I continue to worry about (and worry) the issue of what the experience of the past generation tells us about the relationship between short-run cyclical economic downturns and long-run enterprise, entrepreneurship, and growth...
From the end of World War II until the beginning of the 1990s, it looked as though the Japanese economy was "converging" to the American economy in living standards and productivity levels--that although Japan started the post-World War II period with a labor force inferior in education, with a lower level of installed technology, and with a capital stock deeply depleted by the fact that Curtis LeMay's bombers had made the rubble of Japan bounce, that eventually Japan's economy would "catch up" to that of the United States.
Last week for Practically Friday, Jared examined conflict resolution looking at evidence from married couples. This week for Valentine's Day, we look at something essential to any successful relationship, whether business or personal: trust.
Just as there are many reasons a person chooses a spouse, numerous factors determine whether or not venture capitalists or angel investors will fund a company. The traditional and most frequently studied reasons include market size, past performance, and the company's future projections. But that's not everything. "This approach, widespread though it is, fails to consider that an investment in an early-stage company is a decision to commit to a business idea and, just as importantly, to an entrepreneur who will lead the business idea," says Kauffman Dissertation Fellow Lakshmi Balachandra, an assistant professor at Babson College. In her Ph.D. dissertation (abstract and executive summary here) she examined two research questions regarding the role an entrepreneur's perceived trustworthiness has in an investor’s decision to provide capital:
To determine how trustworthiness played a role in funding, Balachandra looked at 101 videos of entrepreneurs pitching to angel investors and analyzed them based on the ultimate investment decision, post-pitch survey results, and the demographic information of the involved parties, as well as third-party ratings regarding the behavior of the entrepreneurs during their pitch. Her results were as anticipated:
Investors’ assessment of the entrepreneur’s trustworthiness following the pitch directly impacts and moderates any interest in investing that they had from evaluating the economic factors of the business. I found that, as hypothesized, the economic factors of the venture are the primary consideration for angel investors. However, the investors' evaluation of the trustworthiness of the entrepreneur directly influences the way the investors then assessed the economic factors of the business. That is, when investors found the entrepreneur to be trustworthy, they rated the economic factors as more attractive as well.
The difference? A full 10 percent: "when entrepreneurs 'pitch' more trustworthiness, they are 10% more likely to have investors interest[ed] in investing in their business." So what qualities made an entrepreneur appear more trustworthy? Coachability or character (who a person is) mattered three times more to investors than competency (aptitude at a point in time and prior experience).
So what did these entrepreneurs actually do to appear trustworthy? (Since this is Practically Friday and all.) Most importantly, they:In considering if they can trust the entrepreneur from his/her pitch, investors must believe they can make up for any lack of competency of the entrepreneur. For example, if an entrepreneur doesn’t know financial accounting, a professional accountant can be hired to fill this knowledge gap. This is in stark contrast with character: there is no way for an investor to compensate for differences in character which I measured as coachability in my study. This quality is critical to the investor since if the investor invests, the investor will be working with the entrepreneur for the foreseeable future.
I have been staring at a very gloomy graph--at the Congressional Budget Office's forecasts of "potential output", of what the economy can produce without starting to "overheat" and putting upward pressure on inflation:
Looking at this graph tells me that:
If you missed the 2013 Kauffman Foundation State of Entrepreneurship event yesterday, a video of the entire program is embedded below. Other materials and event information are available on the official Kauffman website.
Event Video:
I’m focusing this post on the panel discussion that took place after opening speaker remarks and Kauffman CEO Tom McDonnell’s address. I’ll organize my thoughts about the panel discussion along three major points, with the overarching theme that startup activity is on the rise:
After quick introductions, moderator Robert Litan, director of research at Bloomberg Government, set the stage for discussion, quoting federal statistics about startup activity and employment. A couple of other speakers at the event also referenced these stats; I think the most concise presentation is in Reedy and Litan (2011), which we’ve highlighted here on Growthology before, but it bears showing again.
This chart demonstrates the downtrend in new startups since 2005.
The two charts above speak to the decrease in total employment by startups and the decrease in their average starting size.
The data in these charts are only available up through 2010. With this in mind, Litan asked the panelists what they thought more recent years have looked like. My general sense is that the panel was in large agreement that the current state of entrepreneurial activity is much more positive—that is, they expect that these official data will show upticks when additional years are added. This was, I think, the primary theme of the panel.
Here’s a one-sentence summary of their discussion: More platforms enable community support of and participation in startup activities now more than ever. There are, of course, more nuances to what was covered, which I detail below.
When discussing trends, right off the bat, the topic of geography came up, with many panelists echoing a theme we’ve discussed here countless times—startup activity happens outside of Boston, Silicon Valley, and New York. The panel offered examples like participation in the Startup American Partnership or the Kauffman Foundation’s own 1 Million Cups.
A more informal measure was also given—an increase in number and geographic dispersion in invitations to speak at startup-related events. Speaking to general interest in starting up independent of geography, a casual poll of Harvard Business School graduates was cited: Out of 90 students, 86 stated that either upon graduation or at some future point in their career they want to start a business. Additionally, there is a reported 50 percent increase in the number of HBS graduates starting up right after graduation. All told, the panel spoke to a groundswell of interest in startup activity. We will have to wait and see if this plays out in official statistics.
Related to this point, the panel spoke about recent developments like crowdfunding (donations-based already available through things like Kickstarter; securities-based regulations still under development)1 and other investment platforms such as AngelList that enable the discovery of different geographies of entrepreneurs and informs investors about opportunities to invest in their local communities.
Thoughts on crowdfunding were peppered throughout the latter portion of the panel, so it’s difficult to pull them as separate points, but I shall try. Crowdfunder.com founder Chance Barnett reported that rulings for securities-based investment by accredited investors could be established relatively shortly, but there will be a longer delay in rulings for non-accredited investors (predicted second half of this year).
Generally speaking, I think I am correct to say that the panel thinks that crowdfunding can be a good thing, particularly in light of the catalyst role it can play in local communities, and that concentrating on the potential negatives is not as productive. The panel did not say that there are no concerns about crowdfunding investments not working out, but rather the potential outweighs these issues.
In a point I’ll touch on next, in light of the increased focus of venture capitalists on high-technology startups, crowdfunding could be important in supporting startups in underserved industries.
I felt the panel offered a qualification on the first point about increased startup activities. The panel went on to distinguish between startup activity generally and startup activity in the high-technology industry.
There were various comments about how high-tech startups are increasingly ample in numbers and that this is a “hot” space—perhaps too hot. There were comments that tech startups are well-served by the existing capital ecosystem, but startups outside of this industry are being underserved, and the panel called for paying increased attention to startups outside of the high-tech sphere.
A Q&A session at the end offered the following nuggets:
1 For more background information on crowdfunding, see the Jumpstart Our Businesses Act which was signed into law last year. Wikipedia has a decent summary.
After arguing a few years ago in a Kauffman paper that the VC industry needed to shrink back to heath, it has mostly done so. Granted, the industry isn't exactly thriving yet, but most of the asset class shrinkage is now over, so further gloom and doom is more a reflection of a particular writer's psychological state than of the merits of cutting VC industry by larger amounts from here.
From the WSJ, here is a new graphic showing same:
I would have liked to see the industry contract somewhat more, but we're not far off where I thought we would get to, back to a run rate not far off -- in inflation-adjusted terms -- where we should be based on 1990s figures.
Where do we go from here? Guess is we will see an uptick in allocations to venture against this year, even if the number of firms funded doesn't increase markedly. Nevertheless, improvement equity returns and a better IPO market will bring more investors into the fold, for better or worse, and even a collapse in the embarrassingly overheated accelerator segment -- a collapse that will almost certainly come later this year -- will not change that materially.
I am not terribly surprised by the results. We might intuitively expect video failing to stream smoothly or quickly would lead to viewers giving up on watching the video. But the authors importantly establish a causal link and offer some nuanced findings that I think are informative. My high-level takeaway is that as internet speeds increase, consumers become more impatient and expect better quality from video providers. Here are some selected highlights from the paper:
Knowing this is important because abandonment rate, how long videos are viewed, and return viewers are all factors for generating revenue.
My overall point in this post is to say that interview timing and order matters a lot. Perhaps the early bird does get the worm after all. More nuanced explanations follow below after I present some stories and evidence. Now, onwards to the text…
Growing up, I played alto saxophone for a number of years. I played on my own and took lessons while also playing in the official school bands in middle school and for most of high school. And like many band members, I attended band camp—specifically for me, Midwestern Music Camp at the University of Kansas for an entire week (you stay at the KU dorms; you rehearse in Murphy Hall and perform at the Lied Center; very cool for a band kid etc.). I think I did this for four or five summers.
KU runs a very large camp, so they split campers into multiple bands depending on skill level. My recollection is that to decide skill level and chairs,1 you audition with the department head of your instrument at KU. I’m foggy about the exact process, but I remember signing up for an audition time and spending hours in agony practicing and waiting before being able to get the audition over with. Don’t quote me on this, but I want to say that you could check-in and audition in the morning and afternoons over a two-day period (perhaps it was only one day; I can't remember).
I was not even the best saxophonist at my own high school, but overall I was fairly good. One of the later years I attended band camp, I made 2nd chair in the top flight band, which I was estatic about. What displeased me, and to the best of my recollection the rest of the saxophonists in the band as well, was the skill level of the individual who was given 1st chair. Frankly, this person was very mediocre. They misplayed all week long and at multiple points just dropped out of sections of songs entirely because they could not keep up with the music. I was very annoyed that this person was given 1st chair ahead of me.
Perhaps it had something to do with the audition timing.
I’ve been a longtime reader of Ed Yong, who a couple of years ago highlighted a paper by Shai Danzigera, Jonathan Levavb, and Liora Avnaim-Pessoa that documents an odd trend in judge parole rulings (Ed Yong’s summary here; full paper here). Here is the most relevant chart from the paper:
What this shows is the proportion of parole rulings that
favor the prisoner over an average day of rulings (tick marks on the x-axis
note every third case). Data were collected from 1,112 hearings over a 10-month
period. The dotted lines represent food breaks and effectively creates three
ruling sessions each day. The chart shows that prisoners at the beginning of
each session have a much greater likelihood of receiving a favorable ruling
than those at the end of each session. This holds across the entire sample of
judges and rulings (more controls for other variables and explanation are available
in the full paper). What Danzigia and his co-authors theorize is that the
judges' mental resources are used up early in each session, so they are sticking
with the easier status quo decision as they tire out; the food breaks help judges reset. Whatever the interpretation, there is clearly some unfortunate bias against prisoners who receive rulings scheduled later in each session.
A recent paper by Uri Simonsohn and Francesca Gino analyzed thousands of interview timings of MBA students (gated full paper here; earlier working paper version here; press release summary here). They find that interview position matters here too. Over multiple days of interviews, what does an interviewer do if the best applicants all come on the same day, or even all on the same day right next to each other? Simonsohn and Gino find that an interviewer expects to recommend the same number of applications each day and that this constrains their ratings. Once they near this subconscious daily quota on each day, they are hesitant to approve additional applications from that day regardless of their overall merit. This means that interviews early in the day have a negative impact on interviews later in the day; if early interviews are given high scores, the subsequent applicants are more likely to receive lower scores regardless of the applicant’s characteristics. This effect grew even stronger as the day wore on.
I cannot remember what time of day I auditioned at band camp so many years ago. However, knowing myself, I would have been sleeping in and saved a couple of hours to practice at KU before the audition, so there is no way that I auditioned in the morning. If we assume I am objectively able to rate and compare my saxophone skills, I can say that I am now disappointed to now find out years later that logically it looks like my audition timing helped seal my second-best chair position. I perhaps did not look as strong in the afternoon as I might have in the morning.
I think the research I’ve summarized here extrapolates well to startups—who have to interview, pitch, and audition to various parties all the time—particularly the interpretation from the MBA interview paper that high scoring early on creates a bias against later candidates. This is particularly important to consider in the context of startup competitions or submission of competitive bids. I will weakly suggest that if you have an option, perhaps going early in a competitive scenario is better than waiting. The more powerful interpretation is something you have no control over—hope that your strongest competition isn’t interviewed or reviewed around the same time you are? Yikes, that’s depressing. Perhaps judges and reviewers should make sure to take plenty of breaks when they are reviewing and scoring pools of applicants.1 Chair is music terminology referring to skill and seating position within a band or orchestra. The best player of a given instrument is 1st chair of their section and second-best is 2nd chair, and so on and so forth.
It’s no secret that we at the Foundation think
entrepreneurial activity benefits the economy. Working off this premise, we
often promote policy changes that lower barriers to becoming an entrepreneur
along the following lines of logic:
However, this series of events is far from obvious. Another outcome seems entirely plausible:
Essentially, more companies is far from given to be an unalloyed good so we cannot be certain that a simple increase in the number of business is a net positive.
An excellent new empirical paper by Hombert, Schoar, Sraer and Thesmar presented earlier this month at the American Economic Association’s annual meetings investigates one such instance of lower barriers (the paper, Should We Make it Safer to Start a Business?”, is not yet publically available pending publication but we will post it here when it is). They measured the effect of a decrease in cost of entry by studying a large French reform intended to encourage unemployed people to start businesses. Not unsurprisingly, they found that more firms entered after the reform went into effect. They also found the new firms not to be of lower quality than start-ups previous to the reform—they are just as likely to succeed and to create new jobs. They do find evidence of crowding out--that is the number of incumbent firms decreases in response to the influx of new firms, with the job creation from new firms offset by job destruction in dying firms. However, they also find those old firms that exit to be less productive than their young counterparts, a narrative consistent with Schumpeterian creative destruction. So on net, they find that lower barriers don’t actually create more jobs but do improve productivity.
This seems to be a clear tally in favor of the first narrative. I wonder, however, about two more things. First, while it seems clear that the effect on welfare is positive given the large productivity gain, I still wonder how these gains compare to the cost of publically financing the reform and the implications for Pareto efficiency.
Second, surely not all barriers to entry are equal? That is, removal of some will result in more innovation while others will result in more productivity while still others may lead to the second narrative above. Perhaps the paper would benefit from a theoretical model that would clarify the mechanism.
I hope we are approaching the end point in the patent troll game. Recall, patent trolls -- non-practising entities that obtain patents and sue operating companies (especially in software) -- have been playing an increasing role in innovation economies. They often threaten young companies with lawsuits as soon as they obtain funding; or hamstring older companies, forcing them to divert cash into costly licenses for absurd patents rather than pay for costly defenses in uncertain, patent-friendly jurisdictions.
New data from Colleen Chien of Santa Clara University shows the situation. According to her research, 61% of patent lawsuits in the U.S. in 2012 have been brought by patent trolls. 61%. This is a record, both in relative and absolute terms, as the following graph (from a recent presentation of Ms Chien's) shows.
There must be changes in patent laws to prevent this sort of abuse. One approach, the SHIELD Act, would force patent trolls to pay for unsuccessful litigation in a "loser pays" system. While it's far from perfect, and fundamental reforms are needed to U.S. patent law, it is noteworthy that there, at least, some attempts being made to deal with a patent system that is increasingly consuming itself, while the rest of us pay for the litigation and misplaced resources.
[Update] A law colleague of mine points out tonight that some of the 2011 and 2012 increase in lawsuit activity is a function of the America Invents Act changes in September 2011 that prohibited having multiple defendants in one suit. As a result of this unbundling, there are more NPE suits, making them a much larger percentage of overall patent lawsuit activity. At the same there has been a reduction in the number of operating companies being sued, as the following figure shows.
What does this mean? It means that some of what we're seeing in the first graph is partly a result of rule changes, which is worth noting. At the same, there is a reduction in the number of companies being sued, which, given more suits, means more patent litigation, in general, at any given firm.
[Update 2] Colleen Shien at Santa Clara University points out to me in separate correspondence that even these numbers are subject to confusing factors. For example, in a recent case Cisco received more than 300 NPE letters before that turned into an eventual patent-related action. Even if that number is considerably lower, say 25-50:1, it is exceedingly burdensome, especially for smaller companies subject to NPE nonsense.
Add to this the costs involved, which according Prof Shien's work is roughly as follows:
It is, indeed, a species of tax on innovation, one whose proceeds goes to economic vandals.
