Paul L. Caron

Friday, November 11, 2022

Weekly SSRN Tax Article Review And Roundup: Eyal-Cohen Reviews Helman's Innovation Funding And The Valley Of Death

This week, Mirit Eyal-Cohen (Alabama; Google Scholar) reviews reviews Lital Helman (Ono Academic College) Innovation Funding and the Valley of Death, 76 SMU L. Rev. ___ (2023).

Mirit-eyal-cohenEconomic theorists have long held that innovation is the key to economic development and many positive spillovers. Alas, as a public good with high risk, non-rivalry, non-exclusive characteristics, it may suffer underinvestment and underproduction in the free private market. Accordingly, almost every legal system in the world has long incorporated an array of innovation incentives that overcome this inherent market inefficiency. Some of those stimuli mechanisms include intellectual property rights (IP), cash transfers (mostly grants and prizes), and various tax incentives. In their recent article Innovation Policy Pluralism, Daniel Hemel & Lisa Quellette discuss ways to combine, complement, and alternate between such innovation policy mechanisms based on the overall government purpose (allocation or incentive) in each case.

Undeniably, developing innovation doesn’t occur in a linear manner but on a continues path. Thus, this Article does a great job describing the various stages of the innovation process as beginning with a concept, continuing with a protracted experimental stage and with quite a few iterations, progressing to diffusion into the market, and to constant adaptation to competition and changing market trends. According to the author, the middle phase between R&D and commercialization (termed “valley of death”), proves fatal especially for startup in the high-tech industry that need vast resources to be able to transfer their inventions into products that would sell competitively in the marketplace. It entails large investments in product development, marketing, pricing, and sometimes further R&D to modify the innovative product or technology 

Subsequently, the main claim in this Article is that the current innovation incentives framework overlooks this major stage in the innovation lifecycle. The pre-market period between the beginning of the innovation process to the point that the startup starts selling its products receives little to no government intervention and no targeted stimuli exist. Patents and other IP rights must be secured at the innovation stage, but it pays off only when the IP monopoly generates commercial value. Grants are awarded ex ante to support R&D costs while prizes are given out ex-post for achieving predetermined requirement goal. Such cash transfers only target the R&D stage. They are sporadic, competitive, and barely help cover research & development (R&D) expenses.

The author further dismisses the idea that patents and IP rights provide benefits before the sales stage. Continuous deterrence of current and future competitors who are aware of the exclusive rights and the costs associated with copying a protected invention are not significant, in the author’s opinion. Securing patents as signal to investors and facilitate negotiations with other market players are immaterial compared to their costs. The author maintains that such “pre-market benefits of patents are of little avail for early- stage firms in the tech space” since startups have scare resources to enforce and sue infringers and that IP strategy works better in a patent portfolio rather than individual patents. The cited empirics on patent filings that focus on size (rather than scope or age) point to known benefits of economies of experience but do not reinforce the conclusion that patent filing in the pre-market stage is futile.  Patent protection, like any other investment, whether in salaries, R&D, or marketing, is a form of insurance for current and future benefits that startups may or may not chose to undertake based on their product type and priorities. The claim that patents “generally do not cover the premarket stages of innovation for early-stage tech startups” seem like a big stretch. Lastly, when it comes to tax incentives the author notes they are ex post and useful only for firms with positive income at the later stages of the startup life, as was recognized by Susan Morse, Eric Ellen and others. Transferring losses to third parties such as investors require expensive tax planning that startup companies do not have (yet the article resorts to this option as one of its normative solutions).

Venture capital (VC) firms and other investors that deliver startup capital need to overcome uncertainty, information asymmetry, and agency issues. To tackle such problems,  VC investment financing is oriented towards stages, milestones, and prior rounds of funding, focusing on concentrated industries, while offering more competitive funding. The author faults such VC market climate as requiring a stable monthly recurring revenues as a condition for investment, increased control over younger entrepreneurs, and focusing more on unicorn (big tech) companies. The current VC climate, the author points out, does not internalize the opportunity costs and distributional asymmetries of not funding early-stage tech companies.

Accordingly, the author argues, the longest and most critical stages of the innovation lifecycle, that is the pre-revenues stage between invention and market penetration of young companies is largely unaddressed by the government although such stage between invention and profit is lengthier, riskier, and bears highest costs. The Article goes as far as claiming the current innovation policy even harms early-stage tech companies and society as a whole. The underfunding during the “valley of death” stage results in high startup failure rates and limited market competition. It drives firms to focus on cashflow at the expense of furthering innovation and create disproportionate effects on entrepreneurs with less access to capital. The lack of government assistance during this crucial innovation phase, the author holds, also leads to competitive advantages to established companies that can polish, sell, and hire top personnel. It diminishes the incentive to invest in innovation, which results in substandard innovation.

Indeed, I have argued here, firms that enjoy economies of experience (scale, scope, and age) benefit from a competitive advantage on the expense of those that lack thereof. From a distributional perspective, most new business owners have trouble obtaining capital when they themselves do not have financial experience or goof credit history. They must rely on private market finance and are vulnerable to the VC industry's inherent prejudices. Undeniably, as pointed out here, minority entrepreneurs face greater hurdles in executing, scaling, and promoting innovations due to unequal access to finance, knowledge, networking, and personal connections. Nevertheless, the solution I proposed was more targeted than and involved tackling bias and discrimination via increased lending, mentoring, and learning opportunities focused on minority entrepreneurs.

The Article goes on to warn that the “valley of death” problem is turning into “a startup funding crisis” but could use better sources to document its magnitude. The failure rates cited in the Article include all small businesses (rather than early-stage tech companies at subject) and points to 42% cause of reason for failure as “no market need”, 23% as “not the right team”. Only 29% of small businesses surveyed noted their failure stemmed from “lack of cash”.  In fact, most media tech reports (like this and this) point to other reasons such as single co-founders, founder’s inexperience, wrong market product fit, lack of business model, etc. as leading explanations for startup failures. Running out of money, which happens multiple times in any firm’s life according to these reports, does not kill a company but at the end of the day is it is lack of proper planning and founder underperformance that do.  

Admittedly, the author notes there is no way to assess whether the failure rates are too high or low because of lack of funding itself rather than bad ideas or bad execution of good ones. Moreover, the author ignores the part of innovation theory that attributes tremendous value to entrepreneurial failures. She considers all startup failure as waste and “considerable opportunity costs, because the time, money, and effort that were invested in ventures that failed could have been used for various forgone productive activities”. Yet, as I have argued here, entrepreneurial failure is as important as entrepreneurial success in reaching efficient innovations and learning what strategy works and what doesn’t. Not all firms can develop a product and usher an idea all the way to the final product sales stage. It often times takes economies of experience and successful market scalability. In fact, a known exit strategy of early-stage companies is not to initiate production but to appeal to established firms that buy out the ideas (and often the talent) from startups that lack knowledge and capacity to do so.  

The author blames “the law takes a curious approach” the “valley of death” phase by  adopting “a policy that encourages planting seeds, but ignores the conditions for the seeds to flourish cannot be right”. She further asks, “Why is it so that innovation should not rely on the market economy in its earliest and latest stages, but must rely on the market economy in the long time in between?” She objects to the claim that the “valley of death” is an efficient way to vet companies for best use of innovation resources and that private investors such as VCs, provide expertise and mentoring essential to accomplish a fruitful commercialization stage. Alas, there are many unworthy innovations, that are deemed failures, and that should not be kept afloat. How else would we differentiate between the apples and the lemons? This is exactly the moment when the marketplace plays its central role in sorting out the innovations with the utmost potential for supra-competitive profits. While the author recognizes the idea of the capital market as a screening mechanism, she notes that markets are suboptimal proxy for societal welfare as many market players such as VCs are misinformed and self-interested.

It is evident, though, that the truly successful and innovative products will get to survive this stage with the leap of faith (and tangible funding) from angle investors (hardly discussed in this Article), crowdfunding (same), and VCs, while those that are not will have to recalibrate or die. Innovation theorists have long held that successful innovation depends on the market’s litmus test. This is not a systemic “incongruity” as the legal system should not fund projects that the market deems as uncommercialized. Basic research and scientific innovations are supported elsewhere by non-profits, universities, and via direct and indirect government subsidies. That is not the case of for-profit startups. Keeping afloat futile endeavors via (rather limited) public funding will not increase public welfare but deplete it and create much deadweight loss. After providing initial public boosts via grants and prizes and with the future promise for further public stimuli via IP and tax benefits, at some point, the administrative state—that holds no expertise in assessing innovations—has to turn to the private market to gouge have the potential to succeed and which do not.  This it the nature of the public-private market partnership that is the foundation of innovation and economic theories.

The Article suggests three ways to tackle the concerns it raises by applying existing incentives to the ‘valley of death” stage. For example, the author proposes to “stretch” innovation incentives to the post-invention-pre-market stages like granting unregistered inventions a period of more limited patent protection. Yet, aside from the importance of registering patents by providing important market notice, it is unclear whether vis-à-vis the increased market uncertainty of having unregistered patents appearing unexpectedly, the enforceability costs of such “quasi-rights” will be lower than in the case of ordinary patents. Second, the author recommends expanding the use of cash transfers by awarding grants and prizes to subsidize the market penetration, successful market experimentation, or pilot programs. Yet, it seems like shifting the timing of cash transfers will inhibit the ability of startup companies—similar to the case of conditioned VC capital—to obtain funding until their reach milestones and successful strides yet without providing the means to reach such goals. In a similar manner, the article suggests using the tax system by replacing startup losses with transferable tax refunds, refundable credits, or allowing use of losses at the startup owner’s level (the latter was used widely prior to the loss limitation rules of TCJA). Alas, such measures have huge revenue costs, encourage excessive risk taking, and are very susceptible to gamesmanship (which were the leading reasons for los-limitation rules in the TCJA). Lastly, the Article mentions briefly the need to adopt policies that narrow the startup funding gap by opening the VC-controlled space to more private competition via less burdensome crowdfunding, Corporate Venture Capital (CVC), special purpose acquisition companies (SPACs), and blockchain options.  

To summarize, there are areas where there is documented underinvestment in socially beneficial innovation due to enhanced features of risk, non-rivalry, and non-exclusivity such as the case of promoting vaccine technology discussed here. Inherently within developing innovation, investors lean towards innovations that produce supra-competitive profits in a shorter period and less costly manner. However, there are different platforms and ways to fund and develop social entrepreneurship. It is long established in innovation theory that for-profit entrepreneurship depends on market demand and financiers’ faith in the future value of prospective innovative products that create new combinations and new markets. It is what economic theorists point to as the source of economic development and business cycles. Indeed, the government should identify and preserve highly beneficial welfare spillovers via offsetting underinvestment in specific for-profit-but-socially-beneficial innovations. But in this private-public partnership, expecting the government to hold the hands of all early-stage tech entrepreneurs—even those that are deemed or should fail—is costly, wasteful, and unrealistic.

Here's the rest of this week's SSRN Tax Roundup:

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