The Apple Saga: Rethinking the Risk-Reward Ratio

Apple has been in all sorts of hot water recently. The company has had to contend with charges over troubling labor practices at its assembly facilities in China, as well as not doing enough for employment in the United States.

In addition, the fact that America’s most iconic company — and the world’s most valuable, based on its current stock market capitalization — had no manufacturing operations at home seemed to contravene the much-acclaimed rebirth of U.S. manufacturing. The company finally relented and has announced plans to start manufacturing some of its Mac computers at a so-far-not-specified U.S. location.

However, the goodwill from that announcement proved short-lived. The company, like other U.S. multinationals, soon had to contend with charges that it had been too artful in booking its profits in locations that offer very low rates of taxation.

And yet, for all the twists and turns the Apple saga has taken over the course of little over a single year, what is truly remarkable is that the main issue at stake from the vantage point of the American people and American taxpayers has not even begun to be addressed.

The United States, which is by far the company’s largest market, is not just where many of Apple’s profits are generated in the United States. It is also the place where the initial innovation was funded — but not by Apple itself.

In fact, many of the revolutionary technologies that make the iPhone and other products and services “smart” were funded by the U.S. government. Take, for instance, the Internet, GPS, touchscreen display, as well as its voice-activated personal assistant, Siri.

But the Cupertino, California-based company’ did not just benefit from the U.S. government-funded research activities. Apple itself received its early stage funding from the U.S. government’s Small Business Investment Company program (SBIC).

Apple may not be widely known to be in the top ranks of financial companies, but it can be considered one of the most successful arbitrageurs in history. Arbitrageurs typically engage in the practice of taking advantage of a price difference between two or more markets. Apple put a new twist on this kind of activity.

What Apple did masterfully was put together a lot of technologies funded by the U.S. government (and hence the American people) and exploit those technologies in its own products.

What makes this issue significant beyond the fortunes of an individual company is that Apple is not the only Silicon Valley-based company to do so — not by a long shot. Others, such as Google, whose search algorithm was funded by the National Science Foundation, have profited in a similarly immense fashion.

In fact, many new economy-type companies that like to portray themselves as the heart of U.S. “entrepreneurship” have very successfully surfed the wave of U.S. government-funded investments. Hence, the secret to Silicon Valley’s success was its active and visible hand, in stark contrast to the Ayn Rand/Adam Smith folklore often bandied about.

The U.S. government, through DARPA and other initiatives, stands out worldwide for its astoundingly positive track record in funding true innovation. This includes the government’s most recent claim to fame, its steadfast financial support of (controversial) shale gas and fracking technologies, begun over three decades ago during the otherwise much-maligned Carter Administration.

Indeed, as the clean tech sector demonstrates, the venture capital industry is proving itself more risk-averse than U.S. government agencies. The latter are the ones funding the capital-intensive and highest-risk projects.

Even development banks in emerging economies, like China and Brazil, are doing more than Silicon Valley-type “entrepreneurs.”

In a business context, the role of the U.S. government is often portrayed as providing a safeguard against market failure. But that traditional understanding must be widened to include the active — and often catalytic — role that the U.S. government’s risky investments have played for technology-based corporations.

While many U.S. economists have focused on market failures to justify government intervention, the U.S. government’s range of “mission-oriented” investments, which has funded development projects such as the Internet, points to a role far bigger than a mindset devoted to just fixing problems.

These technology activities do require a vision, a mission and a plan — and lots of money spent from upstream research to downstream commercialization.

It is not by accident that the National Institutes of Health spends $31 billion a year on supporting innovation in biotechnology and pharmacology. Academic predilections and conventions notwithstanding, such an investment can hardly be considered as just “nudging” a sector.

The crucial question to be answered is not just whether the present system is geared toward the government showing a lot of the entrepreneurial courage, but why it is systematically badmouthed, despite its many successes.

An even bigger question for the American taxpayer is whether such support leads to a “parasitic” innovation ecosystem. Consider Apple. Despite benefiting directly from taxpayer-funded technologies, it has strategically “underfunded” the tax purse on which it has in the past directly depended.

Apple set up a subsidiary in Reno, Nevada, a state without a corporate income or capital gains tax. Apple channeled a portion of its U.S. sales there, instead of including it in the revenues Apple reported in California, where its headquarters are located. Apple reportedly saved $2.5 billion in taxes.

While such tax loopholes need to be closed, the tax system is not the only way to recoup the benefits that the U.S. government helped trigger with its investments in risky innovation.

What to do to make the field of technology funding less parasitic? Part of the solution must entail the government getting a “reward” for the high-risk areas it funds directly.

Wherever technological breakthroughs have occurred as a result of targeted public sector interventions, there is potential for the government, over time, to reap some of the financial windfall. This can occur through retaining a “golden share” of the royalties from patents, retaining a portion of equity, or also administering so-called income-contingent loans, similar to those now offered to students.

Clearly, the role of government is not to run commercial enterprises, but to spark innovation in strategic areas. But given ever-tighter public budgets, unless an innovation fund can be regularly replenished with some returns from the successes, innovation itself is under threat.

Government should never have an exclusive license or hold a large enough portion of the value of an innovation so that its commercial use would be deterred in any form or fashion.

But at the same time, it is self-defeating even for private-sector innovation if private firms are the only ones to gain all the reward. Indeed, the same criticism made about banks — socialization of risk, privatization of reward — holds for the innovation economy.

If the United States wants to continue on its successful arc as a leading technology nation providing a good quality of life to all its citizens, then it must urgently redress the current grave imbalance in the risk-reward ratio governing the technology sector.

Editor’s note: A slightly different version of this article was published Taxpayers Helped Apple, but Apple Won’t Help Them, on the Harvard Business Review’s blog, on March 8, 2013.