Moonshots

In the last half-century, technological progress has stagnated. The century from 1870 to 1970 brought electricity, running water, telephones, television, automobiles, and airplanes. Life expectancy at birth rose from 45 to 72. But since the early 1970s, progress has been incremental. Innovation has become synonymous with computers and smartphones because there have been so few transformative technologies in other fields.

Some economists believe that the economy has simply picked the low-hanging fruit. But there are plenty of emerging technologies with the potential to reignite productivity growth – including artificial intelligence, renewable energy, and nanotechnology. The problem is that each of them requires a moonshot – a project to commercialize a new technology that requires billions of dollars of capital over a decade or more. Moonshots can generate attractive returns if they succeed, but most companies are reluctant to take the risk.

Corporate law scholars have long debated whether the structure of the modern public corporation discourages long-term investments. The “short-termists” argue that public company managers are forced to prioritize short-term stock performance over long-term shareholder value. They contend that managers forgo long-term investments to avoid being targeted by activist hedge funds seeking quick returns. They propose to remedy the problem by insulating boards of directors from shareholder pressure. Skeptics of the short-termist account argue that shareholder pressure makes managers less accountable. They contend that board insulation would lead managers to take excessive pay and fund vanity projects.

In recent years, empirical research has bolstered the skeptics’ position. Studies have shown that board insulation doesn’t increase long-term shareholder value. Yet studies have also shown that firms targeted by activist hedge funds are more likely to cut R&D spending, just as the short-termists claim. These results suggest that the short-termist critique may be missing important nuance. It’s possible that managers may be passing on certain valuable long-term investments, but that board insulation is too blunt an instrument to solve the problem.

In my article Moonshots, I defend a more modest and specific short-termist argument, one that I hope the skeptics will embrace. I argue that moonshots face agency problems that other long-term projects don’t always face. Then I show how the market has developed a new corporate structure designed to solve these problems, which relies on a subtler form of insulation.

A company attempting a moonshot confronts extreme uncertainty. The company’s managers might not learn for years if the technology will work, if consumers will demand it, or if it will ultimately be profitable. The uncertainty creates two overlapping agency problems. The first is a monitoring problem: Shareholders can’t easily observe the performance of the managers overseeing the project. The second is a motivation problem: Managers can’t give their employees the right incentives to bring the technology to market. Managers who anticipate these agency problems won’t invest in a moonshot even if they believe it has a positive net present value.

The monitoring problem arises because the process of commercializing a new technology doesn’t generate interim feedback that would reassure shareholders. Investors are willing to finance an innovation project when early results from the project – revenue trends, user growth, clinical trial data – reliably indicate future profits. But moonshots can require years of unstructured experimentation, and they target untested markets. Managers might be unable or unwilling to share the information that gives them confidence in the project because the information is qualitative, tacit, or confidential. When managers predict that they won’t be able to reduce this information asymmetry quickly enough to convince shareholders that they are faithful agents, they won’t greenlight the project.

The motivation problem arises because managers can’t easily give employees the incentives to bring the new technology to market. Managers may fear that employees will treat the project like academic research – an exploration of interesting ideas, rather than a focused effort to build a profitable product. Managers could overcome this agency problem if they gave the employees a financial stake in the moonshot’s future profits. But managers can’t properly motivate the employees by rewarding them with the company’s stock, because its price wouldn’t track the value of the moonshot alone.

The most innovative part of the economy, the venture capital (VC) market, has evolved structures to address these agency problems. A startup’s capital structure solves the motivation problem. Entrepreneurs and employees are compensated in illiquid stock, so the value they create is locked in until the startup is acquired or goes public. The strong incentives attract employees who believe in the project and motivate them to bring the technology to market. VCs have also developed strategies to monitor entrepreneurs: serving on their startups’ boards, staging their financing, and syndicating their investments.

But there’s a catch. The structure of the VC market favors short-term innovation. The cause is a second-order monitoring problem. The limited partners (LPs) in VC funds need to monitor the VCs. Therefore, the LPs insist that VC funds have a limited life, typically 10 years. The limited life lets the LPs assess the VC’s performance and then decide whether to invest in their next fund. The limited life of VC funds requires VCs to exit their investments through acquisition or an IPO only a few years after they invest. Consequently, VCs look for startups that can scale quickly and exit on their timeline. In recent years, VCs have been concentrating their investments in startups that develop software, because it can scale faster other technologies. Startups that focus on atoms, not bits – hardware, materials, and energy technology – are receiving a smaller share of capital. In the words of one infamous VC: “We wanted flying cars, instead we got 140 characters.”

Moonshots argues that there’s new hope for flying cars – and other, more socially valuable technologies. In the past several years, a new structure designed to commercialize long-term innovations has emerged. I call it the “venture carveout.” A venture carveout is a private company with one or two public company parents, outside private investors, and employee ownership. In the language of corporate finance, the parent “carves out” part of the equity of its subsidiary so that outside investors and employees can own part of the new company. The first venture carveouts were formed in response to the agency problems of developing autonomous vehicles (AVs).

Consider Cruise, the first venture carveout. Cruise is a privately-held Delaware limited liability company (LLC). It was born as a venture-backed startup developing AV technology. General Motors (GM) acquired it in 2016. After the acquisition, GM let Cruise retain some operational autonomy. Then in 2018, GM decided to experiment with a new structure. Cruise became a meaningfully independent legal entity. Cruise’s employees were granted equity in Cruise, not in GM. Cruise raised outside capital from GM’s competitor Honda, other public companies like Microsoft and Walmart, the Japanese conglomerate SoftBank, and the investment management firm T. Rowe Price. Cruise is now valued at over $30 billion. In the last few years, three of Cruise’s competitors have also become venture carveouts: Alphabet’s Waymo, Ford and Volkswagen’s Argo, and Hyundai’s Motional.

Venture carveouts solve the motivation problem as a venture-backed startup would. Employees receive stock in the carveout, not in the parent company. The value of that equity is locked in until the carveout is acquired or has an IPO, which motivates them to bring a product to market. The carveout’s managers are technical experts, which makes it easier for them to assess their employees’ efforts on technical tasks. Venture carveouts also borrow from VCs’ strategies to mitigate monitoring costs: investor board service, staged funding, and syndication.

Venture carveouts differ from venture-backed startups in the long-term commitment from their corporate parents. Cruise is GM’s sole bet on AVs, and GM isn’t only seeking a financial return. GM is hedging against the risk that AVs will disrupt its core auto manufacturing business. Cruise’s outside investors include public companies that want access to private information about AV technology and institutional investors interested in a long-term bet. GM’s commitment to Cruise gives the outside investors more confidence that Cruise can overcome short-term setbacks. At the same time, the carveout’s managers owe a duty of loyalty to the carveout, not to the parent. GM’s public shareholders can be reassured that GM’s directors aren’t running Cruise as a personal vanity project because GM doesn’t completely control it. The net effect is that Cruise is partially, but not fully, insulated from shareholder pressure.

It’s too early to know if venture carveouts will succeed. The carveouts developing AVs continue to raise capital, but they have yet to bring AV technology to market. If they succeed, though, venture carveouts could change the structure of innovation. Many of the moonshots of the last century were undertaken by the research divisions of monopolists – AT&T’s Bell Labs, IBM Research, and Xerox PARC. Corporate R&D spending today is heavily concentrated in the largest tech companies. Venture carveouts could enable moderately-sized companies to invest in moonshots, compete with the tech giants, and reignite technological progress.

This post comes to us from Professor Matthew Wansley at Yeshiva University’s Benjamin N. Cardozo School of Law. It is based on his recent article, “Moonshots,” available here and forthcoming in the Columbia Business Law Review.

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