The incentives for entrepreneurial risk

Cross-posted from the Bio Business blog

I have been teaching innovation management for more than 15 years at three different schools. In most cases, I kick off the course with a discussion of the incentives for innovation, a topic of particular interest to Berkeley economists such as David Teece and the late Suzanne Scotchmer.

The fundamental idea is that innovation is risky in many ways: the innovator doesn't know if the technology will work (technological uncertainty), whether the market will value it (market uncertainty) or whether the innovator will be able to hold off imitators and other competitors long enough to make a profit (appropriability and ompetitive uncertainty).

As with any other gamble — whether investing early-stage companies or lottery tickets — the innovation winners have to pay above-normal returns to cover the partial or total losses from the losers. Business is an experiment, and if you don’t compensate for the risk, then entrepreneurs, managers and investors will avoid risk. (We can debate the magnitude or the approach to providing incentives — as Scotchmer and others have done—without denying the inexorable need for such incentives).

Of course, outsiders only see the winners of the lottery or the IPO jackpots. They don’t see the dry wells, the failed companies or the other investments that fail to pan out. So the big success of blockbuster drugs attracts attention (and populist attacks) from those who don’t factor in the cost of failures. In many cases, this is due to economic ignorance — innovation costs or economics more generally — and in some cases this ignorance is willful.

Forbes columnist (and former Pfizer R&D head) John LaMattina attacks such ignorance in his February 3 column “New York Times Op-Eds Misleading Regarding The Biopharmaceutical Industry.” The column is balanced and thoughtful, allowing for the basis of most of the criticisms while decrying the economic ignorance (willful or otherwise) beyond the criticism.

In the category of willful ignorance has to be that of economics Nobel Laureate Joseph Stiglitz, a “frequent” critic of the pharma industry (and, IMHO, capitalism more broadly). Let me briefly except LaMattina’s comments on the Stiglitz op-ed:

1) “In generics friendly India, for example, Gilead Sciences, which makes an effective hepatitis C drug, recently announced that it would sell the drug for a little more than 1% of the $84,000 it charges here.” – Actually, “generics friendly India” really means that India has its own rules when it comes to intellectual property (IP) and often refuses to recognize legitimate IP positions.
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2) “Overly restrictive intellectual property rights actually slow new discoveries by making it more difficult for scientists to build on the research of others and by choking off the exchange of ideas that is critical to innovation.” – This is a stunning misrepresentation of the R&D process in the biopharmaceutical industry. For any investment to be made in R&D, be it the 3 person start-up company or a Big Pharma, the promise of a financial return must exist. An absolute requirement for these investments is having sufficient IP to justify that a project, if successful, will provide such a financial return.
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3) “As it is, most of the important innovations come out of our universities and research centers, like the NIH, funded by governments and foundations”. – As I have said in the past, these contributions are very important in the search for new medicines. But Stiglitz, like many other critics, is either ignorant of the amount of R&D carried out by the biopharmaceutical industry or chooses to minimize that the industry’s applied research is what converts nascent ideas and discoveries to the breakthrough medicines that are continually generated by the industry.

I would be naturally sympathetic to LaMattina’s criticisms due to my free market bias, which stems both from my first experience as an entrepreneur, what I’ve learned studying technological innovation for the past 20 years, and of course what I’ve also learned teaching students how to run innovation-related businesses.

However, his three criticisms have particular salience now that I’ve co-founded a new (pharmaceutical) startup that is a spinoff of my current employer. It is (as he says) a 3-person startup, bootstrap funded for now, trying to bring a breakthrough therapy to market.

My two co-founders and I are working nights and weekends — alongside our regular jobs — to raise funds, validate the science, and try to get something approved by the FDA. We wouldn’t be working so hard (#2) unless there was some possibility of a big return at the end: hypothetically, if we’re each putting $10,000 worth of effort into it each year, then if we have a 10% chance of success then we’d each want a $100k+/p.a. return (actually more given due known entrepreneurial optimism biases).

Of course, we wouldn’t have started down this path without IP. We have to talk to the government, CROs, CMOs, potential investors, industry execs and others to make our idea feasible. We are a tiny company with no full-time employees and minuscule resources: almost anyone we talk to is better equipped to bring this to market than we do. All we have is an idea, a vision and the (patent pending) IP that we hope will allow us an exclusive to bring this to market (if we can overcome all the uncertainties).

Finally, we have thought long and hard about commercialization. Even if every NIH or other government grant goes our way, we’ll have certain regulatory, manufacturing, distribution and (yes) IP costs that won’t be covered by government grants. These costs are far beyond what we can bear personally, so unless the potential returns are attractive enough, we won’t get the equity investment necessary to bring this therapy to market.

The Stiglitz ignorance (or misrepresentation) is depressing but utterly commonplace, particularly among economic populists. But sometimes these populists can see the light.

In the 1970s, there was no more outspoken populist among national political figures than George McGovern (1922-2012), the South Dakota senator and 1972 Democratic presidential nominee. After retiring from the senate, he opened a hotel in Connecticut and found out firsthand how little politicians know about business risks.

As McGovern wrote in a June 1, 1992 Wall Street Journal op-ed (quoted in a 2011 Forbes article):

In retrospect, I wish I had known more about the hazards and difficulties of such a business, especially during a recession of the kind that hit New England just as I was acquiring the inn’s 43-year leasehold. I also wish that during the years I was in public office, I had had this firsthand experience about the difficulties business people face every day. That knowledge would have made me a better U.S. senator and a more understanding presidential contender.
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We intuitively know that to create job opportunities we need entrepreneurs who will risk their capital against an expected payoff. Too often, however, public policy does not consider whether we are choking off those opportunities.

So there is hope for intelligent people who get out of the Ivory Tower (or the Beltway) to try to make a living in the real world. McGovern was a man of modest means — a modern-day Harry Truman — trying to put away money for retirement. Millionaire politicians and academics are unlikely to leave their comfort zones, but there’s still a chance for skeptics to experience this epiphany.

Risk-taking and risk aversion

The cover of the Wall Street Journal† Monday proclaimed:

Risk-Averse Culture Infects U.S. Workers, Entrepreneurs
By Ben Casselman

Three long-running trends suggest the U.S. economy has turned soft on risk: Companies add jobs more slowly, even in good times. Investors put less money into new ventures. And, more broadly, Americans start fewer businesses and are less inclined to change jobs or move for new opportunities.

The VC story isn’t quite as compelling as promised. Some of the story is already known — that VCs keep hoping for another Internet bubble that won’t return (but spawned excess entry). At least one measure — share of VC for seed capital — the trend isn’t monotonic, but shows peaks and valleys.

The concentration of VC in Silicon Valley can be read two ways: VC only wants Silicon Valley entrepreneurs, or entrepreneurs know they should move to Silicon Valley to get funding. And as everyone knows, the companies that VCs fund are only a small fraction of the nation’s startups.

And while Casselman reported new specifics, we know that the last four years has been a jobless “recovery.” Citing the work of Maryland economist John Haltiwanger, he wrote:

In the eight recessions from the end of World War II through the end of the 1980s, it took the U.S. a little more than 20 months, on average, for employment to return to its pre recession peak. But after the relatively shallow recession of the early 1990s, it took 32 months for payrolls to rebound fully.

After the even milder recession of 2001, it took four years. Today, nearly four years after the end of the last recession, employment has yet to reach its pre crisis peak.

No, what was really troubling is what the story said about America’s entrepreneurial culture. This is what made America successful over the past 150 years, and the envy of the world. (It is also why, as some have argued, the country needs a new frontier to keep entrepreneurial processes alive).

Instead, Americans are changing cities often, changing jobs less often, and working more for big companies than for small companies. Even family businesses are not being passed down, as the children of entrepreneurs opt for the safety and comfort of corporate jobs.

As a natural consequence of this cultural shift, young companies account for a declining share of both the population of companies and national employment. This is terrible for the country, because we know (especially from Prof. Haltiwanger’s research) that young companies account for all the net job creation in this country. These little companies are finding it harder to compete against established incumbents.

I wish I had an answer. The country has become more regulated and bureaucratic, and it’s taking a toll on entrepreneurial intentions. Thirty years ago, we had an effort to reset the country’s attitude towards risk taking and free markets, but the tide has been inexorably coming in ever since.

† It’s to the Journal’s credit that they devoted so much space to the topic. Twenty years from now, we’ll hold this out as an example of why newspapers were once a good thing and tragic that they all died.

Chasing what is not yet known not to work

Today was one of the best events of the year for Bay Area cleantech entrepreneurs, with a panel discussion by three CEOs and one chairman of local biofuels companies (Amyris, Cobalt, Solazyme and LS9, respectively). I organized the event on behalf of the MIT Club of Northern California.

It was a great evening of very sharp leaders talking about how to make a successful business in a high-tech, high-risk industry based on biotech and chemical engineering. We had a standing room only sellout crowd, based in part on favorable publicity from the Merc and Biofuels Digest.

While we learned a lot from all the panelists, a unique perspective was offered by Noubar Afeyan, a Boston VC (and MIT alum) who appears to be a serial (perhaps chronic) entrepreneur. His Flagship Ventures web page says he’s “co-founded and helped build 24 successful life science and technology startups,” including roles building Applera and Celera in the biotech segment.

Afeyan is the chairman of three biofuels companies: LS9, Joule and Midori. The Bay Area’s LS9 was his firm’s 9th life science startup. As he said, “we number our companies the way that MIT numbers buildings.” (Inside joke for us MIT alumni: buildings, courses, majors are all given by numbers rather than names.)

In his opening slide, he showed an oft-quoted cartoon about the optimism of two archaeologists looking at a tiny pyramid in the desert, with the caption “This could be the discovery of the century. Depending, of course, on how far down it goes.”

This set up one of his best laugh lines of the evening, in which he said all the entrepreneurs in the industry were chasing “what is not yet known not to work.”

That seems to capture what makes high-tech entrepreneurship different: we don’t know what technologies will work and won’t work, so we invest in pursuing things that might work (or at least are not yet known to fail) in hopes of finding the one that does work. That seems almost the definition of entrepreneurial optimism: if it isn’t known to fail, it’s worth trying.

The inevitable need for Plan B

Many if not most tech entrepreneurs eventually face a wrenching problem: when do I give up on Plan A and go to Plan B?

In some cases Plan A and B (or A,B,C,D …) co-exist alongside each other in a successful diversified revenue model. In other cases, the company is too small to have more than one plan or the initial plan is such a loser (or another such a winner) that the answer is obvious.

However, in many cases it’s hard for managers to admit the correct decision — either because the data is ambiguous or because of emotional involvement. I suspect that most founders will have a hard time letting go of Plan A, because of the psychic investment and legacy role. Or if Plan C comes from your new CEO — and it bombs — it’s often hard to decide to ditch the plan if it might also mean ditching the CEO.

On Wednesday, I stopped by Pinger, a mobile software startup located walking distance to my SJSU office. CTO Jocelyn Cloutier — who worked for Yahoo, AOL, Bell Labs and as a Montreal C.S. college professor — happens to be married to one of my friends and co-authors.

A venture funded startup that’s not quite 4 years, Pinger spent 2 ½ years trying to get its Pinger voicemail multicast system established. Despite a few high profile wins (like the 2008 presidential campaign of John Edwards), like so many other tech startups it found itself flogging a solution in search of a problem.

Cloutier said that at some point, the management team had to admit that the original company concept wasn’t working: “I just put two years of my life into there, so let’s try something different.”

So when the iPhone App Store launched in the summer of 2008, Pinger carefully evaluated it. On the one hand, ”we didn't know at that time that app store is going to be the thing.” In retrospect, the App Store proved to be a smash success — but as in any startup, it’s tough to make a decision when the future is unknown.

Still, Pinger saw iPhone apps as a big potential opportunity, based on the prior success of the iPhone and its increasing momentum. It jumped in with both feet: in little more than a year, Pinger released four iPhone aps:

• Dec 2008 Pinger Phone: an enhanced souped up IM client (ala Adium) with some other friend features. ad supported
• Feb 2009. Textfree: a freemium SMS client, naturally segmented by the # of messages per day
• July 2009: Doodle Buddy, a kid -oriented drawing program (that allows collaborative color sketching over a network)
• Today (Aug. 20). Free2Call, a new app (approved while I was there at Pinger) that tells consumers which calls are in-network.

While the first application is no longer being sold — the cost structure didn’t work — it paved the way for all the future apps. As Cloutier said: "Pinger phone showed us there's volume there. We can put an application out there and we are going to have a lot of downloads. Now the question is how can we have an application that they're going to use every day and are going to pay for?"

For Pinger, Plan A was a hosted service and Plan B was peddling iPhone apps at $0-$5 each. (Textfree Unlimited has an annual subscription).

It turns out the technology wasn't very similar between Plan A and Plan B, but the technologists were. The founders were veterans of Handspring — and thus understood the whole device-constrained software model — which enables the team to do a good job of designing something for a 320x480 screen with no keyboard and no mouse.

Pursuing Plan B, Pinger has made it so far, but there are lots of uncertainties and no guarantees. International growth is problematic: most of their products are tied to US-specific telecom industry features (Free2Call) which would require data or localization or negotiation for each country. The iPhone/iPT is only a small part of the US market; although ISVs would like to reach other handset owners, it's not clear which app store will catch on next.

More generally, there's also the inerhent problem of package software sales — as opposed to services like If you’re Google or Verizon Wireless, which make ongoing revenue off a customer after acquiring only once.

Software products — like vidoegames, records, movies — are prone to the one hit wonder problem. Once everyone buys your hit, what do you sell them next? If you don’t sell them another product — or an upgrade like Office 2023 or EA’s annual NFL Football update — then once everyone in your segment has bought the product, the income flow stops.

This one-time nature of software product sales nearly killed my own company, as initial strong sales fizzled out as we quickly reached the limits of unexpectedly small niches.

At Palomar we went from Plan A (consumer apps) to Plan B (developer apps) to Plan C (semi-custom OEM utilities) to Plan D (retail OEM utilities). We worked through the 4 business models in the first 4 years. At year 6 dumped all but Plan C (which was cash flow positive and the long run the only one that made any money).

What’s the take home? Entrepreneurs face several tough decisions, including when to look for Plan B (or C or …), when to implement Plan B, when to abandon Plan A. This choice is obscured by the various uncertainties: not knowing what customers will want, what competitors will do, where the industry will go and how effective our execution will be.

There is also the diversification vs. focus problem. Do you hedge your bets, or does spreading your bets guarantee that neither will succeed? Do you put all your eggs in one basket — all the weight behind the arrow? If so, how can you recognize that all-or-nothing bet has become controlled flight into terrain?

Illegitimate startups

In grading business plans this week, I was struck by a common blind spot: my undergraduates were overly optimistic about their chances of gaining sales (or distribution) from day one.

They didn’t realize that they would be handicapped by the inherent lack of legitimacy that a brand-new firm has. This is something I lived as a software entrepreneur, but also a well-known problem to strategy researchers.

Just as innovation and entrepreneurship scholars often trace back their core theory to Schumpeter’s “gales of creative destruction,” those worried about the disadvantages faced by young firms go back to sociologist Arthur Stinchcombe and his 1965 book chapter which coined the phrase “liability of newness”.

Subsequent research (such a 1986 ASQ article by Singh et al) has shown that the liability stems in large part to the lack of external legitimacy held by the new organizations. (The test was with nonprofits, but the principle is the same).

I had trouble finding something suitable for undergraduates to read; perhaps this is a publishing opportunity. However, I but did find a closely related 2008 article in Entrepreneur entitled “Credibility is King.”

In class, I tried to tease out the difference between legitimacy and credibility, but given the impromptu nature of the discussion I have to admit I was mostly winging it. In my mind, legitimacy is whether or not you’re in the consideration set. Credibility (as in the political context) is whether or not customers believe what you say.

We brainstormed the reasons or conditions for a lack of legitimacy, and I noticed that they all boiled down to two issues. One is the lack of information (e.g. about the unmeasurable quality of your good). The other is for cases of high risk: making a bad decision on a bicycle helmet is different than doing so for buying an ice cream cone. Again, this is something I hope to elaborate in a future article.

In terms of solutions, most of our options boiled down to two. One is to borrow legitimacy, such as from suppliers (“Intel inside”), dealers, or testimonials by buyers or celebrities. The other is to reduce the risk faced by buyers, such as by providing a free trial.

Again, this is something I’d like to write up sometime, but at least I have a starting point to sensitize future students to this challenge they will face as entrepreneurs.

Tech startups are always an experiment

Last fall, I taught entrepreneurship for only the second time since I got to SJSU. (I’d previously taught it as an adjunct at UCI, building more on my experience as an entrepreneur than any formal preparation).

About 2/3 of the way through the semester, as part of making a point about the lack of sufifcient information in any startup situation, I wrote on the board

Business is an experiment

which will become the mantra for all my future entrepreneurship courses.

To explain my thinking further:

• if you’re doing something new whether new to the firm or new to the world — the answer doesn’t exist;
• in a startup, for many questions you won’t have the time (or money) to get a definitive answer; so
• you need to make and implement a decision with the recognition that the experiment may fail — and thus both look for signs of failure and find an expedient way to mitigate against (rather than prevent) such failure.

That leads me to an an interesting quote from Carol Bartz (newly appointed Yahoo CEO). It came from her 2001 talk at Stanford about encouraging entrepreneurship in established companies: at that time she was CEO of Autodesk, the CAD software company.

As an aside, I’d disagree with her use of the term “entrepreneurship”: if you use the term to refer to any form of innovation or business initiative, then the term doesn’t have any real meaning. While “corporate entrepreneurship” is a bit of an oxymoron, at least it demarks a form of initiative distinct from starting a new company.

However, I couldn’t agree more with her on the philosophy she brought to Autodesk to deal with the turbulent dot-com era, a philosophy she called “Fast Fail Forward.” As transcribed by Scott Fulton of Beta News:

I had to do this during the dot-com time, where everybody panicked and decided that you guys [Stanford students] were going to rule the world. … [P]eople got even more cemented in and scared to take risks, because what did it mean in an established company?

So we started this thing called 'fail-fast-forward,' and the whole idea is, listen, failure is very acceptable. When it happens, make sure you identify it quickly, and hopefully it's in a forward motion. And then start going again.

In other words, nothing new happens without risk, and the only way to deal with risk is to accept it rather than try to completely prevent it.

Hat tip: to Scott M. Fulton, III of BetaNews.