Access to Finance for Innovation: Rationales and Risks of Public Intervention

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1 Access to Finance for Innovation: Rationales and Risks of Public Intervention As gaining access to finance is an important challenge for firms that would like to innovate, many governments around the world have developed specific policies to facilitate it. This policy brief reviews the different rationales for public intervention in this area, explores the limits to (or risks of) government intervention, discusses how market and government failures determine the optimal design of an intervention, and considers some potential options. By Albert Bravo-Biosca How do firms finance innovation? A large body of evidence demonstrates the financial constraints faced by many innovative firms. Numerous studies have shown that innovation activities are more difficult to finance than other types of investment. 1 As a result, according to the European Union Innovation Survey, financial constraints are consistently ranked as one of the top two barriers to innovation by firms. Firms can use both internal and external sources to finance innovation, although the rate of return required by entrepreneurs investing their own funds and that required by external investors often differ. Due to a variety of market failures, discussed in detail below, the internal cost of capital is typically lower than the external cost of capital. In other words, it is cheaper to finance innovation with retained earnings (or the entrepreneurs own savings) than with funds raised in external capital markets. Entrepreneurs savings are limited and retained earnings are often insufficient as well, so many firms have no option but to raise funding from external providers, whether in the form of debt, equity, or some other hybrid or project-based instrument. 1 See Hall and Lerner (2009) for a review.

2 The choice of instrument depends on a combination of factors. Cost is one of them. Peckingorder models suggest firms prefer to fund their investments with internal funds and then with debt, and only failing that by issuing new equity, since the cost of funds increases with the severity of asymmetric information problems (see below). Taxation also influences the relative cost of each source, since in many tax systems around the world interest payments are tax deductible, which distorts the choice between equity and debt in favor of the latter. Other factors also impact the choice between equity and debt. Issuing new equity dilutes an entrepreneur s control of the firm, and can become a source of conflict if disagreements among shareholders emerge, even if it also increases risk sharing and gives the entrepreneur access to the investor s networks and expertise. In contrast, with debt financing an entrepreneur maintains full control of the firm something most owners of small and medium-sized enterprises (SMEs) strongly prefer. But debt financing also implies more volatile returns on equity as well as higher risk of bankruptcy, which can result in total loss of control, a wiping out of all shareholders equity, and the liquidation of the firm. Moreover, bankruptcy is typically an inefficient and valuedestroying process. The stage of development of the firm (which is closely linked to its ability to generate reliable cash flows) also influences what sources of finance are available. Established firms that have strong track records, assets that can serve as collateral, and significant cash flows can easily obtain bank financing. They can also access capital markets to issue bonds or new equity or use alternative sources, such as private equity or mezzanine financing. In contrast, young, innovative firms have to rely on friends and family, business angels (individually or through networks), and crowdfunding platforms 2 or accelerators, and commonly only in the form of equity. Only once the business becomes more developed can it raise venture capital (VC), from an independent or a corporate VC fund, and if very successful, through listing in the stock market with an initial public offering (IPO). 3 Finally, firms can also obtain funding for their innovation activities directly from the government, whether in the form of grants or precommercial procurement contracts. These sources are of a very different nature and thus not considered here. What makes innovation difficult to finance? Raising funding from external sources involves a series of challenges. Some are common to any type of investment, while others are specific to (or more severe for) innovation activities. In particular, two characteristics of innovation make it more difficult to finance: 1. Innovation produces an intangible asset. Intangible assets (such as patents or brands) do not typically constitute good collateral to obtain external funding. Much of the knowledge created in innovation processes is tacit rather than codified and is embedded 2 Crowdfunding platforms raise money in individually small amounts from a large number of people through the web. See the policy brief in the Innovation Policy Platform on crowdfunding platforms for further discussion. 3 A variety of hybrid forms that combine features from equity and debt, such as venture debt, and asset-backed instruments are also available. In particular, new forms of asset-backed finance for intellectual property and intangible assets are emerging.

3 in the human capital of a firm s employees (who can leave) and in its organizational capital. Even when this knowledge is codified and registered for instance, in the form of a patent its value is hard to measure. In contrast to tangible assets such as machines, which can easily be redeployed to other uses, the value of intangible assets can be difficult to separate from the other assets in the firm. Therefore, they typically have limited salvage value in case of bankruptcy. Ongoing attempts to create more liquid IP markets may help temper some of these concerns, but only for a subset of intangible assets. 2. The returns to innovation investment are highly uncertain. The distribution of returns for an innovative project is unknown, which makes innovation not only a risky activity, but an uncertain one as well. In other words, quantifying the probability of success and failure (which is common) is typically not possible, and thus the expected return to the investment cannot be estimated. This uncertainty creates significant problems for standard risk adjustment methods used by funding providers. The market failures that reduce financing for innovation Markets generally provide less financing for innovation than the social optimal. This is why many governments intervene, designing schemes to reach or get closer to the optimal level of innovation investment (even if the massive uncertainties intrinsic to innovation activities make it difficult, if not actually impossible, to precisely determine what this optimal level is). Markets underinvest in innovation for several reasons, which are used to justify government intervention: 1. Asymmetric information. Not only is information limited about whether a particular innovation project is likely to succeed; it is also asymmetric. Inventors looking for financing, whether entrepreneurs or firms, have more accurate information than potential investors, both about the promise of an innovation project as well as about their own effort and choices when developing it. This leads to two classical sources of market failure: a. Adverse selection. If banks don t know the default risk of a particular borrower, they can only price loans based on the average default risk. As a result, low-risk borrowers face higher interest rates than they would if the lenders had perfect information, and they may choose not to seek loans. This increases the risk of the remaining pool of borrowers, since those who are willing to pay high interest rates are usually also high-risk, which pushes up the interest rates the banks need to charge to break even. The higher interest rates in turn may discourage lower-risk borrowers from applying for funding, increasing the default risk in the remaining pool again. Adverse selection affects equity financing, too. The firm issuing equity has better information on its own value than potential investors, so

4 it will seek to raise financing when stock markets overvalue the company and avoid it, if possible, when the stock is undervalued. b. Moral hazard. The bank cannot perfectly monitor the activities of the inventor after the loan has been approved. As a result, an inventor may be tempted to take on a more risky project than what had been originally agreed, since in case of success he or she gets of all the upside, while in case of failure the loss is capped. Moreover, if the firm is close to being in financial distress, the cost to the inventor of taking on additional risk becomes negligible, which can lead the inventor to choose recklessly risky projects. In other words, debt may induce firms to take more risk than optimal, although it may also have the opposite effect. Specifically, debt can have a disciplining effect in comparison to equity, since monthly payments and the possibility of losing control in case of bankruptcy can help focus an inventor s mind. Equity financing is also subject to moral hazard, in this case due to corporate governance issues created by the separation of ownership and control. In short, the inventor has the incentive to undertake projects that benefit him or her even if they don t maximize profits, and external shareholders may not be able to observe easily whether this behavior is deviating from that which maximizes shareholder value. The outcome of adverse selection and moral hazard is that projects with positive net present value (NPV), which inventors would choose to undertake if they had enough money, might fail to attract sufficient external capital and thus not be developed. In practice, different ways exist to reduce the impact of asymmetric information. Inventors can try to signal the quality of their projects for instance, by obtaining a patent, which certifies to external investors that they have developed a unique technology. 4 Investors can finance the firm in stages. Banks can also require the inventor to provide some collateral they can seize in case of default, and/or a personal guarantee. This signals the inventor s belief and commitment to the project, aligns his or her incentives with those of the bank (both ex-ante and ex-post), and reduces the loss for the bank in case of failure. Most collateral is in the form of tangible capital, but some forms based on intangible assets are also emerging (for example, a patent or brand can be used as collateral in some circumstances). 5 Last but not least, finance providers undertake significant due diligence before a transaction and monitor the inventor s behavior after it. The uniqueness of ideas makes due diligence and monitoring expensive, however. It is easier to value a house or a 4 Signaling is more effective at separating high-quality from low-quality inventors if the cost of the signal is higher for low-quality inventors, in which case high-quality inventors may be willing to pay to signal their type even if the signal has no other benefits (that is, it is unproductive in every respect other than providing a signal). 5 Such an intangible asset can have some recovery value in case of failure, but it may also serve as a commitment device. Even if its value outside the firm is limited, the firm may have limited value without it. See the policy brief in the Innovation Policy Platform on IP-based financing for innovation for further discussion on IP-based instruments.

5 plane than a new technology or business model, with all the uncertainties they involve. As a result, the cost of due diligence can exceed the benefits obtained from the transaction for instance, when the margins are low, as with SME loans, or when the deals are small, as in early-stage VC. These relatively high due-diligence costs for small investments are behind the early-stage equity gap concept applied by many governments, as they can prevent early-stage deals from happening and shift VC s attention toward larger, later-stage deals. Whether this is sufficient justification for government intervention is discussed in the next section, but the short answer is no at least not on its own. 2. Externalities. Innovation activities generate externalities, since inventors rarely can fully appropriate the returns their activity generates. Among other strategies, inventors can use intellectual property, secrecy, or first-mover advantage to capture these returns. This cannot prevent other firms, however, from learning from an inventor s successes (as well as failures, which can also provide valuable lessons), and replicate, fully or partially, some of these successes, whether by launching similar products or services or adopting similar processes or business models. As a result, the social return to innovation investment is higher than the private return, so markets invest less in innovation than is socially optimal. This market failure is a common rationale for several innovation policy interventions, such as research and development (R&D) tax credits, which aim to close the gap between social and private returns to R&D by increasing the latter. 3. Coordination failures. Innovation activity happens within a system, with different actors and networks, as well as underlying infrastructure and institutions. Entrepreneurs come up with ideas, investors back them with their funding, and these new firms try to attract talent, suppliers, partners, and customers. If successful, they expand, go through an IPO, or are acquired in a profitable trade sale. Most (if not all) parts of the system need to be in place for it to function well, and missing parts may not emerge if others are missing. This creates the typical chicken-and-egg problem and is one of the reasons clusters are so difficult to replicate. Venture capital provides a typical example of coordination failure. A VC industry will fail to develop in a region unless it has a good pipeline of promising startups, business angels to back them in their earlier stages, lawyers able to negotiate VC deals and IP agreements, sufficient experienced investment professionals, and developed exit markets (among other conditions). Yet many of these will not emerge without a developed VC industry existing in the first place. Given that place and history matter, shifting to a new, superior equilibrium may require temporary support from government, until the system is fully developed and hence self-sustaining. 4. Institutional failures. To work, markets require a set of well-functioning institutions. While not a market failure in a strict sense, an institutional failure can severely damage access to finance for innovative firms. Individuals will not invest in building innovative

6 businesses if property rights are not guaranteed and their firms (or gains) can be confiscated. Inefficient contract enforcement leads to relationships among different parties being governed by trust rather than contracts, making it more difficult to raise funding beyond family and friends. Inefficient bankruptcy regulation reduces the recovery value in case of financial distress, discouraging the provision of credit in the first place. IP markets and IP-based lending cannot really develop without an efficient intellectual property rights (IPR) system. Similarly, banking regulation and accounting standards can also have an important impact. Consequently, while institutional failures do not fall within the market failure definition, guaranteeing these institutions are in place is a fundamental role of government action, and one that typically only governments can fill. The market failure rationale is not the only approach that can be used to justify government intervention in the realm of access to finance. Another approach commonly taken by policymakers considers instead the innovation system and its failures. The innovation system consists of the set of actors, rules, and relationships that interact in the innovation process. System failures which may include, for instance, the institutional failures discussed above thus refer to the components of the system that are not working appropriately and therefore should be fixed. While sometimes the market- and system-failure rationales are presented as conflicting, they are actually complementary ways to look at the problem, since system failures point to the elements of the system that are not working and market failures can help understand why this is the case and how to intervene to address them. Some access to finance interventions can also be justified as part of a mission-driven policy. Rather than fixing a market or system failure, the motivation is to address a social challenge or develop a new industry. In other words, governments identify a goal considered to be socially desirable (for example, reducing climate change) and design a set of instruments to increase access to finance for innovations aimed at tackling it (for example, clean energy technology). In this case, financing is typically only one of several policy levers used to coordinate action to address that particular challenge or goal. Some other justifications for government intervention have also been used, sometimes linked to behavioral biases and information gaps. In contrast to market failures which emerge when rational behavior by market actors leads to a suboptimal outcome, some of these other arguments are based on the premise that actors in the market, whether entrepreneurs or finance providers, do not always make optimal decisions, and that the government can help fix that, or at least nudge them in the right direction. For instance, firms may not put sufficient effort or have enough information to become investment ready, failing to present themselves as an investable opportunity due to the low quality of their business planning, financial management, or governance systems. Because of this, many governments consider that merely increasing availability of funding for innovation is not sufficient, and that measures to support entrepreneurs and firms so they become investment ready also need to be considered.

7 Similarly, some policymakers argue that financial intermediaries can engage in short-terminist behavior, focusing excessively on short-term results while failing to invest in profitable long-term opportunities due to a misaligned incentives structure. Or that they may have a misperception of the private returns to innovation investment because of a poor legacy of returns in some asset classes, such as VC in many parts of the world. Or alternatively that they fail to experiment with new asset classes or financial instruments that have the potential to perform well but do not yet have track records. Inefficiencies in the functioning of financial markets over the economic cycle may create another rationale for intervention (as well as affect the performance of different schemes). Interventions that aim to offset a credit crunch may be welfare-enhancing, increasing funding for innovation as well as aggregate demand. The booms and busts in venture capital cycles have also been used to argue for additional public support during the down years following the burst of a bubble. Finally, some have used barriers to diversification as a rationale for government intervention. A variety of collective action and corporate governance problems may make it difficult for investors to create sufficiently diversified portfolios with low volatility of returns. Governments, on the other hand, may have the ability both to take on larger risks and to spread their bets more widely. Overall, the validity of some of these rationales for government intervention is widely debated, not only in an ideal world with enlightened policymakers free from distorting external influences, but also in the real world, in light of the series of potential government failures discussed next. Government failures: The risks of government action The existence of a market failure is not a sufficient condition for government intervention. The decision to intervene needs to weigh both benefits and risks, since a number of government failures can make public intervention impractical or even counterproductive. In other words, not all market failures are fixable, at least not at a reasonable cost to society (relative to the benefits). Therefore, rather than assuming all market failures can or should be fixed, the focus should be on tackling those that are socially desirable to address, given the limitations of government action. Important to the consideration of government failures is to define what failure is in this context. A predictable failure could have been anticipated at the outset, while an unpredictable failure only emerges afterward. In other words, governments routinely experiment with new policies. In some cases failure is predictable, while in many others it is the result of unforeseen circumstances and part of the normal learning process involved when trying out new schemes in an uncertain and complex environment. Therefore, even if the distinction is not necessarily clear cut, these two types of failures should not be treated equally. The discussion that follows refers mainly to predictable rather than unpredictable government failures.

8 Government attempts to fix market failures (as well as system failures) with regards to access to finance may fail to work as desired for several reasons: 1. No advantage relative to the market to fix the failure (and maybe at a disadvantage). Governments may not be able to improve upon the market allocation of resources, as they are subject to some of the same limitations. For instance, governments don t have an advantage relative to the market when undertaking due diligence, yet they still have to pay for it to reduce asymmetric information problems (and they may be less good than private investors at it). In addition, governments typically have less information than markets and may not be able to take advantage of market prices to gather it Asymmetric information and misalignment of incentives. Many interventions to provide access to finance rely on financial intermediaries to manage or deliver the scheme. This introduces an additional layer of adverse selection and moral hazard problems, in this case between governments and financial intermediaries. For instance, public loan guarantee schemes may give banks an incentive to be less careful when selecting which companies to fund, since the government is picking up an important share of the losses. While funding higher-risk loans may be the intended aim of the policy, governments sometimes have little control over whether the wrong type of risky companies is being selected (that is, low-productivity firms close to bankruptcy rather than risky innovative firms), or on the level of effort banks put into monitoring the loans (and collecting in case of financial distress). Direct funding provision through a government-owned bank provides greater control, but it may also worsen adverse selection and moral hazard problems. Soft budget constraints 7 and political objectives can lead to poor credit cultures without sufficient discipline, not only when lending but also when choosing how to proceed if the firm defaults. Among other potential pitfalls, this may lead to a tendency to subsidize underproductive firms, reducing the creative destruction that drives productivity growth. 8 Misalignment of incentives can also emerge in equity schemes for instance, when the schemes are too generous or unrestricted. Tax incentive schemes that allow investors to make double-digit returns even if their investments are losing money may lead to poor choices. Schemes with few or no restrictions may channel investment to areas other than policymakers priorities, although adding restrictions can introduce a complexity that may also hamper a scheme s effectiveness. 6 A fundamental advantage of markets is that prices aggregate information both on preferences and costs from all market participants. For instance, the price of a stock aggregates the different views on the market about the value of the firm (even if markets are not always efficient either). 7 Government-owned banks can have access to taxpayer funding to cover any of their losses, which can make less disciplined when deciding how to allocate credit. 8 Productivity growth is faster in an environment where new entrants with high productivity can grow to replace low productivity incumbents, which shrink and exit the market.

9 3. Limited additionality and crowding out. The impact on aggregate innovation investment of access to finance interventions may not be as high as desired because of crowding out. Some schemes may be successful at giving private investors an incentive to provide additional funding, increasing overall investment by more than the public funds committed. In others, aggregate investment may increase by less than the amount of public funding provided, or in some cases it might not increase at all if government spending fully displaces private investment. In other words, if there is full crowding out and thus no additionality. The outcome depends on at least two factors. The first is the policy levers governments have available to them. Because the set of tools at their disposal is limited, governments may find it difficult to design schemes that don t subsidize investments that would have taken place in any case, reducing the additionality of the policy. The second factor is the size of the intervention relative to the market s (or system s) ability to absorb it. Very large interventions, for instance, can be counterproductive, not only crowding out current investment but also damaging the future development of the industry. Without additional investable projects, more public money may only reduce the opportunities available for private venture capitalists, reducing their returns and thus forcing them out of the market or making it more difficult for them to raise follow-up funds in the future. 4. Rent-seeking and capture. Many who have the potential to benefit from a particular policy, whether in the private or the public sector, may engage in rent-seeking activities to lobby in favor of it. As a result, government action may be captured by special interest groups, leading to inefficient interventions that deviate from the socially optimal ones. More targeted interventions (for instance, picking winners ) have a higher risk of capture than broader-based horizontal policies, where the benefits are typically more diffuse, but the latter can also be captured by special interests. Given that established incumbents in the market are typically better connected to policymakers, they can use their influence to distort the playing field against new players entering it. 5. Political factors. Governments are led by politicians, whose actions may be influenced by many factors. For instance, election cycles and promotional opportunities may encourage politicians to choose policies that focus in the short term (even if they are less desirable in the long term). Similarly, media bias when discussing failures may discourage risk taking in favor of overly conservative policies (even when experimentation with new schemes would be welfare-enhancing). The potential for corruption and capture (as discussed above) are also important factors to consider, particularly when checks and balances are missing or inadequate.

10 6. Implementation failures. Schemes that look good on paper may not work in practice for a variety of reasons, sometimes related to the design of the policy but often due to flawed implementation. This may be the result of an inefficient bureaucracy that is not fit for the purpose, able neither to deliver existing policies nor to cope with change and adapt processes to new circumstances. Another factor may be the qualifications and experience of government staff, who are typically paid less than their private-sector equivalents but are still expected to deliver at the same level (for instance, when undertaking due diligence or negotiating deals in public VC funds). The complexity of the policy is also important. A policy based on providing tax incentives to VC investors, for instance, is easier to implement than one based on setting up a new fund to develop technology platforms in collaboration with businesses. As a general rule, the more sophisticated the policy, the more skilled and honest the policymaker ought to be, even if simple policies that require little judgment and have little room for discretion can also go wrong. The success or failure of a government scheme to promote access to finance for innovation ultimately depends on a variety of factors. The quality of institutions in each country determines how important some of the sources of government failure are. More generally, the characteristics of the innovation system in the region also have an impact on a scheme s effectiveness, as does the wider policy mix. In summary, institutions, context, and place matter. A scheme shown by rigorous evaluations to be very successful in one location may not work in another, so it is important to extract the right lessons from earlier examples and rigorously evaluate subsequent implementations of the scheme. Ultimately, very few interventions (if any) are without caveats, so the task of the policymaker is to judge continuously which of the alternatives including doing nothing is best or, at least, less bad. Identifying the right rationale The design of a new intervention to facilitate access to finance for innovative firms requires a clear diagnosis of what specific market failures it aims to address and how long this is likely to take for instance, externalities require a different approach than a coordination failure. Therefore it is important to link the features of the intervention, particularly its duration, to the specific failure it is trying to fix. Three scenarios are common: A permanent intervention due to a permanent market failure, such as externalities from innovation activity A temporary intervention until a superior equilibrium has been reached, at which point the intervention is no longer necessary. This may be the case with coordination failures,

11 resulting perhaps from a structural shift in the environment or new opportunities emerging. Some other forms of externalities may also justify a temporary intervention, such as testing the feasibility of alternative models of funding provision and generating learning by doing that spills over across the industry. A temporary intervention due to cyclical factors for instance, to offset a credit crunch until financial markets go back to normal Regardless of the scenario, it is important to minimize policy uncertainty and create a stable policy framework. The metric used to measure the success of an intervention should also be linked to the market failure it is trying to address. The private rate of return is often used to assess many fund-based interventions. Yet a high rate is typically evidence that the intervention is no longer required if the main rationale for it was developing a new market (for example, if it was attempting to address a coordination failure or experiment with new models); or that it was never required if the main rationale was asymmetric information and due diligence costs, since these tend to be predicated on poor returns without public support. Social rather than private rates of returns would be a more appropriate metric if externalities were the main rationale, although this information is not typically available. Extremely high rates of return can also be evidence of failure rather than success, since they may imply that many other profitable opportunities, even if not as good, were not backed, maybe due to insufficient funds. Therefore, amounts invested is a useful metric to consider, with the caveat that more is not always better, if it ends up backing very poor projects. Separating the impact of the scheme from the underlying market trends is also a challenge when measuring the success of an intervention. Because of this, evaluations should rigorously estimate the additionality of the intervention (for example, backing investments that would have happened in any case is not the best use of public money) and not ignore the rationale that was originally presented when introducing the policy. The equity gap rationale used by many governments to justify intervention in the early-stage financing market conflates many of these issues, so it is a useful example of how to consider them in practice. Specifically, the argument states that the high cost of monitoring and undertaking due diligence required to minimize asymmetric information problems makes small deals not worth doing and focuses the attention of venture capitalists onto larger ones. This creates an equity (or funding) gap between those deals that are too large to be financed by friends and family and business angels and those too small for standard VC funds. 9 Consequently, the argument goes, government should intervene to fill this gap for instance, setting up a VC fund or providing tax incentives for investors. 9 Different thresholds have been used to determine the boundaries of this gap, and these have evolved as market conditions have shifted over time (for instance, with the emergence of so-called super angels ).

12 This justification is, however, problematic, since the government does not have an advantage over the private sector in undertaking due diligence. If anything, some may argue, it is at a disadvantage, given that civil servants are much less experienced than private venture capitalists on how to undertake due diligence and structure VC deals, and attracting expert talent has typically been difficult. The cost of due diligence is, therefore, at least as high for the government as for private VCs. Even if delegated to the private sector, however, its cost is still higher than the returns the investment is expected to generate, and this is the case regardless of who pays for it. Consequently, asymmetric information is not a valid justification for intervention, at least not on its own. In other words, the benefits of fixing the market failure do not compensate for its cost if this is the only rationale for intervention. This does not mean government intervention in the VC market is not justifiable, but rather that asymmetric information is not the right market failure rationale with which to justify it. Governments may do the right things even if for the wrong reasons, since other market failures could justify interventions in the VC market. Externalities may provide an alternative rationale. VC funds typically finance the development and deployment of innovative products or services. In the same way R&D tax credits and grants are used to fund innovative activities in the private sector, support for VC funds could be considered another channel to subsidize investment in innovation. This rationale is implicit in most government policies that support VC activity, yet making it explicit raises one significant question: if externalities are the main motivation, why focus only on those segments of the market where equity gaps exist rather than supporting the full market? In other words, externalities could be a justification for government intervention even if no equity gap existed and innovative firms were not financially constrained. There is, however, a reason, even if not typically acknowledged, to focus on financially constrained firms even if the externalities from their innovation activities are of the same magnitude as those from unconstrained firms: additionality. One dollar of public funding given to a financially constrained firm is likely to increase innovation investment by more than if the same dollar was given to an unconstrained firm. So while addressing the asymmetric information market failure to close the equity gap is not a valid rationale for public intervention on its own, the stronger additionality of public support for financially constrained firms (and the externalities it generates) may justify targeting those groups of firms that are more likely to experience financial constraints typically, the young innovative firms. Views differ, however, on whether externalities are strong enough relative to potential government failures to justify a permanent intervention in the VC market. In contrast, coordination failures are a widely accepted rationale for a temporary intervention in the VC market. The aim is to kick start the market until all the components of the system are in place and it becomes fully established and self-sustaining. The much-cited Yozma Fund is the clearest example of a successful temporary intervention, even if context matters when trying to replicate it in other locations. These are not the only rationales for public intervention to close the equity gap. Government support for experimentation with new funding models for young innovative firms can generate

13 useful lessons that private intermediaries can then apply (this is another version of the externalities argument, applied to innovative funding instruments). The case has also been made that a government decision to support a firm can generate useful public information about its value that attracts private investors. This certification effect, if the signal is credible, reduces the due diligence cost for investors (as if the due diligence process were pooled, to some extent), and it may help increase funding for innovation. In addition to determining the precise rationale, two other crucial questions need to be considered when designing government interventions to increase access to finance for innovative firms: whom to target and how to intervene. They are discussed next. Deciding whom to support Most access to finance interventions implicitly or explicitly target a particular group of firms (even if there are some exceptions). It makes sense to focus public funding on those firms that have innovative projects with high social returns that would not happen without government intervention in other words, those firms for which the policy will have high additionality in the outcomes of interest, and which typically (but not necessarily) are more likely to be financially constrained. Yet accurately implementing this targeting is nearly impossible, and the attempt to do so may in some cases be counterproductive. Innovation is difficult to define. Moreover, very different types of investment are involved in the innovation process, such as R&D, design, marketing, or training, just to name a few, and the externalities they produce also differ. In spite of this, a case could still be made for targeting innovative (or intangible-rich) firms in many of the existing interventions. 10 While some schemes do so (such as VC schemes), many others are quite generic (for example, SME loan guarantee programs), focusing on reducing financial constraints for a wide population of firms regardless of the spillovers they generate, even if the rationale for this is not always clear. Most targeting of government schemes is based on some characteristics of firms that are correlated with barriers to finance, rather than an explicit assessment of firms financial constraints (even if some schemes do explicitly assess the firms constraints by requiring them to prove they were unable to obtain funds from other sources). Size and age are the most common proxies used, since young and small firms are more likely to be financially constrained than older and larger ones. Sector is another factor sometimes considered. Young firms face much uncertainty regarding their future cash flows, lack collateral assets that can be used as guarantees, and have shorter track records (which may be less welldocumented, given their weaker audit and reporting standards). Older SMEs share some, but not all, of these features, yet despite the many differences they are very often given the same treatment as young firms. 10 Or, more generally, targeting those firms or activities that generate spillovers, such as innovation or exporting.

14 Large established firms don t have these handicaps. They have much easier access to external funding and can also take advantage of their own internal capital markets to allow innovative projects in one division to be funded by other cash-rich divisions in the same firm. Sometimes they may even have the opposite problem too much free cash flow, which can lead to poor investment decisions. (This is why debt is sometimes referred to as a disciplining device, since it forces managers to return the funds to the firms creditors.) When selecting specific young or small companies to support, governments have at least three options: To support all firms that qualify within this group for instance, by offering tax incentives to all individuals that invest in young firms To delegate to private financial intermediaries the choice of which firms to fund, giving them a set of criteria to follow To set up a public institution to distribute funds to firms directly As discussed earlier, the choice to delegate has both advantages and disadvantages. Delegating the task of picking firms to private-sector financial intermediaries is typically the preferred option, in particular for lending and VC schemes but only as long as it is designed very carefully, avoiding misalignment of incentives and gaming (which, among other considerations, requires the right compensation agreements). It also needs to provide clear guidelines for selecting which companies to invest in, avoiding complex and overengineered rules that limit the effectiveness of the scheme as well as extremely simple conditions that open the door to public funding being used for very different aims than those originally intended. Other criteria beyond size, age, financial constraints, and innovation and growth potential are often used by governments to select which companies to target. Some prioritize certain groups, such as minorities or women, while others are mission-driven and focus on specific social challenges (or particularly underserved regions where socioeconomic returns are deemed to be higher). Ultimately, these schemes can have distributional consequences, creating winners and losers, so a political choice is often involved as well. Finally, a very large gap may occur between original intentions and reality when it comes to the companies that eventually end up receiving funding from government schemes. While these schemes are often aimed at helping companies take risks, innovate, and grow, this may not always happen in practice. For instance, funding may end up supporting the survival of struggling firms with poor business plans and cash flows that could not find funding elsewhere. In other words, despite the original intentions, some of these interventions may damage creative destruction and productivity growth if they end up supporting underperforming incumbents (or underperforming startups) that would otherwise exit the market, stifling competitive pressures and hampering the expansion of the high-productivity innovative firms with the potential to grow the most.

15 How to intervene Governments can consider a large array of options to increase access to finance for innovation. Some involve using taxpayers money, while others, sometimes with more impact, just rely on changes in the regulatory framework. Among the most common interventions is the provision of capital, directly to firms or indirectly through financial intermediaries. An example of the former is setting up a public bank or fund; an example of the latter is using a co-investment or fund-offunds model. A risk to consider when injecting large amounts of public money is that they can potentially depress the returns private investors receive, which may damage the long-term development of the financial intermediaries the policy aims to support. Another common set of schemes has the goal to increase the private rate of return, which incentivizes private investors to provide more capital to fund innovative activities. This is often achieved using tax incentives for individuals who invest in qualifying companies or funds, resulting in lower income tax and/or capital gains tax payments. Other schemes try not only to increase returns, but to reduce their volatility. This is done by providing downside protection in the case of failure. For instance, government loan guarantee schemes provide partial insurance to banks, limiting their losses in case of default. VC schemes may provide either downside protection or instead increase the upside potential in case of success. The options are multiple. Under some VC schemes, governments commit to take on the first losses of the fund. In others, governments put a cap on the returns they will receive if the fund is successful (among other ways, this can be achieved by giving private investors the option of buying back the government share at a predetermined price, as the Yozma fund in Israel did very successfully). Facilitating transactions is another common type of government intervention. One way is to reduce the cost of due diligence by increasing information about opportunities. For instance, winning a competitive R&D or technology development grant (or a precommercial procurement contract such as a U.S. SBIR award 11 ) provides a signal to investors about a firm s innovative potential a sort of certification effect that, if credible, will make them more likely to fund the firm. Governments can also impose strengthened disclosure requirements, although this can be costly, particularly for small entrepreneurial firms. Some governments subsidize the creation of information (for example, through IP audits) that may be useful to financial intermediaries. Alternatively, many help innovative entrepreneurs become investment ready through a variety of schemes, making it easier for investors to find suitable opportunities. Governments can pursue more ambitious agendas, as well, such as supporting the development of new models and helping create new markets. This approach can take different forms. One is providing funding to those experimenting with new models of financial intermediation, since the learning they generate changes private investors perceptions about the feasibility and returns of new instruments, promoting investor activity if successful. Another 11 Small Business Innovation Research, a US government program.

16 is to de-risk early adoption for instance, offering a temporary public guarantee for SME bonds to kick start this market. Yet another lever available is modifying regulation to facilitate the emergence and consolidation of new models, as is currently being done with regard to crowdfunding, or as was done some time ago to allow pension funds to invest in venture capital. Interventions can also try to solve coordination failures, both at a system level, when some actors will not emerge unless others are already in place (such as in the VC example discussed earlier), or at more micro level, by setting up business angel networks that may not emerge without some initial support. Finally, governments can also create the underlying infrastructure required for new markets to function. It can, for instance, set up an up-to-date IP registry that provides accurate information on the current owner of a patent rather than just the original one information that is often missing, which makes it more difficult to use IP as collateral and thus hampers the development of IP-based financial instruments. More generally, governments can influence access to finance for innovation through financial regulation. For instance, the Basel III accord on banking regulatory standards includes a specific treatment for SMEs. Similarly, the treatment of different types of intangible assets in the calculation of required capital ratios will affect availability of credit for IP-rich firms. Finally, it is the role of government to maintain well-functioning institutions that guarantee property rights, contract enforcement, and efficient bankruptcy processes, and provide other vital services. Their impact cannot be underestimated, so access to finance schemes cannot be seen, nor should they be, as a substitute for high-quality institutions. The list of potential alternatives for government interventions on access to finance for innovative firms could go on much longer. Ultimately, the specific rationales (as well as the risks) for all these types of interventions need to be carefully considered, not just generically but also in the particular context where the intervention is being contemplated, taking into consideration the financial landscape and the innovation system, as well as the wider policy mix into which these interventions fit. 12 Further reading Brassell, M. and K. King Banking on IP? The role of intellectual property and intangible assets facilitating business finance. IPO, London, UK. Hall, B. H., and J. Lerner The Financing of R&D and Innovation. NBER Working Paper No OECD Financing SMEs and Entrepreneurs The policy briefs and case studies in this module of the Innovation Policy Platform on access to finance provide detailed discussions and examples for most of these interventions, as well as several others.

17 Rigby, J., and R. Ramlogan Access to Finance: Impacts of Publicly Supported Venture Capital and Loan Guarantees.. Compendium of Evidence on the Effectiveness of Innovation Policy ( Nesta Working Paper No. 13/02.