June 11, 2008

Lessons for Rhode Island from Silicon Valley: An historical reflection on an actual innovation economy

Donald B. Hawthorne

With the economic crisis in Rhode Island, there is much talk (e.g., my recent post and Ian Donnis) about what it will take to generate real change and economic growth in the state.

Leonard Lardaro, professor of economics at URI, offers his thoughts in a ProJo editorial Only RI Cure: Cut spending and taxes, where he writes:

...There is a great deal of angst about our state’s economy by both citizens and lawmakers. In a recent exchange, a member of the legislature’s Joint Committee on Economic Development took the head of the Economic Development Corporation (EDC), Saul Kaplan, to task for his alleged contribution to our state’s current economic dilemma. According to a May 2 story on the exchange (“EDC is grilled on bad R.I. economy”), EDC was: “chastised . . . for allowing the state to slip into . . . the Northeast’s only recession.” Wow! I never imagined Mr. Kaplan was powerful enough to single-handedly draw us over the edge into recession!

Pardon my sarcasm, but I remain stunned by what this quote reveals: how grossly out of touch with economic reality some of our state’s legislators are. What a vivid illustration of the paropic (parochial and myopic) mindset held by so many of our state’s leaders!...what was sorely missing from this exchange is cause and effect.

To understand the state’s problems, it is necessary to go back to the end of 1987, when Rhode Island first became a post-manufacturing economy. The rules of the economic game today are very different from those in the “good old days” of manufacturing. Because job loss today often entails the permanent elimination of jobs, job creation has become job initiation, not job resumption (factories rehiring after usually temporary layoffs). And since the initiation of new jobs is more risky and costlier than job resumption, production and employment costs are more critical to the success of states in creating jobs.

Taken by itself, this presents one glaring problem for Rhode Island in the post-manufacturing era: Our tax and cost structure (which includes fees, regulations and potential problems with the skills of our labor force) is nowhere near as competitive as it must be for us to be successful in this post-manufacturing environment...

But, getting back to the exchange with the EDC, given Rhode Island’s current non-competitive tax and cost structure, what “cards” does EDC have to play in attempting to expand businesses and employment here?...

This brings me to the second problem for Rhode Island: What is our state’s dominant niche? Recently, we decided to move toward biotechnology, pharmaceuticals, life sciences and oceanography. Is our tax and cost structure consistent with success in this niche? I doubt it. How far will our existing economic climate be able to carry us? Will we be able to generate the levels of employment, income and tax revenue that will allow us to attain our desired economic goals?

It is on this count that the glaring deficiency of our non-competitive tax and cost structure exacts its toll. All too often, EDC is forced to make deals with individual companies or industries to generate these types of economic gains. How large have these gains been? Generally, not large enough, as employment here has continued to fall since January of 2007.

In terms of fairness, these deals add insult to injury for existing firms here, which wonder why they can’t receive better treatment all the time. Efforts to expand existing businesses and to get new firms to locate here absent specific incentives have not been sufficient for us to be as successful as we should have been in this post-manufacturing era...

Because the legislative and executive branches, along with the EDC, have jointly failed to produce a competitive tax and cost structure, economic growth here has suffered...

The deficits we now face are largely self-imposed, resulting from unsustainable spending practices over the last 20 years, the failure of our paropic leaders to redefine our state in terms of a niche with a compatible tax and cost structure until very recently, and a separation of economic leadership that, as the exchange between the EDC and legislature shows, is all too often "us" versus "you."

Deficits are not pleasant, especially when largely self-imposed. But they will serve our state’s long-term interest by forcing the type of fiscal discipline that has been so sorely lacking, and, hopefully, an end to factionalized economic policymaking.

Tax and spending policies by RI government do matter in a big way and fixing those problems in the short-term is an essential part of an overall solution. But unwinding the taxation and spending disincentives in RI only opens the door to a positive future. There are more changes which have to happen as part of a total solution.

One way to look to the future is to learn lessons from the past. And no place has been an economic growth engine like the innovation economy of Silicon Valley over the decades, a place I lived and worked in for 17 years.

What were the critical success factors which powered entrepreneurial innovation there? It is a conversation I have been having with friends and colleagues for years. And in the last few weeks, I went back to venture capital, investment banking and university technology licensing friends from Silicon Valley to continue the conversation.

Here is what we pulled together as some of the critical success factors:

  • Stanford Engineering School Dean Fred Terman: Terman hired faculty with industrial experience and encouraged academic/ industry relationships. This dated as far back as the 1930's so there was a cultural legacy of interactions between the two communities. More on Terman here and here.
  • Stanford University Office of Technology Licensing: With its outstanding engineering/science/medicine programs, Stanford was both a center of technology development and had more liberal technology licensing practices which encouraged commercialization of innovation. The university also allowed faculty to spend time doing outside work. This provided a pipeline for new technologies which, over time, was supplemented by technology within companies.
  • Management Development: Businesses can't grow without a pool of talented and trained management. The early growth at both Hewlett Packard and Fairchild/Intel, including both their legacies of excellent management practices and at least HP's original practice of regularly spinning off new divisions, provided a number of decades of management training and development. Their efforts, like Genentech later in the life sciences area, provided much of the original management team infrastructure as newer ventures were launched.
  • California's Entrepreneurial Culture & Services Infrastructure: While the nice weather didn't hurt either, California's historical culture was inherently entrepreneurial and, over the decades, an entrepreneurial culture took root and led to an ongoing practice of starting new companies and providing infrastructure services to those companies.
  • Capital Gains Tax Rate Reduction Powers Early Stage Financings: The capital gains tax cut in 1978 really launched the growth in the venture capital world and provided the financial capital infrastructure to fuel early growth.
  • Local Investment Banks Provide Later Stage Capital: Local investment banks, such as Hambrecht & Quist, Robertson Stephens, and Montgomery Securities, themselves entrepreneurial organizations, were formed to provide later stage capital. In addition, led by Frank Quattrone, some leading New York City-based investment banks set up operations in Silicon Valley, creating an even more competitive environment for later stage capital.

Here are some comments from my friends:

  • You're spot on with the influence of Fred Terman. His should be a household name for all the contributions he made and culture tone he established. I think he's the real hero of the story and more should be written about him.
  • By way of contrast, it's noteworthy that RTP in NC has been promoting itself as a tech center since the 1950's, only gained traction from the 1980's on, and built itself primarily through the Chamber of Commerce route of attracting large multi-national companies, with start-ups being an after-thought until they started to evolve and grabbed some of the spotlight.
  • At a time when universities are paranoid about blurring the distinction between academia and industry it's instructive to recall that the Varian brothers's company made and shipped Klystron tubes from a Stanford lab during WWII, and that technology transported back and forth between Stanford labs and HP in the early days. We should collectively learn that current conflict-of-interest phobias preclude arrangements such as these, which ultimately were of tremendous benefit to both the local and national economy.

  • Current practice of most tech transfer offices impedes entrepreneurism, and the most productive approach is found in those offices that minimize these barriers. For those who think there's some abdication of the public trust in this view, I query why it is better from a public policy perspective for [a big pharma company] to profit from a new drug than a local start-up, so long as the drug comes into public use...and I would postulate that the amount of financial return that Stanford would have obtained from the most perfectly optimized licenses from all that early technology traipsing out to HP is dwarfed by the magnanimous giving of the Hewlett and Packard families--giving born out of the goodwill generated by Stanford being helpful to them in their early days.
  • The Stanford Licensing Office was formalized in 1970, and Niels Reimers ran it with an approach different from any other university licensing office. Rather than staffing it with JDs, PhDs and/or bureaucrats who focused on filing patents, Niels focused on marketing, and filing patents only when a licensee was identified (see article). Most importantly, Niels made his priorities clear: our job was to ensure Stanford technology was efficiently put into public use and benefit; that the best technology transfer is the graduating student; that our job was to create opportunities for research staff and students; that exclusive licenses were not only acceptable but desirable to provide companies incentive to commercialize; and that--whenever possible with the above, we should try to obtain a financial return to Stanford (as opposed to many offices, where they act to maximize every dollar they can up-front, which is to their long-term detriment). Niels kept a long-term view on creating opportunities, with faith that our activities in promoting industry - university connections was justification in itself, and that the financial returns would take care of themselves. As the office grew, Niels maintained an entrepreneurial and marketing-oriented approach. Every licensing person had a high level of freedom to negotiate a license, with review only at the end of the process (we knew what terms were important to safeguard, and were given freedom to negotiate other--mostly financial--terms to the best of our judgment). This enabled us to work expeditiously. It also kept us focused on industry, with a respect for their needs. Stanford's overall attitude enabled researchers to devote time to outside activities and consulting--as you point out. Although the amount of time for outside consulting was the same as other institutions (such as UC), the key difference was that Stanford encouraged researchers to interact with industry. At many institutions, the culture has in the past been (and often still is!) adversarial to this. Seems like every researcher I knew at Stanford kept a business plan in the top left drawer of their desk--they'd pull it out after every meeting and would ask if I knew any VCs...The cultural issue is huge, and has been tough for other institutions to duplicate. The strongest lever for change is the Faculty Club Effect, where researchers sit at lunch and stare enviously at the guy who just made $10 million from selling his company, and gripe to themselves that they're at least as smart as him...Every institution seeking to replicate Stanford's culture has to have at least one success story, place that guy in the Faculty Club, AND change top administration's attitude so they're more enlightened (and not sending out the conflict of interest police to find alleged corruption underneath every desk).
  • ...the risk taking/supportive culture [was] a shocker coming here from the East Coast. There were all sorts of services - VC, banking, legal, real estate, equipment leasing, etc. that would believe and take chances on these companies and enable them to take risk. If they succeeded, they would be celebrated. If they failed - most importantly - that was not viewed as a disgrace but instead a learning experience that made them more valuable to the next venture. A few more modern day success stories that sprang from Stanford - SUN, Silicon Graphics, MIPS (of which the current Stanford President was a founder), Cisco, Yahoo, and Google all started as projects within Stanford.

There are some clear lessons for Rhode Island in this review:

  • Consistent, long-term incentives drive lasting economic behaviors: People and institutions respond rationally to explicit and implicit economic incentives. Consistent, long-term incentives matter the most and drive structural changes in behaviors. Offering taxation incentives and then taking them away, as has been proposed recently during the budget crisis by some on the Left, sends a clear signal to the marketplace that RI is not serious about creating the necessary long-term incentives which will lead to favorable investment decisions in RI.
  • Competitive alternatives exist and will be favored until RI's taxation and regulatory policies are competitive: The greater Boston/Cambridge area, with the influences of many existing companies, MIT, Harvard, Massachusetts General Hospital, etc., is a place where experienced management and services infrastructures already exist without the uncompetitive taxation burden and budget problems of RI. One-off solutions like selling portions of the Lottery do not solve the fundamental competitive disadvantage problem and are, therefore, not viable solutions which will make RI a place to favor for new business development, especially given the nearby alternatives.

  • No economic czars are needed: If broad economic incentives are consistent, favorable and there for the long-term, individuals and organizations will have all of the proper incentives to act rationally and bring business into the state. There is no need for an economic czar or targeted tax incentives here. As the Frenchman Bastiat wrote in the 1800's: Paris gets fed...without any central planning and it occurs because knowledge is shared and the right incentives exist for people to act, people who don't even know each other. A future post will explore further how the role of knowledge, tacit and otherwise, drives economic decision-making and why centralized economic planning will always fail.
  • Quality of state services and public education matter: A crumbling infrastructure and lousy public schools create a disincentive for people to bring their families into RI. Why pay higher taxes for worse services? Why pick mediocre RI public schools when MA schools just across the border offer a better education to kids?
  • A sense of urgency is critically important: One of the central lessons from Silicon Valley is that its economic growth engine did not come about overnight. Building the management development engine and the services infrastructure took time. Yet there is no sense of urgency among state leaders in RI to either grasp the lessons from Silicon Valley or implement policies which create the required consistent, long-term incentives that will lead to such infrastructure solutions.

We will see the budget proposals shortly from state officials. Will they show any real leadership and offer serious proposals for change? Will they change the long-term economic incentives which will contribute to economic growth? Or will they dither and make it even more likely that the only solution for RI will be to let it blow up and then pick up the pieces? Bluntly, there is little reason to be optimistic. I hope I am wrong.

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An excellent summary about how SV has become the top high tech area of the world.
While I would credit Stanford, HP and Intel (Shockley's alumni), H and Q, Let's not forget other models, especially Apple. The Steves had no degrees and no money. Don Valentine, VC, sent them to Mike Markulla, angel investor, and the founding trio started today's $100B valuation company.

What really makes SV, and the Boston area work are the people, who immigrate from other areas, plus the home grown folks -and great universities which incubate the talent.

The "128" economy got its start in WWII with Raytheon, MIT's "rad lab", followed by the minicomputer companies, and the telecomm companies that grew out of DEC and A&T.

These 50 year tech histories cannot be replicated in RI or anywhere else in the US.

RI people need to focus new business opportunities in areas where RI leads - boat building and services, fine and graphic arts, leisure services,

Bob W
40 year high tech business veteran, and new to RI (2005)

Posted by: Bob W at June 12, 2008 12:06 PM
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