Friday, December 30, 2011

A Route Less Travelled

Book Review: Creating Risk Capital by Ian Whalley,Vision Books/Business , 222 pp; Rs495 (Paperback)

Peter Drucker said "Because of its purpose is to create a customer, the business has two and only two functions: marketing and innovation. Marketing and innovation produce results. All the rest are costs". The idea holds true, once we think on the potential risk capital; investment funds allocated to startup firms with potential is primarily procured through the combined strategies of marketing and innovation.

In Creating Risk Capital, Ian Whalley strengthens the case for royalty funding as a financial solution for the ownership of an enterprise. The idea of the royalty fund however remains an elusive even after one has read the book. To postulate an explanation, the royalty fund exists as an alternative to traditional systems of borrowing — bank loans, venture capital, private equity — that allows risk finance to be raised without compromising on ownership or control of the firm/startup. This method of funding is grounded in licensing wherein enterprises pay for the invested risk capital by means of royalties on the sales revenues they achieve, instead of becoming debtors or partners to those who provide funds. The author's arguments offer an unclear explanation on the functioning and benefits of this innovative model of risk capital formation. Whalley declares that, "Licensing will be the cornerstone of the royalty funding system...It involves the granting of permission by the owner of a property to another party, allowing the later to make use it "again appears too much formal and further this quote "royalty funding is a form of risk capital, but it is not the equity or owner ship capital which is risk capital in its classic form," which only adds to the ambiguity.

The next complication arises from the fund's narrow focus on areas of business; the royalty fund essentially targets specialised businesses and also follows a very technical line of project hunt. Hence, its suitability for small and medium business as an option for risk capital option dwindles. Moreover, big businesses hardly need the royalty fund, so is the case with mid size ventures that have easy access to reasonable debt or the option of going for public listing. It is important to realise that unlike the saturated markets of Europe, businesses in emerging markets will certainly opt for other routes of financing risk capital rather than falling into the vicious trap of permanent sharing their earning owing to royalty funds. Royalty funds function with the motive of acquiring maximum, stable earnings throughout the span of any business. Where the market is dynamic, there would be feeble chances of this untested innovative model to succeed. In this context, the book fails to explain the diversities of business and the specificities of various markets accordingly.

There have been very few books that address the issue of risk capital, thus the basic contention of the book is important. The first two parts of the book, however, reproduce textual basics of financial management, which can generally expected of management students to who are necessarily acquainted with the world of finance. Even for the general enthusiast, this book creates little value with its excessive emphasis on conceptual details as opposed to context specific examples which would have proven to be more useful. The other big impediment lies in the author's point of view where he (somewhat erroneously) uses the UK business model as a universal system of business planning and ownership. It is only in the third and final section of the book that Whalley provides some workable insights on the subject of royalty capital much to the reader's solace.

With regard to the Indian economy, it is imperative to keep in mind that the Micro, Small and Medium Enterprises (MSME) sector not homogenous, but comprises three different sub-sectors. These sub-sectors need to be serviced separately. For micro enterprises, access to credit is priority. For small enterprises, access to credit is relatively easy, though limited, and therefore remains important along with cost. For medium enterprises, access to institutional finance is easy though the cost incurred on credit is quite high. In the present scenario, collateral based lending offered by banks and financing companies is normally made up of a combination of asset-based finance, contribution-based finance and factoring-based finance using reliable debtors and guarantors. Substantial numbers of MSMEs are falling short on collateralised security needed for bank loans, and lack the prospect of high returns to attract formal venture capitalists and other risk investors like private equity funds. So, there is potential for experimentation from banks in order to find a niche as the source of risk capital.

Beyond banking sources, there are only a few options left for funding small and medium businesses. Venture capital, as financial intermediary, does not providing viability to SMEs. The process of securing finance is critical and most difficult for any business. It’s applicable to startups seeking VC funds or mid-size companies that need cash to grow. So venture capital is most suitable for business with large up-front capital requirements which can’t be financed by cheaper alternative such as debt. Another financing option, private equity shows explicit interest s in typical leveraged transaction, where it buys majority control of a growing or mature firm. This works differently from a venture capital or growth capital investment fund where investors invest in young business and rarely bid for decisive control. Therefore, this is equally afflicted by the syndrome of permanent sharing of profits like royalty fund, and hence stood little chances for sustainable business, if taking things straight. Beyond these lesser suitable options, banks remain the most viable option but though a lot of change is required in their procedures and composition of providing futuristic risk capital products. While the right kind of financial innovation is needed, following the route of the royalty fund, a somewhat exotic source of risk capital seems like chasing a will-of-the-wisp and that ends up nowhere.
Atul Kumar Thakur
December 29, 2011, Thursday
(Published in Business World,January 31, 2012/ )

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