Finance for InnovationA Policy Framework

Knowledge Economy Forum IV, Istanbul, March 2005

Fernando Montes-Negret, World BankSector Director

Private and Financial Sector DevelopmentEurope and Central Asia

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A Policy Framework

I. Why Finance for Innovation?

II. Government Intervention in Innovation Finance?

III. Key elements of successful Government Interventions

IV. Instruments to promote Innovation Finance

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Definitions

Innovation is the introduction of new ideas, goods, services, and practices and their application in a commercially successful way.

Innovations result from formal Research & Development (R&D) and less formal on-the-job modifications of practice, through exchange and combination of professional experience and by many other routes.

Innovation Finance is the allocation of finance resources to fund innovative activity

I. Why Finance for Innovation?

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Why Finance for Innovation?

Strong theoretical and empirical links between Innovation and Growth (Romer 1982; Lucas 1984)

Empirically, investments in Research & Development can be shown to have a return on investment (RoI) of 78% on a macro-level – far above normal market returns (Lederman/Maloney, 2004)

But, does the link between Innovation and Growth justify Government Interventions?

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Why Finance for Innovation?Leverage strong Science & Technology tradition in

ECA • ECA benefits from a strong Science & Technology (S&T) tradition that should offer a key comparative advantage, but, so far, S&T capacity does not translate into innovations

• DELETE? ECA countries need to catch-up with OECD investments in Research & Development

• Low levels of funding and deterioration of secondary & tertiary education cause brain drain and depreciation of human capital.

•DELETE? Focus on promotion of private R&D to increase efficiency and commercial targeting of knowledge production and innovation

• EU8 face significant challenges to increase R&D spending from 0.8% of GDP to EU Lisbon Strategy Target of 3%

EU Target = 3%

Average new EU member states (EU10) = 0.8%

II. Government Intervention in Innovation Finance?

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Government Intervention in

Innovation Finance?

Knowledge• Education

• Universities• ICT

Idea

BusinessEnvironment

IntellectualPropertyRights

Yes

Funding for Early Stage Technological Development (ESTD)

•Business Plan•Prototype

Entrepreneur?

Funding for Commercialization

•Venture Capital•Private Equity

Funding for Expansion

•Capital Markets•Strategic Investors

•Banks

Yes! Yes! Yes! Yes!

Yes!

Yes!

Yes!

Innovation

Innovation

Innovation

Innovation

Innovation

Innovation

Innovation

Innovations need to overcome many hurdles:

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Government Intervention in

Innovation Finance?

Market failure (1):

Knowledge is not completely appropriable despite Intellectual Property Rights (IPR)

Innovation generates positive externalities for which the investor will not be compensated: Private Investment < Socially Optimal Investment

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Government Intervention in

Innovation Finance?Market Failure (2): Funding Early Stage Technical Development

ESTD funding in the US

34%

34%

25%

4% 3%

Corporate VentureFederal and State Governm ent (SBIR, etc.)Angel Inves torVenture CapitalUnivers ities

Mainstream financial intermediaries like banks and institutional investors avoid Early Stage Technological Development:

High information asymmetries, uncertain cash-flowsNo proven track record of technology

Even in the US, the Government provides 34% of ESTD funding:Most financing is provided internally by bigger corporations (34%) or by “Angel Investors” (25%). DELETE?Both typically have established relationships with innovators and only invest in markets they are specialized in.Venture Capital plays a minor role in ESTD

Source: Branscomb / Auerswald, 2003

Funding for Early Stage Technological Development (ESTD)

•Business Plan•Prototype

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Government Intervention in

Innovation Finance?

Implications for ECA countries in financing Early Stage Technological Development:

Incentivise corporations to invest in in-house R&D through matching grants, reduction of tax distortions etc.

Only few “Angel Investors” in ECA: Enhance investment framework to bring Venture Capital into Early Stage Technical Development Phase

Create robust Government Funding mechanisms for ESTD modeled on global best practice

Funding for Early Stage Technological Development (ESTD)

•Business Plan•Prototype

III. Key elements of successful Government Interventions

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Key elements of successful Government Interventions

Knowledge• Education

• Universities• ICT

Effective Policy Design: Create pre-conditions

Establish high quality learning systems and align them to provide skills demanded by market economies

BusinessEnvironment& Comptition

Improve business environment & market competition to drive innovation in the private sector

IntellectualPropertyRights

Strengthen legal framework and Intellectual Property Right protection and enforcement

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Key elements of successful Government Interventions

Effective Policy Design: Avoid rent-seeking, capture and moral hazard/free-riding:

DELETE?Prevalence of corruption and capture of government processes by interest groups place a heavy burden on the design of successful policy instruments

Grants, credits and other forms of funding allocations need to be independent and based on technical merits

Innovation finance is not a tool for industrial policy. All innovations in all sectors are good innovations

Funding needs to preserve the incentives for the entrepreneur through matching mechanisms etc.

Design transparent control mechanisms, for example: Continuous evaluation of selected projects against performance of random control sample with identical level of funding

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Key elements of successful Government Interventions

Effective Policy Design: Sequencing of interventions

Sequence of Government InterventionsAppropriate interventions depend on the innovation environment, i.e.:

Business environment and legal framework need to be in place before finance interventions

Build “deal pipeline” through ESTD interventions (i.e. matching grants) before Venture Capital Interventions

Business Environment Financial Framework

Intellectual Property Rights• Establish incentives for private R&D through IPR framework

• Enhance enforcement of IPR through judiciary, patent office etc.

Innovative Capacity• Improve education and increase pool of scientists and engineers

• Strengthen science and ICT infrastructure

Grants, Credit, Technical Assistance• Increase access to finance for early-stage technological development

• Incubators, Technology Centers, Investor–Scientists networks

Risk Capital Markets / Venture Capital

IV. Instruments to promote Innovation Finance

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Instruments to promote Innovation Finance

Grants and matching grants ✔Provide direct government funding for R&D projects in private enterprises, typically matching investment of own funds

Government shares the risk of the innovation project with the entrepreneur providing incentives (and funding) to engage in innovative activity

Matching grants (i.e. 50% of total costs) preserve performance incentives of the entrepreneur

But: Grant allocation vulnerable to distortion, capture and rent-seeking. Transparency is key!

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Instruments to promote Innovation Finance

Taxes ✔✗Tax incentives - like preferential tax rates for R&D - are prone to be misused for tax evasion. Tax incentives are only viable in countries with efficient and effective tax collection systems ✗START-UPS HAVE NO INCOME TO USE BENEFITS

However, R&D expenditure should be made tax deductible and not be capitalized in order to reduce tax distortions compared to other expenditures ✔

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Instruments to promote Innovation Finance

Government Owned Funds have not performed in most

countries. A good Civil Servant is rarely a good Venture

Capitalist! Crowding-out of private capital ✗

Partial Guarantees for investments attract risk capital, but

distort risk assessment and investment discipline of investing

funds ✗

Government Risk Sharing in private risk capital funds –

Very successful in stimulating venture capital industries in US,

UK, Israel, Australia and Korea. Investment decision is taken by

private investor! Leverage increases potential returns and

provides incentives for risk capital to finance risky innovation

projects ✔

Interventions in the Risk Capital Market ✔✗

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Panel

• Tom Nastas (IVI): A Venture Capitalist Perspective

• Nuket Yetis (TUBITAK): Innovation Finance Programs in Turkey

• Marc Schublin (EIF): Trends in Innovation Finance in Europe