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A few weeks ago I was meeting with a woman at Stanford.  She is a Visiting Scholar, from Kyushu University where she studies innovation in the Japanese automotive and semiconductor industries.

Over coffee at Bytes, she shared with me her model of innovation.  In it, large companies hire teams of researchers to develop new technologies and businesses–in other words, to innovate.  As with any innovation, sometimes they are successful, sometimes not.  But in her world, the best innovators are in large companies, and everyone else wishes they were in large companies too.

This is not my world.

And I’m not convinced it’s her world, either.  Maybe ten years ago.  But today Japan has plenty of innovative young companies, even if the culture has still not completely embraced entrepreneurial innovation.

I tried to explain the new model of outsourced innovation that has developed here in Silicon Valley, and spread around the world over the last decade. These days, large companies often encourage innovation among startups, wait to see which startup has reached some level of success, then acquires the technology, team, or company. While they may pay more, they are generally assured of getting a success. Many large companies that rely on innovation have in-house venture capital arms to help stay on top of innovation outside the company, and to facilitate the acquisition of successful technologies or companies.

We started discussing what factors a society needs in order for companies to leverage this outsourced innovation model.  In other words, how do you encourage a healthy entrepreneurial ecosystem?

Three Factors Encourage Entrepreneurs

In my experience, it comes down to three factors:

  1. Encourage big rewards for entrepreneurial success,
  2. Minimize the long-term negative impact on entrepreneurs when their company does not succeed, and
  3. Make it mechanically easy for people to start companies.

All of the policy debates, cultural discussions, incubator strategies and more come down to these three factors. Let’s look at each of them, and how they interrelate.

1. Encourage big rewards for entrepreneurial success

Entrepreneurs don’t start companies to get rich. They start them because they want to see a product or service come to market, or because they want to control their own destiny. However, they do need to see the possibility of large financial reward; without it, few people would take on the risks of starting a new company. To put this another way: the prospect of large financial gain is not sufficient to start a company, but it is necessary to do so.

The prospect of large financial gain is not sufficient to start a company, but it is necessary.

Entrepreneurs witness the success of their friends or peers or even complete strangers, and they decide to give it a try. Kill the opportunity for riches, and you kill the willingness of people to become entrepreneurs.  Nobody plays a lottery that never has any winners.

This can play out in many ways: high marginal or capital gains tax rates, investors who pound through terms that leave little for the founders, down rounds or dilution, the lack of exit opportunities, etc.  There are infinite ways to kill the upside for entrepreneurs, and plenty of well-intentioned policies have done so unwittingly.  But it’s vital to ensure that upside is still there, and remains enormous.

2. Minimize the long-term negative impact on entrepreneurs when their company does not succeed

The flip side of encouraging big rewards for success is to minimize the long-term negative impact when a company does not succeed.

The reality is that most startup companies fail. Very, very few are large financial successes, or even moderate technical successes. And this is a very good thing; if every company were a success, that would tell us we aren’t pushing the bounds of innovation nearly hard enough.

In any innovative endeavor, there is a fairly high chance that the innovation will not work. Starting a company has many risks: technical success, market success, the ability of the team to “gel” and execute, timing with respect to the financial markets and business cycles, and even regulatory risks. Yes, a good team can minimize those risks. However, if we are talking about true innovation (and not just “me too” following), even the best team cannot eliminate the risks.

Years ago, I learned about a survey of oncologists, which examined the survival rates of cancer patients. At first blush, you might expect that most cancer patients would want the oncologist with the highest patient survival rate. But it turned out that some of the very best oncologists actually have the very lowest patient survival rates. Why is this? Simple: because they are so good, they accept only the most difficult, most challenging cases. Routine patients can be treated by another physician. The result was that the best oncologists are working with a set of patients with a far higher base mortality rate than the general population of cancer patients.

Similarly, a crack team of entrepreneurs who take on the most challenging innovations are more likely to face failures than a mediocre team that simply follows the herd. To use a sports analogy: the best home run hitters also have the highest strike out rates.

So if we want to encourage innovation, we have to recognize this fact, and separate the failure of the company from the failure of the individuals who were creating it. In other words, we have to examine the actual performance of the founders to see if they performed well. Was the company’s failure due to failure of the management? Or simply failure in the innovation?

Obviously any founder would prefer to have their company succeed. And the company’s failure will undoubtedly create some hardship for the founders. But if that hardship is too harsh, it tilts the risk/reward equation too far, and no sane entrepreneur will want to take that risk. If the long-term penalties of failure are too harsh, the best entrepreneurs will find some other way to earn a living.

So what does this failure mode look like? In Japan, having been part of a failed startup can be career suicide. Nobody wants to hire someone who worked at a failed company. In addition to being shortsighted (since those people may well have some amazing experience they bring to the table), it has the effect of scaring people away from taking risks.

Other ways this can have an effect: forcing founders to take on too many personal guarantees so that they face financial ruin when the company fails, having a strong social stigma attached to a company failure, disallowing tax losses, etc.

3. Make it mechanically easy for people to start companies.

In many ways, this is the easiest factor to encourage entrepreneurship, and it is the one I see cited most often: simply make it easy for people to start companies.

This takes many forms. A good legal system that allows people to set up a company, issue cheap equity to founders and sell more expensive equity to investors. Setting up a company should take no more than a few hours to a day. The mechanics of issuing equity should be similarly straightforward. Issuing debt or other financing mechanisms should be no harder.

It also helps to have a community of experienced people around who can help the founders navigate this process the first time they do it.

Likewise, the easier it is to deal with all of the administrative overhead attached to running a company (payroll, HR, accounting, taxes, regulation, contracts, etc), the more time the founders have to spend on actually building the essence of the business. Forcing every company founder to jump through a series of challenging hoops just to create or run a business does nothing for encouraging innovation. Let the founders focus on innovating by having an army of people who can help them with the necessary overhead, lifting that burden away.

Bottom Line Results

It seems so simple to create a system that encourages innovation, and yet too few places have done it. If governments want to encourage innovation, they can do so. But even in regions where the government does not, there is nothing stopping a private company from creating these same conditions in an “incubator” or innovation center, and taking advantage of the results.