Successful Innovation Requires Failure Too

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President Obama, in his state of the Union Address, called on the nation's taxpayers to fund new investments aimed at making the U.S. more competitive. Joining a long line of Presidents from both parties, his call goes beyond funding scientific research and sets specific industrial policy goals, particularly in the energy and transportation sectors.

Obama's tax reform plan may be based on eliminating loopholes and subsidies for favored industries, but he apparently wants to make exceptions for his own favorites. The technologies Obama has selected on our behalf include wind, solar, nuclear, clean coal, biofuels and natural gas along with high speed rail and electric cars.

Any of these could well play a significant role in our future economy. I have my favorites and I bet you have yours. Whether they make the U.S. more competitive, however, depends entirely on whether the businesses built around them create value or destroy value.

Once technology businesses scale up the profitable ones will add to the nation's wealth, generating jobs, tax revenues, and investor returns that can be plowed back into new innovations. Businesses that lose money year after year will make us poorer, destroying jobs, eroding tax revenues, pushing down investor returns and starving other potential innovations of capital.

No one knows which of the President's technology picks will be winners and which will be losers. The important question, however, is what happens after we find out?

Venture Capitalists also don't know which of the technologies we back are going to succeed. But we do know that most startups do not take off pursuing their original idea. That's why the lion's share of the time, energy, and money we invest on a day-to-day basis is not spent selecting which technologies to back, but fixing technology companies we've invested in when they go wrong.

And something always needs fixing. Is the technology working as planned? Do we need to invest in feature enhancements or cost reductions? Have we attracted the right distribution partners? Does the business model or pricing plan need surgery? Is there a sufficient competitive differentiation or should we seek refuge in adjacent markets? Is it time to fire the VP of sales or recruit a new CEO? All of this is pursued with the utmost intensity because our own personal money is riding alongside that of our investors.

Like test pilots frantically trying to restart an engine that flamed out, we try to make things right before the plane augurs into the ground. Sometimes we actually succeed. But when we fail we are mercifully blessed by the fact that we don't have infinite time or money. Eventually we have to give our bad investments a decent burial. Every venture capital firm has these. Firms that have more winners than losers stay in business. The rest don't.

How does this approach to managing failure compare to government investments?

To begin with, industrial planners do not gamble with their own money. They gamble with yours. For them, success is not measured in capital gains but in votes. Much of the money they need to campaign comes directly from the industries, businesses, and entrepreneurs they favor with grants, loans, subsidies, tax breaks, earmarks, and mandates. It is within their power to spread losses across all the taxpayers while enriching favored investors and entrepreneurs who know how to express their gratitude.

Second, industrial policy makers do not involve themselves in day-to-day corrective actions at individual enterprises in danger of failing. Most of their time is spent defending and expanding their turf. Failure of any kind is usually ascribed to not spending enough, justifying a bigger budget next year. Like most government programs, when it comes to industrial policy only intentions are measured and not results.

Third, businesses run by political entrepreneurs attracted by government favors follow one ironclad rule, and that is to keep their patrons happy so the subsidies keep flowing. Losing taxpayers' money year after year is preferable to making changes that might disqualify them from receiving more, even if these changes are the right thing to do for the business. Safety is pursued by growing too big to fail and too influential to stop.

Finally, federal bureaucrats believe that they have infinite time and money to get things right. I suppose they do since the government can't go out of business and the Fed can print up as much money as it pleases. But imagine how competitive our country would be if thousands of companies that failed and went out of business were still around, propped up with taxpayer dollars and a perpetual hunger to feed at the public trough.

Actually, we know exactly what this looks like in the energy and transportation sectors. It looks like Amtrak, corn ethanol, and Government Motors. Has anyone bothered to add up all the taxpayer money that Amtrak has destroyed? Yet Obama is promising to bring high speed rail to 80% of Americans.

Is there anyone who believes making ethanol out of corn is anything but an economic, environmental, and social disaster? Yet it remains the nation's largest alternative fuels program. As for GM, time will tell whether the auto industry bailout has made America more or less competitive. But if the Chevy Volt should end up as well loved by customers as the Edsel, does anyone believe that GM will incur the wrath of its political patrons by giving it a decent burial?

Bill Frezza is a fellow at the Competitive Enterprise Institute, and a Boston-based venture capitalist. You can find all of his columns, TV, and radio interviews here.  If you would like to have his weekly columns delivered to you by e-mail, click here or follow him on Twitter @BillFrezza.

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