The Way Forward

Venture capital: Are we learning from others?

Ananya Raihan

Although the term 'venture capital' is not new in the business lexicon of Bangladesh, the country is yet to see a true venture capital initiative, both in the private and public sector. While the government and private sector are striving to diversify Bangladesh's economy, diversification of the financing remains on the side line. In the creation of a new economy, new entrepreneurs must be supported by all means, particularly in a country like Bangladesh, which is running a risky export portfolio with the risk of crashing down with all our achievements any time. As gaining 'access to finance' by new entrepreneurs remains a painful exercise, it is worthwhile to explore new financial mechanisms, one of which is venture capital. Let us investigate, what are the impediments for such a venture and what went wrong with surrogate initiative called Entrepreneurs' Equity Fund (EEF) in Bangladesh?

Back to the basics
Venture capital is generally invested in a relatively new enterprise believed to have the potential to provide a return of several times in less than five years. This sort of investment is generally highly risky, and many of the investments fail entirely; however, the large winners are expected to more than compensate for the failures. In return for investing, a venture capital investor may claim a major equity stake in the capital receiving firm and demand also seats on the board of directors. In majority of the cases, venture capitalists act to increase the chances of survival and rate of growth of the new firm by active intervention and assistance. Their involvement may extend to several functions: helping to recruit key personnel, providing strategic advice, introducing to potential customers, getting strategic partners, later-stage financiers, investment bankers and various other contacts. A venture capitalist therefore is more than just a money supplier, and this is a crucial difference between venture capital and other types of funding. The venture capital industry has, more recently, specialised even by stages of growth: there are early or seed funds, mature-stage funds, and bridge funds.

A venture capital process is complete when the company is sold through either a listing on the stock market or the acquisition of the firm by another firm, or when the company fails. For this reason, a venture capitalist is a temporary investor and usually a member of the firm's board of directors only until their investment is liquidated. The firm, in general, is a product to be sold, not retained. The venture capital process requires that investments be liquidated, so there must be an exit option for the firm. Erecting impediments to any of the exit paths (including bankruptcy) or lack of availability of exit mechanisms is a serious handicap to the development of venture capital industry. This is not to say that such situation can not foster entrepreneurship.

Prior to World War II, government or government-sponsored institutions were the only source of risk capital for entrepreneurs. In general, private financial institutions were reluctant to lend to new entrepreneurs due to high risk and lack of collateral. After World War II, a new type of investors in the private sector emerged, particularly in the US, whose sole activity was 'investing in fledgling firms'. From its earliest beginnings, venture capital gradually expanded and became increasingly formalised. In the USA, the locus of the venture capital industry shifted from the East Coast to the West Coast, and the focus also shifted largely on to in the electronics sector.

As the beginning of the venture capital was with highly risky venture and mainly in the knowledge based industry, some myths about the venture capital evolved. There are myths about the venture capital. One of them is that only start-ups receive the capital. In reality, many venture capitalists invest in or buy entire companies at various stages of their business life cycle. The second myth is, venture capital is invested in high-tech companies. Practically, venture capital is also invested in transportation, financial services or any industrial products. And finally, the general perception is that venture capital is always high-risk investment. This is also not always true. By and large, venture capital firms in the US take a higher risk than European ones. Americans comparatively invest more money in start-ups; Europeans engage in management buy-outs or management buy-ins.

Global picture
Venture capital remained as an American phenomenon until it emerged in other countries. Although venture capital spread into all continents, the USA is still the centre of the global venture capital industry. Twenty years back, there were a few American venture capital funds managing around USD1 billion, and investing about USD 0.6 billion per year in 300 companies. In early 2000s, there were more than thousand venture capitals managing up to USD 120 billion and investing over USD 110 billion in over 7,000 companies. Globally, venture capital and private equity combined reached about USD 286 billion in 2004.

Venture capital started to play a visible role in transition economies like Russia, the Czech Republic or Hungary. With the exception of Israel, India and very recently South Africa, venture capital has played hardly any role in most of Africa (Nigeria emerged recently), Latin America, and the Middle East.

In the US the government played an important role in the developing venture capital, though for the most part it was indirect. This indirect role was probably the most significant. Following sound monetary and fiscal policies for ensuring relatively low inflation was the most important indirect role played by the US government. As a result, the financial environment and currency were stable. U.S. tax policy, though it changed repeatedly, has been favourable to capital gains, and several decreases in capital gains taxes may have had some positive effect on the availability of venture capital. The stock market, which offered exit strategy of choice for venture capitalists, has been strictly regulated and characterised by increasing openness. This has created a general macroeconomic environment of financial stability and openness for investors, thereby reducing the external risks of investing in high-risk firms. Put differently, an extra set of environmental risks stemming from government action was minimised a sharp contrast to most developing nations during the last six decades.

Another important policy in the US was willingness to invest heavily in university-based research. This investment funded generations of graduate students in the sciences and engineering, whose research and innovations in tern, resulted in the formation of firms that were funded by venture capitalists. U.S. universities, such as MIT, Stanford, and UC Berkeley, played a particularly salient role in this regard.

Israel was able to introduce a venture capital industry during the 1990s, whereas India started to attract venture capital in a significant volume in the late 1990s. In both countries, the government played an important role. To begin with, Israel and India could ensure an environment that was conducive to venture capital. First, both countries have excellent ties and contacts to countries with a stock market. Israel has good connections in New York Stock Exchange. Israel and India have strong ties to Silicon Valley, the citadel of venture capital. Second, both countries educate a significant number of highly-skilled people. Third, both countries have a relatively reliable business environment (although this might be subject to short-term change, as was observed in Israel in early 2000s; peace in South Asia is also an issue).

Lessons from the neighbour
India is one of the miracles as regards growth of venture capital. In India, venture capital investments reached $1.3 billion in 2004, a growth of 49% over 2003, according to National Association of Software and Service Companies. In 2001 and 2002, the VC and private equity investments were at $1,135 million and $1,050 million respectively. Interestingly, most of the investments came from private sector.

From a rigid 'mixed economy' model, India successfully switched to the open economic paradigm. Leveraging the potential growth through venture capital, India is claiming now a leading position in global knowledge industry.

The boom of venture capital in India came in 1990s. The success of Indian entrepreneurs in Silicon Valley that began in the 1980s became far more visible in the 1990s. This attracted attention and encouraged the notion in the U.S. that India might have more possible entrepreneurs. The greatest source was the entrance of foreign institutional investors. This included investment arms of foreign banks; however, particularly important were venture capital funds raised abroad. Very often, non-resident Indians were important investors in these funds. In quantitative terms, the was a dramatic change in the role of foreign investors. The role of multilateral development agencies and the Indian government's financial institutions decreased meanwhile. The overseas private sector investors became a dominant force in the Indian venture capital industry. While foreign funded venture capital started to gain from investment in 'risky' ventures, in reality, those investments were not so risky because, most of the firms receiving foreign venture capital, were also receiving US outsourcing contracts.

What are we doing?
It would be an overstatement to say that nothing was attempted in Bangladesh as regards venture capital. Grameen Telecom and subsequently Grameen Phone has actually been a success story in venture capital and more interestingly with foreign funding.

The success of GrameenPhone was an isolated event in terms of securing financing for new ideas. Subsequently, following lobbing by ICT entrepreneurs, the government launched in 2000 a structured financing mechanism for risky but promising ventures, which was called Entrepreneurs' Equity Fund (EEF). The coverage was for agro-based industry and ICT industry. Initially, the floor for receiving finance was too high (Taka 40 million). After more than one year of the launch of EEF it was observed that not a single entrepreneurs applied for this EEF and obtained any amount under the software industry category. After the issue was brought up to the then Prime Minister by the author, the slab was reduced to Taka 15 million. However, the terms and conditions remained too onerous for new entrepreneurs. On behalf of the Centre for Policy Dialogue, the author prepared a brief for reviewing the terms and conditions. It was brought to the notice of the policymakers that the design of EEF both for software industry and agro-based industry was same. The value chain of agro-based industry was compatible with the product design of the EEF where the initial cost structure is skewed to fixed cost. On the contrary, for the software industry, cost structure is skewed to operating cost (in the traditional sense) where its major component is compensation for human capital. The mechanism for evaluation of human capital was not developed yet. This became the major impediment for the entrepreneurs in approaching for EEF. The provision for compulsory dividend after three years was also against the spirit of supporting 'risky ventures'. Subsequently, major obstacles were removed and number of applicants, both in agro-based industry and ICT categories increased. Since inception of the EEF up into fiscal 2005, agro-based industry received approval for Tk. 4.94 billion against the total project cost of Tk. 12.38 billion. However, actual disbursement was only Tk. 1.62 billion, which is around 33 per cent of total approved money. For ICT industry the situation is less enthusiastic. Against Tk. 1.55 billion of project cost the companies received approval for Tk. 644.1 million. The rate of disbursement for ICT companies is a bit higher, 57 per cent. The waiting list is for EEF rather larger than the disbursement status. For the agro-based industry projects worth Tk. 16.59 billion projects are waiting approval after completion of all formalities. The requested volume of fund is Tk. 7.53 billion. In case of ICT industry, the queuing projects cost Tk. 1.4 billion, whereas request was Tk. 671.4 million. The dual role of Bangladesh Bank and fund disbursing banks is an impediment in providing timely support to the entrepreneurs. Furthermore, corruption has also been reported by some of the entrepreneurs.

What are the lessons?
The EEF has been stopped due to concern over non-performing ventures. The factors, which led towards these circumstances can be listed as follows:

a. Bangladesh Bank and issuing banks limited their role with 'evaluating the proposals' for financing and disbursing funds. Unlike ideal venture capitalists the banks did not or could not provide strategic advice, ensure introduction to potential customers, find strategic partners, later-stage financiers, investment bankers and various other contacts. They remained only a money supplier and could not come out of the traditional banking approach. This is major reason for lack of success.

b. The banks have little expertise and midset for dealing with venture funds.

c. There is no clear-cut exit policy for funded ventures. The exit policy overall for the financial industry is missing. As a result moral hazard is a common phenomenon and high non-performing asset in the industry is a manifestation of absence of such mechanism.

d. The tax policy is also dwindling year over year which is reflected in the national budget and confuse the investors in the capital market. The tax policy should be favourable for capital gains. The government thus itself remain as a risk factor for the development of the capital market and the financial industry.

e. Connections with international stock market were missing.

It is unlikely that venture capital could play a decisive role in Bangladesh overnight. Among the pre-requisites, a few are important:

a. A stock market is a key precondition to venture capital growth because venture capitalists need to float their company to cash in gains in the end.

b. Having enough highly-skilled people who can generate ideas that are marketable.

c. Stable business environment that venture capitalists thrive on. Andreas Pfeil wrote that, “It would be inconceivable to think of venture capital in Burkina Faso or Colombia”. Thank God, he did not write about us.

d. Ties with Silicon Valley were other important factors for success of venture capital in India and Israel. However, the alternate venture capital mechanism in India can show a path for Bangladesh.

e. The US example shows that following sound monetary and fiscal polices is important for ensuring low inflation.

End word
There has been much debate about the pre-requisites for venture capital. One obvious conclusion is that entrepreneurship is the precondition for venture capital, not vice versa; however, this is a misleading statement in a number of dimensions. At some level, entrepreneurship occurs in nearly every society, but venture capital can only exist when there is a constant flow of opportunities that have enormous upside potential. Information technology has been the only business field that has offered such a long history of opportunities. Thus, entrepreneurship is a precondition, but not any type of entrepreneurship will do. Moreover, venture investing can encourage and increase the "proper" type of entrepreneurship, i.e., successful venture capitalists can positively affect their environment, GrameenPhone is such an example.

The world for venture capital is divided into three camps. A functioning and flourishing venture capital industry exists in countries that belong to the “technological innovators” category. It is about to spread to countries in the “technological adopters” category such as India, Israel, South Africa, East Asian including China. The third camp includes the countries which exclude technology do not have any access to venture capital, i e, rest of the world. The technology does not mean hi-tech. Bangladesh can too be the part of second echelon, given that the government plays its designated role as the facilitator.

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The author is the Executive Director, D.Net