A helping hand from the government can be useful

You sometimes hear people claim that “The government shouldn't get involved in the corporate world”. But is this actually the case? Until recently, Professor Sophie Manigart felt it was better for government bodies not to get involved in funding (young) companies. On behalf of the IWEPS, the Walloon Institute for Evaluation, Forecasting and Statistics, she carried out a comprehensive literature study into the funding of young and innovative companies and the potential role of the government in encouraging access to this funding. These days, she has a more nuanced opinion.

Negative selection and a lack of skills

“For a long time, studies appeared to show that young companies which were funded by the government were significantly less successful than start-ups which were able to attract private capital, for example from venture capitalists. This was thought to be because the government was not managing to select the best companies and give them optimal guidance”, says Sophie.

And she explains why: “The government is said to apply different investment criteria to those used by independent financiers. For example, they try to serve broader social interests rather than corporate interests. Government officials are also said to possess insufficient expertise to give these young companies proper guidance, as after all they do not have the same skills as entrepreneurs. There is also talk of a negative selection effect: in the first instance, the best projects and companies are said to look for private funding and only tend to approach the government if their attempts are not successful. This is because private funding benefits your reputation: you can attract better staff and are more credible to clients and suppliers.”

The right financial mix for the right companies

However, these studies do not distinguish between full or partial government funding. More recent research does make this distinction, however, and reveals that the situation is more nuanced than was previously thought. For companies with the government as the only financier, the result remains negative. However, companies in which the government becomes involved alongside independent investors tend to do well, often even better than companies which have 100% private funding.

We can see that companies which are financed by a mix of public and private funds tend to focus more on research and innovation, which leads to stronger patents in the long term and more of them. Why is this? Private investors mainly tend to focus on product launches, market introductions and growth, whereas the government might find it easier to focus on the long term. “However,” adds Sophie, “it's important to emphasise that the positive influence of direct government funding only applies to young companies. It will absolutely not benefit a mature third-generation family-run company.”

“To summarise, you could state that direct government funding works, on condition that the government limits itself to the market segments and companies for which private funding is inadequate because the risks fail to outweigh the potential returns, but which could still prove economically and socially profitable in the longer term. And on condition that the government collaborates with private players to the greatest possible extent,” she concludes.

The answer to market failure? A more effectively enforced legal framework

According to Sophie, one of the most important insights revealed by the study is that the government can make the biggest contribution by tackling market failure. However, this is not the only area which requires attention. Start-ups suffer from market failure all over the world, yet the failure levels vary from country to country. In other words: market failure depends on the environmental factors.

What advice would she give the Belgian government, then? “Rather than setting up yet another fund, it would be better to focus on institutional measures – on a transparent, properly functioning legislative framework which clearly stipulates the rights and obligations of entrepreneurs and financiers – and ensure that these laws are actually enforced.”

For example, she feels that the recent improvement in our bankruptcy legislation is a step in the right direction, but still leaves a little to be desired in the area of investor protection. She explains: “In some cases, certain creditors are given protection to which they are not actually entitled, whereas others are unjustly left out in the cold. If creditors with guaranteed debts are always given priority over subordinated creditors, in bankruptcy proceedings this rule unfortunately tends to get trampled underfoot. In general, this legal uncertainty tends to frighten off investors. Incidentally, comparative studies show that in countries with a clear, unambiguous and (above all) binding legal framework, the private sector invests more heavily in companies than in countries in which the existing legislation is applied in a less consistent way.”

Confidence is the key word

“I am therefore arguing in favour of a more transparent and consistently applied institutional framework which gives investors confidence and makes it easier for them to assess the risk-return ratio. I think there could be greater emphasis on this point.”

While no country unites all the best practices, Sophie thinks that Luxembourg is a good example of a country which has established a clear framework with a view to not obstructing the operational management. “Under pressure from the more stringent transparency legislation and the justified battle against money laundering, it has created an improved legislative framework which has eased the way for financial services in this country. All kinds of investment funds have their administration departments in Luxembourg, not only because of the clear legislative framework, but also because everyone is confident it will be enforced.”

And she concludes: “Good laws alone are not enough, you must also make sure they are binding.”

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