Inovation Engineering Episode 12 pps

Financing Innovation 297 to 4 year period between the designing of the vehicle and its actual development and launch in the market, the flexibility of design being a key factor in the competition between Japanese and European manufacturers since the beginning of the 1990s. Figure 17.1 illustrates the various problems associated with the financing of innovation: how does one resolve the difficulties specific to the beginning stages of the project which are the riskiest in the whole process of innovation? What are the respective roles that public and private funding should play in financing? How can one optimize the relay between the various categories of resource providers? How can the company divide its business plan into successive stages that would correspond to as many “pools”? Regarding finance, innovation leads to three categories of needs: material and intangible investment, increase in the need for working capital that arises with the progress in development activity, and finally expenses related to the project (for example, remuneration of the personnel involved in the research and development effort) that could incur losses and even a negative cash flow. These three needs, which are directly related to the implementation or development of the project, appear in the finance plan. The company will have to mobilize resources in order to finance them. Total needs Physical and intangible investments + Negative net cash flow What resources? + increase of working capital Figure 17.2. Operating needs in the financing plan Investment is defined in accounting by the acquisition of goods, property and securities that are not consumed at the first use and that are meant to be used sustainably in the activity of the company 1 . Material investments represent equipment and material necessary for innovation whereas intangible investments cover expenses associated with R&D and intellectual property, marketing or 1 Let it be noted that in conformity with the principle of investment, companies may “activate” certain expenses incurred during a financial year if this will enable returns in future financial years so that they do not weigh too heavily on the indicators of performance in the year in which they are incurred. For example, the activation of R&D expenses is possible if the corresponding projects are clearly identified and if they have a good commercial earning capacity in conformity with the rule of conservatism that governs private accountancy. 298 Innovation Engineering: The Power of Intangible Networks software or training. Within the framework of a strategy of external growth or partnership, the company can also carry out investments in the form of financial participation. The investment of companies is characterized today by the predominance of intangible and financial investments, which raise the delicate problem of their evaluation. 17.1.2. The financial lifecycle of innovation By assuming certain linearity in the implementation of the innovation project, it is possible to define four phases within the concept of a financial lifecycle: design, launching, development and maturity. For each one of these phases, expenditure, the level of sales and results change in the case of specific financial difficulties. The phase of design is characterized by intense R&D activity, and by an effort to define the marketing strategy of the product. During this initial phase in the life of a project, the investments made are primarily intangible; the sales turnover of the new product is still zero. The losses incurred during this period are characteristic of this first phase and involve a strongly negative cash flow whereas the risk is maximum, as technical and commercial uncertainty weighs heavily on the innovation at this point in the process. Cumulative profit zone sales results maturity Cumulative loss zone launching design development Figure 17.3. Financial lifecycle of an innovation project In the phase of industrial and commercial launching, the risk is still very high but the visibility will gradually improve. The costs increase and include in particular physical investments (industrial tools) and expenditure associated with marketing (deployment of a sales team, development of distribution channels). This expenditure will be gradually compensated by the sale of the new product. It is only during the phase of growth that the project can become profitable and release positive cash flows. At this stage, the risk becomes an economic risk Financing Innovation 299 inherent in any activity, whereas the innovation has proved successful in the market. If the growth is particularly strong, the company will in general continue its investments and will have to incur expenditure and meet an increase in working capital to be able to increase the production capacity, develop its marketing policy, ensure its international presence and, if necessary, ensure the technical readjustment or the improvement of its product. The search for investors able to accompany this growth is then a key element in the success of the project. Several parameters influence the financial lifecycle of an innovation project and consequently the terms and conditions of financing of companies: – duration of the cycle, due to technical constraints (development time) and marketing (timeframe of the commercial launching of the product, deadline for market returns); – the economic model of the company and its capacity to generate growth and profit; – criteria of validation of the innovation by the market and the potential growth of the market; – importance of the expenditure generated by the innovation, particularly that related to R&D and marketing which are in general the heaviest. The biotechnology sector is a perfect illustration of the difficulties of financing innovation: it shoulders the increasing cost of R&D; the obligation to carry out pre- clinical and clinical tests means that the duration of the projects is around 8 years; that of obtaining the requisite approvals and authorizations of the concerned medical authorities before the product can be launched in the market is about 12 to 24 months; the level of risk, higher as the process has not yet reached the development stage, forces companies to multiply the number of molecules being developed which gives rise to corresponding expenditure. The “pipeline” in Figure 17.4 represents these various constraints. Research Development Approval Clinical trials Stage 1 Stage 2 Stage 3 Pre-clinical trials Failure rate 80% Failure rate 12% Figure 17.4. The “pipeline” Thus, the principal criteria of evaluation of biotechnology companies are the size of their R&D budget, the number of molecules under development and the equilibrium of the portfolio of molecules making it possible to ensure the regular 300 Innovation Engineering: The Power of Intangible Networks release of new products. To survive, biotechnology companies, which by their nature are “devourers of capital” and which are generally in deficit, have to greatly resort to external financing which is provided to them by public and private investors or by industrial partners. The crossing of the critical stages of the “pipeline” determines the life of these companies and conditions the progressive arrival of capital that they need. Data 2002 – in millions of dollars – source [ERN 03] USA Europe Turnover R&D expenditure Net losses Number of companies 33.6 20.6 1,500 5,368 3,164 1,189 1,351 Table 17.1. Biotechnologies This situation, which is very specific to the biotechnology sector, is illustrated below with the example of the first 10 years of the financial lifecycle of a small to medium-sized company. In spite of a constant increase in its sales turnover, the company reached its break-even point only in year 10. The cumulated losses of this long period were financed by the capital brought in by financial and industrial investors. Figure 17.5. Financial lifecycle of a small to medium size biotechnology company in thousands of Euros -10 -5 0 5 10 15 20 12345678910 Turnover Results Financing Innovation 301 17.1.3. The financial fragility of innovating small companies The financial difficulties evoked above become more or less critical for different categories of companies, depending on their size, their age and the diversity of their activity. Whereas a large company has the possibility of financing the expenditure associated with innovation because of the profitability of its other activities within the framework of portfolio management and an allocation of total or combined resources, a young company that is not yet into diversification must bear the full risk of the innovating project and cannot depend upon self-financing, which means that it has to look for external sources of finance and to convince investors. The financial structure of small and medium-sized companies is generally characterized by meager capital stocks or funds, a strong dependence on inter-firm credit and a debt level that is often high. The INSEE statistics show that the financing of these companies is in itself a risk, since the failure rate is higher the smaller the size. These companies distinguish themselves by their low life expectancy; only half of them survive for more than 5 years after their creation (source: INSEE). Innovation adds to the intrinsic risk associated with these companies, either by imposing a breaking situation on the existing company or by weighing upon a risk that is already high due to the creation of the company. The handicap to innovation is particularly obvious in a financial context that is hardly favorable for it, as banks offer essentially short-term finance and the majority of investors displaying certain timidity when it is a question of assuming high levels of risk over long timeframes. 17.2. Adaptation of resources to innovation: “patient” and “loseable” money Taking into account the specificity of financing needs associated with innovation, the resources that are adapted must have three characteristics: – the first relates to “patient” money, i.e., for which the investors are ready to wait several years before recovering their initial investment and hoping for a return on investment. In the field of venture capital, for example, the timeframe of such participation is on average 5 to 8 years; – the second relates to “losable” money, i.e. accepting the risk inherent in any innovation. From the investor’s point of view, the risk should imply a greater return on investment which is called a risk premium. Capital investors measure the performance of their investments by calculating the rate of disaster (proportion of projects in which they lose their investment amount) and by the TRI, i.e. the internal rate of return (see on this subject [ERN 02] and [AFI 03]); 302 Innovation Engineering: The Power of Intangible Networks – finally, investing in innovating projects requires strong expertise of the investors to appraise projects and the teams which implement them. This requires time and involves relatively high costs which can be redeemed only on future investments. 17.2.1. Arbitration between debt and capital All companies dispose of resources that are provided by two categories of actors: equity shareholders and lenders. Shareholders bring resources at the time of the constitution of a company or new issues of capital which mark its development. They also enable self-financing by the company, when they forfeit their dividend which constitutes their part of the profits of the company. The financing policy of the innovating company is based on the fundamental arbitration between its financial debt and capital. Taking into account the needs that were analyzed above, it appears that the innovator, particularly for the phases preceding innovation, will have to privilege “losable” and “patient” resources. After having explained the reasons of this arbitration, we will show how the innovator can harness the possible components of a pool of varied resources. In the debt contract, the borrower makes an initial commitment as regards the terms of reimbursement and payment of interest. Consequently, the debt involves fixed costs, independent of the economic performance of the company. This is at the origin of the financial risk associated with the impact of the debt on the returns of the capital of the company. The debt also involves a risk of liquidation associated with the capacity of the company to meet its commitments on their respective due dates. Financial theory and analysis of investment options [VER 03] teach us that resorting to debt is convenient if the cost of the debt is higher than the operational rate of profitability: the income that the company draws from its assets must enable it to remunerate the resources which enabled it to acquire these assets. The company can then bear a higher level of debt, as its profitability increases and becomes more stable in time, and it has a better visibility of its future performances. It benefits in this case from a positive leverage effect. In a young and innovating company, which has, in principle, a low visibility on its future economic performances and that could incur significant losses at the beginning of its creation, the cost of the debt, even if it is low, is then hard to bear. The selection criteria retained by banks and their principle of care eliminates dossiers or projects that are too risky because of the lack of visibility on the results and financial flows. In addition, when the debt must be used to finance intangible Financing Innovation 303 investments, the difficulty of the guarantee and the appraisal of the value that could be created by such investments arise. Financial lever: net financial debts/equity capital Considered a risk above 100 to 120% Reimbursement capacity: net financial debts/capacity of self- financing Considered risky if it is above 3 Ratio of interest cover: operating results/financial expenses Considered comfortable beyond 3 or 4 Figure 17.6. Banker’s ratios Capital is a resource that is fundamentally different from debt for two reasons. The shareholder is a “residual creditor” of the company [BAT 99] and takes part in the risks of the company: in case of liquidation, he will be considered after all the other creditors and will receive the residual value of the assets after retirement of all the debts. In the worst case, the shareholder could lose the entire amount he invested. In addition, the return on capital, contrary to the remuneration of debt, depends on the level of performance of the company and the decisions relating to the allocation of profits. Capital returns are adjusting data. A double uncertainty thus weighs on the committed capital: the risk of profitability, which relates to the level of return on capital, and the risk of bankruptcy, which corresponds to the risk that the capital is devalued or wasted (hence the expression “losable money”). The concept of duration is associated with that of investment. This requires the investor to define at the very start, the advisability of his commitment, by resorting for example to an actuarial calculation making it possible to define the current value of future flows that could be generated by the investment. Capital bears the risks of the company. As their remuneration is more uncertain than that of a debt, the shareholders expect to be better remunerated than creditors: they expect a risk premium that implies that the projects thus financed have a strong potential for high returns. Therein lies the difference for the innovator: whereas the banker defines a fixed interest rate by contract, the shareholder evaluates the appropriateness of his participation by measuring the potential of profitability founded on forecasts of activity and performance. Consequently, capital is an expensive ingredient that obliges the innovator to convince investors of the potential of his project, particularly with the help of a “business plan”, a genuine tool for dialogue between the innovator and the investor. 304 Innovation Engineering: The Power of Intangible Networks When the innovator chooses to go through the stock exchange, he must give great importance to the quality of his financial communication. On his part, the investor must have true expertise meeting multiple criteria, which could be a limiting factor as the appraisal of projects is long and expensive, and often requires the ad hoc appointment of teams. Another characteristic of capital – and not the least important – relates to the right of control that is associated with it. The shareholder owns a part or a fraction of the company, and thus has controling rights on the management of its assets. The opening or issue of capital can be blocked by the cultural reserves of entrepreneurs/shareholders that have a particular vision for their company. As regards investors, the existence of a right of control leads to behavior that can be analyzed within the framework of the theory of the agency [KOE 99]. Thus, investors in venture capital, for example, constitute what the theory of the agency calls “blocks of control” and can provide counseling and accompaniment that could often be useful for the innovator. 17.2.2. A pool of resources Taking into account its need for financing, the innovator must generally create a pool of multiple resources, with a good linking of its components according to their characteristics and their adaptability to the constraints of the various phases of the process of innovation. Figure 17.8 indicates the principal categories of these resources and their possible distribution throughout process of innovation (for a statistical outline of the financing of technological innovation in industry, refer to [LHO 01]). At the start of the process, and particularly in the case of young companies, innovation relies on resources that can bear a high risk over a long period of time. The first of these resources is often brought by the innovator, his collaborators and people close to them 2 , or by businesses angels. Certain national, regional or local public aids add to this private capital. Self-financing constitutes a useful resource for companies that can afford it: this is not generally the case with young companies in the process of starting their business activities, which often have to bear losses associated with the setting up of a business and have to turn to external investors for finance. Among these external investors are investors in venture capital, which take minority shares in young and high tech companies or projects with strong potential, 2 French legislature has recently created a new vehicle: the Fund for Investment of Proximity, which should facilitate regional industrial investments by providing fiscal benefits. Financing Innovation 305 with the intention of making a profit (due to appreciation in value) through the sale of their share over a medium term period of 5–8 years. One can classify the investment pattern of these investors into four categories: seed capital that makes it possible to finance an innovation project in the early stages of the company, risk capital that invests in young companies (usually less than three years old), the development capital that invests in companies that are at least three years old and that show tremendous growth; and finally, certain investments in capital stocks which are meant only to finance transmissions of companies and LBOs (leveraged buy-out) and tend to distance themselves from the problems associated with innovation. Love money Business angels public financial aids Seed capital Venture capital Development capital Co-financing by clients or partners Bank Self-financing Stock Exchange R&D stage Stage of industrial and commercial launch Development stage Figure 17.7. A pool of resources for innovation It is only later, when the visibility of the project improves, that debts become a viable resource. It should be noted that bank credits today have a relatively low after tax cost (about 3%), which make them an invaluable resource for companies that have achieved regular growth and are able to provide guarantees to the lenders. Lastly, the Stock Exchange can be a source of financing viable for companies that are hungry for capital. The creation of the NASDAQ at the beginning of the 1970s in the USA, and the appearance of similar stock exchange compartments during the 1990s in Europe – in France for example, the New Market was created in 1996 – allowed significant lifting of capital in favor of young companies with a strong growth potential. 306 Innovation Engineering: The Power of Intangible Networks Apart from the financial sphere, it is necessary to underline the sometimes essential role that customers and partners can play in the financing of innovating companies, through R&D partnerships that include clauses of co-financing or even through minority acquisitions of a holding from a strategic and not strictly financial point of view. In the case of biotechnology for example, the SMEs of the sector systematically develop research partnerships 3 with pharmaceutical groups, whose existence brings to these SME, a scientific and marketing guarantee and often determines their access to other investors. 17.3. The financial system of innovation 17.3.1. Capital-investment Even though capital investment has been much talked about since the past few years, this method of financing has very old roots: in his time, Christopher Columbus obtained financing from Ferdinand and Isabella of Spain to undertake a voyage towards India by the West: then one spoke about a “loan for a great adventure”. During the past 30 years, venture capital has been illustrated by many success stories: Intel, Motorola, Genentech, Biogen, Microsoft, Apple, Dell and still more recently Yahoo!, to mention only a few, that are the jewels of American technology that benefited from the contributions of venture capital. Generally speaking, three-quarters of the companies financed by the capital investment employ less than 100 employees. In France, the legal and tax framework of capital investment was defined at the beginning of the 1970s, with the creation of the FCI (Finance Company for Innovation) statute. Since then, other legal structures have been created: the CCR (Company of Capital and Risk, created in 1985), the CFIR (Common Funds of Investment in Risk, created in 1993) and finally the CFII (Common Funds of Investment in Innovation, created in 1997). The general principle underlying these various statutes is to encourage investment in young and non-quoted companies by reducing taxation on returns or profits made on these investments. Capital investment seems a resource particularly adapted to the financing of the innovation, for two essential reasons: in the first place, its contribution in capital that strengthens the top of the balance sheet of the innovating company can bear the risk of the innovation; in addition, this resource necessarily involves an expert appraisal of the project, which often leads the investor to help the innovator to put together a 3 According to the terms of these partnership contracts, the groups co-finance the research done by the SME and in return could obtain a contract for exclusive intellectual property rights. The right to exclusivity involves the payment of royalties to the SME when the new product is commercialized. [...]... Entry on to the Stock Exchange Industrial transfers Others Losses Total 1998 347 1999 361 2000 291 2001 201 2002 114 2003 90 259 630 138 1,374 448 593 167 1,569 456 487 164 1,398 547 428 136 1, 312 240 417 155 926 129 567 53 897 Table 17.3 Transfers in numbers of transfers – source: [AFI 04] Transmission capital relates to the financing of repurchase and the transmission of companies with set-ups such... private industrial research through the credit research tax (see www.impots.gouv.fr for more information on these fiscal incentives) 4 Visit the websites www.bourse-de-paris.fr and www.euronext.com  312 Innovation Engineering: The Power of Intangible Networks The state also directly participates in the financing of start-ups and in venture capital investment through a budget managed by the Treasury of Deposits... will allow us to concentrate better on the tools of sharing on the Web, the subject of this chapter 12 One must remember CompuServe, which was the archetype of BBS or systems of sharing data such as FirstClass, as well as Lotus Notes (whose positioning is more particularly that of groupware) 326 Innovation Engineering: The Power of Intangible Networks surprised by the number and diversity of forums on... 1994 43 25 1995 28 20 1996 37 36 1997 13 28 1998 86 38 1999 -7 -1 2000 -19 -5 2001 -6 0 13 33 18 41 36 20 8 11 4 Table 17.4 TRI per year and per type of investment, in % – source: [ERN 02] 310 Innovation Engineering: The Power of Intangible Networks Since 2000, capital investment has witnessed the reversal of the economic situation that weighed heavily on technological firms, the climate being unfavorable... raised and invested: [AFI 04] Several factors can explain this recent development First, there are fiscal incentives that are offered to capital investment along with the creation of new 308 Innovation Engineering: The Power of Intangible Networks vehicles of investment over the last few years At the same time, the state has considerably increased its financial participation in capital investment, particularly... without the Web This movement is at the root of the new paradigm which is in the limelight today: Open Source and its counterpart, the software patent Chapter written by François DRUEL 316 Innovation Engineering: The Power of Intangible Networks This auto-maintained double movement is at the base of a certain number of innovations Some of the most important of these are being dealt with in this chapter... stand to benefit from it: more international, more practical, more modern, more flexible to use and encash than the good old copyright And does everything happen for the best in this world? 318 Innovation Engineering: The Power of Intangible Networks Well no, not really, as there is a “small detail” which makes everyone sit up: a patent does not come for free: it has to be purchased, and sometimes very... anti-globalization Richard M Stallman, its religious head and symbolic guru of some kind of “ecolo-freak”! 3 www.w3c.org 4 By an English pun, it is sometimes called “copyleft” as opposed to copyright 320 Innovation Engineering: The Power of Intangible Networks In fact, beyond its pleasant or even comic aspects, Open Source asks the eternal question of the place of research in society Since the beginning of the industrial... sometimes counterbalanced by verification and cross-checking In certain fields, this question can even be crucial and searching on the Web should be done intelligently The power of the 322 Innovation Engineering: The Power of Intangible Networks Web should be well understood as it allows the easy diffusion of various data It is well known that the text is not the only type of data that can be published:... population born after 1970), it still has not penetrated all strata of the population The different cultures have neither melted nor unified to form a single model In the same way, despite 324 Innovation Engineering: The Power of Intangible Networks impressive progress, computers and the Internet have not yet entered all homes In France, at the end of 2003, the number of Internet subscribers in the residential . 114 90 Industrial transfers 259 448 456 547 240 129 Others 630 593 487 428 417 567 Losses 138 167 164 136 155 53 Total 1,374 1,569 1,398 1, 312 926 897 Table 17.3. Transfers in numbers of. fiscal incentives). 4 Visit the websites www.bourse-de-paris.fr and www.euronext.com. 312 Innovation Engineering: The Power of Intangible Networks The state also directly participates in the. Clinical trials Stage 1 Stage 2 Stage 3 Pre-clinical trials Failure rate 80% Failure rate 12% Figure 17.4. The “pipeline” Thus, the principal criteria of evaluation of biotechnology