Innovation, Inventions, and Investment

Stephen DeAngelis

July 7, 2009

As I noted in my post entitled Innovating the Future, more and more headlines are asking where are all the jobs are that were supposed to be created by Congress’ trillion-dollar stimulus package? In earlier posts about how to get the U.S. and global economies back on track, I have promoted the notion that the Obama administration and Congress should pay more attention to fostering conditions that will promote innovation and entrepreneurs (see for example, my post entitled Entrepreneurs and Economic Recovery). New York Times‘ columnist Thomas Friedman is also a believer in the power of innovation [“Invent, Invent, Invent,” 27 June 2009]. He reports about a chance meeting he had in St. Petersburg, Russia, with the former chairman of Intel Craig Barrett. He asked Barrett how the U.S. could get itself out of its current economic conundrum and Barrett surprised him by saying that every person who gets a driver’s license in the U.S. should have a high school diploma first. His logic was simple: “No diploma — no license. Hey, why would we want to put a kid who can barely add, read or write behind the wheel of a car?” Like Friedman, you might wonder what getting a driver’s license has to do with getting the U.S. out of its current recession. Friedman writes:

“Now what does that have to do with pulling us out of the Great Recession? A lot. Historically, recessions have been a time when new companies, like Microsoft, get born, and good companies separate themselves from their competition. It makes sense. When times are tight, people look for new, less expensive ways to do old things. Necessity breeds invention. Therefore, the country that uses this crisis to make its population smarter and more innovative — and endows its people with more tools and basic research to invent new goods and services — is the one that will not just survive but thrive down the road. We might be able to stimulate our way back to stability, but we can only invent our way back to prosperity. We need everyone at every level to get smarter. I still believe that America, with its unrivaled freedoms, venture capital industry, research universities and openness to new immigrants has the best assets to be taking advantage of this moment — to out-innovate our competition. But we should be pressing these advantages to the max right now.”

Almost everyone has been exposed to the notion that most new jobs are going to be created by small businesses and in new industries. That being the case, we can only sit back and marvel as the government spends so much time and money trying to save dying businesses. The future awaits; but it won’t wait for long. Friedman continues:

“We should be taking advantage. Now is when we should be stapling a green card to the diploma of any foreign student who earns an advanced degree at any U.S. university, and we should be ending all H-1B visa restrictions on knowledge workers who want to come here. They would invent many more jobs than they would supplant. The world’s best brains are on sale. Let’s buy more! Barrett argues that we should also use this crisis to: 1) require every state to benchmark their education standards against the best in the world, not the state next door; 2) double the budgets for basic scientific research at the National Science Foundation, the Department of Energy and the National Institute of Standards and Technology; 3) lower the corporate tax rate; 4) revamp Sarbanes-Oxley so that it is easier to start a small business; 5) find a cost-effective way to extend health care to every American. We need to do all we can now to get more brains connected to more capital to spawn more new companies faster. As Jeff Immelt, the chief of General Electric, put it in a speech on Friday, this moment is ‘an opportunity to turn financial adversity into national advantage, to launch innovations of lasting value to our country.'”

Friedman’s point about finding ways “to get more brains connected to more capital to spawn new companies faster” is one the things that the state of Maryland is trying to do [“Biotech Start-Ups Show Dedication, Line Up Again for Tax Credits,” by Kim Hart, Washington Post, 29 June 2009]. Hart reports that a Maryland tax credit program “encourages investment in Maryland biotechnology start-ups by letting investors receive a tax credit for 50 percent of the money they put into eligible companies. The state provides $6 million a year for the tax credits. The funding for the program was in danger of getting slashed this year due to tightened budgets, despite Gov. Martin O’Malley‘s efforts to increase it. The credit cannot exceed $50,000 for individual investors and $250,000 for corporations and venture capital firms.” The program is so popular that individuals and company representatives begin lining up for “first come, first served” opportunity a week before applications can be submitted. For the first time, the state has made University of Maryland’s BioPark facility available to applicants beginning five days before applications can be submitted. The building has a gym, a shower and carpeted floors. Applicants used to have camp on the street outside. The fact that Maryland’s legislature threatened to cancel the program indicates how out of tune many politicians are with solutions that have the best chance of making a difference in the future. The first four companies waiting in line to receive the tax credits this year were BioMarker Strategies, a cancer diagnostics company, Zymetis, an alternative fuel-producing firm, Sequella, which develops treatments for infectious diseases, and Gliknik, a firm that develops drugs for autoimmune diseases.

To find out how someone in the state felt about the tax credit program and how it affects economic development in Maryland, I contacted Dr. Richard Zakour, Executive Director of the MdBio Division of the Tech Council of Maryland. He said, “In leading the effort to organize a campaign to maintain the funding of this program, the Tech Council of Maryland has stressed how successful this program has been since its inception four years ago. The state’s investment of $18 million has been more than matched by $30 million of private investment in 38 different companies in Maryland. This funding has not only helped many of these companies to survive, but has led to the creation of new jobs that will be around for a number of years.” Dr. Zakour notes that this program is recognized as being one of the most innovative in the country.

Another organization that sees a bright future for innovative companies and is willing to invest in them is Google. It recently announced that it was establishing a for-profit venture fund that would invest up to $100 million over the next twelve months [“Google to Announce Venture Fund,” by Miguel Helft, New York Times, 31 March 2009]. Helft reports that “Google will tap the connections of its employees and its ties to the venture capital world to find promising startups in areas like the Internet, clean technology and life sciences.” Some analysts argue that the problem today is not too little but too much venture capital [“Venture Capitalists Look for a Return to the A B C’s,” by Claire Cain Miller, New York Times, 6 July 2009]. Miller writes:

“The biggest names in the industry are concerned about low returns and are blaming several factors: funds that have grown too large, the M.B.A.’s that have invaded the industry and older partners who have lost touch with what is new in technology. ‘I personally believe and I think the evidence proves that the venture industry has gotten too big, the funds have gotten too big,’ said Alan Patricof, an investor for 40 years who backed America Online and Apple, at a recent venture investing conference in San Francisco. ‘Our biggest challenge today for venture capital is to think smaller.’ Mr. Patricof is part of a growing chorus of voices calling for the amount of money in venture funds to shrink drastically to levels last seen two decades ago. His firm, Greycroft Partners, is taking a retro approach with a $75 million fund that makes smaller investments.”

It may seem counterintuitive during a time of crisis to conclude that there is too much investment money available. It wouldn’t really be a problem if there were enough good ideas to go around. In the post cited at the beginning of this one, I discuss an article by Michael Mandel of BusinessWeek who believes that that past decade has seen a drought of new ideas. As a result, too much money is chasing too few ideas. Miller continues:

“Instead of figuring out how much start-ups actually need, too many firms calculate how much they have in their funds, divide it by the number of partners and the number of boards they can sit on, and come up with a sum to invest in each start-up, said Ben Horowitz, a partner in a new venture firm, Andreesen Horowitz. That often means forcing $3 million into a company that needs $300,000, he said. Overfinancing results in too many firms backing too many start-ups that do the same thing, some critics say, and it inflates the valuation of companies so that investors get smaller returns when they eventually sell.”

The good news is that VC firms looking to invest less could actually stimulate greater innovation. Entrepreneurs are more likely to believe they have a chance of obtaining venture capital when the amount they are seeking is modest. Although most VC firms are looking for significant returns on investment, not all good ideas are found in the for-profit world. There are innovative ideas in the non-profit world that also deserve access to capital, but finding that capital is challenging — very challenging. A New York Times’ editorial discusses a White House initiative that could make the challenge of finding capital less daunting [“Communities, Innovation and Washington,” 1 June 2009]. The editorial staff writes:

“Central to the initiative is the creation of a Social Innovation Fund housed at the Corporation for National and Community Service. Congress has authorized the fund, and President Obama’s 2010 budget allots $50 million for it to start. The plan recognizes a hard reality of the nonprofit world: It is a lot easier to secure foundation grants and other short-term financing to develop a model program than it is to come up with the capital to expand successful programs and their potential for systemic change. The fund is supposed to address that problem by identifying successful high-impact programs prime for further development and expansion and then using government dollars as a catalyst to raise sustainable financing from foundations, businesses and individual donors.”

The Social Innovation Fund would be a source of seed money to help programs prove themselves worthy of further investment. Sometimes a little money can go a long way. Netflix, the popular movie provider, understands that the future belongs to innovators. About three years ago it announced a million dollar prize for anyone coming up with a software program that would “that improve the movie recommendations made by Netflix’s existing software by more than 10 percent” [“And the Winner of the $1 Million Netflix Prize (Probably) Is …” by Steve Lohr, New York Times, 26 June 2009]. Lohr reports that “after nearly three years and entries from more than 50,000 contestants, a multinational team says that it has met the requirements to win the million-dollar Netflix Prize.” Is this a good deal for Netflix? Run the numbers. If each of those 50,000 contestants had spent only one hour on the project and had been paid $50/hour, that would have been $2.5 million in effort. Some “contestants” consisted of teams of more than one person and those people spent many more than one hour on the project. The savings for Netflix is enormous as are the likely rewards. Netflix says that accurate recommendations increase its appeal to its customers. Lohr writes:

“The Netflix Prize contest has been hailed as prime example of ‘prize economics’ and the crowdsourcing of innovation. Prize economics refers to running a contest to generate a new innovation at less cost than an in-house research and development effort, and crowd-sourcing refers to using the proverbial wisdom of crowds to accomplish a task. Netflix has said that $1 million would be a bargain price for an improved recommendation engine, which would increase customer satisfaction and generate more movie rental business.”

The probable winning team is an interesting group that is actually “a coalition of four teams calling itself BellKor’s Pragmatic Chaos — made up of statisticians, machine learning experts and computer engineers from America, Austria, Canada and Israel.” What is even more interesting is that they began as competitors in the contest and then joined forces.

“BellKor’s Pragmatic Chaos is a pretty elite crowd. The group is a collection of the 2007 and 2008 winners of the Netflix Progress Prizes — $50,000 a year for the teams that made the most progress toward the 10 percent improvement — and a pair of engineers from Montreal who have long been near the top of the contest’s leaderboard. The team includes Bob Bell and Chris Volinsky of the statistics research department at AT&T Research (members of the 2007 and 2008 Progress Prize-winning teams); Andreas Toscher and Michael Jahrer, machine learning experts at Commendo research and consulting in Austria (members of the 2008 winning team); Martin Piotte and Martin Chabbert, engineers and founders of Pragmatic Theory in Montreal; and Yehuda Koren, a senior scientist at Yahoo Research in Israel (a member of the 2007 and 2008 winning teams).”

In a way, the Netflix Prize served as a collaborative space that generated what Frans Johansson calls the Medici Effect — the valuable and surprising results of sharing ideas across sectors. Individuals involved in the contest from both Netflix and the apparent winning team admitted that collaboration was the key to meeting Netflix’s challenge. Under the rules of the contest, competitors now have 30 days to beat the winning entry. If none of them do, the prize will be awarded to BellKor’s Pragmatic Chaos. The articles by Friedman, Hart, Helft and Lohr share one common thread, the belief that innovation is going to mark the path to a more successful future. I agree with them. Only Miller’s article threw a dash of cold water on the innovation environment; but even her article underscores the fact that there is money to be found if an idea is good enough.