Published 02 May 2017

Avenues of new dreams: the government’s future role in capital supply

There are two main arguments why the government should intervene in the capital market for new and small companies:

  • to stimulate positive spill-over effects
  • to resolve market failures.

The government can have an interest in stimulating enterprise as it gives rise to positive spill-over effects, for example employment, innovations and structural change. It seems that the government’s role as ”catalyst” in these contexts should be greatest when the activities are set up and the market is immature.

Market failures are often due to information asymmetries, in other words, imbalanced information and a lack of communication between financiers and business proprietors. If the financier knows less than the proprietor about the business concept, it can lead to uncertainty resulting in investments not being made or being limited as a consequence of higher interest rates and yield requirements.

Market solutions can sometimes lead to partial failures – financial gaps. It might entail a lack of capital in early phases of development or difficulties for businesses in certain regions to obtain financing.

There are consequently arguments in favour of government interventions, but it is important to resolve the right problem in the right way. Otherwise, the government’s own initiatives can lead to undesired effects, for example, keeping inefficient companies afloat or crowding out private actors.

International experience shows that government interventions tend to focus on supply – it is assumed that it is the shortage of capital in the market which constitutes the problem. The demand side has not attracted equally great interest.

In Sweden there has long been a structure of government actors which supply capital to new and small companies, often in the form of venture capital. However, it might be the case that there are insufficient companies with the right growth potential for venture capital investments? Neither do all business proprietors want to finance their companies with external capital, for reasons such as independence and control.

It has, however, been difficult for government interventions in the VC market to achieve success. The good examples that can nevertheless be identified show that the context and the exchange of knowledge between the actors are significant. The long-term nature of the government’s interventions is also emphasised, and the importance of focusing on continuous initiatives rather than on specific financial gaps.

According to Landström, there is a need to change the perspective for new policy measures within the area of capital supply. The point of departure should be the lack of knowledge and demand rather than the lack of capital. To formulate the right government interventions, we need to have a better understanding of entrepreneurs’ financial behaviour and decision-making.

It is often assumed that new enterprises need large amounts of capital from VC-investors and business angels, but that isn’t always correct. The majority of businesses are small livelihood companies which neither want to nor can attract venture capital. Numerous successful IT and service companies have also been set up with small amounts of capital. However, it should be stressed that there are a number of new and small businesses which need a large amount of capital for their establishment and development, not least some technology-based and growth-oriented companies.

For most small and new companies, internal capital is more important than external. The predominant form of external finance is bank loans. Many small businesses also use alternative methods for external financing, so-called bootstrapping.

The group of new and small companies is extremely heterogeneous, for example in terms of which resources they have access to and the way they are set up. The differences mean that it is hard to formulate general government interventions. But there are also similarities which mean that certain categories of company, for example, family businesses, can be expected to share similar financial problems.

Some recommendations for the future policy discussion:

  • It is important to create an environment (context) where both entrepreneurial activity and a properly functioning financial market can be developed and flourish.
  • Knowledge and learning are central. We need good entrepreneurs with knowledge about external financing, and we need financiers with better knowledge about investing in new and small companies. Interventions which focus on learning are thus important.
  • Government financing initiatives need to be more anchored in today’s enterprise and the resource requirements that these companies demand.

Landström concludes by formulating a number of starting points for a discussion of future policy measures for financing new and small companies. His main message is that understanding of the entrepreneur’s perspective and financial decision-making is required when government interventions are formulated – if we want them to have real significance for companies’ development.

This results in a stronger focus than previously, partly on the business proprietor’s perspective, his or her behaviour and financial decision-making, and not on the supply of capital and the investors’ motives, partly on the knowledge which is available surrounding entrepreneurship and its financing, and not a search for best practice that can be copied into a new context.

Title
Avenues of new dreams: the government’s future role in capital supply

Serial number
PM 2017:03

Reference number
2013/014

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