Regulation

Why innovation needs regulation

A ban on advertisement of healthcare drugs on national television in The Netherlands. Free public phone calls in Singapore, just a one-time 10 cent connection charge. Mandatory health inspections in restaurants in North Carolina, with regularly updated door-posted scores. Those are great examples of how government regulations provides better quality of life to its citizens.

But in the United States we generally balk at any form of government regulation as if it is poised to erode the freedom we set out to create. It makes for good press to publicly support a free world and anarchy rather than the opposite. Being a freedom fighter is good karma.

Regulation is not an option, but a requirement
But regardless of government involvement our world is riddled with self-imposed regulations. We stop when pedestrians cross the road (regardless of whether they should), and show more respect to elderly than we are often given. We raise kids as best as we know how, and send them to the best schools we can afford. Most of us are decent people who respectfully comply to our individual interpretation of the definition of decency; a set of self-imposed regulations.

Regulations, self-imposed or governed, are the foundation of free-market principles (see our extensive coverage on free-market principles). And free-markets only function well when they stimulate or enforce behavior that builds transparency and trust, pulling in new participants and thereby allowing the marketplace to grow itself.

Everything in life is a marketplace (in the macro-economic sense of the word). And we have the option to growth those marketplaces based on a meritocracy, or create excessive walled gardens that, when the impact on our economy becomes too big, risks the enforcement of regulations by our government.

Innovation is a marketplace
In large part early-stage innovation in The United States is fueled by the investment dollars from Limited Partners (LPs), allocating their money to invest in the ideas of the entrepreneurs, using Venture Capitalist (VC) as their conduit and decision maker. In the marketplace of innovation the LP and the entrepreneur represent supply and demand with the VC acting as the arbitrator of the marketplace.

The preponderance of evidence makes for a lousy marketplace in which the VC acts as the Emperor with no clothes:

  • Less than 10% IRR of the venture sector in the last ten years
  • Few truly disruptive innovations are born
  • The number of entrepreneurs are declining (according to Kauffman, see attached chart)
  • The number of LPs and investment dollars are declining

The VC as the systemic risk to innovation
It is ironic that so many VCs who are vehemently against government regulation (and put their efforts at attempting to stave it off) actually are themselves the ones that aggressively use arbitration to regulate (with their peers) the restrictions that are put upon the entrepreneurs. They collectively set standards on deal intake, technology focus, valuations, syndication, geographical proximity etc., and allow for very little deviation that is inherent to a marketplace meritocracy.

Simply put, VCs are the ones that violate many of the free-marketplace rules (stay tuned for a detailed deep-dive) and prevent the innovation marketplace from prospering, thereby inhibiting the creation of disruptive innovation.

Why we need new regulations
Frankly, we messed up and we should be ashamed of ourselves.

Innovation is a crucial ingredient to our economy, as explained in my previous blog entry The Systemic Risk of Venture Capital. We need to remain at the forefront of innovation for our immediate benefit and how we set an example for (not arbitrate) the rest of the world. Innovation has a big impact on GDP growth and spirit.

We, marketplace participants and government should do our part in fixing the innovation marketplace that is so sorely broken. Our government should force VCs to exhibit transparency (one aspect of marketplace rules). LPs should do a better job of hiring VCs with relevant early-stage operating experience to create more trust. The integrity of the new marketplace we create together will improve the integrity and quality of entrepreneurs it attracts.

We are responsible
The point I am making is that every marketplace requires pretty much the same amount of rules and regulations to instill transparency and trust, no matter where you apply that marketplace. The owners of the marketplace, by virtue of their performance, get to decide how much of those regulations they can deploy themselves. Bad performance with big economic stakes is punished by government intervention.

So, rather than to discourage and blame the government, we as marketplace participants should instead re-install the support for free-market principles in innovation that promotes the meritocracy, spirit and entrepreneurial capacity that this country was founded upon.

Stop blaming someone else and join me in this effort for the sake of our global competitiveness.

 

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