The Burden of Proof: Building an Evidence-Based Case for Kría in Today's Startup Ecosystem

In a guest post, innovation policy expert Eszter Czibor discusses what an evidence-based case for keeping the Kría fund alive could look like.

Photo by Ali Abdul Rahman on Unsplash

Póstur dagsins er gestapóstur frá vinkonu bloggsins, Eszter Czibor. Eszter er hagfræðingur sem hefur sérhæft sig í opinberri stefnumótun á sviði nýsköpunar (e. innovation policy). Hún hefur sem ráðgjafi unnið fyrir fjöldann allan af opinberum aðilum sem fjármagna nýsköpun beggja megin Atlantshafs, m.a. Innovation Norway, Innovation UK, NASA SBIR, UNDP og Alþjóðabankann. Hún fékk doktorsprófið sitt í hagfræði frá háskólanum í Amsterdam og vann síðan við Chicago-háskóla. Eszter flutti til Reykjavíkur frá London árið 2021 og hefur mikinn áhuga á að tengjast betur inn í sprotaumhverfið.

Endilega sendið mér línu og ég kem ykkur saman. -kh

The Burden of Proof: Building an Evidence-Based Case for Kría in Today's Startup Ecosystem

Last week, the committee for government efficiency proposed dissolving the New Business Venture Fund Kría, on the basis that the “market failure” which necessitated its creation might no longer apply. Responding to the proposal requires an evidence-based examination of both the rationale and methods for public innovation funding in Iceland.

Public Funding for Innovation: The Why

To begin, let’s quickly revisit the market failure-based rationale for public funding for innovation. Innovation comes with what economists call "positive externalities," typically in the form of knowledge and technology spillovers. As a result, the economy-level benefits of developing and commercializing groundbreaking ideas often exceed their private returns; left entirely to market forces, we are likely to underinvest in innovation. This is a non-controversial idea, often used to justify e.g. R&D tax credits – and I’m fairly sure that the committee members weren’t referring to this “market failure” in their justification.

(Side note: A different but related argument for government intervention underlies mission-oriented innovation. Rather than a call to boost economic growth by increasing the quantity of innovation, this approach calls for steering the direction of innovation to focus on societal and planetary challenges, where the gap between private and social returns is the largest. At this stage, it is unclear whether the new Kría will specifically support innovation in “challenge” areas – as Kiddi explains in last week’s post, the innovation dashboard suggests it might –, but in the absence of a clearly articulated mandate, this angle is hard to assess.)

Then there is the observation that even ideas that have the potential to generate sizable private returns struggle to access funding from the market due to the high uncertainty (and to some extent, intangibility) of these returns and the information asymmetry between innovators and investors. Financing early-stage innovation, particularly for young and small firms in complex, resource-intensive sectors, remains challenging, leading to calls for government intervention, including direct investment.

Public Funding for Innovation: The How

Public equity investment instruments come in different forms, from government-run VC funds to co-investment funds and fund-of-funds (to date, it is less clear which of these models the new Kría falls under). GovVC programs have been established to boost the development of the private venture capital market, and to provide a signal of quality which may help new firms unlock additional funding from other sources. Even when local private venture markets are well developed, there are numerous international examples of partnerships between public and private investors, often in the form of matching funds requirements. Whether such a model is the best use of public money depends on (at least) three considerations.

Risks

First, we need to recognize that the “existence of a market failure is not a sufficient condition for government intervention” – that is, we also need to consider the potential risks and costs associated with the intervention. In this case, we need to convincingly demonstrate that sustained public presence in the VC arena does not crowd out private financing or cause distortions in the market. Kiddi discussed this point in more detail.

Returns

The government efficiency group contextualizes the required returns on Kría’s investments by highlighting their opportunity cost: selling the fund’s assets could be used for government debt financing. A common response is the claim that the fund’s investments are essentially self-financing: they supposedly pay for themselves in the form of the future tax income and export revenue that they generate for the state. This is a powerful argument, and it might be true (though probably not over a short time horizon), but we need better evidence to demonstrate it for the Icelandic case. This is notoriously difficult to do well due to the potentially long time for the benefits to materialise, the intangible nature of some of these benefits, the skewed distribution of impacts, the challenges of attributing positive firm outcomes to a specific source of funding, etc.

A good place to start would be to bring together statistics on the positive economic outcomes generated by startups funded through Kría’s predecessors, and to comb through evaluations of similar programs in peer countries to get a ballpark estimate for the financial returns they generate for the public. These returns are likely tied to the fund’s mode of operation: a cross-country OECD analysis found that “GovVC-backed firms tend to perform less well than Private VC-backed firms. This is particularly the case when GovVC are the sole investors into a firm; when partnering with a Private VC (through mixed investment), no difference in financial outcome is observed.”

(Back to our previous side note: if the fund will indeed have an outsized focus on social challenges, then it would make sense to treat it as an impact investment fund and assess its returns as such.)

Alternatives

Government investment in startups – whether direct or in collaboration with VCs – is just one option in the policy toolkit to improve access to finance for innovative projects, alongside R&D grants and tax credits, loan guarantees, convertible grants, pre-commercial procurement schemes, challenge prizes, advanced market commitments, and more. Reducing coordination failures in the system is another approach that has been used in Iceland with apparent success over recent years.

For a tailored and targeted mix of policy interventions, we need to articulate a deeper, more nuanced understanding of startup financing challenges. What type of startups struggle most to access funding from angels or VCs in Iceland? What are the root causes? Under what conditions and in what form could government investment make a meaningful positive difference? Many people in the startup ecosystem have strong and informed opinions on these questions: these should be aggregated and backed up with case studies and data where possible, to form a convincing theory of change.

Looking Forward

Over the last decade, the startup financing landscape in Iceland has evolved considerably. We've seen a substantial increase in available capital, coming both from institutional sources and from entrepreneurs who've reinvested their wealth after exiting their companies, and the ecosystem now benefits from a much richer pool of knowledge, stronger networks, and experienced talent.

Against this backdrop, the case for government venture capital seems to have become less clear cut. Keeping Kría alive might very well be the right policy – but if so, we'll need a more comprehensive, evidence-based argument for its continued existence (and the same scrutiny could be applied to other funding mechanisms, too). This presents a good opportunity for the startup ecosystem to bring strong, data-backed claims to the debate on the effectiveness of public innovation support.