Sunday 27 April 2008

Leveraging IP to finance early-stage technology: First Part

Innovation can be defined as investment in knowledge made in anticipation of profits. (Rogers 2002). Economists across the political spectrum have well demonstrated that innovation can be considered a proxy for future cash flows and growth opportunities. (see: Schumpeter 1934, 1939, 1942; or Freeman 1982; for further discussion see Idris 2003). From an empirical point of view data supports these theories. When relating economic growth to the composition of GDP it can be shown that the world’s wealthiest nations heavily depend on knowledge based production and services. (European Intelligence Unit).

This trend however is not equally observed in many developing nations, which often depend on agriculture, primary manufacturing and low value added goods and services.
Developing countries are increasingly demanding access to the knowledge economies, recognizing the economic impact of technology and innovation, as well as the role of indigenous research and development in providing solutions to problems of poverty and health. Access to finance is a key element that makes or breaks the success of a technology project, be it companies or research centers.

Nelson and Arrow (Nelson & Arrow 1962) demonstrated already forty years ago that competitive markets may fail to provide socially optimal levels of technology investment.
Technological innovation is surrounded with uncertainty, imperfect monitoring and – in some cases imperfect intellectual property rights. (Rogers 2002). Adequate protection of intellectual property is essential to guarantee ownership of the innovation.
Private investors, whether equity or debt investors, are driven by the aim to maximize returns while keeping risks as low as possible. Many early-stage technology projects have difficulties in passing this test. Risks associated with the technological viability itself, the uncertainty of the size of the potential market for the technology, and lack of precedent make the valuation of early stage technology firms a non- obvious task to investors.

Little knowledge about intellectual property (IP) and even less experience in valuing and understanding the nature of IP assets can be seen as key obstacles in access to finance. The skepticism surrounding early-stage technology investment is often further hampered by inadequate capital market communication, expressed by inaccurate accounting standards or alternative reporting methods of a firm’s IP assets. As a consequence many technology-based entrepreneurs are underfinanced and poorly positioned to extract the value of their innovations. (For empirical evidence on this problem in developed countries see: Kamien & Schwartz 1982, Holmstrom 1989, Teece 1998 and Anton & Yao 1994). Sectors associated with low levels of verifiability are associated with low levels of investments.

As an additional problem entrepreneurs in developing countries are confronted with the absence or low sophistication of functioning capital markets. An early stage technology project can tap into different sources of funding, be it risk capital or different forms of loans.
Private equity markets are virtually absent or hardly developed in many developing countries. From a global perspective venture capital is concentrated around five hubs: The US, UK, Canada, Korea and Israel. Yet, even in these countries venture capital markets are small. Taking the US as en example the market size hardly accounts for ½ a percentage point of GDP. (Baygan 2002).

Commercial banks on the other side focus on investments that provide lower rates of return (on average around 7%), but are associated with lower levels of risk. As a consequence late stage firms rather than early stage companies get funded. Banks offer financial instruments for companies that can already offer some historical evidence of revenue flows. To finance early stage technology firms many banks lack in-house competence and business models that would allow them to grasp the value of early stage IP assets.

Given that capital markets in developing countries fail to provide the amount of capital needed to provide optimal levels of finance, and considering the positive impact of knowledge based industries on economic growth, governments and intergovernmental development agencies are called to take an active role.

What are possible choices from a public policy point of view?
Read the next part and find out!

by Roya Ghafele[1]
[1] This paper was presented at the OECD conference on Financing University Technology Transfer. St.Petersburg State University/ OECD. St. Petersburg December 14-15, 2004

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