Financing Innovation: Venture Capital

Innovation

It has been over 60 years since Nobel Prize laureate, Robert Solow, first established the link between innovation and long term growth (Lerner, 2012; McKinsey Quarterly, 2014; OECD, 2012; Rosenberg, 2014). Solow found that ‘inputs’ only account for 15% of actual growth in the economy and that 85% came from technology innovation i.e. how you transform those inputs (Rosenberg, 2014). Thus innovation is now widely recognised as the driver of long term growth and living standards.

More recently, the innovation agenda has become a stronger focus of economic growth due to the increased understanding that start-ups and investors play a significant role in generating and commercialising innovations.

Why start-ups matter

Innovation is not just the outcome of R&D in a university laboratory or at large corporate. While important, start-ups (that is, new and small ventures) actually generate half of the innovations in young industries or in industries that rely on technology (Lerner, 2012). This due to reasons such as:

  • Less barrier to entry;
  • large firms can be incumbent and ineffective from a focus on existing products;
  • new firms choose higher risk strategies and can ‘pivot’ more easily to adapt to the markets demands or gaps; and
  • the rewards for successfully starting a business and commercialising an innovation (Acs & Audretsch, 1988; Koutroumpis, Leiponen & Thomas, 2017; Lerner, 2012).

Yet it is also hard work and high risk starting a new firm, with 90% of start-ups failing (Forbes, 2015). However, if those new firms can commercialise their ideas and grow, then they tend to be more competitive, create higher skilled jobs and generate spill overs that grow the innovation ecosystem. In fact, if they go on to become a high growth firm, they will disproportionately generate a greater share of all new jobs than any other business sector (OECD, 2014).

Governments around the world widely now recognise the powerful link between new firms and innovation, job creation and international competitiveness (European Commission, 2012). Most are now actively reviewing policies, laws and taxes to support new firms to start and grow; and this includes support for investors (Capital Pitch, 2018).

Start-ups and venture capital

Academic research has found that entrepreneurs and venture capital play a significant role in stimulating innovation (Awuah & Ulu, 2008; Lerner, 2012; and OECD, 2012). Venture capital is an important source of equity that start-ups need to commercialise their ideas. This is because venture capital is prepared to invest in untested business models with no track record – and essentially, fill a void in traditional finance (Zider, 2008). Therefore venture capital is considered an important component in the innovation pipeline (OECD, 2016).

Venture capital: is money provided by professionals who invest alongside management in young, innovative rapidly growing companies that have the potential to develop into significant economic contributor (Awuah & Ulu, 2018). Venture Capital is a subset of private equity (i.e. equity is capital is not listed on a stock market) and provides support for pre-launch, launch and early stage development phases of a firm (Invest Europe, 2018). Investments are typically high risk and short to medium term from 3-10 years, with the intended return on investment is mainly in the form of capital gains (rather than long-term investment involving regular income streams) (ABS, 2018).

Research shows venture capital backed firms  have “higher survival rates than non-VC- backed firms” and are more likely to evolve into gazelles AKA high growth firms which create 50% of all new jobs (Awuah & Ulu, 2008; and OECD, 2014). While Lerner (2012) notes that dollar for dollar, venture capital returns 3 to 4 times as much as corporate R&D; and is associated with a significant time reduction in taking a product to the market.

Selecting a Start-ups

Due to the high risk nature of the investment, venture capitalists need to be very strict in how they select firms to ensure they are able to generate a return (Awuah & Ulu, 2018). Venture capitalists typically need a return of 25% to 35% per year over the life of their investment (Capital Pitch, 2018; Zider, 2008). However the reality is that they might invest in 10 firms and around four will fail, three will breakeven, one-two will have a reasonable outcome and at least one will hopefully return the whole fund, plus more. Thus the following criterion is generally applied:

  • “market attractiveness (size, growth and access to customers)’
  • product differentiation (uniqueness, patents, technical edge and profit margin);
  • managerial capabilities (skills in marketing, management, finance, and the reference of the entrepreneur);
  • environmental threat resistance (technological lifecycle, barriers to competitive entry, insensitivity to business cycles, risk); and
  • cash-out potential (future opportunity to realise capital, gains by merger, acquisition or public offering (cited in Lerner, 2012)”.

Most venture capital investments also provide intensive oversight of the firm to ensure a return. They will “actively work alongside start-ups as coaches and advisors, assisting founders in developing their businesses and curating their strategic direction (Capital Pitch, 2018).” Therefore in addition to capital, other benefits include:

  • mentoring, strategic direction and sometimes leadership;
  • specific industry expertise and business advice across a number of business decisions, including financial management and human resource management;
  • connections to new market access, contacts and can attract new investors if required
  • incentives and accountability to help founders to succeed; and
  • facilitation of exit strategy (ACCAL, 2018; Capital Pitch, 2018; Lerner, 2012).

All of support provided by venture capitalists has been found to substantially strengthen and modernise certain industries and accelerate growth, through their focus on the market and incentives offered for ‘revolutionary’ products and services (Capital Pitch, 2018).

Investing in Start-ups

Venture capitalists typically invest a $1 million plus in a firm and this will be dispersed in stages known as rounds. These rounds include pre-seed, seed, start-up and other early stage and then later stage (OECD, 2016). Staggering investment in this manner improves the outcomes of venture funding through creating invectives and milestones but also allow greater control for the venture capitalist to manage risk and continue to have oversight strategic direction of the firm.

Venture capitalists hold preferred stock in firms rather than common stock. While both represent a part of ownership in a firm, the difference is that preferred stock holders have a greater right to a firm’s assets and earnings if the company is liquidated. That is, preferred stock is paid out before common stock providing a greater security for limited partners (Investopedia, 2018; Lerner, 2012).

Returns are generated only through a “liquidity event” or exit and include:

  1. Share Purchase: when investors equity in a firm is purchased;
  2. Acquisition or merge (M&A): when a firm buys another firm to support its strategic direction and competitiveness; and
  3. Initial Public Offerings (IPO): when a firm raises funds by offering its stocks to the public for the first time (Investopedia, n.d; Medium, 2015).

You can read more at the ABS about how venture capitalists establish their fund, governance structures and lifecycle of investments.

The Status Quo

Though not a new concept, in the past two decades, the venture capital industry has shown an incredible growth and become recognised as an important part of a well-developed innovation ecosystem. Venture capital should also not be at the expense of focus areas, such as universities, corporate R&D, and STEM but does need to be recognised as an important component of the ecosystem (OECD, 2012). This is because venture capital:

  • provides start-ups with capital and expertise not otherwise available;
  • supports the creation of firms and knowledge spill overs;
  • is necessary to support commercialisation of innovations; and
  • supports creation of new industries and help to mature industries to adapt and become more competitive (AVCAL, 2017).

Despite these benefits, in the majority of countries venture capital remains a significantly underdeveloped market, generally less than 5% of GDP. The two major exceptions are Israel (39%) and the United States (33%) and are widely acknowledged to be global innovation leaders (OECD, 2016).

Over the last 10 years, the Australia venture capital market has grown substantially but it is still in its infancy. In 2015, venture capital in Australia represented only 2.3% of GDP, a rate less than half of all other OECD nations. While Australia ranks last in the OECD for commercialising this research (ABS, 2018; Lerner, 2012; AVCAL, 2017).

So what can government do to support and ignite the venture capital market?

 

Reference:

Lerner, J (2012) Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have failed–and What to Do About It. Princeton University Press: New Jersey.

Commodity Traps and Super-Cycles

For nations that heavily produce and export commodities such as food, oil and other minerals, those rents it receives are important source of national income. More importantly, if invested wisely, commodity rents can be a basis for future growth and prosperity.

Economic rent “is an excess payment made to or for a factor of production over the amount required by the property owner to proceed with the deal (Investopedia; N.D.)”.

However, over dependence on the commodity sector and miss-use of commodity rents can lead to worse economic outcomes – this is known as the paradox of plenty.  This is because production capacity (capital, labour)  is diverted into the industry leading the growth cycle, while its associated rents are not reinvested in a way that strengthens the economy more broadly (Natural Resource Charter, ND).

Paradox of plenty “refers to the idea that resource-rich counties often have less economic growth compare with countries which have fewer natural resources (Natural Resource Charter, ND).

Collier (2007) even finds that commodity rents are also “particularly unsuited” to democratic situations with autocracies out performing their democratic counter parts. This is for several reasons including, that:

  1. democratic governments are pressured by election cycles leading to short sighted investments;
  2. democratic governments use rents as ‘slush funds’ to influence election outcomes; and
  3. tax payers appear to be less concerned with the way revenues are spent because they have not been ‘earned.’

That is, governments and tax payers treat the revenues more like the winnings from a night at the casino!

More specifically, Giugale (2014) notes that there are five main problems associated with commodity growth cycles and include:

  1. Dutch Disease – where non-commodity exports become less competitive as the economy focus on the resource sector. This occurs as Economic focus begins to target this high-income industry sucking in workers and production capacity from other sectors driving up prices;
  2. price volatility – complicating investments decisions often leading to short-term outcomes;
  3. over borrowing – lenders are more likely to provide greater debt access to governments that are expect to raise large amounts of revenue;
  4. sustainability – the amount of natural wealth to preserve for future generations; and
  5. corruption – the larger the rent, the ‘greedier’ a government and business can become leading to immoral and poor decisions.

While Collier (2007) adds that in developing nations two other problems include:

  1. a reduction in the implementation of democratic institutions – as government want to hold on to their power and wealth; and
  2. an increase in the likelihood of conflict – as a combination of the other problems destabilises growth, the government and society more generally.

The paradox of plenty is relevant to both developed and developing nations.  Academics (Collier, 2007; Giugale, 2014) agree that resource rich societies must have good policies, institutions and governance to ensure strong economic outcomes. These include those that protect budgetary checks and balances, transparency of spending, and accountability mechanisms to ensure impacts that enhance citizen welfare (World Bank, 2016).  An example is Norway’s Sovereign Wealth Fund, the world’s largest equity fund, set up to provide an autonomous investment mechanism to reinvest the surplus wealth produced by petroleum sector to provide alternative revenue streams that can be reinvested diversify the economy (McCarthy, 2017).

While there must be the right mechanisms, it is also imperative that there is greater awareness of the traps and mindfulness regarding the need to reinvest rents in long term initiatives that build capability and future growth potential. Otherwise, the alternative is that commodity rents can actually lead to a reduction in growth and development.

Super-cycles

Until recently, the concept of commodity super-cycles had been widely discussed but never proven.  In 2012 the UN (2012) claimed to have found evidence of commodity super-cycles which has now lead to wider agreement on their existence (Guigale, 2014).

Commodity super-cycles are defined as “periods of about forty years when commodity prices steadily climb for a decade or two, only to fall slowly back to where they were” (Guigale, 2014).

Super-cycles differ from business-cycles which are typically short-run and typically have micro-economic impacts. Super-cycles differ due to two main features, being:

  1. the presence of a “long wave” of growth of at least 10-35 years and the whole cycle taking 20-70 years; and
  2. the impact can be observed in a number of commodities across the economy (UN; 2012).

The key driver of a super-cycle is the “sudden rise in demand, often caused by technological innovation” and can lead to periods of increases in urbanisation and population. Increased demand associated with these factors drives long periods of growth in both prices and output before tapering and returning to pre-growth levels. Super-cycles also suffer from “acute capacity constraints” despite increased in production output and technology development (Guigale, 2014; (DeRooij, 2014). Whilst, tapering off within a cycle is driven from a number of factors including diminishing returns from technology, or, urbanisation and population growth steadying and the economy readjusting as a result.

Evidence suggests that in the last 150 years  the world economy has experience at least three super-cycles, each over a period of four decades, each driving up commodity prices “20 and 40 percent” before returning to previous levels. Examples include Britain’s industrial revolution where prices for coal, cotton, sugar and tea increase as well as production (DeRooij, 2014).

From a government’s perspective, recognition of super-cycles is of “critical importance” to ensure the right decisions are made in regards to inflation, currency, balance of payments, and re-investment of rents. Businesses also need to identify super-cycles to ensure capital investments are used to fund long term production expansion and not be distracted by short-term price fluctuations (DeRooij, 2014).

We can now see that we are in a super-cycle or perhaps, we have just hit tipping point. This cycle was largely driven by China and India’s appetite for commodities.  However, there may still be opportunities, as many people in South East Asia and other developing nations are still to transition to a more urbanised economy (DeRooij, 2014).

Thus, the question therefore is, are we to sit back and ride the wave out? Or do we ensure we maximise our future growth potential and extend the ride before through high impact re-investment?

Collier, P. (2007) The Bottom Billion: Why the Poorest Countries are Failing and What Can Be Done About. Oxford University Press: New York.

Giugale, M. (2014) Economic Development: What Everyone Needs to Know. Oxford University Press: New York.

 

Institutions and Incentives: A Guide for Policy Practitioners

Have you ever thought what stops some places from developing? Why is it hard for some places to implement progressive policy? What stops people from being more entrepreneurial? Well it can often be the institutions, the “legal and administrative organizations” that underpin society and they predict the ability of a place to prosper (World Economic Forum, 2015).

Institutions are a “consistent and organized pattern of behaviour or activities (established by law or custom) that is self-regulating in accordance with generally accepted norms” (Business Dictionary, ND).

Institutions “are the rules of the game in a society, […] the humanly devised constraints that shape human interaction. […] They structure incentives in human exchange, whether political, social or economic” (North, 1990, p. 4).

Why are institutions important?

Institutions are important because they form what is called the ‘enabling environment’ (World Economic Forum, 2015). Institutions move beyond the concept of an organisation to encompass social structures that guide “human interaction and activity” and include formal and informal rules. Institutions are important social structure as they “create stable expectations for the behaviour of others,” and create the incentives for economic and political development (Hodgson, 2006). Institutions therefore provide a framework for social cohesion and long term prosperity Bakir, 2009).

The four key sectors where institutions play the most effective role in promoting growth are “finance, education, justice, and public administration” and as a result, Institutions need to be a consideration for in policy and program design in both the developed and developing world (Paul, 2017).

In particular, strong institutions support economic development by:

  • reducing the costs of economic activity by lowering transaction costs such as search and information costs, bargaining and decision costs, policing and enforcement costs;
  • promoting a return on investment through common legal frameworks (e.g. contract terms and contract enforcement, commercial norms and rules);
  • reducing oppression, corruption and encouraging trust by providing policing and justice systems; and
  • Encouraging collaboration between public-private sectors to increase social capital (Bakir, 2009; Ferrini, 2012; World Economic Forum, 2015).

More specifically, institutions affect the level of production, adoption of new technologies, entrepreneurship and venture creation, environmental protection, ability to attract investment, property ownership, law enforcement, and levels of bureaucracy and red tape. Thus, institutions need to be a key consideration when designing policy and programs.

Depositphotos_9467051_original

Institutions and Policy

Often when transformational policy is required, consideration of the institutional framework is paramount. There are four different types of influences on institutions that practitioners should be aware, these include:

  1. Rational choice: where intuitions are influenced through ‘feedback’ that reinforces the decisions and actions to become norms. For example increasing returns on investments is a positive feedback that reinforces the norm;
  2. Organisational the adoption of common practices (i.e. imitation) and norm from other successful organisations and leaders;
  3. Discursive institutionalism is when self-interests and cognitive ideas are pushed until adopted as norms; and
  4. Historical institutionalism is a mix of the above three where logic and idea have amalgamated over time to become norms (Bakir, 2009).

Practitioners should examine the changes they wish to achieve against identifiable institutions.  Incentives or more specifically, pigouvian penalties can then be designed to help shift behaviours and actions in line policy positions.

Incentive: a moral, coercive or remunerative motive behind an individual’s particular course of action (Johnson, 2005). Incentives do not have to provide positive motivations.

 Pigouvian penalties: is a tax to deter or counterbalance market activities that generate negative externalities (the Economist, 1017).

 Examples:

  • Public transport: Policies to promote public or physical transport uptake may only become effective when society recognises that cars have a negative impact on the environment and are willing to change their behaviour to protect the environment. Policy practitioners may needs to consider the individual rational choice, self-interests and historic institutions that support people to drive cars. For example, if parking was increased in the CBD to support institutional change around driving, does it just push people in to suburban areas where driving is still more cost-efficient? Is advertising to change values and perspectives (self-interests) on driving required? Are additional services or upgrades required to change the efficiency of public transport in addition to car and parking taxes?
  • Welfare: Income welfare that supports disadvantaged people can be relatively ineffective in enabling long term dependents to transition into the mainstream economy when the alternative is low skilled and repetitive work. Thereby dis-incentivising people to transition to employment. Policy practitioners may need to consider if the community, formally or informally, agrees that welfare is a right? If individuals have intergenerational dependency and therefore share similar aspirations? And what are the real incentives that encourage employment and discourage unemployment? Otherwise actions that just consider capabilities will have limited impact.
  • Innovation and technology adoption: for societies wishing to promote innovation and technology adoption, it is also important to look at existing intuitions that may disincentive action. For example what are the red tape barriers (costs) to setting up a business and commercialising ideas? Are there any Government Trading Enterprises that crowd-out the private sector innovations? Are technology rebates and R&D subsidies promoted widely and easily accessed? Does the government have a consistent view and is their machinery (departments and agencies) progressive in their policies?

Finally, strong institutions may not ensure robust growth in the short term but in the long term, a society cannot expect to prosper without them. Thus the policy practitioners need to consider institutional environment when designing interventions.

North, D. C., 1990. Institutions, Institutional Change and Economic Performance, New York, Cambridge University Press.

Part 3: the Innovation Ecosystem – Roles and Responsibilities

To drive an innovation-led approach to economic growth, it is essential to understand the roles of both the public and private sector, including academia; and how each can enhance to the ecosystem.

Innovation ecosystem: is the flow of technology and information among people, enterprises, and institutions central to an innovative process. It contains the interactions between the actors needed in order to turn an idea into a process, product, or service on the market (OECD, 1997).

PUBLIC SECTOR

The public sector has responsibility for creating an environment that ignites innovation and supports entrepreneurs. Yet, as Isenberg (2016), notes “there’s no exact formula for creating an entrepreneurial economy; there are only practical, if imperfect, road maps”.

However, it is generally acknowledged that government have various tools at hand. Governments can create ‘demand factors’ for innovation such as policy, regulation and innovation targets the cause the market to change direction (this is essential to enable economic structural change). While Innovation ‘supply factors,’ may include research and development (R&D) credits, academic partnerships and university graduates.

In Mazzucato’s book, The Entrepreneurial State (2014), she argues that government has a bigger role beyond tax credits and the enabling environment. That is, government can also invest in transformational R&D where there is a public good, the risk is high and long term investment is. Marzzucato suggests that such investment by government often leads to transformational change that can create entirely new sectors and markets. Examples of these types of investment include the nuclear energy, the internet and GPS. For government to take this approach it needs to have a long term agenda for technology change; and work with in partnership academia and the private sector so they too can seize the opportunity along the way to add new information to develop spinouts.

Workforce development is also directly linked to the future of businesses creation and economic growth.  Government set the policy, run many of the programs and fund many academic institutions that develop skilled workforce essential to the capability to develop innovation commercialise but to also enable economic transformation when required (Fetsch , 2016).

Fetsch (2016), Moretti (2012) and (Sandbu, 2017) all argue that government can also drive immigration policy that supports innovation policy through three main factors:

  1. importation of skilled workforce to compliment or build a competitive advantage;
  2. immigrants “play a disproportionate role founding companies that make a big economic impact” because they are naturally risk takers having immigrated in the first place; and
  3. Foreign Direct Investment (FDI) flows often through the expat community to enable innovation and business growth

Isenberg (2010) provides a localised perspective and suggests that many government efforts focus too narrowly on building ecosystem determinants. Instead he suggests that government should focus on the following nine principles to “turbocharge venture creation and growth”. Isenberg’s principles include:

  1. Stop emulating Silicon Valley. Rather you can develop your own culture and practices that underpin entrepreneurship and innovation. Also see the ‘rules’ described in the Hwang and Horowitt (2012) book the Rainforest: the secret to building the next silicon valley;
  2. Shape the ecosystem around local conditions. Home grown solutions that compliment “local entrepreneurship dimensions, style, and climate” (Isenberg, 2010);
  3. Engage the private sector from the start. Reach out and understand industry needs;
  4. Favour the high potentials. This is through focusing on gazelles (high growth firms) and applying economic gardening approaches, as noted in Part 2;
  5. Get a big win on the board. Celebrate successes as success can spur more innovation and entrepreneurship;
  6. Tackle cultural change head-on. Governments can help to promote the benefits of innovation, the opportunities entrepreneurship through setting values that celebrate innovation and entrepreneurship, encourage collaboration and by building a tolerance of failure;
  7. Stress the roots. Let the market determine value – be careful propping up ventures;
  8. Don’t over engineer clusters; help them grow organically. Clusters occur naturally when an opportunity exists and are an important element of an ecosystem. However, government shouldn’t be picking winners, just backing them; and
  9. Reform legal, bureaucratic, and regulatory frameworks. Over regulation at all levels can stifle innovation and entrepreneurship. Examining the institutions and incentives is essential to ensure an ecosystem is guided by positive regulation.

 

PRIVATE SECTOR

The private sector is the main agent of innovation and value creation. They are the ones that take the risks, commercialise the products and services, and create jobs. Yet private stakeholders are often multifaceted, holding many roles along the innovation pipeline.

Entrepreneurs are the people with the ideas and are risk takers. In his book, Worthless, Impossible and Stupid, Isenberg (2013) notes that entrepreneurship is defined by an individual’s ability to perceive, create and capture extraordinary value.

A Start-ups is an early stage business that is beginning to scale rapidly. Angel investors “Incubators, accelerators, universities, and public agencies” typically provide the majority of help establishing the business in its early stages (Startup Europe India Network, N.D). Most start-ups die in their first two years in a period called the valley of death.

Valley of death: is a common term in the start-up world, referring to the difficulty of covering the negative cash flow in the early stages of a start-up, before their new product or service is bringing in revenue from real customers (Forbes, 2013)

While Small to Medium Enterprises (SMEs) are small businesses that have overcome the valley of death, tested the viability of their product of services, established a customer based and achieved growth that has allowed them to employ staff. Yet SMEs often lack the knowledge on how to scale-up and lack the resources to invest in innovation to fuel productivity and development (OECD, N.D). Once a business has gotten to this stage of its development, it has greatest potential to become a gazelle (see Part 2).

Investors are typically defined based on the capacity they can invest.  Most types of investors provide more than capital, also offering business support, networks and sometimes markets.

Typically early stage investors offer small amounts of capital and include business angels, incubators and accelerators[1], and some seed stage venture capital funds. As the start-up grows, it requires more investment to fund its expansion and will seek an investment from the venture capital investors who are considered growth-stage investors. Private equity investors and corporates are typically investors at a later stage business growth which may include business merges, stock market listing and buy-outs (Startup Europe India Network, N.D).

Hwang and Horowitt (2012) put forward a softer model in their analysis of the innovation ecosystem and identify:

  • Business leaders: who have a reputation of being innovative. What culture, process and strategy does individual business set to in place to innovate within their business to support innovation?
  • Keystones: individuals or businesses who serve as agents that connect people, ideas and investment to catalyse diverse action. Keystones can also exist in the private sector.
  • Stakeholders: anyone who is an entrepreneur, investor, support organisation or participates in the innovation ecosystem.
  • Role models – local entrepreneurs that are visibly successful in the community and offer examples of success and failure. They are people that promote a positive innovation and entrepreneurship culture. They challenge aspirations and values.
  • Community – the industry sectors, services providers and collective human capital that underpin an ecosystem.

 Industry: However ecosystems are also place-based, in that innovation, R&D and spill-overs are happen in a place, that is proximity is important for knowledge diffusion and is primary influenced by local innovation capacity (Rodríguez-Pose & Crescenzi; 2008). As a result a places industry base and industrial clusters become another important organising principle and stakeholder group for analysis.

Industrial cluster: “are geographic concentrations of interconnected companies and institutions in a particular field. Clusters encompass an array of linked industries and other entities important to competition. They include, for example, suppliers of specialized inputs such as components, machinery, and services, and providers of specialized infrastructure (Porter, 1998)”.

Crescenzi & Iammarino (2016) note that “economic and innovation trajectories do not depend exclusively on localised productive and knowledge assets but need to combine ‘local buzz’ and ‘global pipelines’”. Thus looking at a places external linkages through the lens of FDI flows, global supply chains and multinational corporations offers the opportunity to extract information and opportunities to leverage innovation, build capability and establish new markets.

Finally, academia, which provides an institutional framework for developing workforce skills and values that support and drive innovation and enable agglomeration forces which drive productivity. Academia can even compensate for some businesses that are not as well-equipped to do under take R&D through the production of skilled workers; public-private partnerships; and the generation of patents that diffuse into the local innovation ecosystem (Cauce, 2016).

CONCLUSION

No matter how you analyse your ecosystem, fundamentally what drives success it is how we join up and collaborate to create value. Hwang and Horowitt (2012) note that ecosystems “thrive because of normative culture that accelerates the evolution of human organisation into ever-increasing patterns of efficiency and productivity”.  In other words, we need to create value systems and networks that enable collaborative and symbiotic behaviours across all actors if we are to achieve well-functioning innovation ecosystems. No single individual or stakeholder group can do it alone.

 

Book References

Isenburg, D (2013) Worthless, Impossible and Stupid. Harvard Business Review: Boston.

Hwang, V. and Horowitt, G. (2012) The Rainforest: the secret to building the next silicon valley.
Regenwald: California.

Mazzucato, M (2015) The Entrepreneurial State. PublicAffiars: New York.

Moretti, E (2012) The New Geography of Jobs.  Houghton Mifflin Harcourt Publishing: New York.

 

[1] private incubators and accelerators are often owned by investors who use the structure as a mechanism to identify investment opportunities.

Part 2: The Entrepreneurial Ecosystem – Gazelles, Job Creation and Economic Gardening

SMEs are now viewed as a major force in job creation and innovation policy. In particular, the start-up seen has had a lot of attention to what is known as ‘gazelles’ or high growth firms (HGFs).

While representing only around 6 per cent of all business, HGF create around 50 per cent of all new jobs (OECD, 2014). This is because HGF’s have identified a market opportunity and tend to be ’first-movers’ in responding to or changing customer demands (i.e. innovation of new products). For this reason, HGF are “thought to drive productivity growth, create new employment, increase innovation and promote business internationalization” (OECD, 2014).

HGF are also important because they pop up in all sorts of diverse geographical areas, responding to local challenges and opportunities. They also encourage further spin-offs their industry and stimulate wider entrepreneurial activity (Fetsch, 2016).

High Growth Firm: There is no single definition of a HGF and what constitutes an extraordinary growth rate. However, most agree that a firm that is able to increases its revenues by at least 20 per cent annually for three years or more is considered high growth (Financial Times, N.D.; Investopdeia, N.D; OECD, 2012)

Research from the UK found that the majority of these HGFs have less than 50 employees but were relatively established in the market and over five years old. These firms were also found in all industry sectors (e.g. food, health), not just the technology sector (OECD, 2014).

Given the economic benefits of HGFs, it is now recognised that it is important for governments to understand how these firms are established, what drives them and ways to encourage more business growth. To do this, there needs to be a greater focus on support for growth-oriented entrepreneurship, and economic gardening is one tactical approach that could support the establishment of HGFs locally.

Economic gardening: “is an entrepreneurial approach to economic development that seeks to grow the local economy from within. Its premise is that local entrepreneurs create the companies that bring new wealth and economic growth to a region in the form of jobs, increased revenues, and a vibrant local business sector. Economic gardening seeks to focus on growing and nurturing local businesses rather than hunting for “big game” outside the area (ICMA, 2010)”.

Economic Gardening is different traditional types of business assistance as services such as business planning, accounting or workforce development. Instead it about supporting growth firm and letting business owners know how important they are to their community (ICMA, 2010).

The Edward Lowe Foundation (2017) notes that economic gardening is about supporting businesses to:

  • build market intelligence such as trend analysis and new resources;
  • Identify and understand new and existing markets;
  • Raise the visibility of the business through modern advertising such as search engine results and blogs and online communities;
  • To uses the same mechanisms to gain feedback on their products, customers and competitors;
  • Refine strategy to build a competitive advantage and sustainable mechanisms to retain it; and
  • Build the capability leadership and management team development.

Part 1: the Innovation and Entrepreneurial Ecosystem

Recently, entrepreneurship has become a core component of economic development policy all over the world. It is now recognised that entrepreneurs and innovation are key determinants in job creation and economic wealth.

Entrepreneurs play a key role in any economy as they are the people who take risks and have the initiative and capability to develop new business ideas and innovations. If successful, their reward is profits and business expansion, that is, economic wealth and job creation (Investopedia, N.D).

As a result, governments are now striving to create the conditions that foster entrepreneurship, with the “entrepreneurship ecosystem” becoming a common development strategy (Isenberg, 2014).

Entrepreneur an individual who runs a “business and assumes all the risks and rewards of a given business venture, idea, or good or service offered for sale. The entrepreneur is commonly seen as a business leader and innovator of new ideas and business processes”. (Investopedia, N.D)

Entrepreneurship “is much broader than the creation of a new business venture.  At its core, it is a mindset – a way of thinking and acting. It is about imagining new ways to solve problems and create value (Cited in Post, 2017)”.

Entrepreneurial ecosystem:  “refers to the interaction that takes place between a range of institutional and individual stakeholders so as to foster entrepreneurship, innovation and SME growth (SEAANZ, 2014).

Innovation ecosystem: is the flow of technology and information among people, enterprises, and institutions is central to an innovative process. It contains the interactions between the actors needed in order to turn an idea into a process, product, or service on the market (OECD, 1997).

Entrepreneurs may only look at three factors being “accessible markets, human capital/workforce and funding & finance,” however, the ecosystem that enables entrepreneurs to succeed, is a wider and more complex (World Economic Forum, 2013).  The concept of the entrepreneurial ecosystem argues that is it not just business minded people (entrepreneurs) that are required but an environment (i.e. the ecosystem) made of public and private players, which nurture and sustain entrepreneurs and businesses (Financial Times, N.D).

As a development strategy, the entrepreneurial ecosystem can be used as a conceptual framework designed to assess and foster economic development via entrepreneurship.  It contains a set of interdependent actors and factors that stimulate and enable creativity, innovation, small business growth and investment within a place (SEAANZ, 2014).

There are many assessment frameworks and each considers various intervention levels (national, regional and local), as well as various ecosystem determinants (such as policy, enabling environment or culture). These frameworks include the:

On review of these various frameworks, the Aspen Network of Development Entrepreneurs (2013) found that there are three areas of assessing the entrepreneurial ecosystem being:

  1. Entrepreneurial Determinants – the various factors that affect entrepreneurship, and include:
    • Finance (debt access, venture capitalist, access to grants , angels, stock markets);
    • Business support (industry networks incubators/ accelerator legal/ accounting Services);
    • Policy (tax rates, tax incentives, cost to start business);
    • Market (domestic sales, international sales, target market size);
    • Human capital (graduation rates, quality of education)
    • Infrastructure (access to telecom, access to electricity, access to infrastructure)
    • R&D (patents); and
    • Culture (entrepreneurial motivation, leadership/visibility, creativity);
  2. Entrepreneurial Performance – the specific activities that entrepreneurs perform that will ultimately deliver the impacts, and include number of firms created, employment generated and wealth; and
  3. Impact – the value created by entrepreneurs, and entrepreneurship, which may be measured economic growth, job creation and poverty reduction.

Based on an assessment from the aforementioned mentioned frameworks, governments can evaluate whether they have a strong entrepreneurial ecosystem and what actions they should put in place.

However, it is important to recognise that that each entrepreneurial ecosystem is unique and all determinants in the ecosystem are inter-dependent. Thus, governments should also be cautioned against relying on a single element to transform an economy. Instead governments should aim to create a balanced functioning entrepreneurial ecosystem by:

  • building the capabilities of local assets (e.g. innovative firms, universities, incubators);
  • promoting the networks and visibility of entrepreneurs and innovators; and
  • support financing for growth (e.g. venture capital).

 

Part two will discuss the gazelles and job creation.

Part Three will discuss the role of public and private actors in creating the ecosystem.

How Regions and Places Create Wealth and Grow

With more than half the world’s people now living in cities, cities play a new economic role in the global economy (World Bank Group, 2015). Cities have become their own strategic territories due to their size and location which facilitates a dynamic called economic agglomeration – a powerful force in economic development. It is Agglomeration forces that largely determine why some places grow and become richer and why others decline.

Agglomeration is defined as the “benefits that come when firms and people locate near one another together in cities and industrial clusters” (Edward Glassier, 2010).

Agglomeration is an interesting concept because it contradicts normal economic trends such as supply and demand. For example, the co-location of similar firms does not necessarily reduce demand and profits for goods and services through increased competition. Instead, agglomeration can support productive efficiencies, innovation, job creation and higher incomes which drive the competitiveness of firms and higher living standards for its residents (World Bank Group, 2015). Agglomeration is also an accumulative process, in that, growth continues to attract more people, investment making it places more productive and wealthy.

The following is a summary of the work by Mario Polèse[1], explaining the seven pillars of agglomeration and the economic rationale for growth.

  1. Scale economies in production

Agglomeration enables the firms to benefit from economies of scale through lower fixed costs through the centralisation of their production processes into a single location. Economies of scale is defined as “factors that cause the average cost of producing something to fall as the volume of its output increases (Economist, 2008)”. Locations that offer economies of scale tend to be cities where it makes economic sense for firms to concentrate their production facilities and locate those facilities close to lots of workers, driving down the cost of production.

  1. Scale economies in trade, transportation and distribution

In order for trade to occur in an orderly and efficient manner, facilities such as infrastructure and logistic networks need to be maintained and again this involves fixed costs. Places where there is a concentration of firms using these facilities, tend to have better maintained facilities, more accessible networks and lower unit costs, driving productivity. This is because, for governments and the private sector to invest in supplying such facilities they need to be economically viable and that is driven by scale – users and production through facilities.  When firms are able to benefit from supply chain efficacies and market access, it leads to the attraction of new firms and increased traded out of those places. Increased trade leads to higher incomes and the attraction of more workers propelling the creation of cities.

  1. Falling transport and communications costs

Firms need to be able to access a large enough market to generate a profit and it makes little sense to do this if the cost (time and money) of transporting goods or communicating (e.g. services via the internet, fibre optic etc. ) to the market and suppliers eats into a firms revenue.  Therefore the cost of transport and communication is therefore a “powerful barrier to market expansion”. Falling transport cost and communication enable firms to concentrate activities in one place to be closer their market or market access points to more effectively distribute to or establish new markets.

  1. The need for proximity: industry clusters

Industry clustering is about the benefits that firms receive by being located close to other firms in similar or interconnected industries. Cluster development is not just about the benefits of locating firms in the same place but about the collaboration and competition between competing companies that leads to a range of benefits. These include:

  • business transactions and information that can build economies of scale and improve output;
  • knowledge sharing and industry diversification through spill overs and spin offs’;
  • potential for specialisation (i.e. competitive advantages) and innovations;
  • specialised pools of labour and supports wider workforce development; and
  • lower unit costs of infrastructure.
  1. The advantages of diversity

Firms also benefit from variation and diversity which can only really occur in places such as cities that have large markets. For example, variation supports firms to rapidly scale production due to access to diverse customers, skilled workers and suppliers; and to develop niches that are only viable in large markets. In addition, variation and diversity also supports intangible benefits such as culture and creativity which underpins innovation and therefore the competitiveness of firms and the city.

  1. The quest for the centre

Firms need access to their customers and it makes economic sense to be located in the geographic centre of their markets. However, ‘centrality’ (the centre of somewhere/thing) can also be man-made, as investment overtime can make one location more central for access to other areas and markets (i.e. ports that can act gateway – especially intermodal and ones with multi-connections such as Heathrow, Singapore or Dubai). Consequently, for firms that export, it will be places that provide the best access to customers via market-access infrastructure. Either way, the most strategic location for a firm is one that minimises the cost for the majority of its customers to reach them – and that generally is a city.

  1. The buzz and bright lights

People are also driven to agglomerate. The majority of us, to some extent, want to be located near to near people and with people of similar skills (clusters). People also want access to better services, amenity, culture, and better jobs and higher incomes – all which can generally be found in cities. As Polèse’s notes, agglomeration is undoubtedly an economic driver but it also “fulfils a social need” which makes it a virtuous cycle.

 

[1] Polèse, M (2009) The Wealth and Poverty of Regions: Why Cities Matter. The University of Chicago Press. Chicago.