Inside Startups

Norman Cheung, CEO, Boxful

MAR

Inside Startups - Boxing clever in the burgeoning storage business - Hong Kong poised to hit the heights as a fintech hub - Forget government aid, try a DIY start-up

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CONTENTS Cover story

4

Strategising to stake a niche in the storage business MAY CHAN RHODES

Trends

10

Hong Kong ready for the financial technology revolution BRIAN YEUNG

Policy

14

Start-ups should skip government policy support and try DIY instead GEORGE CHEN

Start-up doctor

16

A lesson on digital marketing GUY PARSONAGE

Inside Startups is published by Education Post, South China Morning Post Publishers Ltd. All rights reserved.

ISBN: 978-962-8148-38-7

Money talks

18

Practical, pragmatic advice CHRIS DAVIS

Co-working space

20

Collaborative workspaces offer wealth of facilities to nurture start-ups VICKIE CHAN

Discussion

22

Is there a start-up funding bubble in the US? HAL WEITZMAN

Paper

28

Why non-compete agreements are not always good for business JASJIT SINGH

4

Cover story

Strategising to stake a niche in the storage business Text: May Chan Rhodes Photo: TNS

ON AVERAGE, AN INDIVIDUAL IN HONG KONG ONLY HAS 0.5 SQUARE FEET OF SELF-STORAGE SPACE

New businesses are born and developed every day in Hong Kong, which has been hailed as one of the most exciting places for startups businesses. Several valet storage companies have mushroomed in the past few months in the race to provide the best service to the millions of people struggling with small, crowded living spaces.

Most of these start-up companies boast tailor-made, flexible storage price-points and arrangements made possible by the proliferation of technologies.

They offer more control for users during the whole process. Storage boxes are delivered and collected at the door. The users can keep track of their inventory any time as they photo the contents of the box and upload the images to their online accounts.

The users can also store however small or large a quantity at different time intervals ranging from weeks to months, at an entry fee that is little more than the price of a Starbucks coffee. They can even recall the boxes whenever they want with just a flick of their finger on their smartphones or tablet devices.

Inside Startups

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Cover story

Norman Cheung, co-founder and CEO of Boxful, says there is a void in the self-storage market because people are put off by traditional warehouse services, which usually require users to make the trip back and forth to the warehouse, and offer a limited choice in storage space and lease duration.

Cheung and co-founder Carl Wu were quick to act on their idea. It took them only about 10 weeks to build the business from scratch and secure US$1.5 million in venture funding that allowed them to invest in the technology, enter into long-term leases with warehouses, hire their own fleet of vans, and roll out various marketing campaigns including print advertisements and social media advertising.

Cheung is ambitious about creating a lifestyle change in the market by educating the public about the creative solutions to the ubiquitous problem of the shortage of storage.

“On average, an individual in Hong Kong only has 0.5 square feet of self-storage space,” he says. “On the other hand, new flats on the market tend to get smaller and smaller.

Norman Cheung

WHEN YOU HAVE A GOOD IDEA, KEEP IT AS QUIET AS YOU CAN UNTIL YOU ARE READY TO ROLL OUT YOUR BUSINESS

“We want to tell people that there is an easy, affordable solution, and they will have a better lifestyle because of it,” Cheung adds.

Miles Davison, co-founder of another valet self-storage company, StuffGenie, has a similar vision. Previously a general manager overseeing the logistics of a lifestyle company in Shenzhen, he started the company with his brother, Charlie, a web developer.

However, the two took a different approach to starting their business: instead of raising funds through other investors, it was privately funded. After laying down the business framework and systems, the Davisons quietly rolled out the service by first testing it with family and friends, before launching it in the wider market.

Miles Davison

Integrating the founders’ professional experience in logistics, warehouse management and web development, the company also boasts its own technology system capable of keeping track of the location and condition of the goods in storage. In order to maintain a high level of professionalism, the Davisons also train their staff and partners, including the van drivers, in how to use their box scanners and warehouse management system.

Inside Startups

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Cover story

“We are aware that there is a lot of competition in the market. And that is why we believe in the importance of word-of-mouth,” says Miles Davison. “The high quality of customer service is going to be the key differentiator for StuffGenie in the market.”

Kevin She, founder and CEO of SC Storage, Hong Kong’s first personal storage company, shares a few tips on how start-ups can stay in the game. Founded in 2001, the company now boasts 50 branches in 20 districts, making it the largest player in the market.

She urges start-up businesses to think about ownership and their appetite for risk. Being a risk-taker himself, She ran a highly leveraged model by funding a rapid expansion in the market through bank loans. However, he did not consider raising funds by selling the equities of his company to other investors.

“Selling equities is the most expensive form of fundraising,” he says. “You may have an investor who helps you out by buying 10, 20 or 30 per cent of your shares, but what happens when your

Kevin She

business becomes successful and generates millions of dollars of revenue? The shares you have sold will be worth so much more then, and it may not be easy for you to buy them back.”

While the speed in setting up a business is important for enjoying the “first-mover advantage”, She also warns never to skimp on the time invested in drafting legal documents and seeking counsel when it comes to business agreements. Sad as it seems, he has witnessed entrepreneurs being cheated out of business because they had misplaced trust in their partners when signing a piece of paper.

Asked if there is one thing he would have done differently with his business, She says he would have been more low-profile at the start.

“When you have a good idea, keep it as quiet as you can until you are ready to roll out your business, and then grow as rapidly as you can,” he says. “It is not only about doing the right thing, but also doing it at the right time.”

Inside Startups

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Trends

Hong Kong ready for the financial technology revolution Text: Brian Yeung

Photo: Bloomberg

The rise of technology has revolutionised the financial industry, allowing tech giants and start-ups equal opportunities to provide services that compete with traditional financial institutions. Hong Kong is fast catching up, but can it sharpen its edge from being a global financial centre to one of the world’s financial technology (fintech) hubs?

Fintech, which has seen a threefold increase in global investment, from under US$930 million in 2008 to more than US$2.97 billion in 2013, according to Accenture, is being touted as a game-changer for the world’s financial industry. The term covers a wide range of innovative technological solutions, but payment systems, financial data analytics and peer-to-peer (P2P) platforms are particularly on fire, causing even banks to turn to start-ups for such innovative

IN 2013, 83 PER CENT OF GLOBAL INVESTMENT IN FINTECH WAS INVESTED IN USBASED VENTURES

solutions. To unlock the market potential of fintech, many economies are now aiming to get a head start in the global innovation race.

Currently the United States is at the fintech frontier. In 2013, 83 per cent of global investment in fintech was invested in US-based ventures, according to reports by Accenture. But Britain and Ireland are fast catching up, and together accounted for more than two-thirds of Europe’s total financing, at US$265 million in the same year.

Hong Kong takes pride in being China’s global financial centre but its fintech ecosystem is still at an infant stage of development.

The inaugural FinTech Innovation Lab Asia-Pacific accelerator programme only kicked off at Cyberport last year. Given the city’s position in China, where its P2P lending market will reach US$7.8 billion in 2015, according to research firm Celent, experts believe that Hong Kong has all the conditions in place for the innovation race.

Dr Wilson Chan, assistant director of City University’s (CityU) MBA programme, sees Hong Kong’s potential as an R&D hub. He says: “Hong Kong can ride on the city’s free access to information, and its experience of being an international financial centre, to serve as a research and development hub targeting the highly lucrative China market.”

Hong Kong’s first P2P online lending platform, WeLend, is a classic example. The platform allows individuals to apply for loans withInside Startups

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Trends

out going through a bank. Its success in Hong Kong has enabled the platform to expand rapidly into the China market, with a total of US$ 20 million in Series A funding.

Despite favourable conditions, however, there are challenges for local companies, the first of which is understanding the market landscape in the mainland. CityU’s Chan acknowledges that it is difficult for local entrepreneurs to explore the mainland market themselves, but a good mix of talents could provide a solution.

He explains: “Many of the emerging generation of ‘sea turtles’, who decide to return to China after years overseas, are based in Hong Kong. They know the China market.”

The second is to cultivate a corporate culture that welcomes innovation. Dr Mak Wai-ming, MBA programme director at Polytechnic University (PolyU), points out that a risk-averse business culture and bureaucracy may prevent financial institutions in Hong Kong from being innovative.

As he puts it: “Innovation within an organisation is a two-way street. While you need talent with tech background and entrepreneurial flair, you also need to cultivate an organisation culture that favours intrapreneurship, so that new ideas will be turned into innovations.”

But notwithstanding all the perceived obstacles, global start-up accelerators are impressed by the potential of local entrepreneurs.

Startupbootcamp, named as Europe’s largest start-up accelerator

by Forbes, hosted its pitch day specifically for fintech start-ups in Hong Kong in January.

As Markus Gnirck, co-founder & global COO of Startupbootcamp, says: “Hong Kong has the resources and the talent needed to be one of the world’s fintech hubs. Given its strong capital market and trading hub, the city is in a good position to be part of the global game.”

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14

Policy

Start-ups should skip government policy support and try DIY instead Text: George Chen Photo: Bruce Yan Among all the successful start-up companies you know, including Google, Facebook and even China’s smartphone maker Xiaomi, can you find one that succeeded due largely to government policy support and funding? Not really.

In the world of start-ups it is widely known that one of the keys to success is DIY, or do-it-yourself. A typical start-up story often begins with the founders putting their own money into their project despite the risk they may lose everything if their business fails.

Later, if they are lucky, they get venture capital funding to support business growth and expansion.

In China, one of the long-held misunderstandings about start-ups is government support. Start-ups are definitely not new, despite the fact that Premier Li Keqiang began to promote them recently. There

have been hundreds of thousands of start-ups on the mainland over the three decades since late paramount leader Deng Xiaoping tried to push economic growth by encouraging private business and capital to participate.

One of the results was that at one time we had way too many socalled “hi-tech development zones” backed by different local governments, from the commercial capital Shanghai to little-known third-tier cities.

To be fair, there have been some success stories out of these government-led “development zones”, for example, in Shanghai’s Zhangjiang, where several start-ups in medical equipment and microchips have already managed to list in the US. But most “hitech development zones” on the mainland ended up being “face projects” for local governments.

In Hong Kong, one of the most-often heard complaints among the younger generation has to do with lack of government support.

But when Walt Mossberg, one of the most influential technology industry watchers in the US, visited Hong Kong last week and met with hundreds of start-up founders and would-be entrepreneurs, he advised them not to rely on the government so much.

“It’s a gigantic mistake to assume the government will do it for you,” says Mossberg, a former technology editor and columnist at the Wall Street Journal, who later launched his own tech and media business Re/code.

“If you look at [successful start-ups] in the US, do you think those guys waited around for the government to create some special economic zone for them or open some shared workspace?”

Ironically, sometimes the government is left behind in technology and innovation. New York Times reporter Alan Wong recently spotted on the official website of Hong Kong chief executive Leung Chun-ying a suggestion for visitors to use the Netscape browser to view the site. Netscape? When did you last hear of that? Leung’s office later updated it after the out-of-date information went viral.

Don’t set your hopes too high for government policy support for your start-up business.

Inside Startups

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Start-up doctor

A lesson on digital marketing Text: Guy Parsonage Photo: Bloomberg

If the first thing you think of when it comes to digital marketing is display ads, then your strategy is dead, because display ads are dead. They aren’t shareable, our eyes are trained to avoid them, and the model is beyond broken (CTR has fallen from 50 per cent to less than 0.1 per cent over the past 20 years).

The digital marketing landscape is changing fast.

It’s not just about demographics anymore – it’s about knowing what your customer has read today and which video they’re about to watch on YouTube. It’s about delivering content that will make them stop and choose to engage.

Moreover, the various tools we have at our disposal are more powerful than ever.

Advanced AI and data-driven technologies are driving personalisation in advertising to all-new levels. Browsing behaviour, past purchases, location, demographics and literally millions of additional data points are used to form highly accurate predictors of consumer action (and reaction).

While these metrics optimise delivery and increase the chances of speaking to the right audiences, you still need more than a pretty flash image and a one-liner to seal the deal.

Smarter marketing strategies are abandoning the interruption model, transitioning to content that is engaging by its very nature. Some of the highest performing content is “micro” – high-quality short form, easy to consume, a pleasure to look at, and fleetingly relevant – engaging consumers voluntarily with content they actually care about, regardless of whether this content comes from a brand.

For instance, as workplaces and online threads filled with loud opinions about the contentious colour of #TheDress, a handful of clever marketers took immediate advantage of the hype, earning outstanding engagement with a few brilliantly apropos ads.

It all really comes down to knowing your audience and staying on top of what’s happening in their lives – not just blindly broadcasting to the internet in hopes of making a sale.

Guy Parsonage

Digital marketing trends are moving quickly, and staying on top of the different methods and technologies available is more important than ever.

Over the next few months I’m going to be taking a closer look at digital marketing – what works, what doesn’t, and how the landscape is adapting to the constantly evolving market.

The floor is open to any and all comments or questions, so feel free to drive more meaningful conversation around the digital marketing trends you’re most interested in by e-mailing guy.parsonage@ fluidhk.com.

Inside Startups

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Money talks

Q&A

Text: Chris Davis

Practical, pragmatic advice Nurturing an idea and turning it into a start-up business is an exhilarating experience. However, acquiring the “right� type of funding is a crucial part of the process and can have an impact on success or failure.

Christine Chow, adjunct associate professor, department of finance, school of business and management at the University of Science and Technology (HKUST).

Every start-up company is different; however, are there any fundamental steps that every start-up company needs to take to attract funding?

The questions to consider are actually what the start-up is looking for in terms of funding and the time frame in which it is needed. Most of the time, rather than just funding as we understand it, which is financial capital, what start-ups need is the social and intellectual capital from their funders.

What are some of the important issues a start-up enterprise should consider when seeking funding?

The decision where to raise money will impact a start-up enterprise’s ability to succeed as a business and has far-reaching consequences. Creating the right founding team is by far the most important decision you can make as an entrepreneur. Individual angel investors with deep knowledge of your marketplace can not only help in terms of financial support, but also through advice and validation. Alternatively, venture capitalists may bring valuable experience and a different level of support in getting a start-up business off the ground and up and running.

Christine Chow

As a start-up, should founders seek funding from angel or venture capital investors?

Although it is hard to give a precise percentage of each, as it differs depending on circumstances, a combination of strategic and financial investors is often the best way. Many will say angel investors, who are often asset owners themselves, tend to be more patient.

Meanwhile, as an alternative means of raising capital, at the very early prototype stage, start-up enterprises could consider attracting investments from participating and winning start-up funding competitions.

How can entrepreneurs and the founders of start-up companies prepare to make presentations to possible funding sources?

Practise, practise, practise! Make sure there is a 10-, five-, threeand one-minute pitch. Investors come across many opportunities every day and if the founders cannot engage the audience within 30 seconds, they are out. Multimedia presentations can also be a great help. For example, a video can be shown to potential investors and also online.

When looking for funding, what are some of the do’s and don’ts?

Do the homework with data to support the valuation used. This helps to build confidence for potential investors, and most importantly, shorten the negotiation period. A strong board of directors and advisers also helps build investor confidence. It is important that any investment agreements cover legal liabilities; for instance, clear intellectual property rights. Under no circumstances take short cuts. Don’t just cut and paste a standard term sheet found online. Proper documentation forms a strong foundation to attract institutional capital over time.

How is the Hong Kong start-up funding landscape looking these days?

The funding landscape is certainly more robust, with the emergence of specialist venture capital funds that are sector- and regional-specific. For instance, health care, agribusiness, education, and fintech. A new generation of family offices – usually set up by third- and fourth-generation families – is also looking for investment opportunities. Meanwhile, corporates such as AIA and Swire have established accelerator programmes, while government support such as InvestHK StartMeUp programmes and other government funding has become available for start-ups and social innovation enterprises.

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Co-working space

Collaborative workspaces offer wealth of facilities to nurture start-ups Text: Vickie Chan Photo: Bloomberg While start-ups have been proliferating in the business and, of course, tech landscape, so have collaborative workspaces such as Wynd in Central and Cocoon in Tin Hau, to name just two.

On top of providing a rentable hot desk and useful networking, these spaces host events and workshops that benefit members and attendees by offering advice, support, training and inspiration – without beneficiaries having to take a degree in computing or an MBA. Wynd hosts a series of events and workshops called “happenings”.

These vary in length, time of day and cost, although some are free.

The topics are wide-ranging, from how to draft a business plan, to the relationship between mainland China and Hong Kong. Meanwhile, Cocoon’s roster includes pitch night and hackathons – both with real cash prizes on offer – while a number of events are hosted by well-known organisations such as The Women’s Foundation.

General Assembly stands out as an education provider rather than a workspace. However, as such, it offers a great space for students to join in activities, field trips, networking and making the most of alumni support.

While General Assembly was founded in New York, and has campuses in Britain, the US and Australia, the focus in Hong Kong is on digital industries such as business, tech and design. Courses include web development immersive, digital marketing, mobile development, data science and user experience design.

Riley Batchelor, senior regional director (APAC), explains the thinking behind the institution: “We focus on relevant business application and practical knowledge, designing courses in response to the skills that employers want or that individuals need to get hired.”

The goal is to give people the skills to be promoted or pursue a new career at a fraction of the cost of graduate school. Partnering with over 4,000 employers to curate the right curriculum and provide real-world experiences helps General Assembly get its courses just right.

Based in Sheung Wan, Paperclip has quite a different approach.

There is a co-work space available but founder and entrepreneur, Deepak Madnani, says Paperclip is about the community, because it’s the engagement and personal experience that makes for lessons, not just understanding the ideas.

Offering workshops that can benefit any early-stage company – including tech – its mentors include venture capitalists, serial entrepreneurs, accountants and legal experts. “We focus on sharing best practices – not education. Our workshops centre around what is being found useful or is common practice in Silicon Valley, or tools that might be known at key universities but haven’t hit Hong Kong yet,” Madnani explains.

Given that Paperclip is useful for any early-stage company, including SMEs and corporations, networking is also more varied and the method is “lecture light, practice heavy”. Madnani adds: “It’s about using the ideas we offer and making your idea work. Our workshops are very interactive – with about 60 per cent doing.”

Mentors are also available for follow-ups.

WE DESIGN AROUND FAILING FORWARD. GOING BANKRUPT ISN’T ABOUT SHUTTING THE DOOR

Madnani stresses one crucial point for start-ups: “Why do I say we appeal to early-stage companies? Because you will fail – I have failed twice – and there is a stigma against failure. We design around failing forward. Going bankrupt isn’t about shutting the door.”

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Discussion

Is there a start-up funding bubble in the US? Text: Hal Weitzman Photo: iStockphoto Waverly Deutsch and Scott F. Meadow, clinical professors of entrepreneurship, and Ira S. Weiss, clinical professor of accounting and entrepreneurship, University of Chicago Booth School of Business, analyse the start-up bubble. Discussion hosted by Hal Weitzman, Booth’s executive director for intellectual capital.

Weitzman: Tens of thousands of start-ups get funded in the United States at very early stages, but relatively few companies get funded at the Series A stage or beyond. What does that bottleneck mean for the industry?

Deutsch: In this country, over 500,000 people launch new companies every year. In 2011, 66,000 of those start-ups got angel funding, but only 2,000 got venture funding. So how are they going to grow their businesses? If there is this dependency on external funding, a lot of companies that think they’re now entitled to several million dollars of Series A venture funding aren’t going to get it.

Weitzman: Why is there such a big gap between angel and venture funding?

Weiss: Structural changes over the past seven years have affected start-ups and the funding side. First, it costs less than US$100,000 to get a technology company off the ground. A lot of companies go from starting company to “proof of concept” inexpensively.

Secondly, the cost of getting your first customers has gone down drastically. Now you can market on Google or Facebook, so people get to that initial point much earlier. Thirdly, you now have crowd sources of funding. These mean that tens of thousands of early-stage companies have enough external validation that people are willing to write cheques.

The venture-funding stage is more difficult. First, there was a very significant contraction in the venture-capital industry during the downturn: 30 per cent of venture funds are gone. Secondly, that leaves larger funds, which have had a lot of success raising US$500 million and up, but there are very few funds in the US$100 million - US$250 million range. Those are really the funds that have historically played more in the Series A and Series B. Thirdly, many more start-ups are addressing the same problems. The venture capitalists can sit back and say: “Who has the best team? Who has the best Inside Startups

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Discussion

traction?” So the next rounds become that much more competitive.

Meadow: Institutional investors tend to look at: is it a start-up, is it a growth equity project, or is it near-term liquidity? They’re pretty strict with their definition of growth equity – you have a management team that can take it to the promised land. Because we’ve had a tremendous amount of success out in the public markets and in gaining liquidity, more and more naive funding is flowing in at the early stage. But when it comes to the post–proof-of-concept execution stage, you’ve got a much more sophisticated audience.

Weitzman: Some in Silicon Valley say we are in a funding bubble, that investors are taking on too much risk and it’s not sustainable.

Are there parallels with the tech bubble of the late 1990s?

Meadow: There was certainly a reduced level of due diligence that went into any project. I’m seeing that now. There was also a problem that the firms with the most prestigious franchises were able to continue to sustain the funding because of their own franchise.

Other companies that were just as worthy as the ones that those firms supported couldn’t find that money. That goes back to this problem of a dearth of growth equity.

Deutsch: The question of if we’re in a bubble is all about risk reward. We’re investing about US$25 billion of venture capital – the question is, where do those investors get their returns? A lot of investors, particularly in Silicon Valley, are funding a lot of business models without revenue models. So it may be worse this time around. In the internet bubble, they had revenue models based on e-commerce. Now, we have these things like WhatsApp, which is purely about distribution: get on every phone, get in front of every person, and you’ll get bought for billions of dollars. Where are the investors looking for their returns when we have companies that go public without self-sustaining revenue models, and the investors get to shift the burden from the funds and their limited partners to the mainstream investor and the stock-buyer? We’re getting more and more of those kinds of companies. Facebook and Twitter didn’t have self-sustaining revenue models when they went public, so that’s where the investment bubble on the venture-capital or private-equity side can impact the economy.

Weiss: There are some signs of a bubble at certain funding stages.

A lot of start-ups are not just pre-revenue but pre-metrics. Over the past 12–18 months, many more companies are getting funded

WHATSAPP IS AN ANOMALY, AND IT’S A DISASTER FOR YOUNG ENTREPRENEURS

pre-revenue and pre-launch. That feels similar to the tech bubble.

There are a lot of differences, though. Most of the money goes into companies with a verifiable revenue model. The WhatsApps of the world are the anomaly. Mostly you have a lot of really good business-to-business investments by tech venture funds that have external validated data, revenue models, and growing revenue, and a lot of the money goes in for marketing and growth.

Deutsch: I agree that WhatsApp is an anomaly, and it’s a disaster for young entrepreneurs. One in two million companies are going to do what WhatsApp did, but everybody thinks they can achieve it.

Meadow: What I see as a sign of a bubble is more and more naive investors coming in at earlier and earlier stages. There is no question in my mind that there’s going to be an explosion like before.

Deutsch: Naive capital is a really important thing to talk about.

Venture capitalists have a lot of experience doing due diligence on their deals, and there are a lot of great angel investors, many of them former venture capitalists. But there are 300,000-plus people in the US who act as angel investors. In 2011, angels invested about US$25 billion. Venture capitalists invested about US$25 billion across all stages. So there is a lot more money coming from individuals who are not necessarily professionally trained, and who are investing their own money and so have different fiduciary responsibilities and different goals, coming into the market at these

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Discussion

early stages. It supports a lot of innovation, but it does create these unrealistic expectations.

Weiss: Think about the maths: US$25 billion from angels going into companies. That number’s been constant for the past decade.

But the cost of creating companies has come down so much, so you have 10 times as many start-ups getting funded at the first stage.

One sign of a bubble is that the big funds have raised so much money that they’re willing to pay valuations that are not based on external metrics. A lot of it’s driven by their need to put really big cheques to work. That feels like a bubble. At the later stages, there are a lot of big funds that are pricing things in ways that are not based on economic fundamentals. However, it may unfold very differently than the last bubble. Then, you had a lot of companies going public with no revenue, and that public market fuelled a lot of what happened in the private market. That is not something we have now. Now, to go public, the average revenue you have to have is about US$55 million a year. So you could see a smaller correction, a 25 or 30 per cent correction in the public markets.

The public markets are open. If they shut a bit, the later-stage funding markets will shut a bit, and it will cascade like that. But I don’t see a big bursting like last time.

Deutsch: But even a correction has ripple effects that reach the average person. Lots of companies have parts of their pension funds or their investment portfolios in this tech game. So it won’t be the disastrous tech crash, but it will affect the broader market. In a very high stock market, if there were to be a correction, investor confidence could be hit, and you could see a ripple effect across the stock market, just like we did in 2007-08.

Meadow: Investor confidence plays out the way you would think: there’s a flight to quality. Franchise firms can fund as a result of that franchise. Not only do they have their own capital for their projects, but they are also able to bring in people from all over the country. The problem is, that shrinks the number of funds, which hurts entrepreneurship in general.

Copyright, republished from Capital Ideas, the online business journal of the University of Chicago Booth School of Business.

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Why non-compete agreements are not always good for business Text: Jasjit Singh Photo: AP

Locking your employees in might seem tempting in order to protect your firm’s intellectual property, but have you also considered the potential downsides?

Consider Silicon Valley, which has become the most entrepreneurial area not only in the United States but also in the world. Not only are formal alliances commonplace among the local firms, it is also, arguably, one of the most dynamic labour markets in the world. It is not unusual for your engineers or executives to switch allegiance to a competitor down the road, taking their knowledge with them. Here, the culture is one of loyalty to the profession rather than to a firm. Equally, there is nowhere else on the globe that can compete with the number of start-ups which successfully launch and, more importantly, stay in business and go on to be global leaders in the industry. But what drives this collaborative environment?

Silicon Valley’s vibrancy can’t all be pinned down to one factor.

Scholars have tried linking its success to a combination of initial conditions that kick-started a favourable dynamic decades ago, and a multitude of agglomeration benefits that continue to sustain this virtuous cycle. However, one critical characteristic of Califor-

nia is that firms simply cannot enforce non-compete agreements on their employees – as the state doesn’t recognise them legally.

Contrast that with the state of Massachusetts, where courts enforce non-compete agreements – one of the reasons for the significantly lower inter-firm employee mobility and a resulting decline in the once-vibrant information technology cluster along Route 128 in the Greater Boston area.

In regions where the legal system does allow such documents , asking employees to sign a non-compete agreement should, in principle, give employers the reassurance that recruits will not leave on a whim, taking sensitive knowledge to a competitor. One would think this practice would make the firms more willing to invest in expensive R&D and cutting-edge human capital. But what if the very idea of having to sign such an agreement came in the way of your being able to attract the best talent in the first place? What if the flexibility of being able to switch employer was so important that a potential employee avoided going to work for companies in regions where non-competes were prevalent? And what if this ultimately translates into certain regions, and the firms located there, being less competitive economically?

My research paper Regional Disadvantage? Employee non-compete agreements and brain drain, co-authored with Matt Marx of MIT Sloan School of Management and Lee Fleming of the University of California, Berkeley, examines the issue of how allowing legal enforcement of non-compete agreements can affect a region’s ability to retain talented engineers. In initial analysis leading up to this research, we found that states enforcing these agreements do indeed face a greater extent of “brain drain”.

To establish that this correlation represents a causal relationship, our follow-up analysis relies on an interesting “natural experiment” we stumbled into. In particular, we looked at what happened when unrelated regulatory changes associated with anti-trust policy in the state of Michigan led to the region’s law inadvertently being changed to allow the imposition of non-compete agreements within the region’s firms. Our data shows this change was accompanied by a sudden increase in emigration of successful inventors – those that had previously filed one or more patents while residing in the state. Further, the most affected workers turned out to be the most creative and collaborative types, as they were more likely to emigrate to states that did not enforce non-compete agreements,

ALLOWING LEGAL ENFORCEMENT OF NON-COMPETE AGREEMENTS CAN AFFECT A REGION’S ABILITY TO RETAIN TALENTED ENGINEERS

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so that they wouldn’t feel tied in to a specific employer for their entire careers.

Talent exodus While there is no ready-made public dataset on the migration behaviour of individual engineers across regions, we used inventor records from the US Patent and Trademark Office (USPTO) to construct employment histories for all inventors who had registered one or more patent with the office between 1975 and 2005. We then used this data to examine emigration patterns for the patenting inventors for the state of Michigan. Our particular focus was on comparing emigration dates prior to versus post-1985, as 1985 was the year that non-competes became enforceable. What we found was that, following the policy change, the relative risk of workers likely to leave the state of Michigan to go to other states where non-competes were not in place was twice as high as in states that continued not to enforce non-compete agreements. In particular, we observed that inventor types who had an impact in their respective industries (those actively registering patents) demonstrated a relative risk of emigrating 186 per cent higher than inventor types in other states who were not bound by non-competes.

Inventors who were particularly collaborative showed a relative risk of leaving the state 237 per cent higher after the policy change than collaborative inventor-types in other states. This can probably be explained by their being more likely to hear about job vacancies, as well as by the likelihood of being known outside their firm and receiving outside offers. From the point of view of Michigan, this would be a particular worry given that these indeed are the very people it would normally like most to retain to enhance the state’s future innovative capacity.

Our paper provides plenty of additional analysis to make a convincing case that the effect is driven by the non-compete policy change and not other factors that happen to be correlated with it. For example, while Michigan is known to be a state with an over-representation of the automotive industry (an industry which has been in decline for several decades), this was not a factor which led to the brain drain. Even removing data specific to the automotive industry, the emigration levels remained constant. Talent was clearly leaving the state because of the policy change, regardless of industry.

Zero-sum game From our findings, there is clear evidence that talented workers feel a pull towards states where they can change employers freely and take their creativity with them. In today’s collaborative business environment, this raises some questions about whether non-competes really are the best tool for protecting intellectual property and recouping technological investments, even from the perspective of the companies involved. It is important to recognise that these are a double-edged sword. Preventing employees from going to work for a competitor could not only hurt your competitor, but it could be hurting your own business too if one looks at the bigger picture. Because finding the right match between an employee and employer is a little like the dating game – some are matches are made in heaven, some are not – and it is beneficial to be able to break the relationship as easily as possible, should the need arise.

If, however, your own employees and your competitor’s employees are unable to find the right match for fear of breaking a contract, the only outcome is a zero-sum game. In this situation, the degree of experimentation between employees and firms becomes that much harder, leading to an inefficient labour market.

As well as being detrimental at firm level, the consequences are felt across the industry and region. On the whole, states who choose to enforce non-competes could be doing more harm than good for their regional development by reducing labour market mobility. As my colleagues Bruno Lanvin and Paul Evans note in their recent article, talent attracts talent. The challenge, therefore, at policy level is to ensure that the best talent is attracted in the first place and that a regional disadvantage isn’t brought about by encouraging the most skilled workers to leave for more relaxed states in terms of job mobility, and where enterprise and growth are encouraged. It is no surprise that many regions have of late been debating whether they should move away from allowing policies like enforceable non-competes that might come in the way.

At the firm level, there is much to be said for being more selective in relying on non-compete agreements. You could consider other ways of protecting your intellectual property – such as relying on more specific legal provisions like patents and trade secrets. If your region’s policy does enforce these, there might still sometimes be a case for your firm using non-competes. But it is crucial that the potential downsides have also been recognised and factored in before you reach such a conclusion.

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