Below is my thinking after having read about how different developing countries like Germany, Israel, Chile achieved (or fell short of) establishing a VC ecosytem.
The Ideal Setup
Turkey needs a hybrid scheme where government and private LPs (limited partners) contribute to the VC fund(s) which operate independently with the right incentive structure.
Facts
Some relevant papers that I gathered are here http://tinyurl.com/7balwve
The Ideal Setup
Turkey needs a hybrid scheme where government and private LPs (limited partners) contribute to the VC fund(s) which operate independently with the right incentive structure.
Facts
- A government engineering of the VC market can be desirable in two ways
- Certification hypothesis: Government can certify a technology thereby bringing private investors with lower risk appetite.
- Government can invest in areas that private parties will not.
- If there is an R&D spillover, that is there is a public benefit that cannot be captured through company profits, VC's might not want to invest.
- Limitation: how to prevent lobbyists to impact fund creation decisions. Make the decision committee as diverse and large as possible.
- The way the US venture capital market came to being cannot be duplicated in other countries for historical reasons. (adoption of NY Civil Code in CA, World War 2 Boston area research labs, linking Stanford to electronics industry through Stanford Industrial Park, post World War 2 decision on how to finance retirement security). Even though it's not possible to follow the US's path, the end state of the VC industry that the US reached is attainable and should be the goal.
- Small Business Innovation Research (SBIR) enhanced the VC market not started it. It addressed the lack of capital issue in fields other than IT and healthcare fields. ( at that time 92% of the funds went to these two industries)
- First and foremost, we need the following institutions as a prerequisite:
- honest courts
- effective auditing profession
- informational and reputational transparency
- Three central inputs are necessary to the engineering process. You need at least two of them to be present to attract the third.
- Capital
- Specialized financial intermediaries
- Entrepreneurs
- Most government programs try to do 1 and 2 simultaneously that makes the programs fail. Best example is Germany's WFG program that failed miserably.
- Government was both 1 and 2 and the intermediaries didn't have adequate upside. No board member was awarded or penalized for performance. Hence the investments were passive. In the contrary, silicon valley VC's are very hands on. They replace more than half of the founding entrepreneurs. WFG never replaced even one entrepreneur.
- IRR was -25%.
- What is required?
- Very high power incentives for all participants - investors, GPs, and entrepreneurs coupled with very intense monitoring.
- Both explicit and implicit contracts are used. (This ensures VCs provide financing as well as non-tangible support on execution, go to market strategy, networking etc.)
- Repeat play and reputation mechanism.
- Israel's YOZMA program (a successful VC engineering effort by the government)
- Yozma created 10 VC funds that invested along with private investors. Why did it work?
- No guarantee against loss. Co-invested along with private partners. Fund managers and private investors bore the downside risk along with the government.
- Unlike WFG the call option was held by the other investors (rather than by the entrepreneur) that gave the fund manager unlimited upside.
- Yozma didn't invest directly to any company. All investments were made through funds where manager were highly incentivized.
- Focuses primarily on the incentives of the financial intermediary. Hence, CORFU is closer to the US venture capital contracting model. (2.5% fixed annual fee and a carried interest based on fund performance)
- They also developed mechanisms to substitute the reputation market (since early on VCs won't have reputation) that would signal market the quality and incentive of the fund manager to succeed.
- Each fund has at least 5 unrelated investors of 10% or more equity or one institutional investor with at least 20% equity. (that will increase fund monitoring)
- Fund manager is required to invest more in the fund with his money (compared to that of the US)
- CORFU also capped its own return on its investment.
- Reduction in capital gains tax and labor regulations increase the ratio of investmant to high-tech and early stage companies.
- Request proposals for venture capital funds. Select funds but DO NOT participate in the capital allocation process.
- Government will neither have the expertise or the incentives to provide non-capital inputs.
- Also if government official influenced the supplier decisions of a start-up, it could run the risk of political pressure.
- A requirement of matching non-governmental investors.
Some relevant papers that I gathered are here http://tinyurl.com/7balwve