The Double-Edged Sword of Government Funding

By Susie Allen | February 1, 2019

Jason Rathje was an aeronautical engineer in the US Air Force when he began to notice something unusual. The Air Force regularly sought partnerships with private companies, but only a few were interested in applying—and those that were became regulars, seeking military contracts again and again.

For certain projects, it wasn’t surprising to see the same familiar faces. Only a few US companies have the ability to make planes. “There are only so many Boeings and Lockheeds,” Rathje says. But the lack of diversity in government contractors didn’t make sense for other aspects of the Air Force’s work, such as cybersecurity and IT.

Why, Rathje wondered, don’t more companies want to partner with the government? How can public-private partnerships be made more appealing and effective? And when private companies and the government do work together, what kinds of technologies emerge?

As a graduate student in Stanford’s Department of Management Science & Engineering who is studying with STVP, Rathje is undertaking research aimed at answering these questions. He’s looking at the relationship between government funding and innovation. In particular, his research investigates how public and private organizations’ conflicting motivations shape the outcome of public-private partnerships.

In comments edited and condensed below, Rathje shares the upsides and downsides of government work, and why he thinks entrepreneurs would be wise to embrace multiple sources of funding.

How would you describe your research?

My research focuses on the effect of government funding on high-growth technology firms. Governments internationally have taken on the mantle of funding early-stage scientific and technological development—whether that’s direct funding through universities, or subsidizing for-profit companies to develop more long range technologies.

There’s a lot of reasons why governments want to do this: for social reasons, national security, develop clean energy, etc. There’s also the underlying reason that private capital markets underinvest in more risky endeavors. Why governments would want to fund R&D in private-firms is pretty well-researched.

What I’m interested in is the alternative point of view. When a company decides to partner with the government, how does that affect their strategy? The underlying question is, “Is taking government dollars really a good idea for a company?”

How have you tackled the question of whether government funding is ultimately good or bad for companies?

That’s a difficult question, because a lot of it depends on the company and their intentions. For example, I examine the impact of the government funding on new firm survival and growth. What I find with those studies, which are ongoing right now, is that companies that take government funding end up having higher likelihoods of survival in their earlier stages. They’re more likely to exist past the critical time for an entrepreneur to exist as a firm. But they experience much slower growth.

While this research cannot yet disentangle whether these government funding programs actually slow firms down, or fund slow-growth firms, the reality is that in industries where growth is critical towards long-term survival—so, high turnover industries, nascent markets, etc.—slow growth can be really detrimental for future success.

Ultimately, startups have to understand the nature of this relationship and what it means for their desired outcomes. If a firm has to compete by growing rapidly, government funding may not be the best place to turn. However, if the company needs some initial funding to avoid early failure, a government-funding strategy might be good.

However, companies should be careful not to fall into a potential government funding sand trap. In the US, we see companies that end up taking money from the government early on often end up continually going back to the government for funding. They often don’t experience the growth you would expect with other sources of capital.

If you were an entrepreneur and got offered government funding today, would you take it? How would you go about deciding?

So, the key question is for a CEO is, “What is it about the government dollar that’s inherently different than other sources of money?”—whether that’s using your own money, financing through a bank system or chasing other sources of credit equity to do it.

In the venture community, this is called smart capital. A lot of VCs often compete for the same high-end start-up. What’s their pitch? It’s not the term sheet. It’s driven by the reputation of the company. What does the VC have unique access to? What’s the unique smart capital that they provide to the company, outside of just money?

From the standpoint of the CEO, they’re asking that same question of the government. What are the unique capabilities of the government that this funding is going to help my company achieve, outside of just the dollar amount?

What are some of the benefits of taking government funding?

I came into this research saying, “Maybe if I was a company, I wouldn’t actually take the government contract. I don’t know if it would help my company or not.” But my research shows that taking a government contract can change the way companies think about problems, sometimes in beneficial ways. Because if I’m a company, I’m sitting in my world of near-peer competitors and we’re fighting over these same markets. We’re in the same industry. We’re all thinking in the same way.

Working with a non-institutional peer on some R&D activity—say, through a public-private R&D collaboration—if the government forces their point of view into my firm, it may create conflict. But at the same time, it’s going to force my engineers, my developers and my scientists to think differently about the problem. Because conflict only happens when people are forced outside of their comfort zones, which isn’t always a bad thing.

By investigating the nature of public-private R&D collaborations through this conflict lens, I find that low-conflict collaborations result in high-impact, incremental technologies (that is, technologies with direct market values). Funding tied to high-conflict collaborations often results in more radical, disruptive technologies. This means that those low-conflict collaborations that managers often strive for, enabled by close-knit, informal relationships (as opposed to structured, formal relationships) between government and firm engineers, may increase productivity, but decrease the likelihood of creating some fundamentally new technological paradigm.

What are you working on right now?

What I’m really passionate about right now is a working paper on entrepreneurship and taking government dollars as a very early stage company. The U.S. federal government spends over $2.5 billion annually just on small businesses. So, we have huge government funding programs for companies targeted at the entrepreneurial ecosystem. But, it’s only a small part of other funding available to firms.

Given the availability of alternative sources of funding, there are complementary ways the US can try to allocate these funds, enhancing other sources of funding, or substitutionary ways, by replacing other sources of funding. And, if you talk to a wide-range of venture capitalists and government organizations about how they think about public funds, or what they think about each other, they often think government funding acts along one of these two lines.

But, in reality, there is only so much the government or venture capital can do to determine these effects. Really, it’s on the entrepreneur. Early results in this research show that if the entrepreneur can take a complementary approach, overlapping sources of government and private funding, it can really work in her or his favor. But it’s really on the entrepreneur to do that, not the government or venture capitalist.

Entrepreneurs need to think about government and private funding not necessarily as competing, as one versus the other, but instead bridging together different sources of capital through the lifecycle of the firm so that you can maximize their benefits.

Susie Allen