The big question for this segment is how do market economies finance innovation?

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The financing of innovation is actually very dependent upon firm size.

As the process and instruments are different for larger established

mature firms on one hand and startup, small, young firms on the other.

Established firms are extremely good at incremental innovation at improving near

existing products and services.

And seeking to exploit every bit of value from a considerable investments

in existing business models and strategies.

But new start up firms are much more nimble at introducing

an entirely new disruptive technology.

At exploring what might be possible if business models were reimagined.

In this way,

start up firms are able to steal market share from established players or

create entirely new markets leaving larger firms scrambling to catch up.

So there is a very interesting difference in innovation aptitude between

established firm, incremental and exploitation innovation

compared to start-up firm, disruptive and exploratory innovation.

When established logical operations conduct such a significant amount

of research and development.

Why do they leave themselves vulnerable to this threat from new startup firms?

The answer seems to be that larger established firms are just

not as good at being entrepreneurial and

exploratory, they are much more geared to managing and executing.

Many larger firms recognize this organizational weakness and

are adopting a number of strategies to try to address it including

creating the role of chief innovation officer.

A senior executive with the brief to champion innovative projects and

entrepreneurial culture.

Interesting research by Bernstein documents the effects of capital structure

on firm innovation.

Examining the effect of a firm listing its shares on public equity markets.

Bernstein found that transitioning from private to public did

not reduce the scale of innovation.

But it did reduce the novelty of innovations based on patent

citations by 40%.

Innovation is highly uncertain going public creates the risk that share

holders may mistake and innovation failure for a lack of managerial skill.

So it is much safer to avoid exposure to more uncertain exploratory innovation and

concentrate on conventional incremental innovation.

Larger firms finance innovation in three main ways.

First through internally generated funds which is a funding

source not available to startup firms.

Second, through bank lines.

Large firms are able to provide the collateral or

guarantees to secure a bank finance much more effectively than most start up firms.

There is some debate on the significance on the role of banks

in financing innovation.

Research by William Man, however has found that secured debt is an important source

of financing for innovation.

And patents are an important form of collateral supporting financing with

16% of the aggregate stock of patents at the US Patent and Trademark Office.

Having been pledged this collateral at some point.

Third, as the OSCD documents,

there are a broad range of tax incentives for reasearch and

development, and entrepreneurial activity in most countries.

Startup firms facing much more daunting financing challenge as we just have noted,

internal capital is not available for startups.

This exposes startups to a higher cost of external capital, and

possibly financing constraints.

There is often an information asymmetry between the innovator and the financier,

with the innovator having a better understanding of a new technology's

potential.

Then an external financier who will obviously expect to receive a premium for

investing in a new idea that hasn't been commercially tested before.

Additionally, the uncertainty of disruptive

innovation means that forecasts are incredibly difficult to make.

Sometimes investing in a technology is the best way of determining

potential impact or even the form of the outcome.

So there is a very real evaluative challenge

providing a potential provider of capital.

It may be a cliche, but the first source of capital for an entrepreneur when

an idea is at the early concept stage may well be friends, family, and fools.

Individuals who invest their own money in entrepreneurs and

startups are known as Angel investors.

And often invest small amounts from 10,000 to $100,000 each.

Innovative platform such as Angel list can connect entrepreneur seeking capital

with Angel investors.

And crowd funding platforms are also emerging as fund raising instruments.

Many governments also provide incubators, seed funding, and

loan guarantees to encourage start ups.

Investing more significant amounts in start up ventures is a specialist niche.

And firms that operate in this space are venture capitalist who will often

want to invest at least 3 million in first round or series A funding.

Venture capital firms independently manage dedicated funds that provide

equity investment in private companies with high growth potential.

The funds may be raised in part from high network individuals.

But are predominantly from large institutions such as pension funds

financial firms and

insurance companies which often as part of a diversified investment approach.

Put a small percentage of the funds they manage into higher risk investments.

Venture capitalists aim to invest in a startup and

guide that company until it is developed enough to be sold to a corporation or

listed on public equity markets.

It is the exit at a higher valuation that is the entire rationale for

investors in the venture capital fund.

Venture capitalist will seek to invest in and

nurture a portfolio of start ups and lost a number may not succeed.

Strong returns for a fund portfolio can be achieved with 10% to 20% of funded

company succeeding well, or even one or two companies succeeding extremely well.

There are number of mechanisms venture capitals use to manage their

downside risk.

Including preferential equity positions that ensure

first climb of a company assets in event of failure.

The ability to block and control any decisions around sale or

initial public offering.

Closest protecting against dilution of their share holding,

if subsequent funding rounds take place at lower evaluation.

An options to purchase additional shares at predetermine prices which maybe

below market price if the company is performing well.

Co-investment in portfolio accompanies without advent of capital firms is

also a risk management and portfolio diversification strategy.

A major control mechanism is staged capital infusion.

Series A funding can be followed by series B, C and D funding.

And this requirement on the company to raise additional funds is designed to

ensure the venture capitalist can monitor and guide performance satisfactorily.

The shorter the duration of each individual round of funding,

the greater control and frequency of evaluation.

Venture capital can be considered an ecosystem

where venture capitalist provide funding to individual entrepreneurs and

startups who often cannot otherwise obtain it.

Provide a mechanism by pulling funds which invest in portfolio companies

with the aim of delivering high returns to private investors.

And all going well successfully nurture a steady stream of companies ready to

be sold in conjunction with the investment bankers, corporate advisors,

and public equity markets.

And this entire process hopes to continually fuel creative destruction

within the broader economy.

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Financing Innovation

Creating Innovation

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