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June, 2002 |
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Economy & Policy |
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By Bikash Chandra Bose World Intellectual Property Organisation coined the slogan, Encourage Creativity . In economic parlance, creativity is Innovativeness. This Article on Innovation and Venture Capital, commemorates Intellectual Property Day observed all over the world on 26th April. Innovation, as an economic concept, occupies a secondary role in classical economics. It was Joseph Schumpeter who placed innovation in the centerstage of economic analysis with focus on Entrepreneur as the prime mover of economic system. It is true that his basic concern was to explain the cyclical fluctuations that characterized a capitalist economy, but the role of innovation and entrepreneur as developed by him appears as much relevant in economics of growth. This is more so in contemporary climate of opinion, where privatisation forms the core of economic agenda in public policy. Let
us start with a quick look on the linkage. Growth is an exercise
of interposing discontinuity to breakthrough a status quo so that the
macro economic parameters experience “accelerated evolution”
(a la Allan Wilson). In a competitive scenario, where constituents of
the market are in a constant state of creative tension,
innovations of new ideas as transformed by entrepreneurs into new
economic entities, bring discontinuity in the economy. New values
for society are created through new and better products and services, or
through promoting better ways to make or offer existing ones. The
consequent fallout is coexistence of old and new values for sometime
till the new replaces the old. It is this process of “creative
destruction” caused by the innovative entrepreneurs that Schumpeter
described as the engine of economic progress. The growth component
of the thesis comes from its focus on, "Dynamic Efficiency",
as Prof. Sumantra Ghoshal calls it, "the innovations and
improvements creating new options altogether - moving the system to a
higher level". This is in contrast to "Static efficiency
that makes only the existing systems more efficient". The
process gets repeated continuously and the dynamics of it enable "
the pie to get bigger in a Positive Sum Game in which there is more for
all to share" as contrasted to Zero Sum Game in which more for
someone can come only at the cost of someone else. Stages of Innovation “Innovator is an idea person”. Such an idea combines intuition and knowledge. But to be of economic significance, the idea must pass through various stages of evolution. The process may involve several stages as given in the box (next page). Each such stage from germination of the seed in the form of an Idea to its culmination in the form of a Company that invites public issue, calls for the élan of an innovator and monetary support of a financier. But conventional financiers are apt to shun such enterprises because they are yet to establish themselves and thus they carry an above average risk. Hence the need for such institutions and sources which are dedicated to invest in such high risk enterprises to derive high returns by promoting entrepreneurial innovations. This is, of course, after evaluating by due diligence, whether the enterprise carries the potential for commercial success or not. Innovation & Venture Capital It is to meet this need for Investment support during the gestation period of innovation, that Venture Capital Fund (VCF) assumes economic significance. VCF is “an intermediary between the external investment and innovative enterprise that offers the prospect of above average return but carries above average risk”. From seed to the start up capital followed by the set up cost and the expansion funding to bridge financing preceding the IPO, the VCF financially complements the entrepreneurial initiatives. It is so much so that the latter is inconceivable without the former. If the entrepreneurial contribution to economic growth is recognized, the role of VCF in economic growth follows as a matter of corollary. There are a few striking aspects of the relationship between the two. Innovators are described as “Asset poor and Brain rich" (a la Arie de Geus). This schism between Laxmi and Saraswasti showering their blessings to distinct groups, is by and large confirmed across the countries. Coming together of the two, make both of them more effective than only one of them in isolation. Secondly, even in the less developed countries (LDCs), despite low level of literacy, the innovativeness and entrepreneurial élan are present in a segment of population, the size of which may vary. But the ideas of such individuals die before they see the light of the day. There may be various reasons for this, but one of them must be the absence of financial infrastructure that supports the development of such original ideas. There is hardly any incurable genetic deficiency in LDCs, as otherwise the list of innovators and entrepreneurs hailing from LDCs and blooming in developed countries would not have been so impressive . Thus the growth of VCFs may emerge as a deterrent to skill flight from LDCs, of course subject to the availability of support from other environmental parameters. Thirdly, VCFs are not restricted to support a new enterprise only. If an innovative process/product has the potential to revive a sick enterprise, but the enterprise fails to raise funds from normal financing channels, VCF can provide finance to turn the company around. The application of this role of VCF in LDCs is too obvious to be emphasized. Fourthly, there are a number of instances in countries at different stages of development, where small investors contributed venture capital, which earned for them the caption “Angels.” It is a non formal source of financing innovations particularly at the early stages of its evolution where small individual contributions aggregate to a large financial chunk. Growth of VCFs provide an impetus to such non-formal streams of development financing. Modalities of Funding The
extension of finance by VCFs to enterprises may have different
modalities. Since venture capital is the risk capital conceptually, its
availability in the form of equity or quasi equity provides the best
fit, thereby sharing both profit and loss. It can also take the form of
loan with a difference wherein no interest may be charged and
instead a predetermined royalty is charged on sales once the
enterprise becomes commercially sound. It can be a
combination of Royalty and Interest, rates of both being set at a softer
level. Again, finance may be made available as loan at differential
interest rates - a lower rate in the developing stage of the
enterprise and a higher rate when it matures with a provision of partial
waiver of the loan if the enterprise fails to take off. There is
enough room of flexibility in this regard. There may be financial
securities in the nature of participating Debentures where the interest
rate It should be remembered, however, that preference for participation through equity to channelise VC is not intended to enable the VCFs to control the enterprise. That would hinder their basic strategy to recycle fund. The underlying rationale lies in providing exit route to VCFs through disinvestments of their holding by selling it for reaping Capital Gains. It may take the form of promoter’s buy back, public issue, sale to other VCFs, sale over the counter and so on. For a win-win situation to be arrived, it is better that the entrepreneur can be enabled to buy back the share of VCFs at an agreed pre-determined price, so that the ownership pattern does not get distorted while VCFs on their exit make capital gains and get back the fund for recycling it. International Experience VCFs are recent entrants in the structure of financial intermediaries. Even in USA institutionalization of VC may be traced back only to 1946 with the formation of American Research and Development Corporation in Boston. The legal framework started even later in 1958 with passing of Small Business Investment Company Act. In the late nineties, Silicon Valley demonstrated the potential of VCFs in nurturing and mentoring innovative entrepreneurship. In Europe, pari passu with the movement towards European Common Market, European Venture Capital Association was formed in 1983. Progress was particularly impressive in UK, France and Netherlands. Out of them, experience in Netherlands is worth emulating by LDCs. By a special measure introduced in early 80’s, small VCFs were encouraged to be formed, with risk up to 50% indemnified by the government. As the Guide to Venture Capital in Asia discloses, in Asian countries generally, VCFs started only in the last decade. Leading the flock is China, followed by Malaysia, India and Vietnam. This is of course leaving aside Japan, Hong Kong, Korea, Singapore and Taiwan, who are way ahead of others. But in all the countries where VCF had emerged in Asia, the performances and growth have been impressive. It is interesting to observe that private sector turned out to be the major source of VC in Asia through private investment companies and subsidiaries of industrial companies. In the case of India, Banks, Pension Funds and Insurance Companies etc. hardly accounted for 6% of total venture capital, while Foreign Institutional Investors and domestic Financial Institutions along with Multilateral Development Agencies and Offshore Funds worked around 90% share. It is thus apparent that there is no single unique model of venture capital institutionalization. But there is demonstrated unanimity about the need for it to encourage innovative entrepreneurial efforts to accelerate the pace of economic growth. A country can evolve its own model to that end. Spread of Venture Capital Although historically Venture Capital gets associated with Internet and computer software industry, subsequent evolution of VC extended its sway to include an impressive list of segments. To name a few, industrial products and machinery , consumer goods, construction, medical, communication, healthcare, packaging, business services, distribution/retailing, food processing, bio-technology, energy etc. Similarly, although VCFs are conceptually associated as incubator for start ups, they expand their role also as the fund provider for existing companies with commercially viable new idea including turnaround finance to revitalize sick enterprises. In the same way, VCFs have ceased to be mere providers of funds. Realization has dawned that just as possession of financial capital need not accompany possession of innovative idea, similarly possession of intellectual capital does not guarantee possession of managerial skill. Hence along with finance, the VCFs are to give managerial and marketing skill support (including on-going monitoring of the project) to the new enterprise to accelerate its commercial viability. It may even assist the enterprise in locating and arranging a suitable JV partner. While emphasizing growing importance of non-financial mentoring of VCFs, Brian Dovry, President, National VC Association of America, recommends VCFs to have in-depth knowledge about the industry in which the financed enterprise belongs. IDEALAB Obviously, not all innovative ideas are worthy of getting patronised. Rather, only few of them are worth trying and still few of them survive and thrive in. There lies the importance of due diligence exercise in assessing the potential of an idea and the VCF should have skill for it. But it is also true that there should be opportunity to register innovative ideas, by those who have it. In this connection reference may be made to legendary Bill Gross, who opened a private incubator called Idealab, in California which turned out a number of start-ups. Universities,
management institutes and professional bodies also can work
as incubators of innovative ideas (after proper screening) to provide
the atmosphere to nurture the entrepreneurial spirit and creative
faculty. While such ideas should not be pedestrian, nor they need be
revolutionary. As Jackie McDonald of McDonald Ventures puts it,
“Entrepreneurs don’t have to think revolution, just
evolution”. It may be to quicken the pace still with better result or
it may be a derivative product or a process innovation. The
romantic gloss on innovation as revolutionary is aptly rebutted by the
saying “the problem with once-in-a-lifetime-innovation is that they
come along just once in a life time!” Regulation and Development of Fund - A few suggestions While VCFs are to support Innovations, there should be measures to encourage VCF. Fiscal treatment to Venture Capital is to be made softer, be it on Income Tax or Capital Gains Tax. Development of capital market will itself be an encouragement to VCFs. A reference may be made of establishment of a second tier market by the Amsterdam Stock Exchange with lenient listing requirements, as a facility to VC industry. But registration of VCFs with Securities Regulator is to be made mandatory and a reasonable lock-in-period is to be prescribed before the VCFs can cash out, as a hindrance against fly-by-night operators. Further, exit from an unlisted company may be permitted only at an exit price determined by a suitably laid down formula. In short, to make VCFs effective but aligned to their basic goal of developing enterprises, there should be package of regulation and encouragement. Foreign VCFs may be welcome with reasonable safeguards, as the investment made enriches the economy while management take over does not take place. Conclusion The
innovative entrepreneurs are needed in all economies. The
developed ones need them to keep up the pace of development and less
developed ones need them to impart pace to development. And as Paul
Reynolds (Prof. in Entrepreneurial Studies, Massachusetts) puts it,
“the major factor that sparks business start-ups is growth in
opportunity.” The financial incubation that is provided by
Venture Capital is vital but only one aspect of opportunities. It
is the collective responsibility of government, academic institutions,
business organization, Chambers of Commerce, NGOs and enlightened civil
society to create and grow environment of opportunities, conducive
to generation and development of innovative ideas and (Bose
is MD & CEO of |
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