How to Restart America's Innovation Engine

Harvard Business School professor William Sahlman believes that the most talented start-up management teams with good ideas have no problem getting capital these days.

But to reattain the level of start-up creation America enjoyed in the 1990s, at least two things need to happen: A company like Facebook needs to have an initial public offering that rises in price, and a new technology -- something on the order of the Internet -- needs to emerge and attract business capital investment.

In an interview this past week, Sahlman expressed confidence that there is no shortage of capital available for top-tier entrepreneurs who can field strong teams to go after big markets with good ideas. For those companies, both venture-capital firms and so-called "angel" investors will appear.

Are Angel Investors Better for Entrepreneurs?

Angels are wealthy individuals who pool their funds to invest in start-ups while providing their portfolio companies with contacts and advice. Sahlman pointed out that angels have a distinguished history: Henry Ford and George Eastman, for example, got the capital to launch their companies from angels. Angels also provide that capital at lower costs: They generally don't charge their investors a 2% management fee, nor do they take 20% to 25% of the investment profits as VCs do.

Despite the greater costs associated with taking money from VCs, they're not going away anytime soon, because when start-ups need capital, they often require a smaller amount of money initially, then later require more. Angels may be able to provide sums in the $500,000 to $1.5 million range for companies in the early stages of their development. But, later, when those same companies need $40 million or $50 million to ramp up, it will be the venture-capital firms delivering those bigger checks.

Following the VC Herd

The corollary to Sahlman's observation is that not all entrepreneurs can get capital. Moreover, with the slowdown in the IPO market since the 1990s, getting capital from VCs (who usually are hoping to get their investment back when a company goes public) is harder than it used to be. On June 22, Sahlman made a comment that the VC business would have "zero returns out until infinity."

He reached that conclusion because he's noticed that venture-capital firms have a strong tendency to all invest in the same "hot" products or services. He gave the example that many years ago, hundreds of VCs were all investing in startups that were building new PC disk drives, known as Winchesters, and each company expected to get 10% of the market. Obviously, with so many competitors, actually achieving such a market share was statistically impossible for them, but in Sahlman's view, VCs invest in herds because each one thinks that it will win.

Contrary to comments by Harvard Management Company's Peter Dolan, Sahlman thinks that while VCs are bad for limited partners like Harvard, VCs actually provide a valuable service to society. Yes, their herd behavior contributes to the huge amount of wasted capital in failed startups all going after the same market. But while that results in low or negative returns for the limited partners, it also increases the odds that some of those companies will succeed. Those success stories, even if there are relatively few of them, are good for society -- particularly if they spearhead innovation in areas like clean technology.

The Next Big Thing, or the Next Great IPO

Sahlman seemed to agree with my assessment that if we could discover a new technology that would spur business investment, it would help revive start-up and job creation activity -- much like PCs did in the 1980s and the Internet did in the 1990s. He thought that the Software as a Service (SaaS) model -- a way for companies to pay monthly fees for software rather than licensing it -- might fit that bill. In his view, businesses perceive SaaS as less expensive than buying traditional site licenses. But Sahlman does not see any particular technology -- except possibly clean technology -- that could ignite excitement at the level that the Internet did.

Finally, Sahlman pointed out that the IPO market could revive if Facebook or electric car company Tesla go public and their stock prices later keep rising. Such successful IPOs helped spur the Internet boom -- when Netscape, then a Web browser company, enjoyed a rousing welcome after it went public. Something similar happened for biotechnology in 1980 when Genentech went public and its stock soared. While there have been a few recent technology IPOs, such as battery maker A123 Systems (AONE), most currently trade below their offering prices. (A123, for example, closed Thursday at $9.19, about 65% below its IPO price.)

Can we restart America's innovation engine? The fortunes of startups could revive if public investors start getting rewarded again for investing in IPOs, or if a new technology comes along that ignites business investment. But since 2000, the market has seen little evidence of either profitable new investments or the "next big thing."