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Making knowledge industries a GO: Some commercial considerations

Le développement des industries de l’information,
vu sous un angle commercial
Risto Laulajainen

Resúmenes

Non-academic treatise, essentially based on information in commercial sources. Knowledge industries need ample financing to prosper but ignorance of the ways money is raised and used leads to excessive waste. Macroeconomic factors structure the locational preferences but are unreliable for ranking regions worldwide and even continentally. The underlying data may be unavailable, inaccurate, or culturally biased. Intellectual property rights are a core location factor but governments get interested only when their own industries enter the global marketplace. The multisectoral and many-layered factors become tangible in the competition of American and European pharmaceutical industries.

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Introduction

1In October 2002, a group of Continental economists got together at Uetliberg, on the outskirts of Zurich, to consider the role of financing in the success of new technology-intensive companies in Europe. Most EU countries were represented. At the end of the meeting the participants were urged to publish their ideas in a Workshop Report. Most complied (Thierstein and Schamp 2003). This author did not use the opportunity then and this belated view benefits from the work of others. The feeling during the discussions and reading the Report was that the approach was rather academic and did not pay enough attention to the raison d’être of new companies, high-tech or other, namely the desire to make money. This article tries to balance things. It begins by looking at the sources and sinks of financial resources intended to support new high-tech industries. It queries the whereabouts of such industries, or at least of the environment which is thought to be conducive for their birth and well-being. And it outlines, as an example, the diverging paths of the pharmaceutical industry in the USA and Europe. The approach is commercial rather than academic, reflected in the heavy reliance on the Financial Times and the absence of quotations to learned articles where much effort is spent on conceptual clarification at the expense of empirical facts. There is much anecdotal, even unreferenced material. It has accumulated over three decades and was never intended to be part of a formal treatise. Although unreferenced, it is no less true than, or is as true as, information from the media uses to be.

2Our interest is in new companies which are referred to as “high-tech”, or “knowledge industries”. With high-tech we mean telecommunication, multimedia, microtechnology (nanotechnology), biotechnology, automation, automotive and energy-environment. This is the list of the Innovation Teams of Deutsche Bank for its venture capital loans (Heimer 2003, 128). The areas of automation and automotive obviously also include technologies which cannot be called high-tech, and to biotechnology should be added pharmaceuticals which is a different although related industry. But these remarks belong to the small print.

Capital sources

3New companies, irrespective of their legal shape, need capital. The first capital tends to originate from the private resources of the entrepreneur, his/her family and friends. Thereafter follow banks, petty capitalists (“business angels”), mutual and investment funds, professional venture capitalists and insurance companies. The choice depends very much on the financial culture of the country, whether banking or market oriented. If banking oriented, the availability of risk capital may be poor because a new company has few tangible assets to back the loan, which the banker must, by law, ask for. It is not unusual either that in such cultures there is a general shortage of venture capital (VC), simply because it does not tally with the style of the country. But is not necessarily the case, because banks can establish VC companies to fill the void. Hedge funds, a special kind of investment fund, have an obvious appetite for risk although their investment horizons may be too short (Soros 1994) and domiciles too heavily clustered to be a dominant source (Fig. 1).

Figure 1 : Hedge fund assets in 2001

Note: Hedge funds are lightly regulated funds whose goal is to maximize absolute rather relative investment income. Their volatily is low and so is correlation with traditional asset classes. The minimum investment is generally $1m. The fund manager gets paid on a progressive scale but only when the fund makes a profit and accrued losses have been recovered. Total funds worldwide are estimated at $500-1,000bn or 0.5-1.0% of global financial assets. United Bank of Switzerland is the largest hedge fund manager.

Source: Thomson Financials, cited in Hall 2002.

4It is quite risky to invest in budding high-tech companies, even when managed by specialized funds. A fund manager is supposedly more knowledgeable than an average investor but she/he has many irons in the fire and a reputation at stake. Funds are easily identified by the dominant persons of the management teams whose performance is monitored with greater intensity and numerical zeal than football stars. A bloated ego can go to astonishing lengths in accepting risk and hiding it from chiefs and regulators (Gapper and Taylor 1996; Gapper et al. 1996).

Deutsche Bank had in the mid-1990s a London subsidiary, Morgan Grenfell Asset Management (MGAM). The subsidiary had, among others, three mutual funds with 90,000 investors and £1.4bn in assets, specializing in European companies. The fund manager was a high-tech freak and very knowledgeable in that field. High-tech investments in general were doing well and the manager intensified the funds’ involvement, particularly in new unlisted companies, valued at “manager’s reasonable estimate”. A brokerage and then an investment banking boutique were used for this purpose. All went very well as long as the boom lasted. When it turned, the manager decided to persevere. The valuations declined and the investment objects ran out of money. They had few or no sales and continued to be plain technological promises. It became necessary to support them by additional share purchases. Thereby the funds gained features of VC for unlisted securities, which received an excessive weight in the portfolio. That went against the MGAM internal and regulator rules which stated that a mutual fund can have at most 10% of the portfolio in unlisted securities and at most 5% in a single company. To hide matters the manager put up holding companies in Luxembourg and operated through them. The unlisted shares approached 30% of the portfolio when the matter surfaced and the manager was asked to restructure. Instead, he procrastinated by reshuffling holdings. By that time the matter began to unravel in the public domain, regulators intervened and the funds were suspended. To save MGMA’s reputation, as well as its own, Deutsche Bank bought the largely worthless investments for £180m. Investors withdrew an additional £100m.

5The final stage is that the company is sold, or its product or technology is licensed. It is here when the entrepreneur makes real money, if at all. The purchaser or licensee is normally a larger company which wants to get access to the incumbent’s expertise but has no time or other resources for its own development and invention. Many technology-heavy companies, such as Cisco, Intel, Microsoft and Siemens, have business units for screening interesting objects and evaluating their eventual purchase (Davis 2004). If it is not a sellout, alliance may do the job. Roche, the Swiss pharma company, screens more than 1,600 firms each year and, after a four-stage selection process, offers a deal for 5-10 of them (Jack 2005a). Another way to sell the enterprise is to convert it to a public limited company and offer the shares to the general public in an Initial Public Offer (IPO). This is the highest level of evolution because the company must be known to the investing community and there must be an interested bank to take care of the practicalities. Logically, IPO is more rare than a sellout, at a rate of one IPO against four sellouts. The sales revenue will probably be higher in an IPO than a private sellout, but the attached expenses are easily 15% of the proceeds.

6From the investor angle, listed companies are no panacea either. The theory is that listing on a regulated stock exchange will be a reasonable guarantee that the company is properly run, its published accounts are truthful, and its business forecasts are realistic. Unfortunately, the theory does not always hold in practice and the probability of misrepresentation is largest with new, small companies. The first trap is that these companies are weakly capitalized and lack a solid sales record. Therefore they are not accepted to the main list but to a special list intended for untried and risky firms. The name of the list varies, Alternative Market in London, Neuer Market in Frankfurt, Nouveau Marché in Paris, Mothers in Tokyo, and so on. If the company is high-tech, its true potential is very difficult to evaluate from the outside. Its fledgling sales will put directors under great pressure to keep the company afloat. If they err to unfounded optimism, it is only human. And occasionally the fantasy goes too far (Benoit 2003):

Neuer Markt listed a media company, EMTV. Business did not develop as expected but the directors did not lose the nerve. They forecasted a profit of DM600m in May 2000 but were compelled to revise it to DM50m in November. When accounts were closed, the loss was DM2.8bn. Market capitalisation reacted accordingly, falling from euro15bn to euro100m. Trading was suspended, the directors were charged with misrepresentation of the company’s financial health and found guilty. The verdict was exceptional because the German law of the day put emphasis on general rather than individual interest and the onus of proof rested with the plaintiff. Remarkably, not a single Neuer Markt civil law case, and they have been many, has succeeded in establishing responsibility for damage. Should that happen, damages were payable by the company and not its directors. The law will be changed but the harm has already been done. Neuer Markt got so bad a reputation that the exchange felt it wise to wind it down.

7Venture capital is the most often quoted capital source for new high-tech industry. The capitalists are heavily clustered around top universities and the research centers of large companies, and form a tightly-knit social framework (Waters 2005). The industry is highly cyclical and the cycles of fund raising and investing are mostly out of step with each other. VC investments during the most recent US cycle in 1997–2003 peaked at $100bn and bottomed at $15–20bn (Waters 2004a). The oscillation was larger than normal, due to the information technology (dotcom) frenzy. At the end of 2003, VC funds had an estimated $80–100bn looking for investment. The explanation is partly contractual, an investor cannot cancel commitment as it would be highly impractical for the VC industry to first raise funds and then return the surplus. The funds are invested somewhere but not at the attractive rate as was the original purpose. Attractive or not, the venture fund collects a fee for the trouble. This suggests that much of new high-tech investment is unprofitable. The large variance in performance has duly paved way to a new profession which tracks the performance of funds and advises about their selection. As an example, between 1990 and June 2003 the VC industry raised $195bn of funds. The best quartile got $20bn and returned $80bn in cash to the investors. The remaining three-fourths have so far yet to show a net return; although they may, as the maturing period of VC is long. The European experience is similar. About 100 independent VC companies were set up during the dotcom boom and most of them made big losses (Borgdorff 2004). It is easy to understand that a fund’s reputation matters and that the best of them can be very selective when accepting investors.

8The process works like this (Davis 2004; Firn 2003a; Waters 2004a). One year is used for raising funds. When the target has been reached, the fund is closed (no new investors accepted) and investing begins, hopefully in tandem with the investment cycle. There are two opposing philosophies, minimal administrative effort and risk spreading. The first takes large stakes in few companies and the second the other way round. The London City has appetite for big risks, but $3–15m per object is about normal. A fund investing $50m a year is already large and, this being the case, modesty is an obvious virtue. The investing phase takes 3–4 years and the maturing another 6 years. Thereafter the fund is wound down (investments sold) and the proceeds distributed. It means that ideas should promise quite a lot of money within a comparatively short time span to be attractive. Investors complain about the scantiness of information and difficulty in understanding during this, for them, lengthy period. Such worries are part of the game and the fund manager faces the same problem. The companies are unknown and so are their technologies, by definition. Bill Gates with his MS-DOS operating system was snubbed by an experienced fund manager and turned to IBM as a result (Davis 2004). The inventor is enthusiastic about the technology but has no idea of its commercial clout. But the venture capitalist knows from experience that management, marketing and energetic selling are more important than technology. Access to global rather than just national market is particularly important. The marketing mantra can lead to unexpected consequences. A layman perceives that risk capital is spent first and foremost in technology. Not at all. Dotcoms in their time used much of it in advertising. Easy come, easy go. It is indisputable, however, that managerial input can make or break the effort. Amgen, Genentech, Celltech and PowderJet were limping when private, but blossomed when in the hands of a professional management. This being the case, and the venture capitalist being the most likely person to provide the management, it is easy to understand the desire to be physically close to the investment (Zook 2002). A few hours’ driving time has been mentioned as a maximum (Kyrtsis 2003, 39).

9Company-funded research operates differently. As a manager located in Frankfurt and responsible for coordinating the European research effort of a multinational pharmaceutical company explained:

“I identify a promising researcher, perhaps at a conference, and give him/her a bag of money. He/she collects a team and goes to work. We monitor the work continuously. If it shows success we continue our support, cashflow permitting. If success is not forthcoming we discontinue support. The result will become manifest after a decade or so. One of our best teams right now is in Barcelona. Our worldwide research community will gather there next month, partly to honor their achievement.”

10The discussion has been conducted from the angle of private sector. But the public sector is also involved, particularly in Europe. It is quite usual that governments channel development funds through the banking system, Kreditanstalt für Wiederaufbau in Germany being a typical example. Their tracking can be complicated, however, because some banks are formally in the private sector although owned by the government, when the political wind blows from the left, and reprivatized when it blows from the right. Crédit Lyonnais in France is a well-known case. A less complicated although only partial picture is offered by the European Investment Fund (EIF) (Fig. 2). The largest beneficiaries are the largest economies. This is what can be expected. But there are small economies which have received amounts quite out of proportion to their GDP, specifically Finland and Sweden. We will return to that below.

Figure 2 : European Investment Fund VC portfolio in 2001

Legend: Pan = Paneuropean; East = East European.

Source: Dombey 2002.

The coexistence of private and public naturally leads to competition. EIF wants to be the prime investor and expects the private money to fill up the gaps. Private VC sees matters from a diametrically opposite angle (Borgdorff 2004). It believes that public money pushes private money aside and operates less efficiently because it is tied to a rigid timeframe. Private capital, by contrast, has considerable leeway to choose the proper moment. Therefore, why not let private VC take the first step and let public VC follow? Can that be the reason why projects backed by VC (assumedly private) in the USA are three times more successful than the rest (Geenhuizen 2003, 149; citing Kortum and Lerner 2000)? Or are private investors so much more skilled than the guardians of public money? In balance, there is enough VC in Europe for new technology companies. The problem is not money but that these companies are too few. There is no lack of promising ideas and technologies either, but they do not get molded into viable companies. There simply is a gap between professor and entrepreneur, in sharp contrast to the USA. This leads us to a wider question: why are the differences between countries so large and where are the hot spots?

Spatial angle

11It is generally acknowledged that high-tech or knowledge industries rely on education, networks and appropriate infrastructure. This generalization is very high level, international if not worldwide. Nationally, the activity is catalyzed by demand, express or dormant, manifest in problems crying out for a solution. Once a solution is found, it is time to think about exports. The problems may originate from the society at large, as in healthcare, or daily economic activity, prompting key employees to establish their own companies and putting existing skills to new use in a related activity, as is the case in Swiss watch and medical equipment industries. Ensuing clustering allows economies of scale in infrastructure and support services, which ameliorates diseconomies arising from congestion. Amenity factors naturally play a role. Inventors follow their living preferences, close to their roots, or in intellectually attractive and scenic locations. Companies and investors will follow. These general principles are easy to list. Their consistent measurement and conversion to a rating scale is something quite else. It is worth trying, however.

12Huggins Associates uses 19 variables, collapsed into five composites (Huggins 2004a, 8):

Composite (no of variables)

Contents

Human Capital (7)

employment/capita in key sectors

Financial Capital (1)

private equity investment/capita

Knowledge Capital (3)

R&D/capita, patents/capita

Regional Economy Outputs (3)

labor productivity, earnings, unemployment rate

Knowledge Sustainability (5)

education expenditure, Internet variables.

13The empirical data is normally available by province. When a province happens to coincide with city boundaries, it is possible to descend to that level. That applies only to large cities. Knowledge industries seldom dominate these “regions”. It follows that the data is contaminated by large amounts of noise which has the capacity to distort measurement.

When Finns had recovered from their surprise in the best years of the Nokia saga and started analyzing the phenomenon, a critical commentator reminded that the “Finnish” high-tech research in telecom could be found in a city block in Helsinki, brimming with foreigners who enjoyed a special tax regime. That was an exaggeration but sufficiently true to be couched.

14Many of the variables are coarse tools. Employment statistics are unlikely to differentiate the key scientific workers from support personnel. Applied research (development work) is a far cry from the original (scientific) variant. When a monetary indicator is used, what does it actually include? From a company’s perspective, acquisitions may be part of the R&D budget in disguise. Private equity investment overlooks public funds and the use of internal resources. There are countries where the concept does not exist but where funding, nevertheless, is no problem. Labor productivity is a bone of contention between economists. Much of the difference between the USA and Europe is reportedly due to retailing, hardly a relevant variable in a high-tech context. All remuneration is not cash and need to be converted to cash equivalent. Cash should be scaled by its purchasing power and rates of exchange. The sheer availability of goods and services may be an issue. Available evidence suggests that pharmaceutical tests cost in India 15-20 % of what they cost in the USA, whereas in software development the percentage is 50, broadly in line with differences in salaries (Cookson 2005b). Unemployment is a politically loaded issue and any figures are likely to be manipulated. Education expenditure and the volume of output can be measured but hardly its quality. But in high-tech it is quality that matters. The implicit assumption is that most of the educated will not emigrate, which often is untrue. At least one-quarter of Indian IT scientists do. Foreigners account for one-fourth of the US science and engineering laborforce and in computing the share is one-half. China and India are particularly well represented (Florida 2005). How much do these shortcomings, and others unidentified, distort results? Nobody knows. It is helpful, however, that there are 25 identified and statistically significant correlations (r = 0.20 to 0.74) with correct signs between the variables, based on 125 regions.

15To be usable, the variables must be collapsed to a one-dimensional index. This happens in a three-phase process (Huggins 2004b). First, each composite is factor analyzed and varimax rotated with one or several factors per composite as the output. Each region has a score on each factor. Second, composite scores are handled with an iterative linear programming technique (Data Envelopment Analysis) which maximizes their weighted sum on condition that the sum of each region is within the range 0–1 in that composite. Finally, a geometric mean is taken from the sums to arrive at an overall score. The regions are a judgmental sample, presumably selected to shed light on the most important players in the world of knowledge, globally and nationally. Regions probably scoring high have been sampled more thoroughly than those scoring low. The sample obviously reflects the availability of data. This should not be forgotten when interpreting the results.

16Specifically, there is not a single region from Russia, Brazil, and South Africa. Yet, Russian excellence in high-tech is unquestionable. They were the first in space. Quotes a German source (Asendorpf 2005):

“When a space agency from Western Europe is on the lookout for a new device for space use, the Russian partners pull from the drawer a ready blueprint. .... It contains no fancy electronics but the robust mechanics works.” [it is also resistant to nuclear explosions; our comment].

17Their largest libraries in St. Petersburg and Moscow are on a par with the Library of the Congress in Washington, DC, as is Novosibirsk (and Beijing) with Harvard (Aïssaoui 2005). The Sukhoi-30 fighter, flown by Indian pilots, won 90% of dogfights with American-flown F-15 in a joint exercise in India (Spiegel 2004). Brazil recently sold its Embraer airplane to the US Army for surveillance purposes (www.embraer.com 2004). South Africa has perfected the century-old Fischer-Tropsch technology for converting low-grade coal to liquid fuel and is now offering its expertise for sale (Degli Innocenti 2004). Are these feats high-tech or not? The question is not ridiculous. Three decades ago, this author followed a group of logistics managers to Washington, DC. Some participants went to the Smithsonian Institute to see the first US spacecraft, and returned somewhat puzzled:

“There is not a single technical solution which we would be unaware of. No, but they are joined into a system in a very ingenious way.”

18Few academics would risk their careers by claiming that spacecraft are not high-tech. Logically, these countries should be represented somehow. They may be secretive to an extent, but something is certainly available.

19The scores of the 125 regions are approximately normally distributed (Fig. 3). The two best regions (including Silicon Valley and Route 128) have scores exceeding 200 and the 12 worst have scores below 30. It is a thought-provoking range, recalling that the human intelligence is the same everywhere and that differences in its use by knowledge industries depend on the society. On closer inspection, the distribution is only approximately normal, however. Actually it is biased to the right, there being fewer high scores than low scores. Inserting a limit at 170, we get a second tranche of next-best regions, 13 in all. At the lower end, a similar interval (to 60) gives 15 new regions. But it is reasonable to assume that many similar regions have been overlooked because they would contribute very little to the ranking of top countries. There is another noteworthy feature. In the two highest tranches there is only one non-US region, viz. Stockholm, whereas the two lowest tranches include predominantly Asian (non-Japanese) and south & east European regions. Do Americans really have so clear a lead over the rest of the world, or is the index culturally biased?

Figure 3 : Histogram of the Knowledge score in 2003

Source: Huggins 2004a, 12.

20A holistic mental view can be created by putting the regions on map. Because 125 regions are too many to be handled conveniently in journal cartography two techniques are used. First, a global map gives the average score by country or world region, henceforth called macroregions (Fig. 4). Second, only the best region in a country is given and only in Europe, which was the topic of the Uetliberg meeting (Fig. 5). Some comments about other continents are offered, however.

Figure 4 : Average Knowledge score by macroregion in 2003

Note: The macroregions are Scandinavia, Continent, Pacific Rim (Singapore, Hongkong, Taiwan, South Korea) and Anzac (Australia, New Zealand). Israel is the only country in Middle East. Ontario given a score of 100.

Source: Huggins 2004a, 12.

Figure 5 : Knowledge score of best region by country in 2003

Notes: The markers are approximately where the best region is located. Eastern Europe (”Czech”), Denmark, Norway, Slovakia and Switzerland have not been disaggregated geographically.

Source: Huggins 2004a, 12.

The average scores confirm what is thought to be the accepted pecking order in knowledge industries: the USA leads, with Europe and Japan competing for the second rank. The developing world follows far behind. What may be a surprise is the size of the gap between the USA and its closest contestants, 50 points or about the same as between the Pacific Rim and India. This picture, based on averages, may suffer from the fact that a different percentage of high-tech regions has been included in various macroregions, or that smaller countries have not been properly disaggregated, or that some of the regions selected have no high-tech, or that some obvious choices have been omitted. Some examples of this will be discussed. Toronto, for example, is not among the Canadian regions, an obvious slip. We have given it a score of 100, to be compared with Montreal’s 75. France and Belgium have the same number of regions, namely two, irrespective of the difference in size. The largest French research cluster after Paris is Grenoble (Isère), famous of its microelectronics, rather than the departement of Alsace (Hallinger 2005). Luxembourg is an important place for financial services but unknown as a high-tech location (Pieretti and Bourgain 2003, 23). Sweden has four regions, of which the province of Småland is known for its vibrant small industry. However, the country’s high-tech is very clearly concentrated in the three university clusters of Stockholm-Uppsala, Lund and Göteborg, of which Uppsala is missing (Waxell 2005). Germany has ten regions covering all of the former Bundesrepublik, whereas the UK has only four. The obvious explanation is Germany’s federal structure which offers a denser statistical mesh. But one can ask whether Bremen and Hamburg, two port cities, qualify as high-tech locations. The Airbus fuselage is built in Hamburg but assembled in Toulouse, which is not included. Denmark, Norway and Switzerland, among others, are not differentiated geographically. It may be defensible in Denmark, where Copenhagen is dominant. It is less true in Norway, where Trondheim with its university of technology offers a counterweight to Oslo. It is clearly incorrect in Switzerland, where high-tech clusters are in close proximity to each other but technologically different and where cantonal statistics are easily available (Dümmler 2003, 166–169). The prefectures of Shiga and Toyama in Japan appear to be out-of-place. The former is a scenic area around Lake Biwa with no large cities and, in Japanese terms, modestly high-tech. The latter is located on the west coast, was known for its pharmaceutical industry in the early Edo era, and has now a modest technology park (Park 1997, 145–146). In short, the index can be upgraded by subjecting the regions to strict scrutiny, routine geographical groundwork.

21The shortcomings of average figures can be partially remedied by looking at each country’s top region only. We focus on Europe because it is familiar for us (Fig. 5). The low scores of the southern and eastern Continent have already been commented upon. To this can be added the fact that Poland, Portugal, Greece, Balticum and Balkan are completely “empty”. Their large primary sectors combined with smokestack industries is the off-hand explanation. For various reasons they have not yet reached the beginning of the high-tech track. Slovakia’s inclusion can be traced back to its capital, Bratislava, a Vienna suburb in Austro-Hungarian times. The interesting observations are found in the western and northern parts of the continent. The most conspicuous objection against the results are the high scores enjoyed by Finland and possibly Sweden. Finland smells of Nokia, which is misleading. The company’s rise was very much due to the liberalization of the European telecom market, the early adoption of handsets in Scandinavia, and the good luck to have the GSM technical standard in place when it was generally accepted (Häikiö 2001, 271). Nokia’s research, however, qualifies best as applied. Sweden is a more complicated case. The current champion in mechanical engineering is probably the JAS fighter plane which, judging by the weak sales record, seems to trail competitors. Ericsson is proud of its telecom research but no technological breakthrough has been announced for some time. The applied stamp is obvious. The sharp edge is preferably in pharmaceutical research (with medical equipment) in which the country excels (Barnes 2001). That urges comparison with the UK and Switzerland which are also cradles of the pharma industry. Neither one scores even close to Sweden. Can it be true that Stockholm outdistances the great English universities and research centers with their Nobel laureates so soundly? Most unlikely. It can play even and possibly rank first, but not with the displayed margin.

22If the best regions rather than averages are a more truthful representation of a country’s ability to compete in knowledge industries, then they should also function as magnets for attracting funds: better competitiveness = more funding. That hypothesis must be complemented by another: large country = more funding, for obvious reasons. VC funding from the EIF is available for testing the idea (Fig. 6). The large countries include Germany, France, UK, Italy and Spain. The two variables are from different years but this can hardly destroy the comparison. Indices dated for a certain year normally rest on data from close-by previous years, and EIF funding is the accumulated portfolio rather than loans made during one year.

Small countries

Large countries

Figure 6 : EIF VC portfolio in 2001 as a function of Knowledge Index in 2003

Sources: Dombey 2000; Huggins 2004a, 12.

23The idea holds for the large countries but not the small ones. If the two mavericks, Finland and Sweden, are excluded, the remaining plot outright disqualifies the hypothesis. But since the funding comes from a public source, a general connection cannot be ruled out either. Private funding picked up the gems and left the frogs to public funding. It does not help to consolidate the two hypotheses by adding a dummy (small = 0, large = 1):

EIF = 11.867 + 0.400 Index + 188.2 Large;

R-sqr (adj) = 0.88; SEE = 33.9

24R-sqr is high, SEE is acceptable, residuals are within one standard deviation, but the Index-coefficient is not statistically significant. In other words, the level of knowledge is not decisive for receiving public knowledge funding in Europe.

Intellectual property rights

25The Knowledge Index contains a variable for the number of registered patents per million inhabitants. Patents are granted for tangible discoveries which must be “new, innovative and useful”. Copyright, design right and trademark protect intangible creativity. Patents and trademarks are registered, copyrights and design rights are not. The overall concept is intellectual property rights (IPR). IPR is a fundamental concept; if inventors, writers, composers and supporting entrepreneurs anticipate that their work is available for anybody to grab without compensation, they may never initiate the effort. When discussing knowledge industries and their financing, it is worthwhile to consider what the IPR means geographically. The assumption then is that the applications are recorded by the country of origin.

26We focus on patents because data availability is best there. The number of annual applications in the three major areas is approximately: USA 170,000, Europe 160,000 and Japan 350,000 (Gapper 2005; Pilling 2005; Tait 2005). The figures hide as much as they disclose. The US figure includes patents for software and business methods which are not yet patentable as such elsewhere. The European figure refers to bundles of mutually equivalent national patents although they still must be challenged in the country of origin. Understandably, the European patents are only a subset of the national ones. Japanese are more keen to seek patent protection than Americans and Europeans, partially to ringfence a competitor’s key patent by numerous own ones. The country is strong in electronics, where patents are much easier to come by than in life sciences, which are weakly developed over there. But most importantly, frequencies do not weigh the quality of underlying innovations, although it is plausible to assume that the number of patents correlates with the excellence of research.

27Therefore, we use the Knowledge Index as an argument for explaining the number of applications filed with the World Intellectual Property Organization (WIPO) within the Patent Cooperation Treaty (PCT). The exercise comprises only the 28 countries for which the Index is available, out of the about 100 which filed a total of 120,000 applications in 2004. This data set obviously includes a large percentage of really important applications and is therefore well suited for international comparisons. The USA and Europe maintain relative positions whereas Japan is reduced to one-half of their size (Fig. 7).

Figure 7 : PCT international applications in 2004

Notes: Minimum 1,000 applications. No information about Hongkong and Taiwan.

Source: http://www.wipo.int/​edocs/​prdocs/​en/​2004/​wipo_pr_2004_375.html; as of 22 August 2005.

28There are two ways of how to use the Knowledge Index, the highest country score alternatively the country total of individual scores. They both lead to very similar conclusions. We use the highest country score. USA, Japan and Germany, the largest applicants (Top), differentiate very clearly from the rest. When they are excluded, France, UK, Netherlands and Korea comprise another distinct group (Mezzanine). Thereafter, Switzerland, Sweden, Italy, Canada, Australia and China can be taken apart (Medium) from the remainder, headed by Finland. The groupings have some evolutionary logic but are far from being the only possibility. For descriptive purposes it is rational to keep the Top group separate and differentiate the Mezzanine and Medium groups with the help of dummies. The regression equation then becomes:

PTC = -18 + 8.830 Index + 3703 Mezza + 1414 Medium

R-sqr (adj) = 0.94; SEE = 393; n = 25.

Top group alone

PTC = -1919 + 169.52 Index.

29All coefficients are statistically significant at lower than 5 % risk.

30The interpretation is that excellence as such contributes to the number of internationally worthwhile patents, but given the same ceiling of excellence there still are substantial differences between countries. A country’s industrial structure has a bearing there. So does the efficiency of its research because the number of PCT applications divided by the Index leads to large and often unexpected differences between countries. But the sheer magnitude of effort may not, because the use of the country total score makes only a cosmetic difference.

31Research leading to patent applications benefits from a supportive legal and business culture. Its existence depends much on cultural values at large but it is the job of goverments to give these values a suitable infrastructure by enacting legislation, overseeing the impartiality of courts and enforcing their judgements. Governments are also instrumental in creating a skilled workforce. There are considerable differences between countries and consequently their attractiveness as research locations. To makes things commensurate, Intelleigen Legal Llc., a Singapore-based law firm, has in consolidated 400 variables, mostly dummies, into an IPR Index (Skröder 2004). The index has three sections, each with three components:

32Infrastructure

  • IPR legislation and its enforcement

  • Government commitment

  • Support for technology transfer

33Market

  • Size and affluency

  • Fairness towards foreigners

  • Government incentives

34People and culture

  • Labor skills and literacy

  • Readiness to share ideas

  • Public awareness of IPR

35Countries are evaluated along the variables and scored by section on a –10 to +10 scale. These subscores are then averaged to an overall score. So far, the index is available for the USA, Japan, Singapore, India and China (Intelleigen 2003). The USA ranks highest with a score of +6.84 and China lowest at –3.25.

36This looks familiar. The Knowledge Index average also places the USA at the top and gives China a very low score. The comparison can be developed further by plotting the available country scores in the same axis of coordination (Fig. 8). An almost straight line emerges. China is actually the only maverick with a considerably lower IPR score than its Knowledge score would warrant. In other words, it looks like being the current black sheep of the IPR world. One maker of advanced microchips opted to locate the production in Morocco rather than China, one-third higher cost notwithstanding. The reason was poor patent protection. It admitted, however, that design secrets are difficult to protect anywhere in “Asia” (Marsh 2004). All are not so sensitive. General Electric has one of its four global R&D centers in Shanghai (another in Bangalore), not because of the low salaries but because of the talent and the market. (Swanson 2005). Motorola and Nokia have followed its example. Of course, there are gradations. Japan, being in the current frontline because of its high level of knowledge and proximity to China, prefers to keep its core technology at home (Pilling 2005). A still more drastic measure is to abstain from patenting altogether. Coca Cola is is the classical example of this strategy.

Figure 8 : IPR score as a function of Knowledge score in 2003

Sources: Huggins 2004a, 12; Intelleigen 2003.

37Precautions notwithstanding, things can get crooked in an unexpected way. Pfizer Pharmaceuticals saw the patent granted for its Viagra pills by China’s Intellectual Property Office overturned at the request of 12 local competitors. The GlaxoSmithKline diabetes drug Avandia faces a similar challenge (Matsukata 2004). It is one thing that authorities turn a blind eye to patent infringements or delay legal proceedings, and something else when they overturn patents already granted for products which have been found “new, innovative and useful” in many other countries before them. Has China an agenda of its own, or does it only imitate South Africa’s example about Aids drugs (Pilling and Degli Innocenti 2001)?

38India, although rated lower than China on the Knowledge Index, has a better record. The actual protection may not be so much different, but at least there was a clear, although oldish, philosophy. The patent law, as it was in 2004, granted protection to the production method but not the molecule. It meant that Indian companies could copy molecules that were foreign and manufacture them at will but they could not copy the production methods of domestic companies (Dyer 2004c).

The old perception is that all molecules (and elements) already exist and the only trick is to identify and manufacture them. Modern chemistry has radically changed that and up-to-date patent laws are first and foremost occupied with molecules. Not entirely, however. Sanofi-Aventis, the French–German pharma company, is in the midst of a heated patent litigation which involves the separation of molecule isomers (mirror images), the one healing and the other not, and their salts which profoundly affect solubility and consequently the ease of production (Dyer 2004a).

39The Indian law has been changed as from 2005 which augurs for a policy change, from generics to licensing and further to original research. (Merchant 2004; Merchant and Dyer 2003).

40China’s low IPR score will not last forever and it is by no means a unique case in the IPR history. USA has been characterized as a “pirate nation” in terms of international IPRs in the 19th century and its change of heart may have come as late as in the mid-1980s (Knopf 2005). Japan had the same image in the 1960s and beyond. A 15-year-old anecdote is revealing:

A US company found a Japanese competitor infringing its patent and filed a suit at a Tokyo court. The case somehow vanished from the agenda but surfaced after a decade or so. Yes, it had been an infringement, the court found, but since the patent time had expired there was no point to decree punishment. The case was thereby closed.

41Today, Japan is a stalwart of patent protection and an ardent critic of Chinese practice. Its own legislation is excellent but the enforcement, particularly in copyright and trademark matters, is still wanting. There is a shortage of competent judges and lawyers, and punishment meted out to offenders is too lenient in relation to the felonious economic rewards (Intelleigen 2003, 4). Apparently there is room for a new “theory” stating that the level of patent protection for foreigners is directly related to a country’s ability to launch its own patentable products in the international marketplace.

Pharmaceutical industry

42The pharmaceutical industry is in the midst of much knowledge-related debate and patent controversy. It is a large industry, with sales revenue of about $420bn in 2003, which also includes some medical equipment and healthcare products. For comparison, the global chips industry makes $160bn (Foremski 2004). Pharma is also a very varied industry because the human body is varied, with the ten largest product groups making up only 31% of the total sales revenue (Bowe 2004a). Variance has helped to keep the industry commercially fragmented, the largest company, Pfizer, garnering only 5–6% of the market. Consolidation is under way, however.

43Europeans (roughly British, Swiss, Germans, Swedes and French) used to be comparatively successful in pharmaceuticals, relative to the USA. Americans excelled in space travel, computers, Internet and possibly nanotechnology, and Europeans in life sciences. That is history, however, as Americans have also taken the lead in pharmaceuticals. First came Nobel laureates, most of whom have been based in the USA for the past 20 years. Industry followed. Global pharma companies conducted 50% more research in Europe than America in 1990. By 2001, the tables had been turned and their research in America exceeded Europe by 40%. European pharma companies had about 70% of their research at home in 1990, but only 60% a decade later (Dyer 2004b). How else, one half of worldwide industry sales and three-fourths of profits originate from the USA (Bowe 2004b).

44The accuracy of such figures is relative, of course. The selection process of Nobel laureates is subject to bias. Contributions in scientific journals vary in quality, So does the commercial value of patents. There are not too many drugs selling for more than $1bn a year worldwide, or reaping 500,000 prescriptions a month on the US market. There are quality differences in the PhD examinations. About 90,000 European medical scientists work in the USA and they are certainly not the last quartile of the profession. Their staying power probably depends on exchange rates, business cycles and the schooling of their teenage children. Differences in job roles also hamper payroll comparisons. A European researcher benefits from supporting laboratory personnel, whereas in the USA she/he will shoulder much of the routine work her/himself. The overall picture is undisputed, however. When Novartis, a flagship Swiss pharma company, moves its research headquarters to Boston, MA, alarm bells should be ringing in Brussels (Dyer 2004b). Why are Americans so successful and Europeans such underdogs? The answer must be sought after at many levels: society, government, industry and labor.

45Society. The most fundamental characteristics which differentiate Americans from Europeans is their willingness to take risks, their inclination to unconventional thinking, and their fascination of novelties. That must be in the genes. Venturesome individuals who did not fit in the rigid class society, religious dissidents among others, boarded ship and sailed to the New World to mold their own destiny. ”Or those who did not have a job”, as an American colleague quipped in response. Well, that too. The rest stayed onshore and waved them goodbye. Citing (approximately) Pyotr Kaplitsa, the Soviet mathematician, in a letter to Mr. Brezhnew:

“Of course, the dissidents are troublesome. They are not content with existing structures. They question and challenge them. They propagate for changes. They kick over the shaft. But, Comrade First Secretary, you do not win championships with workhorses.”

46Having crossed “the Pond”, the settlers found a new world. It was important to have an open mind and adapt to new conditions. Success and even survival depended on that. This frontier world is a thing of the past but some of the spirit remains in the national psyche.

47But how to measure curiosity and risk aversion in a pharmaceutical context? Attitudes to stem cell research might be one possibility (Sullivan 2003). Europeans hesitate. Americans are badly divided. Should the federal government contribute to its financing or not? Mr. Bush Jr., the incumbent President, was against and Mr. Kerry, the challenger, was for. Only Asians are not bothered and scientists in Korea, China, Singapore and India are already making a mark in this line of research (Cookson 2005a; 2005b).

48Genetically modified crops (GMC), formerly called “hybrid”, offer perspective from the 1950s. The world population had reached the 2 billion mark and was growing. With war memories fresh in mind, many, including Bertrand Russell, wondered whether so many people could be nourished, particularly in India where famines were regular and which was part of the Free World. One proposal to solve the looming catastrophe was to make artificial protein, a gelatine-like pasta which provided calories but was no gastronomic breakthrough. Another, ultimately winning proposal, was to develop a high-yielding, disease- and drought-resistant cereal with a short, sturdy stalk which would not be beaten flat by rain. Since corn/maize was a staple food in the most exposed countries, and possibly for genetic reasons also, it got most of the attention. Critics raised ethical doubts because the benefits would accrue to large cultivators who could afford the seeds and necessary fertilizers. Their forecast proved correct. That was not allowed to thwart efforts which have been very successful and are still continuing. They rested initially on modest genetic modification, the technique then available, to speed up conventional plant breeding at agricultural experiment stations.

49The methods of modification have become more sophisticated since then, and apparently more frightening. Global famine has yielded media space to other horror scenarios, health hazards in particular, and ethical activists are in full swing. Whether their vision will prove correct a second time is beyond this author’s judgment. But the outcome of their work is there for everybody to see (Fig. 9). There are only few countries where GMC have a worthwhile acreage. The USA leads, partly because Monsanto, the St. Louis-based chemical company, spearheaded the development. Canada follows with a lag. Argentina has fully adopted the idea. Brazil followed suit recently. China is strongly compelled to try the concept. Its population continues to grow and the sprawling cities destroy much of the best agricultural land. The trigger, however, was not lack of food but pesticides which were spread by hand on small cotton cultivations and constituted a significant health hazard (Dyer 2005). Today, two-thirds of its cotton crop is genetically modified. Europe is the large absentee. Its anti-GMC lobby is very strong and aggressive, and governments hesitated for long. Did it matter? The cat was out of the bag anyway and has, by now, arrived in Europe, too. Hopefully, the continent did not miss the train.

Figure 9 : Genetically modified crop acreage by country in 2003

Source: www.isaaa.org/kc/bin/ESummary/index.htm. 2005; as of 30 March 2005.

50It is the biotechnology train, carrying GMC, stem cells and much more. The global biotech industry was estimated in 2002 at 600 public and 3,700 private companies, with more than $40bn of sales revenue. The US share of revenues and new funding was roughly 70% against Europe’s 20%. The magnitude of US leadership is very disconcerting because biotech is increasingly the source of new drugs. But hostility to biotech is a fact of life in Europe where nobody has yet ventured an IPO (Dyer 2004b; Firn 2003a; Rathborne 2004).

51Government. Governments occupy a key position because they initiate laws and oversee their enforcement. A government ban on research cannot be braved head-on. But governments also encourage innovation by creating and administering IPR. And they can be exceedingly supportive when a national interest is identified. Singapore has realized its overdependence on electronics and is diversifying into the pharmaceutical industry (Burton 2002). It uses the conventional levers, investment in research facilities and education, funding of start-up companies, local and foreign joint ventures. The budgeted funds are S$2bn. It might also become an international center for clinical tests because of its multi-ethnic population and excellent medical records.

Ashkenazi Jews and Icelanders have became famous in a similar, although not identical, context (Machlis 2001). Both are genetically very homogenous which offers a fast route for finding an errant gene which causes a certain disease. Icelanders can in addition boast about genealogical records that go back to medieval times.

52Will that be sufficient? The spirit of innovativeness and entrepreneurship in Singapore has been suffocated by decades of governmental stewardship, and the culture in general is unwilling to accept failure, an integral ingredient of frontline empirical research.

53Government is instrumental in setting the prices of medicines because a large percentage, up to three-quarters of the total bill, is reimbursed through the social security system. It is difficult to be precise in countrywide comparisons, however, because of the practice of requiring percentage discounts as from the second market year and the fluid policies towards generics which are much cheaper. There are also strictly commercial discounts initiated by producers and distributors. The balance, nevertheless, appears to be that prices, including generics prices, are higher in the USA than Europe. More than that. Government needs time to make up its mind about a decent price level and the time spent for deliberation is longer in Europe, up to one year (Dyer 2004b). That matters when we recall that the patent time is 17–19 years and that the average time from laboratory to market is 12 years. That does not leave too many years to earn the investment, say $800m, back and make a profit. A successful product should also cover the cost of the 10,000 leads which are laid down at various stages before they reach the market (Anonymous 2000). When a successful medicine sells for $1bn a year and a superstar like Lipitor (cholesterol) or Losec (ulcer) sells for $8bn and $6bn, respectively, at the top of the product cycle it is easy to understand the need to speed up the process and kill as many frogs as early as possibly, preferably before the expensive and time-consuming clinical (patient) tests.

The US authority which sets the prices reimbursed by healthcare programs has a federal mandate and its decisions apply nationally. In Europe each country has its own routines. It means that prices for the same product often differ, exactly as their trade names differ. This leads to unauthorized parallel trade on a continent where customs duties and other monetary trade barriers have largely disappeared. The flow goes from low-price to high-price countries and comprises 5–25% of the market, depending on the drug and country. The USA faces the same challenge, but only from Canada, which makes it easier to control. The activity is in the hands of trading companies and pharmacies and does not benefit consumers (Bowe 2004; Dyer 2004b; Jack 2005b).

54Industry. Competition is much keener in the USA than Europe, and selling is more aggressive. The market is also more integrated, meaning that there are no semi-protected corners where a newcomer can test skills. If the entry is regional and a serious threat to established interests, the wings are clipped by regional discounts. If it is national with focus on general practitioners, a sales force of at least 2,000 is needed to cover the market, which becomes expensive (Mattei 1996, 64). Do recall, there are still no revenues to balance scales. Expenses can be kept down by limiting the effort to specialists and hospitals but the full potential of the market is then not used and patent time is lost. These segments are also less thinly spread than general practitioners, which raises travel costs. The standard solution, therefore, is that distribution is outsourced to an American company which does not have a competitive product. How the proceeds will be split depends on the negotiating strength of the partners. It may happen that the European share is a paltry 10% (Mattei 1996, 67). Indirectly that means that a European product must be much better than an American one to get the same sales backing, which is reflected in the higher sales revenues of American companies. In short, it is more difficult for Europeans to penetrate the US market than the other way round. At the end of the day it means that there will be less internal resources for inventions and product development.

55Europe’s political fragmentation also indirectly plays in, and now we come to financing. There is no single marketplace for listed budding companies, in the way Nasdaq is in the USA; there are several. Originally, there were four of some significance, but after Neuer Markt was closed only Alternative Market, Nouveau Marché and Easdaq, a Nasdaq offshoot, are left. Their small size restricts the size of share issues and negatively affects liquidity. Biotech does not have even this opportunity because there are no listed companies. Without sufficient financing, companies become easy prey for American acquirers (Firn 2003b). A vicious cycle is created. More than that. American VC companies are led by seasoned entrepreneurs as contrasted with investment bankers and consultants in Europe, an apparent competitive advantage (Hickey 2004).

56Labor. As pointed out above, qualified labor for high-tech industries is comparatively mobile. It is almost axiomatic that it is attracted by high salaries, low taxes and pleasant environments. It may be impossible to generalize about environment. The USA and Europe can both offer a wide variety of cultural, educational and scenic environments, as well as lifestyles. Linguistically, it may be easier to move in the western than eastern direction. Taxes are thought to be higher in Europe, best reflected in the share of public employees in the labor force. Their split into income, property, real estate and sales taxes blurs the picture, however. As do special tax regimes designed to attract skilled labor in short supply. Tax progression for nationals is much higher in Europe and that weighs scales in the USA’s favor because high-tech labor is more expensive than average. It is also less dependent on the social benefits attached to high taxes than population in general. Some of these benefits gain importance with age when the inventors of pharmaceutical products become their consumers and may have passed the prime innovative age. In balance, then, salaries and taxes are in the USA’s favor.

57But that is not the whole story because success in knowledge industries requires excellence. Mediocrity is not enough. How can one stimulate excellence? The American answer is options: key personnel are given the possibility to buy a certain number of shares at a given price. When the market price exceeds that threshold, it is time to exercise the option. If the market continues to rise, and high-tech shares are volatile, one sells at a suitable time and becomes a millionaire. So, it is not only the originators of a listed company who benefit. The hot question is how many layers of personnel should enjoy the right and to which extent. Taxing of options is another aspect. The UK taxes 10% of the capital gain if the shares have been kept over two years, against the normal 40%. Silicon Valley has a flat 18% tax (Davis 2004). At least on that, a corner of Europe scores better. The use of options is popular with technology companies, less so in other sectors of high-tech. Why this is so is an enigma. They are also a controversial way of remuneration. When options are exercised, the number of shares on the market increases but the assets and profit of the company are not affected. Earnings per share get diluted which is against the interests of old shareholders. The existence of options is given in the footnotes to the profit and loss account and not as a cost item which would be the explicit way. That would be poor psychology, however, because the full effect can be dramatic. The earnings of large technology companies had been at least one-third lower in the explicit way during 2001-3, against 5-6% at the Standard & Poor’s 500 companies (Waters 2004b). A rule change is in the making, however. On the Continent, the use of options is frowned upon as a matter of principle. As are generous bonuses and salaries. Symptomatic is a Düsseldorf court case where Mannesmann directors were charged for paying allegedly excessive bonuses in the context of the company’s merger with Vodafone. They were acquitted on grounds that the court does not make ethical judgements (Jenkins 2004). Such action may be righteous and it is egalitarian but how much talent is lost to emigration and how much effort discouraged in its cradle can only be guessed.

Conclusion

58The meeting at Uetliberg was organized to give researchers interested in knowledge industries and their financing an opportunity to exchange ideas and forge a common research agenda. This author’s perception, with two year’s hindsight, is that the task is impossible without the cooperation of financiers. The key questions are: Who contacted you and when? What were the details of the project? How did you respond? What was the motivation? If you accepted, how did it develop? What was the financial outcome?

59The research period should cover at least one investment cycle. On the basis of the answers, it is possible to create a realistic idea about the market and the chances for success and failure. It is possible to probe the role of changing environment and the skills of fund managers and venture capitalists. These are very sensitive topics and answers to them in wrong hands can do real harm. It is unlikely that a cold call from the outside will lead anywhere. The research must be done internally, or there must be a deep trust between the gatekeeper of the data source and the investigator.

60The organizers and many of the participants may have entertained the idea that there is an identifiable bottleneck in the financing of innovative high-tech entrepreneurs and companies. That opinion can be motivated by the percentage of applications funded, perhaps one-quarter to one half of those submitted. This author, being a born dissident, cannot see any real bottleneck. If there is no funding by A, then there is funding by B, and that settles the matter. The fallacy of the implied proof for insufficient funding is structural. There will always be more applications than there is money. The fact that some worthy projects are left without is balanced by some worthless ones which are supported, out of sheer statistical error. No, the relevant question is how large a percentage will give a payback and whether the total payback will exceed the total funding with interest. Which translates into the observation that funding becomes more difficult when interest rates increase. But that happens across all sectors of the economy. The gut feeling is that payback exceeds funding, on average. Otherwise the funding would dry up, which it does not seem to do.

61Finding the reasons for success and failure is much more difficult. The prevailing approach in economics is numerical. If that does the thing, excellent. But our feeling is that as soon as we make international comparisons, intangible factors begin to play in. All people, we believe, react positively to economic stimuli, but not the same stimuli and not with the same intensity. It means that numerical results must be modified by soft reasoning. Therefore it is important to be familiar with the culture, the way competitors think. That knowledge is best gained through interpersonal communication. At the meeting, there circulated a rumor that possible future sponsors in Brussels were not interested in financing travel in the USA, Europe’s main competitor. How irrational. The first thing is always to look how the top guy does it, if he permits such an investigation.

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Risto Laulajainen, « Making knowledge industries a GO: Some commercial considerations », Cybergeo : European Journal of Geography [En línea], Espacio, Sociedad, Territorio, documento 320, Publicado el 07 octubre 2005, consultado el 06 diciembre 2019. URL : http://journals.openedition.org/cybergeo/3365 ; DOI : 10.4000/cybergeo.3365

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Risto Laulajainen

Gothenburg School of Business, Economics and Law, PO Box 630, SE-405 30 Gothenburg, Sweden
Risto.Laulajainen@geography.gu.se

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