What government agencies seeking innovation could learn from venture capitalists

One key factor that likely advantages American startup companies relative to those in less-developed economies is the existence of a thriving venture capital industry (VC) that enables bold innovation. In the spirit of the adage that government could learn a lot from businesses, here are some practices and concepts from the VC ecosystem that differ from those found in government, and which some government agencies might be able to embrace. Based on a recent presentation by venture capitalist Rob Ness at a Government Analytics Breakfast Forum event sponsored by Johns Hopkins University and REI Systems, government agencies that seek innovation as a key part of their mission, like NASA, the National Science Foundation and the National Institutes of Health, may find this useful.

SIMILARITIES BETWEEN GOVERNMENT AGENCIES AND VCs

1. Learn what is happening. Both government and VCs are eager to learn about new ideas for products and services, to understand the cutting edge of innovation. Government officials and VCs attend conferences and read new research with an eye toward potential innovation. VCs also look for significant latent customer demand for products and services, while government agencies evaluate their mission and identify unmet needs that innovation could address.
2. Choose innovators and ideas. Both government and VCs select innovators and their ideas. Venture capitalists make deals that provide funding and take an equity stake in a company. Government agencies typically award a grant, cooperative agreement or contract for development and demonstration of an innovation, but do not take an equity stake.
3. Work toward success. Both government and VCs support innovators after selecting them. Government provides funding via a grant award or contract, and may become a continuing customer, offering occasional feedback, technical assistance, and requests for modifications. A VC offers funding, but may also provide strategic advice, introductions to important partners and customers, assistance recruiting key staff, and even office space. The definition of success, however, varies. A VC looks for fast growth toward an unfilled niche with significant demand in the market (ideally one with patent protection or other forms of competitive defensibility that could, at least conceivably, carry that venture all the way to a successful initial public offering). In contrast, the government looks for development and demonstration of innovations that will contribute to the agency’s mission, often filling a key capability gap.

KEY DIFFERENCES

1. VCs aim to be contrarian. A venture capitalist seeks ideas and technologies that are different from those currently in use, or even those rejected by conventional wisdom. A great example is AirBnB. Common perception held that most people would not want to spend the nights of their vacation sleeping on a stranger’s couch. AirBnB, and the VCs that backed it, took the contrary view, and enhanced the model (rent whole homes, not just couches; establish quality standards and user ratings, etc.). The demand that no one else recognized allowed AirBnB to reshape the hospitality market; it now commands a valuation in the tens of billions of dollars. In contrast, federal agencies tend to choose the most meritorious innovation, but almost always within their mission and comfort zone.
2. VCs ruthlessly discriminate in favor of a few investments. VCs only expect to provide sustained support to a select few of the companies they fund – those that ultimately gain dominant market traction. To those few breakout winners in a given portfolio, VCs may provide additional funding, expert advice and job candidates to help accelerate product refinement, marketing, and customer acquisition. The government, in contrast, presumptively wants every awardee to succeed, and may distribute limited support among all awardees uniformly, rather than trying to “choose winners.”
3. Venture Capitalists and government look for different types of value. VCs require an equity ownership stake in the companies and ideas they select, and they want to be able to sell that equity within a limited period of time. The ownership stake means that the VC’s and entrepreneur’s fortunes are tied together. In contrast, government agencies do not take an equity stake, nor do they typically require repayment of the public money contributed. Instead, government seeks value from innovations that provide better services to citizens, make our economy work better, or advance scientific knowledge. These types of value are often difficult to measure or evaluate, and take a long time to realize.

WHAT GOVERNMENT CAN LEARN FROM VCs

1. Set money aside for “blue sky” ideas and contrarian thinking. If a federal agency reserves a part of its innovation funding (say, 10%) for innovations unrelated to the agency’s mission, particularly contrarian ideas, the agency may uncover ideas it didn’t know it needed, but that make a big impact on its mission. And contrarian ideas may have even more potential because they fit into a new but related mission that offers agency stakeholders and beneficiaries even more value than originally imagined.
2. Consider taking an equity stake in funded companies. The government has generally not sought to take equity stakes – in part for fear of playing favorites in the market. But as a result, it does not capture nearly as much value from its investments as VC firms do, arguably because it asks for too little in return. Of course, if the government did take equity stakes, it would need to be very methodical about providing oversight and support in an arms-length manner – otherwise, equity stakes held by government would give rise to real or perceived conflicts of interest or corruption that do not apply to the private-sector context of VC firms. For example, the government might require assignment of an equity stake to an independent non-profit entity that provides ongoing assistance to the company, while also having the ability to return profits and gains in equity value that ultimately deliver a direct financial return back to the public treasury.
3. Set an explicit expectation for failure, and promote a “fail fast” mantra. The government may never be able to entirely avoid media and auditor criticism of its investments in innovations that ultimately fail to produce the desired results. However, it may be useful to manage expectations by establishing a projected failure rate upfront – e.g. that perhaps 70% of early-stage projects funded by an agency will likely fail. This could help create an environment conducive to celebrating success when it happens, while avoiding the penalty for failure that can discourage innovative risk-taking. The “fail fast” mantra is connected with trying many things, but not over-investing in those that do not succeed (i.e., failing quickly after a small investment is better than failing slowly after an extended, long-term investment).

Authors:
Rob Ness is the general partner of venture capital firm Asymmetry Ventures.
Jeff Myers, a senior director at REI Systems, is an expert in government performance improvement, with over 30 years’ experience working together with local, state, federal and international agencies.
Jennifer Bachner, PhD, is director of the Data Analytics and Policy Program at Johns Hopkins University.

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