Maximizing the benefits from R&D subsidies: How some enterprise support policies can discourage high-growing entrepreneurship

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Many governments offer support for entrepreneurs in a bid to boost entrepreneurship and startup success. However, as Annamaria Conti shows, both policymakers and entrepreneurs need to thoroughly assess the impact of that support to ensure that it is having the desired effect.

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Annamaria Conti is a professor of strategy. She conducts research in the fields of entrepreneurship and economics of science.

Known as the Startup Nation, Israel has an envious track record of producing successful high-tech startup companies. With a population of just 8.5 million or so it has the largest number of startups per capita in the world, at around one startup per 1,400 people. One factor behind this enterprise miracle is the fertile environment created for entrepreneurs, partly through the policies of the Israeli government. Yet, unlike the entrepreneurial fail fast, learn fast culture, it has taken policymakers some time to find an appropriate approach for supporting startups.

Take research and development (R&D) subsidies, for example. Fearful of funding domestic startups, only for other countries to capture the benefits of the know-how they created, the government added a prohibitive restriction to R&D grants preventing the transfer of know-how abroad. This created a considerable opportunity cost for ambitious entrepreneurs that envisaged partnership with or a sale to a foreign firm at some point, or offshoring R&D research (to access larger markets, for example).

Furthermore, in 1995 the external transfer of know-how became a criminal offense. Breach the restrictions and a budding Bill Gates or Jeff Bezos could find themselves behind bars, rather than quoted on NASDAQ. Just the kind of measure that might deter great entrepreneurs from applying for a subsidy.

In the event, the restriction was altered in 2005, allowing firms to transfer know-how in return for a compensatory payment. Many other countries have emulated Israel’s approach to supporting entrepreneurship, and, in general, the use of know-how transfer restrictions is relatively common. The US Small Business Innovation Research (SBIR) grant program, for example, specifies  that R&D work financed with SBIR funds “must be performed in the United States”. While at a state level, the Texas Emerging Technology Fund stipulates that “at least eighty-five percent of the Company’s employees and eighty-five percent of the Company’s independent contractors shall be individuals whose principal place of residence is located in the State of Texas”. Other countries such as South Korea, Australia, and New Zealand, apply similar provisions.

Encouraging high-growth entrepreneurship

Annamaria Conti, associate professor at HEC Lausanne, University of Lausanne, set out to investigate the effect of this type of restriction on the take-up of subsidies and the performance of grant aided firms. Conti used data from 2,304 Israeli startups, founded from 1990 to 2014, a period during which the government via the Israeli Office of the Chief Scientist offered R&D grants to startups. Effectively these grants are a conditional loan – repayable if the business turned out to be commercially viable. Conti focused primarily on those startups that applied for a subsidy within two years of their inception in order to assess the effect of R&D subsidies on the initial, crucial years of the startup life cycle.

By exploiting the policy reform, which was implemented in 2006, relating to the know-how transfer restriction, and using before and after data, Conti could gauge the effect of the restriction on the willingness of startups to apply for the subsidy, and on startup performance.

The findings show that the restriction acted as a major disincentive, discouraging the most promising startups, (those most likely to stay in business), from applying for a subsidy. Pre-reform, startups with private funds (those most likely to attract future funding) were 22 percentage points less likely to apply for a subsidy than firms without private funds. After the restriction policy was altered they were equally likely to apply. The effects are similar across sectors.

While more promising start-ups apply for a subsidy post-reform, Conti’s research shows that they use the funding to complement their existing entrepreneurial efforts, rather than to substitute existing private funding for grant funds. Conti demonstrates that the firms receiving subsidy support after relaxation of the restriction exhibit improved performance across a number of different measures including firm survival, attracting external investment, and innovation (unlike the pre-reform subsidized firms). Post-reform, for example, subsidized startups are 14 percentage points more likely to remain active than pre-reform subsidized startups, and 19 percentage points more likely to attract external investment. Conversely, non-subsidized startups do not improve their performance outcomes after the implementation of the reform.

Capturing benefits locally

These are important findings for both policymakers and entrepreneurs. Entrepreneurs need to do full due diligence and scenario plan the possible implications of any government support they receive, factoring the effect of any conditions attached, such as the R&D subsidy restrictions. Conti points out that there were companies in Israel that applied for subsidies pre-reform without realizing the potential impact of the restrictions, and their entrepreneurship efforts suffered as a result.

For policymakers, Conti notes, there is a clear message that imposing restrictions on the use of R&D subsidies, certainly regarding the transfer of know-how, threatens to make the subsidies less effective, and creates a barrier to the policymakers’ objectives of encouraging successful entrepreneurship. This is particularly relevant for smaller nations and markets, where expansion abroad and foreign investment is often necessary for firm survival and growth.

If policymakers are concerned about the return on their resources, Conti suggests that there are better ways of trying to ensure that benefits accruing from subsidized startups, such as knowledge spillover, are captured locally rather than elsewhere. The aim being to incentivize, rather than sanction. One policy intervention might be to provide tax credits for subsidized firms that maintain R&D facilities locally, for example. Policymakers might also make the local enterprise environment ‘stickier’ and boost innovation capacity, by investing in the innovation capacity of local universities and the enterprise network more generally.

Many countries, especially smaller nations, have looked enviably at Israel’s success with startups. Yet although there may be much to learn from the Israeli approach, Conti’s work suggests that it is not necessarily wise to emulate a regime wholesale. It may be better, instead, to be selective about adopting best practice, while at the same time improving on other elements. Otherwise there may be more failing, than learning.

Related research paper:

Conti, A. (2018). Entrepreneurial finance and the effects of restrictions on government R&D subsidiesOrganization Science29(1), 134-153.

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