Governments around the world are getting into venture capital (VC) investing, hoping to replicate what Israel's government in the 1990s did to help launch one of the world's most successful VC markets. Today the governments of countries like Chile and Malaysia are getting stuck in too. India is the latest to look to do so.
But unlike before more governments are beginning to realise that it's only by partnering with the private sector and improving the existing entrepreneurial ecosystem that they will make any headway to boosting high-impact entrepreneurs.
India's move follows an announcement in July by Finance minister Arun Jaitley (pictured above) in his budget speech, of a plan by the Indian government to create a 100-billion rupee ($1.6 billion) VC fund.
Although it's not all that clear how the fund will operate, it seems the government will likely favour partnering with private VC funds, in a kind of fund-of-funds in disbursing the capital. Lending directly to entrepreneurs may not prove so effective, based on recent research (see below).
The government has already been involved in VC funding since at least 1999, through Sidbi ventures, a subsidiary of India's small business funding agency Sidbi. The subsidiary has invested directly into small firms, rather than via private VC funds which chose which entrepreneurs to then invest in.
But concern is growing that India's early-stage venture capital investing lags behind other countries, a 2012 report to India's Planning Commission found. Its authors were also concerned that there was a need to widen the lender-base beyond just Sidbi.
Among other recommendations, including improving the entrepreneurial ecosystem, the report suggested that the government could set up a fund-of-funds to seed other early stage venture funds.
After all the VC sector has been hotting up in India, having more than doubled from US$600-million to US$1.4-billion in investments between 2006 and 2012 according to a report by accounting firm EY. It's still small in comparison to the US ($33 billion in invested capital) or even Israel ($1.7 billion), but it's none the less growing.
But does government really have a role?
The knee-jerk reaction of many is that governments should stay out of VC funding, but many experts believe otherwise. They say governments have a key role to play in the building a VC market for small firms and start-ups, many point to the involvement of the US military as critical in the development of California’s Silicon Valley.
Harvard Business School professor Josh Lerner (pictured left) says governments can prove useful in three ways: by creating an ecosystem that encourages entrepreneurship and venture capital; by ensuring that the programme reflects the needs of the market; and by revising it where necessary.
Added to this Lerner says policymakers must listen to the market and avoid the temptation to jump into popular areas.
He points out that the SBA's SBIC programme, set up in 1958, helped create the US's VC industry as many early VC firms started as SBIC awardees, before opting out. The programme has also built the ecosystem of service providers to the sector.
Even in India the government has helped. EY attributes India's growing number of VC investments in part to the elimination of tax on capital gains and the relaxation of rules preventing foreign investment.
So what's the success rate?
Not many assessments have been carried out on how successful the government has been in VC funding, however a 2013 report (using a sample of 20,446 enterprises in 25 countries), found that companies that received investment from a mixture of both private and government VC entities tended to receive more capital and exit with higher returns than did those backed only by private or by government VC.
The same report also found that privately-funded companies out performed those funded only by government operations.
So what should the Indian government and other governments looking at getting into VC funding consider? Here are three tips:
1-Act as a lender to private sector
When it decides to partner with the private sector, the state can either hand over the capital and not expect a return - or hand it over with the expectation that the financial institutions will be well resourced enough to repay the state on whatever is lent out.
The SBA's Small Business Investment Company (SBIC) programme, which has been in operation since 1958 is an example of the latter. Big names like Fedex, Intel and Apple number among the over 166,000 investments that SBIC has made (into 2,100 funds it has licensed).
In the programme SBICs are licensed and regulated by the SBA and a SBIC must have at least $15 million in capital). SBICs then use their own private capital plus funds borrowed with an SBA guaranty to make investments in qualifying small businesses.
The debentures an SBIC receives from the state have a term of 10 years and provide for semi-annual interest payments and a lump sum principal payment at maturity. In effect the programme operates at no subsidy cost to the American taxpayer.
You might say this only in well developed countries could this model (where private funds pay back what they lent from the state) possibly work, but with India's and other emerging economies' growing venture capital market the SBIC model may just be something to consider. Like this no taxpayer money is wasted. And capital can therefore be better utilised elsewhere - like on roads, healthcare and education.
2-Governments must adapt as they go
Another key lesson is that governments must be prepared to update their VC programmes as the programme advances or as the market changes.
In Chile, the government’s small business support agency Corfo has invested in a number of VC funds via three funding rounds. With each round it has adapted the rules to ensure that funds are disbursed in the best possible way.
The latest change, in 2012, saw Corfo launch two new VC programmes, one to focus on financing early stage companies and another to finance growing businesses - this after the agency found that about 75% of the investments made between 1999 and 2010 were concentrated in established businesses.
3-Get in and get out
Finally the most important tip is for governments to get in, spur the market and get the heck out. If the state stays in too long it risks creating all kinds of problems related to the use of taxpayers money or to the crowding out of the private sector VC market.
Governments should aim to do what the Israeli government did when it invested in Yozma in 1993. The programme effectively gave birth to the country's VC market when the group established 10 drop-down funds, each capitalised with more than $20 million. The government then sold its stake and pulled out of the VC sector when the success of its efforts were evident.
But the experience in Malaysia on the other hand has been different. There the government, like in Chile, remains involved in VC investing over a decade on, through the Malaysia Venture Capital Management (Mavcap).
Mavcap invests in private VC funds (as part of its outsource partners programme) which in turn invest in high-tech Malaysian small firms. The third round was launched recently. The sector is perhaps not ready, even though the third round has involved Mavcap raising capital from partners in the US, Europe and Asia.
But it's not as bad as in South Africa, where a planned R100-million government VC fund which would've invested in at least three private funds, was last year put on hold by the government's Technology Innovation Agency, according to the agency's Pontsho Maruping.
What history has shown so far is that it's not so bad for the state to get involved in pumping up the VC sector.
Creating the necessary ecosystem to support co-investing with the private sector is the hard part, as is opting to exit and leave the rest to private sector VC investors who have grown to become more keen on start-ups and riskier investments.
Stephen Timm writes on small business. Watch out for his upcoming advice on how emerging economies can boost angel investors.
Stephen Timm is a