Finance for Innovation A Policy Framework Knowledge Economy Forum IV, Istanbul, March 2005 Fernando Montes-Negret, World Bank Sector Director Private and Financial Sector Development Europe and Central Asia

2 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

3 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?

5 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?

6 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?

8 Government Intervention in Innovation Finance? Knowledge Education Universities ICT Idea Business Environment Intellectual Property Rights 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! Innovation Innovation Innovation Innovation Innovation Innovation Innovations need to overcome many hurdles:

9 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

10 Government Intervention in Innovation Finance? Market Failure (2): Funding Early Stage Technical Development Mainstream financial intermediaries like banks and institutional investors avoid Early Stage Technological Development: High information asymmetries, uncertain cash- flows No 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

11 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

13 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 Business Environment & Comptition Improve business environment & market competition to drive innovation in the private sector Intellectual Property Rights Strengthen legal framework and Intellectual Property Right protection and enforcement

14 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

15 Key elements of successful Government Interventions Effective Policy Design: Sequencing of interventions Sequence of Government Interventions Appropriate 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

17 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!

18 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 ✔

19 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 ✔✗

20 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