From American Affairs Journal:
July 30, 2018
In 2013, a group of MIT researchers published a study examining the business trajectory of 150 start-up firms that grew out of technology developed at the university.1 These were production-related “hardware” firms that actually manufactured things. The firms were able to attract early stage venture capital (VC) funding. They were also able to find the advanced engineering talent required for the sophisticated manufacturing processes involved. In general, the firms were able to create prototypes of their products in the United States, and they often built U.S. pilot production facilities as well.
But when it came time to “scale up” production of the most successful of these new products, and manufacture them en masse, it was another story. Most firms moved their production abroad. Although some medical device companies were able to scale their manufacturing domestically, when it came to production in sectors such as electronics, advanced materials, batteries, and renewable energy, all that went overseas.
The MIT study identified a not widely discussed but central reason these firms decided to manufacture offshore: financing. While the firms were able to raise American VC capital for their early stages of development, outside of biotech they had trouble finding, within the United States, the large sums of capital required for manufacturing.
MIT professor Hiram Samel, one of the three researchers involved in the study, said: “the VCs who provided the initial financing weren’t interested in funding the manufacturing stage of the project. VCs want things that scale at zero marginal cost, which describes software, not manufacturing.”
Another problem was the time span required. VCs were willing to make the initial investments in these manufacturing firms, but the technology required time to be developed at scale, often two to four years. This would require additional investments, bringing the overall project beyond the average VC fund’s life of seven to eight years.
Hence the manufacturing start-ups needed to look elsewhere for funding. They found it in Asia: Asian countries were willing to provide grants to attract these later-stage projects. The countries also provided guarantees in terms of demand. As a result, the start-up firms in the MIT study very often had no choice but to move production overseas.
This MIT case study encapsulates some of the weaknesses in the U.S. model of innovation. VCs fund the most promising businesses stemming from basic research conducted at universities and government labs. But there is a disconnect—and a critical funding gap—when it comes to domestic mass production of these innovations. Activist industrial policies or outright mercantile practices by other countries fill this gap, or exploit it, so that production moves offshore. The result is “jobless innovation” in the United States.
Further, as production moves offshore, so do the capabilities and skills required for production. The result is a thinned-out industrial ecosystem, including the loss of suppliers, skills, and the overall “industrial commons.” And as deep knowledge of the technology moves to the site of production, the ability to innovate going forward moves along with it. In other words, offshoring threatens future innovation.
There is an additional concern: many of the advanced technologies that America no longer manufactures or even has the capability to manufacture, such as flat-panel displays, are dual-use technologies, with both civilian and military applications. By forgoing the production of advanced technologies, the United States increases its military risks.
The good news is that there are possible solutions to this financing gap facing attempts to “scale up” in the United States. These solutions will allow Americans to not just to innovate here, but also to manufacture here.
Why the U.S. Venture Capital Model Does Not Support Advanced Manufacturing
“Through our VC industry, we have created this fabulous tool that supports innovation in software technology, and entrepreneurship,” says Bill Bonvillian of MIT. Bonvillian, who is the author of Advanced Manufacturing (with Peter Singer) as well as many other books about innovation policy, adds: “The problem is the method we came up with to bring new technology out, doesn’t fit sectors besides software, IT or biotech well.”
The MIT case study was no outlier: in general, VCs prefer to invest in the early stage of a project, which is low-cost, high reward, and which has a quick timetable for success, with five years or so of funding. Investments in software start-ups are ideal. In contrast, “hard” technologies that require manufacturing are capital intensive and can take a decade or more to evolve. Manufacturing can often require more than $50 million dollars up front for a plant and complex equipment, with many technological risks along the way. The costs are very high and so are the risks of failure. Building manufacturing plants simply doesn’t fit the VC financial model. (Biotech is a VC funding exception in that it is capital heavy and takes a long time to reach fruition. It has a unique regulatory structure, however, that makes it attractive to venture capital. As Bonvillian points out, the FDA’s clinical approval process allows VCs to carefully manage risk along the way, and patents for drugs that make it through this process protect returns.)
The U.S. venture capital system can point to amazing successes such as Google, Facebook, and Netflix—in fact the entire ICT revolution. But it falls flat when it comes to funding comparable innovations in manufacturing or manufacturing companies.
These financial realities are reflected in 2017 statistics from the National Venture Capital Association in terms of what was funded by sector.2 As the following pie chart makes clear, VC firms are focused on funding software. This sector accounted for $30 billion of deals or 35 percent of the total. Pharma and biotech received $13 billion in funding in 2017 or 15 percent of the total. In contrast, IT hardware accounted for only $2.7 billion in funding, a mere 3 percent of the total. Energy was even less, at just over $1 billion.
In the past, manufacturing start-ups could have turned to other sources of funding, such as IPOs or acquisition by a U.S. manufacturing conglomerate. But the IPO market has mostly dried up except for large, already mature companies. Meanwhile, U.S. conglomerates have themselves been broken up to focus on “core activities,” with manufacturing outsourced to Asia. Additionally, start-ups lack the collateral typically required for bank financing (try getting a loan to build a new factory in the United States in contrast to a new condo). And the capital requirements for manufacturing are much too large for angel investors or online crowdfunding........MUCH MORE
