How to Get a Breakthrough in Ukraine
The Case Against Incrementalism
At the fall meeting of the Mont Pelerin Society, a preeminent international group of free-market scholars, economists wrestled with how best to implement market principles in formerly communist economies. Under certain circumstances, the surest ideological route from Red Square to Mont Pelerin may be via Silicon Valley. The same can be said for other developing countries. A number of economic and political trends signal a more prominent role for Silicon Valley-type growth fueled by venture capital. The challenge is to mesh this dynamic and innovative form of financing with the goals of development aid providers and governments.
WHAT'S GOOD FOR BUSINESS
There is an increased global awareness that a modern economy cannot reach its full potential without nurturing the innovation of its entrepreneurs, and that realization enhances the prospects for venture capital. Venture capitalists provide equity or other types of financing for small- and medium-size enterprises that have growth potential and are not quoted on stock markets. They combine access to cash not available elsewhere with active management support. Their main objective is long-term capital gains to justify their financial risks.
A new emphasis on the entrepreneurial process in developing countries is not enough, however, to increase and accelerate the flow of venture capital, particularly new capital from the developed world. A government-created "enabling framework" is first needed in developing countries to create an attractive playing field and entrepreneurial infrastructure for venture capitalists.
The replacement of centrally planned economies with free-market ones is stimulating the demand for venture capital. The World Bank lists 80 countries that in recent years have made privatization their primary public-policy concern. (More than 7,000 large-scale privatizations have been undertaken, along with 100,000 small- and medium-size companies that have been sold to private parties.) Many of these newly privatized enterprises are insolvent and thus will be searching for alternative means of financing. For many of these economies, a logical next step should include a primary role for venture capital to nurture the entrepreneurial seeds planted by the privatization process.
Venture capital has benefited from the growth of strategic investment (acquisitions, joint ventures, and alliances) and financial investment (investment in publicly traded securities listed on stock exchanges) in developing countries that have embraced free-market reforms. For example, in the 18 months that ended at March 1993, foreign companies made approximately 1,700 strategic investments in Eastern Europe, valued at $42 billion. In the case of financial investors, U.S. pension funds increased their foreign holdings by $53 billion in 1993; approximately 25 percent of this was in emerging markets. In addition, U.S. pension funds expect to increase their overseas investments by an average of 50 percent during the next three years, according to a recent survey.
The increase in strategic investments provides venture capitalists with more and better exit strategies - ways for the initial investors to reap profits and yield their ownership or control to others. In a developed market, a venture capitalist's primary exit strategies are an initial public offering or an acquisition of the company by other investors. Unfortunately, the lack of a stock exchange or over-the-counter market in many developing countries (and the small number of listed companies in countries that have an exchange or market) often precludes an initial public offering as a viable exit. Venture capitalists in developing countries more often rely on exiting by way of an acquisition.
The increase in financial investments is important because they are made by many of the institutional investors who buy into venture funds. The largest source of venture money in the world, representing approximately 40 percent of new committed capital for U.S. venture funds, is the U.S. pension and mutual fund system. Although most investments in developing countries by pension funds have been in exchange-listed securities, a number of these investors have expressed their intention to increase their investments in privately held companies in developing countries. This will help raise money for venture capital funds.
Venture capital is also increasing in developing countries because of growing consumption of industrial and consumer products there. World Bank figures show that 77 percent of the world population lives in developing countries. While many developed markets are struggling, developing world economies are growing at a rate of five to six percent annually, creating vast groups of consumers. The U.S. Commerce Department has projected that developing countries will account for 40 percent of the growth in international trade in the next ten years.
Venture capital investors have been increasingly adopting global perspectives. In 1980, venture capital markets were practically nonexistent outside the United States. By 1990, more than half of the $80 billion of new capital committed worldwide by institutions and individuals to venture funds was outside the United States. Equity and quasi-equity investments made by venture capital funds increased in Europe from $1.9 billion in 1985 to $4.6 billion by the end of the decade, and in Japan from $500 million to $1.8 billion over the same period. This growth is not limited to developed countries. In the past decade, venture funds have been formed for a number of developing countries, including Indonesia, Malaysia, India, China, Mexico, Argentina, Russia, and Ukraine.
All these factors will result in greater venture capital activities in developing countries in coming years. The question is whether a developing country's own government or a development aid provider like the World Bank or the U.S. Agency for International Development can accelerate this trend and increase these activities in a particular market. Current attempts to increase venture capital activities in developing countries are both legislative and non-legislative. Legislative efforts encompass a broad range of incentives, regulations, and policies that are implemented by any governmental, quasi-governmental, or regulatory body. Most of these efforts can be classified as incentives to enter or exit a market.
Entry incentives reduce the initial costs and risks of an investment, thereby making it more attractive. Examples of these include tax credits, rebates, and income tax deductions for investments in eligible venture funds. In a developing country, entry incentives include efforts to enact corporate and securities laws that modernize the domestic regulatory structure. Exit incentives, such as favorable tax treatment of capital gains, the creation of stock exchanges, or over-the-counter markets, make it easier or more attractive for a venture capitalist to exit from a private equity investment.
Non-legislative efforts include the formation of venture capital funds for equity investment in developing countries. Typically, a development aid provider will assist in fund formation and provide a percentage of the capital committed. Other non-legislative efforts include the creation of professional organizations and networks for venture capital firms, in the hope they will facilitate flows of information and capital between venture capital firms.
What is noticeably absent from most of these efforts, however, is an acknowledgement that an accessible private equity market is the end result of a robust entrepreneurial environment. Yet this is critical to understanding why venture capital flows to certain regions and not to others. To attract venture capital, a government typically focuses on reducing barriers to entry and increasing means of exit for private equity investors. Metaphorically, the government looks to build a road to come in and a road to go out. But ideally it should do more than that: it should provide a climate that encourages innovation and entrepreneurship.
There is a genetic code to economic development, as many commentators have observed, and entrepreneurs and venture capitalists can play a central role in developing that code. While many entrepreneurial regions have developed haphazardly, hospitable places for venture capital investment can also be successfully planned.
SILICON VALLEY REDUX
Silicon Valley has been described as having a "social structure of innovation," an interactive system of venture capitalists, entrepreneurs, skilled labor, universities, support services, and entrepreneurial and supplier networks. It is the most sophisticated entrepreneurial infrastructure in the world and has helped make Silicon Valley the global center for venture capital. For a developing country to create such an entrepreneurial climate, an enabling framework would emulate this structure by codifying an intent to develop synergistic relationships between universities, entrepreneurs, established industries, and government.
The first step is to encourage regional clustering of industries. A country's successful industries are often concentrated in a particular geographic region and clustered horizontally or vertically. This is thought to be caused by, and results in, increased information flows and diffusion of innovations. These activities are particularly prevalent in entrepreneurial areas. Regional clusters can be cultivated by a variety of legislative means: land grants, business incubators, zoning regulations, financial assistance programs, and tax incentives.
Concentrated regions of entrepreneurial activity, whether planned, like Taiwan's Hsinchu Industrial Park for more than 140 science-based firms, or unplanned, like Silicon Valley, often evolve from or revolve around academic centers. But the potential benefits are not limited to regions with preeminent, privately owned research centers that focus on high-technology subjects. The Emilia-Romagna region of Italy, for example, contains clusters that successfully compete in a number of low-technology industries, including ceramic tile production and textile manufacturing. Notwithstanding the alleged lack of rigor and uneven quality of programs offered by the predominantly state-run Italian university system, the Emilia region has benefited from the interaction between universities and local industries. Local educational and research programs tailored to the needs of regional enterprises are a unique source of strength for these interactions. Other steps being taken to encourage interaction between the universities and firms include grants for research, encouragement for academic staff to participate in entrepreneurial firms, on-campus workshops for local businesses, and loans and grants to engage students in work-study programs.
A framework needs government set-aside funds for loans, guarantees, or grants to or equity investments in venture capital firms to assist entrepreneurs in raising new capital commitments from local markets. Such funds could also be made available to establish industrial parks or business incubators or fund university research into technologies suitable for commercial application by entrepreneurs. Development aid providers can strengthen enabling frameworks through technical and financial assistance that encourages industrial clusters and helps provide strategic links between industries and universities.
Tax legislation can provide a comprehensive incentive program for private equity investors and entrepreneurs. Such a program may include capital gains tax relief for gains that are channeled into private equity investments, capital gains tax exemption where gains are derived from private equity investments, income tax or capital tax relief on losses from private equity investments, and up-front tax relief on qualifying investments.
Rather than merely transposing what is working in developed countries' venture capital markets, the framework is an attempt to create a DNA-like social structure of innovation: a small, unique element that holds the promise of a larger, more complex entity. The most prominent features of a regional cluster of innovative firms are the efficiency and rapidity of information and capital flows. A sovereign state desiring to provide its own entrepreneurs with greater access to venture capital or create an entrepreneurial infrastructure should seek to replicate these same qualities.
As developing countries begin to participate in the information-based economy, the challenge will be to find ways to maximize technological innovation and change economic development programs in revolutionary ways. For the World Bank and organizations with similar roles, the first step is to recognize that the dynamics of information and capital flows are not monopolized by Silicon Valley and other high-tech entrepreneurial regions. For sovereign states, the enactment of an enabling framework could usher in a new maxim for economic development in the post-Cold War era: Das (Venture) Kapital.