Thursday, 6 December 2012

A Detailed Scheme for Funding Innovation in the EU

After reading Horatiu Ferchiu's excellent blog post on a scheme for funding innovation and start-ups in the EU, it is time that we elaborate on the subject. Building on the idea that Horatiu has presented, I would like to add some details in order for his plan to become ready for implementation.  The following article consists of almost every idea that should be implement in designing an innovation-funding scheme.

The Entities

At first, a distinction between the EU Investment Fund, based in Brussels or anywhere else in the EU and the Sovereign Fund should be made. 

Sovereign Fund: This fund should be where the innovators should apply at the first round of money and it should be based on each Member-State. The government of each nation should commit itself to contribute no less than 20% (but no more than 70%) of the amount to be assigned to each company, proportionately receiving an amount of equity from the company (for details see Seed Money later on). The rest of the money should be allocated directly through the EU budget. Employees at this Fund should be considered EU employees and receive their remuneration directly from the EU and not the Member-State, to avoid any issues which may arise (favoritism between candidates due to political beliefs or other connections, personal favours, etc). This Fund should be audited twice a year to ensure proper handling of the allocated funds. In addition, to avoid bureaucracy in the Fund, any application whose answer is delayed more than 1 month (given that the applications should be very concise and not exceed two A4 sheets), can be submitted directly to the EU Investment Fund where measures should be taken for punishing Sovereign Fund personnel. Although the aforementioned may appear hard on some, they are not imposed as a means of punishing anyone or to assign blame, but rather as a form of ensuring that the whole procedure flows without any problems in design.

Investment Fund: The Fund should be based in Brussels or any other EU territory, and should be under the supervision of the European Central Bank (ECB). This would ensure that the funds allocated to the ECB are directly used for promoting growth, innovation and start-up businesses. This Fund's duties would include the unremitting monitoring and supervision of the Sovereign Funds, as well as the filtering of applications for greater amounts of funding by EU businesses which have outgrown the seed stage. Continuous monitoring of the procedure would mean that any bureaucratic obstacles can be removed as the Fund becomes more experienced in handling applications; this would reduce the amount of time necessary for a new company to function, and assist the innovator(s) in setting up their business faster. Under the current state of affairs, much paperwork is needed to indicate where the funds received have been used, especially at the state level. The Investment Fund should monitor that every Sovereign Fund uses the same procedures, protocols and forms, which should be maintained to a minimum level, so that companies should be focused on innovation and development and not in endless paperwork.

The Ideas

Although the scheme is aimed in promoting innovation, care must be taken in defining what innovation is. For example, nobody would argue that Facebook or DropBox were an innovation. How about Google? Although most of us would definitely say yes, a careful observer would note that search engines existed before Google. What Google did was not invent something new but improve a current procedure or situation. This is what innovation should be titled.

No less significance should be given to a mechanism improving teaching in universities, than to a new electric car. Both should be considered and treated equally as innovation, and receive funding based on whether that idea is good or not. Another issue that should not bother the Funds is the exact number of the potential market for the products or procedures. Motorola could not even imagine the market for mobile phones when they were invented in 1972, and neither could Steve Jobs and Steve Wozniak when they brought forth the first personal computer (one could argue that this was not an innovation as well. They just assembled the parts in a way nobody had ever thought about before).

Meritocracy is what should prevail in such institutions, and this should be an outcome of the people working at the Funds. A selection of capable and energetic persons should constitute the workers of such places; age does not matter in such context as people with less experience are many times more capable of understanding a great idea than others who are more seasoned. As both the Sovereign Fund and the Investment Fund should be liable and receive remuneration from the EU directly, the ECB or some other organization should be responsible for drafting the first peeople in them. After the first year, the Funds would be able to operate autonomously and thus would be in need for much less assistance.

Course of Action

As can be seen from the graph below the usual startup financing cycle moves from seed money to Venture Capitals, Alliances and Mergers&Acquisitions to IPO's in the open market.
Source: Wikimedia Commons
Thus, in this case as well, the pre-IPO course of action of the aforementioned two organizations should be divided into 2 stages:

1. Seed Money: During this first phase of development, the innovator(s) present their ideas (or products if they have already developed them) to the Sovereign Fund which is to decide whether they should be granted some money to continue development or not. At this point, no detailed business plan will be required as this will only be the starting point of the whole procedure. No more than 1-2 pages describing what the innovator(s) is proposing along with some details on how (s)he is aiming to achieve this. Funding at this stage should approximately be around €20,000 for one innovator, €25,000 for two innovators and €30,000 for 3 or more. For those of you who believe that €20,000 is a very small amount, I would remind you that DropBox began with the equivalent of less than €11,000, as have Facebook and Google. Since this stage is the one where risk is particularly high, all funds should be granted in exchange for an equity share in the company. The Sovereign Fund should collect about 5-7% of equity per company; the owners of the company should undertake their company's registration themselves, before the funds are received but after they have been granted with them. Nevertheless, company registration pending should not delay fund release as time is of the essence in the innovation industry. The idea behind receiving equity for the funds is for the owner(s) of the company not have to repay debts for the rest of their lives just because something did not work out as planned. By forcing them to pay for the company registration themselves, the Fund would make an attempt to make the innovator(s) believe that they have and will put more than just their work into that company; a small part of their hard-earned money has been put to use as well. Given that Member-State governments should commit to contribute no less than 20% and no more than 70%, they should receive an amount of equity proportionate to their contribution while the rest will belong to the Investment Fund. (e.g. 20% of a total of 5% to be received would equal 1% for the participating government. Similarly 30% of 6% equals 1.8% and so on)

2. Start-up stage: This is where the EU Investment Fund first comes in. After the successful completion of the seed money stage, and at the point where the previously received funds have started to decrease dangerously and the company has reached (or is close to) break-even point, the second stage of the procedure should be initiated. The Investment Fund should reconsider all companies which have managed to fulfill their stage one requirements like product development, market analysis or even product launching and grant them another round of funding which should be much greater than the previous one (between €500,000 and €1,500,000). This kind of funding should allow the company to further develop and/or remain alive until its revenues begin to be sufficient enough to sustain its own growth. The Investment Fund should either obtain 7-10% of the company's capital or lend the money to the company with a very low interest rate (as in the Jeremie family of loans where the EU indirectly lends an amount to the company, through banks in the Member-State where the firm is located). Note that a mixture of the above could also work (e.g. 4% of equity plus €400,000 as a loan), but that is up to both the Fund and the company to decide. Banks in the Member-State should not have anything to do with actually granting the loan. The application and whole procedure should go through the EU Investment Fund, so that it could allocate the funds as it deems fit, and avoid unnecessary bureaucratic delays. The Investment Fund should not limit itself just to cases where the company had received previous funding by the Sovereign Fund, but should welcome applications by independent start-up companies, with a life-cycle of less than a year and a half. If a company between 1.5 and 2.5 years would like to apply, then the Investment Fund should only grant it with a Jeremie-like loan, at its own discretion. Nevertheless, for the 1.5-2.5-year-old companies, the application should be made directly at a banking institution of the company's Member-State.

The IPO Phase

As in most start-up companies, a time comes when the firm is "obliged" to go public, so that the organizations which assisted in its creation (in this case the Sovereign and the Investment Funds) can obtain some profit from the whole procedure. As most venture capitalists know, it only takes one Google, or one Facebook every 200 companies to more than make up for everything invested. Thus, quantity of companies gone public should not matter as much as quality. This would mean that even though companies should be "forced" to go public after a certain threshold (i.e. if they are currently employing more than X persons, where X would depend on the size of the country, or if they have a yearly turnover of more than €X million, again depending on the size of the economy). The reasons behind this are that when a company gets larger, it become more important to the country's economy as it both employs a large amount of persons and contributes greatly to its growth. Thus, the authorities should monitor such firms, in order to ensure that thousands of people will not become unemployed in the blink of an eye due to poor decision-making, as recent experience from EU banking institutions has shown. For example, a firm employing 300 people would not have a major effect in Germany if it collapsed, nevertheless it would have a much greater effect in countries like Malta, Greece and Ireland. As already stated, large type of companies are not the norm in any funding organization. Nevertheless, with more companies funded, the probability of having at least one Google-like firm increases.

After the IPO, both government and Investment Fund, will see their equity stakes reduced, and receive cash in their place. From then on, it is on both the government and the Investment Fund whether they choose to sell out and receive cash or continue with the same amount of equity they have left after the IPO. To avoid any speculation, neither the government nor the Funds should be allowed to increase their share of equity in the company, other than the one agreed upon in the first or second phase of funding.

Economic Aspects of the Scheme

Horatiu has proposed the hypothetical amount of €100 billion to be attributed to this scheme. Nevertheless, simple math would point out that even an amount of €1 billion would be sufficient to cover the needs of this program. Assuming that €300 million will be assigned as seed money and €700 million will be used for the Investment Fund, it would mean that even if all companies are in the 3 or more innovators category, approximately 10,000 start-ups firms from all over Europe could be assisted could be assisted. Since, this funding should occur proportionately in each nation, dividing this with the number of MEP's (expected to become 751) and given that the minimum amount of MEP's is 6 and the maximum 96, it would mean that a number between 80-1290 companies per nation can be assisted.

One may only imagine how much 80 companies per year would mean to a small nation like Malta and Cyprus, not to mention the 1000+ companies in countries like Germany, Spain and Italy. Even if half of that amount is allocated (i.e. €500 million), even a minimum of 40 companies per country would still be a significant boost to growth and innovation.

Social Outcome

According to recent data about 5.5 million youths are unable to find employment and 7.5 million people between the ages of 15-24 are out of employment, training or education. The cost of this situation has been estimated to more than €150 billion euros, or approximately 1.2% of the EU's GDP. This situation is not expected to improve in the next periods of time, and many are actually happy that this number will remain stable and not increase. Good news are that these numbers can be reduced. €1 billion is merely 0.008% of the EU's GDP and less than 0.001% of the budget currently under discussion.

Start-ups are not a magic solution however: do not expect that unemployment will be reduced drastically by next year if this scheme is implemented. Expect, nonetheless, that in the next 3-4 years this kind of unemployed will not be present. As companies grow, and more innovative and vigorous people enter the market the situation can only get better. That is if we just assist them in doing what they do best: innovate.

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