CAPITAL MARKETS AND PRODUCTIVITY GROWTH: THE VIEW FROM SILICON VALLEY
Hilton L.
Root
Technology parks are springing up throughout China. Beijing, Shanghai, Nanjing, Hefei are among the many Chinese municipalities that have spent impressive money to build state of the art facilities. They all have one goal in common, the desire to be another Silicon Valley. Their commitment to succeed is massive. On site recreational and housing facilities are included to ensure the physical comfort of the workers they hope to attract. The central Government is playing a supporting role providing handsome incentive packages to lure Chinese engineers home from overseas to the new centers. Is it enough to build the right structures, employ people with the right credentials, and then hope the rest will follow? To see if this expectation is well grounded we will explore how Silicon Valley became the icon of the high-tech revolution, out-performing its many rivals around the globe. What are the core constituent elements of its success and is their replication possible?
Between 1975
and 1990 Silicon Valley generated some 150,000 new technology jobs. By 1990 it
exported more than $11 billion in electronics, more than one third of the US
total. It did this while challenging
the organizational legacy of the vertically integrated corporation, responsible
for much of the great increase in the standard of living of Americans during
the twentieth century. The vertically integrated firm typically controls a
large set of unique assets through a command and control system. This way it
internalizes many of the risks of transacting across markets, allowing it to
capture the benefits of scale economies and to establish market control.
Silicon
Valley’s success, by contrast, is the prototype for the information age. It is comprised of diffuse networks spanning
the entire industry, unlimited by the boundaries of individual firms. This
openness promotes learning and knowledge sharing among specialist workers of
complex, related technologies.
Companies compete intensely while learning from each other. They
exchange managers, owners, and creditors just as easily as they exchange labor
and parts allowing, competitors to be highly informed about the activities of
rival firms. Staff moves about
relentlessly. Transience, restless mobility, shiftlessness, all hallmarks of
the American character, never before went to such productive use. How unlike the traditional corporate model
in which workers passively accept goals set by a central management!
The traditional corporate structure failed to develop new products fast enough to compete with the Silicon Valley model. This is why Silicon Valley eventually surpassed the technology corridor of Route 128 in Massachusetts where large well-capitalized firms, fattened on government contracts, operated according to the traditional model of autarky, secrecy, loyalty and stability. Production activities there were internalized; the corporate hierarchy ensured centralized information flows and control by a few senior corporate executives. Route 128’s large firms internalized most skills and technology and established boundaries between firms and local institutions that were tightly policed to stop ideas from leaking out. However, this model succumbed because it was unable to facilitate face-to-face communication and access or generate open flows of information: It was not organized for continuous innovation in an industry that required it. Its formal decision-making procedures lacked flexibility and responsiveness to fast changing markets.
Traditional
corporate culture regards secrecy and loyalty to hierarchy as a cardinal
virtue, those who leave are deserters, cut off from the family: the only
networks that matter are internal, collaborating with the outside is suspect,
learning and exchanging with others is treason. These formidable hierarchies of
the past were self-contained, stand-alone systems, not suited to production
that depends significantly on information access. Competitiveness in technology
requires shortening information pathways so that the right information gets to
the right person at the right time. To gain this advantage, firms need to decentralize
their structure, to make fast decisions based on closeness to performance and
to accurately assess the cost of outcomes. Vertically integrated firms have the
disadvantage that in inter-company transactions the performance and
contribution of the each constituent component of the enterprise is difficult
to assess.
In Silicon Valley, it was well established that the path to a completed project might be faster in a small start up company than in a large established firm in which the idea originated. Established Silicon Valley producers responded by decentralizing their operations, creating inter-and intra-firm production networks that could capitalize on the region’s social and technical integration and interdependency. Even the internal architecture of the buildings that house knowledge-intensive workers are designed to reduce barriers among different activities within a firm.
The importance
of an open industry architecture facilitating ties into the broader community
is captured in the often repeated phrase, “The story in Silicon Valley is that
people work for the Valley: they do not work for the firm” (Vives: page 193). High value-added
activities require high quality information that must easily jump over the
walls of ethnicity, clan, class, race and nation.
Many
successful economies, especially among developing, nations use strong social
ties to encourage relationship-based investment. In contrast, Silicon Valley
capitalized on weak social ties to both stimulate and finance new ideas. Strong social ties among members of a team
can suppress innovation, stifle creativity and memorialize existing
certainties. Highly cohesive groups focus on maintaining existing local
hierarchies and seek concurrence discouraging the frank exchange of views. The greatest challenge often comes from
outside a closed system, be it an academic discipline, a sprawling
international conglomerate or a proud stand-alone industry like oil or steel.
Unrelated industries or remote analytical disciplines are where the danger to
established certainties may be lurking.
Weak social
ties can actually inspire innovation by providing novel connections and diverse
perspectives. The Valley’s great innovators came from all over the world and
represented a range of intellectual disciplines that span anthropology,
literary criticism and nuclear physics.
More than twenty five percent of firm founders came from overseas. They shared few prior ties and rarely had
ties to inherited wealth or government connections. To learn how to cooperate, they defied the limits of finance,
social organization, religion, ethnic rivalry, and nationalism.
Studies within
the US that compare social capital and levels of innovation measured by
technological intensity and the number of patents filled find that areas with
high levels of social capital tend to be low on innovation. Seattle, Washington, Boulder, Colorado, San
Francisco, California, and college towns in general, all with low levels of
social capital are more innovative than their counterparts with strong ethnic
enclaves, single industry towns or those with stable population bases. By
contrast, the poorest people in the world are trapped in communities structured
by primordial loyalties, often more concerned with correcting the past than
creating the future.
Strong
communal ties can insulate members from outside information and challenges
while promoting conformity. Weak ties
allow new ideas to enter into the network.
Thus social groups with weak ties are more likely to encourage
innovative thinking than are tightly knit communities. This is why sociologists find that the
density of gay couples and artists closely correlates with a region’s
propensity for innovation. Regions that rank high on the gay and bohemian indexes
are likely promoters of innovation. In
fact, demographers have observed creative people flocking to cities with low
social capital where they fit in more quickly and find people who will engage
their ideas.
The lesson:
WEAK SOCIAL TIES ENABLE STRONG MARKET FORCES.
In developing countries business typically enjoy close ties with government. Ideally this should help steer private investment into socially productive channels. Unfortunately government officials often take private interests in the projects they oversee. Licensing allows officials to gain shares in productive activities under their jurisdiction, forcing would-be entrepreneurs to spend time and money courting government officials. In fact, cross-country studies of competitiveness bluntly ask for an assessment of how much time and maneuvering it takes to register a legitimate business and to obtain the permits necessary to stay in business. In Silicon Valley the answer is very little time.
Silicon Valley is characterized by the relative absence of ties to the government. Politicians seek out the Valley more than the Valley seeks out the politicians. Floyd Kvamme heads a high tech committee organized by the Bush administration whose task it is to connect with the Valley in the hope of eventually eliciting support. To the administration’s disappointment, the Valley’s representatives, would like the relationship with the administration to remain distant. They simply do not respond to Kvamme’s efforts to learn what Washington can do for the Valley other than stay away.
The Valley’s leaders seem to prefer the status quo in which government contacts and contracts have had a diminutive role. Historically, the Valley’s companies did not take advantage of licenses or legal opportunities; in fact, many company leaders were foreign born and had no political ties to Washington. They were not political entrepreneurs like business leaders in developing countries, they were market entrepreneurs seeking ways to produce cheaper, better goods and services. They had virtually no political representation and did not engage in collective action for the enforcement or reduction of competition. Government never directly involved itself in company decisions, and Silicon Valley was never a preferred region. Silicon Valley firms were never picked as winners and did not enjoy the status of national champions backed by government largess.
Thus from the perspective of finance, Silicon Valley represents an anomaly. In banker parlance its enterprises lack collateral in the form of fixed assets, bricks and mortar are un-bankable. Moreover, deep social allegiances are lacking from which to raise funds, it is a stranger to government patronage, and firms do not employ vertical integration as a means to overcome market uncertainties. How then can this novel system of industrial relations fund itself?
Several times
I was invited to Korea to help diagnose why well-intentioned efforts to create a
Korean Silicon Valley were faltering.
Korea had brainy young kids, well-trained in engineering, willing to
risk everything to start their own companies and the country had institutional
investors with abundant funds. Throwing money at ideas is not the hard part.
Missing was an important middle stage of enterprise promotion; one filled in
the US by the venture capitalist.[1]
Venture
capitalists are financial intermediaries who manage funds contributed by other
financiers, especially those of institutional investors, who know very little
about the industry in which their funds are operating. Many have never visited
the Valley and would not know a hard drive from a CD-ROM. The venture
capitalists possess know how that neither the investors nor the investors
possess, about how to create a company or to commercialize a product. They are able to pick opportunities for
growth based on broad experience in the many stages of company and product
development from finding suppliers, writing contracts with distributors,
dealing with lawyers, marketers and ensuring that a market exists when the
product is ready for production. Thus venture capital is value added
investment.
Since 1987
venture funding grew from small boutique operations to a major industry that in
2000 invested $103 billion, more than all the foreign direct investment into
China in any given year to date.[2] To understand how this industry grew so
rapidly I will underline two of the essential roles played by venture
capitalists.
A Malaysian
civil servant said to me, “The problem with start-up firms is that the founder
always acts egotistically”. This remark
registered very strongly with me because it emphasizes the same concern
American venture capitalists raise when I ask them to identify how they select
a target for investment. Egotism has
free reign in start up technology firms because the founder has obtained
funding for which the capital contributor has no recourse. There are no assets
to repossess if the founder fails to perform.
Therefore a major concern of the capital contributor is that the firm’s
founder will use the firm’s resources to enhance his or hers personal
well-being instead of seeking to maximize return on investment. Founders are known to like four of the five
essential `P’s’, perks, power, prestige
and pay but not the essential P, performance.
Countervailing
against `founder egotism’ is the first of the two indispensable roles played by
venture capitalists. They seek to
impose a governance structure on the firm to prevent the founder from employing
the firm’s financial resources idiosyncratically, or for private gain, via
asset stripping or transfer pricing. [3]
At the outset,
when the firm’s ownership structure is still amorphous, the founder is in a
position to dominate all the firm’s relationships with the outside. Although personalized authority may make the
small firm work well, it creates barriers to future growth. When the founder has too much power, outside
financing will be harder to obtain.
Future investors are very concerned that governance structures exist to
ensure that the firm manager is constrained by rules to act in the interests of
investors. Knowing this and to protect
their initial investments, venture capitalists like to ensure the professional
management of the firm to make future financing easier and to facilitate the
eventual sale of the firm.
The
expectation of a future Initial Public Offering (IPO) is critical to attracting
the entry of venture capitalists, IPOs represent an effective and often lucrative
prospect for exit.[4] But a
company will be more difficult to dispose of if future owners fear a capricious
and entrenched tyrant undisciplined by an external accountability structure.
This is why professional venture capitalists are especially interested in the
management team and will seek to strengthen it as a condition of their
investment and to be sure that the five P’s
start with performance in terms of returns on capital. Thus they typically
take a seat on the company board.
The other
critical role of the venture capitalist concerns the possibility of enormous
waste that exists in the selection of projects. Each industry success creates more investment capital for future
ventures but costly mistakes are a burden the entire industry must bear. To reduce waste, venture capitalists develop
expertise in supervising the selection of projects by tournament. Before a
project is completed, projects are funded in installments and funding requests
are subjected to repeated tournaments that test progress and product viability.
Where projects
have powerful political sponsors, financially non-viable projects may survive
until they become expensive white elephants.
In Silicon Valley, producers must live with the continuous but
uncomfortable threat of project termination, because venture capitalists with
their money on the line cannot afford to behave like a subsidized government
sugar daddy and borrow more money to paper over previous mistakes. A rigorous
regime of continuous tournaments compels firms to unrelentingly compete for
their next infusion of capital by having new products that markets want. The
result is that expensive mistakes, potential white elephants, will be caught
before they become a heavy burden on the entire industry, and soaks up funds that
might have otherwise sponsored more commercially viable activities.
In these two
capacities, governance and tournament management, the venture capitalist seeks
a management and product structure that will be sensitive to market signals,
ensuring a high correlation between value-added and investment. Thus the
venture capitalist is someone who must learn to loathe the old and rejoice in
the new, something inimical to societies in which political leaders have draw
private interests generally from the projects they sponsor.
How did the
division of labor occur between the venture capitalist and the investing
public? To answer we must consider the
debt Silicon Valley owes to an elaborate infrastructure of contractual
enforcement mechanisms that are embedded in social institutions that coalesced
over generations. The existence of this
debt may come as a surprise to the industry, which prides itself on
independence from the outside; on an ability to pull itself up by its own
bootstraps.
Talented,
highly trained engineers are not unique to Silicon Valley; many live in Russia,
in Asia and in other parts of the world. They may be by their very training and
disposition people on the edge, natural risk takers, but not to worry,
generally they have no money to risk.
Someone else has to put up the funding because a rich aunt or distant
relation may not be available. In technology, that someone is usually unknown
to innovators because they have already exhausted friends and personal
contacts. Typically, they are no longer
sure about being invited to Christmas dinner by the time they turn to external
sources for support.
Having come to
the end of personal resources does not mean an inventor has come to the end of
the line. He or she can take advantage
of a well-established commercial infrastructure that offers many prospects of
finding outside investment.
A wide
diversity of capital instruments enable people to take chances on new ideas and
to match money with talent and ideas. Among the capital market options that
exist for entrepreneurs to borrow against future earnings are junk bonds (high
yield, high risk debt instruments), securities (ownership of equity in the
corporation), angels (professional investors using their own money to make
early stage investments), venture capital (investors of their own and other
people’s money, their high risk, high reward portfolio is a small part of the
larger portfolio held by other usually institutional investors), initial public
offerings (first time shares that are sold publicly), and leveraged by outs
(using existing assets and cash flow as collateral to obtain funds to buy out a
portion or all of the existing management). The vast decentralization of
capital instruments allows risk to be matched with opportunity to those most
willing and most able to carry it. If
not for these instruments, the standard of living in the US would be very
different from what it is today and much talent would have been wasted. Americans would still be living in a world
in which three television networks provided all the news and entertainment. The
refinement of the investment process occurred because risk and return could be
priced at the margin where marginal costs equal marginal revenues.
Capital markets enable perfect strangers, fund providers, to give their lifetime savings over to other perfect strangers, fund users, often through an intermediary they have never met. Fund users then create companies with the savings of individuals who know virtually nothing about the particular technology in which they are investing. This event would be remarkable if it happened occasionally but it is reenacted, not thousands of times, but millions of times in a single day of trading on the NASDAQ, creating billions of dollars of value. New industries provided with the resources to wire the entire planet and launch satellites into space have resulted that allow every human being to communicate directly with any other. Even if the firms that undertake this investment do not prosper, society gains from the creation of capacity that otherwise would not exist.
Compared to
the diversified capital markets in Silicon Valley, entrepreneurs in developing
countries have fewer options when they seek capital. One is to seek funding from thousands of independent individuals,
going door to door, person to person, in the hope of collecting a nickel here
and a dime there. This scenario is
highly improbable and we rarely hear of businesses being started this way. Alternatively, an entrepreneur can turn to
financial intermediaries but here the choices are similarly dismal. Financial
institutions in developing countries are often state-owned or by someone with
close ties to the government. If the
state does not own the banking system outright, it is common to find market
entry restricted and the right to acquire or establish a financial institution
only granted to certain groups with political or family connections. Such institutions are unlikely to take risk
because they do not face competition for the savings they disperse.
Financial
institutions are careful to lend to individuals or enterprises or to which they
share prior direct and indirect connections. Many loans are transacted through
an intermediary who is a friend or family member of the borrower. Because these
societies have high levels of informality, the promise of repayment relies
greatly upon trust.[5] By lending to familiar faces, the banking
system, immersed in informality, compensates for the informational deficiencies
of the faceless market. The resulting
financial concentration immobilizes capital and prevents risk from being
absorbed by those most capable of doing so.
Dependence
upon banks as the sole source of capital is by itself a considerable
obstacle. To bankers, ideas are no
different than dreams. Bankers who require tangible collateral, real estate or
cash flow to service obligations will not find high tech start ups attractive. A techie, however, is likely to have only
ideas to offer.
When sources
of capital are limited, the funding for new technology will be limited to the
needs of already established social interests. This is why social spending in Latin America on information
technology and education has been disappointing. Elites that derive their
wealth from resource extraction are not sensitive to the possibilities of
creating new employment in other sectors.
Knowledge-intensive
production is different from traditional industrial production and from
resource extraction. Unlike a natural resource, which is accessible to anyone
lucky enough to acquire information privately through discreet channels, or to
use visible government infrastructure for extraction, opportunities in
technology come from the inventiveness of a single human brain. There is no secret treasure map to the
source of this wealth. Political access or institutional muscle cannot force
someone to have an idea. An army is
not needed to ensure that products are smuggled across borders to paying
customers. The difference between
wealth creation in the industrial age and in the information age can be
illustrated by the following story of George Bush senior’s initiation in the
Texas oil fields.
Being born lucky, George Bush Sr. came to Texas in pursuit of something tangible in the ground that is depleted by use and one party’s use is at the expense of another’s. The oil I burn in my vehicle is not available for use in yours, which makes measurement easy. Value creation in traditional industries differs from knowledge age formats such as the internet because the more you use my internet network, the more value you create for me, making measurement of the value added difficult.
Let’s get back to Texas in the 1950s. To get the oil out of the ground, George Bush Sr., like many of his counterparts, depended upon a comparative advantage that serviced yesterday’s production handsomely – a number of wealthy personal relationships.
Finally, one night, Bush said: “Geez,
if I could raise some money, do you think we could do that? Maybe get in
business?” And money—to be precise, OPM, Other People’s Money—was the calling
card of the best young Yalie independents.
Earle Craig was playing with Pittsburgh money. So were Ashmun and Hilliard.
(H.T. “Toby” Hilliard was actually Harry Talbot Hilliard, of the Talbots
of Fox Chapel, where the Mellons and friends had their houses,) Hugh and Bill
Liedtke were keyed into oil money from Tulsa.
Without outside money, you could spend a long while hustling leases
before you could call any oil your own.
So Overbey would be happy to show Bush everyone he knew… Bush happily
flew back east to talk to Uncle Herbie.
And Herbie Walker was delighted to place a bet on his favorite, Poppy,
and to tell his Wall Street friends all about the doings of Pres Bush’s
boy. Pres himself went in for fifty
thousand, along with Herbie, and some of Herbie’s London clients, who all got
bonds for their investment, along with shares in the new company—Bush-Overbey,
they called it.
It was about $300,000 when they added it all together. (Richard Ben Cramer, George Bush, How He Got Here, Esquire, June 1991, page 128)
In most of the
developing world, relationship-laden finance – similar to what underwrote the
Texas venture of the young George Bush Sr.- is the only kind available. However, the future will be one of creating
wealth through ideas, of harnessing the unlimited use of knowledge for the
production of wealth. Cozy contacts that
could build oil wells in Texas are yesterday’s solutions because such contacts
of a single individual, no matter how well connected, cannot adequately match
tomorrow’s opportunities with today’s capital. Silicon Valley has depended mostly on private individuals that
investing their own wealth in start-ups of entrepreneurs unrelated to them
through family or prior friendships.
The great
wealth of the future is not in the ground, it is, in the heads and on the
drawing boards of well-trained scientists eager to escape the slums of Delhi
and Manila. Education is essential if
these prospects are to see the light of day. Even more important than
education, people must have a sense of self-efficacy gained from having future
disposal over what they create.
Building schools and hiring teachers is the easy part; these exist in
some of the most repressive cultures and regions in the world. The
transformation of abstract ideas into products that people value represents the
most important path by which poverty will be conquered in the twenty-first
century. Knowledge based production is not only for rich countries but consider
the enormous risks that must be surmounted before ordinary working people in
the world’s poorest nations will buy future shares in productive enterprises,
not managed or owned by family relations. The invisible world of continuously
evolving wealth and production requires strong public ties within and among
nations across the world. This means
that good governance will connect people to the greatest opportunities for
relief from poverty.
To appreciate
the value of social and institutional assets to development, consider the
contrast between a young, untested, penniless investor who has just graduated
with an advanced degree in engineering from an American University and an
equally entrepreneurial soul in the Middle East who similarly dreams of
starting a business of his own. Upon
opening a single person stall in a bazaar, this unlucky individual must fight
off tax -collectors and government officials to protect any surplus wealth that
can be confiscated.[6] Is it a lack of talent or an understanding
of markets that keeps entrepreneurs from appearing? Malfeasance and corruption
create uncertainty that makes it difficult to build a business larger than a
market stall in many parts of the world.
Consider a
less extreme example -- the lack of entrepreneurs in the former Soviet
Union. I made many trips there where I
met the most astonishingly creative people with the most ingenious ideas. Like so many before me, I failed to match
projects with finance. The
insurmountable obstacle is that some gangster will grab the surplus profits not
seized by the government. This is the
threat my Silicon Valley friends never have to consider and it is the invisible
debt they owe to American institutions that, like a guardian angel, is always
there but never acknowledged because nothing is asked in return. Someone from Omaha, Nebraska, that
purchases stock shares from a broker in New York never worries if he really
owns or can be defrauded of his purchase.
A guardian
angel must protect innovation from both private and governmental
malfeasance. It must provide a reliable
set of public goods and services that facilitate contract enforcement at
reasonable cost. This protection must
include well-defined property rights and bankruptcy rules that are clearly
specified in law and a judicial system that can reliably implement collateral
repossession, execute guarantees and deter breach of contracts. Most importantly, investments in high-value
added activities require high quality information.[7] Government can be the greatest insurance of
the integrity of that information or it can be the most important source of its
contamination. This difference makes all the difference.
In conclusion, Silicon Valley provides a simple but compelling message about the possibilities of value creation in today’s world. Success in the knowledge age cannot be accomplished by the simple transference of technical know how. If that were so, Silicon Valleys would crop up everywhere. Trust, laws, social forces, internal governance structures, financial and information-intermediaries, regulators and civil society all make critical contributions. The emergence of these underlying institutions in developing economies will be the greatest challenge for future international economic prosperity.
END
[1] Venture backed firms represent 11% of all new jobs but 1% of the capital.
[2] . In 2001, after the dot com explosion, venture capital investments shrank to $31 billion,. This return to more normal levels still represents significant level of funding. National Commission on Entrepreneurship, 2002 , page 25. A major turning point is considered to be the Tax Reform Act of 1986 that reduced the number of tax shelter schemes for individual investors. Their disappearance sent individual investment dollars seeking other high return options such as venture funds or direct equity investments in entrepreneurial companies. Another milestone in the growth of equity capital was regulation in 1978 that taxed stock sales at lower rates than ordinary income rates, which changed mind-set of individual investors who started to seek out entrepreneurial companies that offered high returns. Also critical were changes to bankruptcy laws also in 1978 that protected individual creditors whose business had failed from losing house and home, thus removing a stigma of failure.
[3] “We found that in more than half of all venture capital backed companies the CEO was removed by the time we observed them (when they were 6.5 years old, on average).” Hellman in Chong-Moon Lee ed.,, 282.
[4] “At the height of the dot-com boom fully half of all the companies that made an initial public offering of their stock were venture backed”, National Commission on Entrepreneurship (2002), page 25.
[5] Banks will be reluctant to lend to people they do not know when their expectations of repayment are not supported by independent judges and good commercial laws.
[6] In Egypt, Hernando de Soto reports 88% of the businesses are informal because it takes at least two years to establish a legal business. 92% of the buildings are illegal including those built by the President because of the difficulty in establishing property rights. Egypt has eight different property systems. Four billion people around the world have the potential of owning 3 trillion dollars in real estate if only they could establish rights to what they use.
[7]
Many technology firms
offer share options to make it easier to obtain and retain skilled workers. To
be appealing these shares must be portable and the firm must maintain high
standards of financial transparency to determine the value of shares when an
employee or manager leaves the firm.