture-capital arm of the Department of Defense created in 1958 in response to Sputnik. Ever since, DARPA’s grants and competitions have played an enormous role in the development of critical technologies, including the Internet, self-driving cars, next-generation robots, and all kinds of new materials. The Department of Energy runs the Advanced Research Projects Agency–Energy (ARPA–E), which focuses more on early stage research than on venture capital investments.
Even the Central Intelligence Agency (CIA) has entered the realm of venture capital with In-Q-Tel, the nonprofit VC firm it established in 1999, which over the years has invested in two hundred start-ups (to the tune of $60 million per year) and currently maintains a portfolio of about one hundred ventures with total assets of $219 million.34 Although In-Q-Tel35 focuses on data analytics and cyber security, it has found success in other fields as well, most notably with Keyhole, a start-up that developed the satellite mapping software that later became Google Earth (Google acquired the firm in 2004). Oracle, IBM, Lockheed, and others have all bought companies that received early In-Q-Tel funding. Not to be left behind, in 2006 NASA contributed $75 million to a partnership with Red Planet Capital, a California-based VC firm, in order to “attract private sector innovators and investors who typically have not done business with the agency.”36
Looking ahead, all of these organizations will have to adapt to a model of venture capital funding that has fundamentally transformed in recent years. Together, the widespread push among start-ups toward sharing equipment and services in incubator spaces and the flexibility of quick, low-cost prototyping with 3D printers have dramatically reduced the capital requirements of the newest generation of “makers.” “You now only need $50,000 to test an idea rather than $5 million,” Kip Frey, a serial entrepreneur and partner at Intersouth Partners, explained during our visit to North Carolina’s Research Triangle Park. “As a young entrepreneur, why would you give away majority ownership in your start-up to a venture capital firm when you don’t need so much money and there are plenty of like-minded angel investors around?”37
Research Through Acquisition
Although research and development are intimately related—which is why they are usually referred to together as “R&D”—they in fact require different resources and approaches in order to be done successfully. Johnson & Johnson, Medtronic, and many other life-science companies now realize that conducting innovative research requires out-of-the-box thinking and a willingness to take risks, for which small, unbureaucratic start-ups are much better suited than big hierarchies. Development, meanwhile, is process oriented and requires stable structure, long-term and substantial financing, and market power—qualities that large corporations have in spades. As a result, acquisitions have become a way of life for big companies looking to stay innovative, as we learned when we visited Minneapolis.
Medtronic, the main player in the Minneapolis medical device brainbelt, provides a good example of how research has moved from claustrophobic corporate silos to fresh innovative start-ups. An undisputed leader in medical device research, Medtronic spends $1.6 billion, or 9 percent of its revenues, on R&D every year—more than three times the percentage of the typical American corporation. For a company that yields over 40 percent of its revenue from products introduced within the previous three years, innovation is a matter of survival, and its in-house R&D program employs 12,000 engineers, scientists, and technicians—about one-fourth of the company’s workforce.38
However, in an effort to address the low yield on the company’s in-house R&D, CEO Omar Ishrak decided to refocus Medtronic’s R&D efforts on acquisitions, firing several thousand in-house researchers in the process. Some detractors lament the gradual disappearance of the internal research activity, and others believe that some of the large acquisitions by many life-science companies are mostly for tax reasons, but most recognize its necessity. Norman Dann, a venture capitalist in Minneapolis, minced no words when he told us: “Large organizations tend to be too slow and hierarchical. Researchers get punished for being wrong rather than for being too late. They become silos that can’t make decisions.” The best R&D, according to Dann, “is done by a small band of researchers without hierarchy who can correct mistakes rapidly and work in a culture that understands that mistakes are unavoidable in research.”39 Therefore, though big companies like Medtronic are still vital in managing product-developmen
t tasks like organizing huge clinical trials and building support systems, innovative, flexible start-ups have inherited the torch of next-generation research.
Private Funding
Entrepreneurs usually raise their first round of financing (ranging from $50,000 to $250,000) from family and friends, from seed capital funds like those started by many universities and by former entrepreneurs,40 or from government-funded programs like Small Business Innovation Research (SBIR). Once these initial investments run out (which can happen quickly), entrepreneurs must then attract outside investors, who look for start-ups with a unique product, an exciting growth story, and a capable management team.41 Venture capital firms also insist on a clear exit strategy that calls for the firm to end its involvement with the start-up within seven years. Their accountability to their own investors means that they often stay away from early stage investments they see as too risky, small, and time-consuming.
Entrepreneur Kip Frey believes that venture capital has become a less important source of capital at the very early stages of start-ups because the old financing model itself has become outdated and not suited to the world of brainsharing and smart manufacturing. “Few [VC firms] have really been successful in an industry that, like the record or movie industry, is driven by the few big hits that pay for the many failures,” he explained, observing the difficulty for most venture capitalists to impress their limited partners (endowments and pension funds) when five or so firms reap 80 percent of the returns. Moreover, local entrepreneurs now see more value in national firms with global talent networks, in anticipation of the days of scaling up their business.
The financing process for start-ups is changing, and three groups have stepped up to fill this funding gap: angel investors, business incubators, and crowdfunders. Angel investors are wealthy individuals, often entrepreneurs themselves, who invest in others in order to scratch their entrepreneurial itch. More and more start-up entrepreneurs are attracted to angel investors because the arrangement gives them much more flexibility than a typical deal with a venture capital firm would. Angel investing totaled $23 billion in 2012 in the United States42 and €5.5 billion in Europe, and there are now over 250,000 angel investors in the United States—nearly ten times as many as in Europe.43
Incubators provide a safe haven for early start-ups looking to take their next steps by providing them with shared lab and office space, and these arrangements often emerge from local or state initiatives to attract young new entrepreneurs. There are 1,400 business incubators in the United States and 1,000 in Europe (half of them in Germany) that support some 30,000 new companies every year. These two growing sources of financing—angel investors and incubators—have become indispensable in both the United States and Europe, making up as many as one-fourth of all early stage investments44 and also often staying in for later investment rounds.
Crowdfunding sites such as Kickstarter, Fundable, and Indiegogo are the newest source of early stage capital and have opened up opportunities for everyday people to contribute to R&D like never before. They enable those with interesting or quirky ideas but who lack real business sense and long-term growth strategies—leaving them hopelessly unable to attract traditional venture capital—to realize their dreams. Form1, for example, raised $3 million from 2,000 backers for researchers from the MIT Media Lab to build an affordable home printer for 3D printable clothing.45 All told, the exploding popularity of angel investors, business incubators, and crowdfunding over the last decade has reinforced the critical role of private capital in the R&D chain.
Recommendations
So, based on our research and analysis of what works—and what doesn’t—in brainbelts around the world, we offer the following recommendations for making the financial environment more conducive to the sharing of brainpower for new product innovation:
• Policy makers should build political consensus for basic research, even with tight budgets. Not funding basic research is “penny-wise and pound-foolish” because its payoffs for innovation, economic growth, and living standards are so high. For example, every dollar of NASA spending yields about nine dollars in economic activity,46 and NASA innovations generate about $1 million in revenue for each of its spin-offs.47 Fortunately, the widespread fears about cutbacks in basic research spending in the wake of the financial crisis largely failed to materialize, but the threat remains. Impatience for tangible results in the form of profitable commercial applications is as alive as it was in the days of Bell Labs. Even if there is no room in school curriculums to study the impact of innovation, political leaders, educators, and the entertainment industry should work together to ensure that starting in high school, students can learn how different daily life would be without the inventions stemming from basic research.
• Government-funded research should benefit from later financial success. If the government already demands high interest rates when it bails out a company in a financial crisis or loans money to college students, then it should also benefit financially from supporting applied research. Legal clauses that make the government a modest financial partner in the companies and start-ups to which it provides grants would create a visible link with success stories and allow the profits from these investments to fund future projects. The technology transfer and licensing programs at major research universities have learned this lesson, and the government should, too. Some of these profits could be set aside to help finance work-study programs for job training.
• Venture capitalists should teach their investors to think longer term and early stage. There is more to innovation than just software, social media, and the life sciences, which receive the vast majority of venture capital. The industry’s maxim is that only one in five investments works out well, but a less skewed investment portfolio would lead to fewer big winners and many more solid performers. As an investment manager, Antoine saw firsthand how a broad diversity of emerging markets stocks helped to mitigate the volatility inherent in making risky investments, and venture capitalists should apply the same lesson by greatly diversifying the range of sectors in which they invest.
Organization and Culture
The main focus of the brainbelts central to our research was always on developing solutions for today’s complex technology challenges. But often that also required creating new work arrangements that would facilitate and enable the collaborative, cross-disciplinary relationships that are necessary in brainsharing initiatives. Because these working arrangements may evolve during different stages of a project, and because the players within an initiative often have very different organizational structures, flexibility is key.
It isn’t easy for global companies, with their large hierarchies and long-standing working relationships, to achieve the necessary flexibility. Jeffrey Immelt, CEO of GE, for example, wants his company to work in multifunctional teams and to partner with educational institutions. But many of his employees are union members, and Immelt’s actions can be at odds with union regulations. Immelt has no desire to do battle with union leadership but seeks rather to convince them that his goal is always to create new jobs, not just eliminate old ones. Accordingly, when opening a new facility or creating a partnership that would create new opportunities, Immelt looks to reduce wage levels where it makes sense and to make less-stringent work rules where it is possible. By using common sense and building trust, Immelt has engineered many deals in the United States that have not only created jobs but also changed how the jobs look. He has also been successful with this approach in France, when GE sought to obtain most of the assets of the French company Alstom in 2014, a deal that was politically fraught and highly contested.
Immelt recognizes that innovation involves more than a technical process—the social and cultural aspects are just as important. He leads the way for other CEOs who seek to create new organizational structures that will accommodate brainsharing and come to terms with unions. This is particularly important in former rustbelt areas where unions played an important role in big
-manufacturing activities—such as automaking and steelmaking—but are less canny when it comes to high-technology sectors.
In Europe, the situation is more complicated, because employers and unions are part of the welfare state that democratic governments have built over the past half century. The promise of the system is that people will be assured of a steady job, but the need for flexibility makes that promise harder to keep. The big question for policy makers is how to maintain solidarity with workers while creating more freedom of movement for companies and individual employees. For decades, Europe has engaged in ideological discussions about how society should be organized at the highest level, but now the conversation is much more practical and regionally focused.
There has been progress in this regard. In the wake of the financial crisis, key players in Germany and Holland—including unions, employers, and political authorities—were willing and able to create more flexible working arrangements, albeit temporary ones in some cases. European policy makers still fear, however, that any changes to the welfare state will expose Europe to the “American disease,” whose symptoms are enormous income inequality and an increasing percentage of the population living below the poverty line. But doing nothing is not an option in Europe. The challenge for European authorities is to respond constructively to the need for more flexibility while devising a new form for social solidarity.