An inconvenient sequel about startup subsidies

August 6, 2017

inconvenient-sequel-about-startup-subsidiesLast week’s piece about my contention that government subsidies for startups tend to be anti-lean in nature generated two almost diametrically opposed reactions. So here are some final thoughts about Lean Startup and subsidies, and then I’ll put the topic to rest for now.

On one end, a couple readers became defensive, questioning how I could even imply that France is not the best country in Europe to start a company by criticizing its subsidies. This reaction did not surprise me; indeed there is a small but vocal segment inside the French startup ecosystem who is convinced that France is the best place in Europe to start a company thanks to its generous programs of government subsidies.

Ironically, I too believe that France is a fantastic country in Europe for startups — and submit that it has become dramatically more appealing over the past decade — yet for different reasons. I would argue that the components that make France a fertile startup ecosystem are not its subsidy programs, but rather a whole host of other attributes, which I’ve discussed previously at length. Furthermore, I could cite a handful of co-investors with whom I have worked across Europe who could make a compelling case for Belgium, Germany, Holland, the Nordics, Spain, and the UK.

The other end of the spectrum of feedback to my contention that subsidies are anti-lean is probably best summarized by the following tweet from my partner Alex:

I agree with Alex’s line of thinking. Not only are subsidies anti- Lean Startup, but they can also create fatal conditions for entrepreneurs who readily accept government loan advances only to find themselves in dire straights 12 to 24 months later. I’ve actually witnessed this a lot. Entrepreneurs take as much up-front non-dilutive money as they can, develop a product which usually is fairly technology-intensive due to the constraints accompanying such subsidies, and then subsequently discover that there is no market for their product. At this point the startup finds itself in a quandary: it lacks product-market fit and faces a debt repayment schedule. Which VC in their right mind would invest in such a venture now ?

One of the most prolific forms of early-stage startup subsidy in France is something called the CIR, which stands for crédit d’impôt recherche. The CIR works essentially as a tax credit for R&D expenditures. Its intention of course is benign: to encourage companies to allocate time and resources toward innovative, research-intensive efforts. The consequence of the CIR in startups is that it makes it dramatically cheaper to hire personnel with engineering degrees. This phenomenon is not unique to France; Holland offers the WBSO, for example, and many European countries offer similar programs.

Beware the hidden costs of subsidies

For all of its benefits, however, the CIR is not devoid of costs, particularly hidden costs.

First, by reducing the effective cost of hiring engineers or personnel with advanced degrees, startup founders feel less constrained in such people, perhaps more than they actually need at the time. Or they pay them more, resulting in a subtle inflationary pressure across the sector. This is not a bad thing per se, but when you have a lot of engineers on hand you need to give them products to develop. Allocating a disproportionate level of resources toward product development at an early stage before the market need is validated is, by nature, anti-lean.

A second hidden cost involving the CIR pertains to future tax audit risk. Almost every growing company in France finds itself subject to a tax audit at some point. For the French tax authority, the CIR seems to be one of the top items on its audit checklist. The central thrust of assessment often investigates whether the claimed expenditures genuinely reflect actual research expenses. Remember, the CIR stands for crédit d’impôt recherche, in other words the ‘R’ in ‘R&D’.  It’s no secret that most startups in their R&D expenses tend to incline more toward development than research. So in the event of an audit, the startup must produce documentation from previous years clearly demonstrating that all expenses which were deducted under the tax credit do properly reflect research efforts. I’ve sat on boards of a number of companies who have successfully navigated such audits, but never without a cost: the time and distraction alone usually set back the company for months.

Perhaps the most pernicious hidden cost of the CIR  and similar subsidies is its opportunity cost. By spending 12 to 24 months developing a product which in the end the market will not pay for means that those 12 to 24 months were not allocated toward a value-generating activity.

In Chapter 4 of The Lean Startup, entitled “Experiment,” Eric Ries underscores the importance of answering four questions:

  1. Do consumers recognize that they have a problem you are trying to solve?
  2. If there was a solution, would they buy it?
  3. Would they buy it from us?
  4. Can we build a solution for that problem?

Government subsidies often encourage the startup to ignore questions 1-3 and jump straight to #4.

The allure of non-dilutive subsidies can be enticing when you’re a resourceful entrepreneur scrambling for whatever financing you can find. Be careful.

 

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posted in venture capital by mark bivens

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