Role of Public Policy in Fostering Entrepreneurship

: Mr. Salman Khalid, an Associate with Manara Equity Partners, Bahrain and an aspiring leader within the Emerging Markets Private Equity and Venture Capital Industry, was invited to deliver a talk on the Role of Public Policy in Fostering Entrepreneurship on December 22, 2009.

Khalid began by delineating the various facets of entrepreneurship: what it really meant, who comprised the entrepreneurial stage and why should public policy practitioners focus on it. From the word “entrepreneur’s” origin in a 13th century French verb – entreprendre – meaning “to do something” or “to undertake” to its modern context of “people who found new businesses, not people who found religions, social movements, or corporate ventures, or people who are just acting creatively” or “any entity, new or existing, that provides a new product or service or that develops and uses new methods to produce or deliver existing goods and services at lower cost”, Khalid argued that entities solely replicating production technologies may or may not come within the purview of entrepreneurship depending on one’s definitional context.

Discussing the anatomy of an entrepreneur, Khalid quoted the findings of Kauffman Foundation’s 2009 study focusing on technology and healthcare industries that contrary to popular belief, a majority of entrepreneurs tended to be middle aged, married with children, well-educated, with significant industry experience mostly belonging to the middle class, and not necessarily from a family of entrepreneurs. Their primary motivations for launching a business were to build wealth, to own their own company and to capitalize on a business idea.

He then proceeded to highlight the significance of entrepreneurship for public policy quoting several studies arguing that entrepreneurship was a primary catalyst for economic growth and regional development, driving innovation and creating a lot more jobs than steady-state firms. Different rates of entrepreneurship accounted for 1/3 or 1/2 of the difference in national economic growth rates. Firms like Microsoft, Google and Intel had driven innovation in technology essentially changing the whole economic paradigm in the USA merely in the last two to three decades. Recognizing this, state and local policymakers now devoted considerable resources to fostering entrepreneurship. Suggesting a research framework for entrepreneurship, he argued for an interlinked three level analysis: the individual level exploring entrepreneur’s characteristics, strategies and achievements, the firm level analyzing size, technology production, managerial style & outcomes, and macro, i.e. the regional and national level studying the relationship between entrepreneurship, public policy and economic growth. The approach should be interdisciplinary exploring the Economic: cost benefits analysis of policies; Sociological: cultural attributes, social class and social networks; Psychological: personality characteristics regarding aptitude for innovativeness, competitive aggressiveness, and autonomy; and Managerial: management systems and practices.

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In discussing the government’s role through the interaction of public policy and entrepreneurship, Khalid explored the associated framework (on the right) constituting Economic Inputs and Resources, Rules of the Game and Entrepreneurial Outcomes. Economic Inputs and Resources needed for entrepreneurship included education, skills development, access to finance through loan programs (subsidized loans and micro-financing), small business research grants, availability of venture capital and opportunities for university R&D commercialization. To start a business, besides some seed money and ‘bright ideas’, one needed a suitable level of education (including math, reading, history), and skills (business, management, science and technology in addition to industry specific skills) including the intangible aspects like prudent risk taking, creative thinking, business acumen and social skills. Giving an example of the MIT’s $100K Entrepreneurship Competition, where students pitched their business plans to a select committee of experts and financers, he argued for creating opportunities and environment conducive for student involvement in entrepreneurial activities stating that the local context even needed a lesser requirement of initial seed money.

Dwelling on access to finance, he argued that information asymmetry was a key characteristic of the market for small and medium enterprise (SMEs – most entrepreneurial firms are SMEs, given the general lack of available economic inputs and resources) primarily due to SMEs’ multiple inherent drawbacks- issues of new firm, lack of track record & product maturity, little management experience and reputation, informal business plan, low profitability, small market and little financial resources. Furthermore, without auditable financial statements, limited cash flow and a lack of collateral, SMEs were rarely funded by financial institutions. Thus financing options were limited to using own money or to raise capital. Typically, most entrepreneurs received initial funding from FFF (friends, family and fools), which could lead to funding market inefficiencies due to adverse selection and moral hazard. For the US, funding through personal and family savings and assets amounted to 72.4%, which would be 80-90% for Pakistan.

To tackle this market inefficiency, venture capital (VC) firms assist start-ups overcome their financial barrier. These independent and professionally managed firms seek funds from institutional (university endowments, pension funds, insurance companies, etc.) and individual investors and typically invest in small, young firms where there are large information asymmetries between entrepreneurs and investors. VC firms focus on equity-linked investments after evaluating the business plans and monitoring prospective firms. Additionally they generally participate in strategic planning and managerial assistance to the firms that they invest in. Quoting a study, he stated that VCs invested in less than 5% of the considered proposals and expected to write off 3 out of the 4 investments. Still a successful venture generated enough money for the VCs to be profitable in this high risk and return business segment.p4

“… almost all businessmen complained of the scarcity of skilled labor directly impacting a number of aspects, foremost being innovation. ”

Having provided an overview of the role of input factors impacting the level of entrepreneurship, Khalid analysed the domestic situation in Pakistan. He stated that in terms of education and skills, literacy rates as well as the quality of education remained low such that most people did not even possess basic skills, let alone higher education. While large number of management schools had emerged, technical and skill-based professional education remained in short supply and overall quality remained low. As a result, almost all businessmen complained of the scarcity of skilled labor directly impacting a number of aspects, foremost being innovation. Thus most entrepreneurship was imitative rather than innovative1. This required greater emphasis on institutes providing training in commercial and professional skills especially sectors with a competitive advantage, for example the Agriculture sector.

Financing, another major economic input, was almost nonexistent. Small businesses had little recourse to bank financing or other financial instruments. Furthermore, there was a lack of ‘business angel’ networks that could provide funds or entrepreneurial help. As of 2008, there were only three VC companies registered in the country, namely TMT Ventures Ltd., TRG Ltd. and AMZ Ventures but these had not achiveved any tangible results because of underlying demand and supply factors 2:

– Insurance companies and Pension funds were not allowed to invest in high risk sectors including the VC Industry hindering investments in entrepreneurship. – Minimum capital requirement to setup a Fund Management company in Pakistan was US$ 4,200,000 com pared to US$ 100,000 internationally creating a significant barrier to VC industry growth. – Annual renewal of license requirement by the SECP for Fund Management companies increased their business risk and conflicted with the VC business model, which worked on longer time horizons reaping investment benefits several years down the line.

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Khalid recommended regulatory changes to remove the mentioned factors in addition to allowing Insurance Companies and Pension funds to invest a small portion of their portfolio if VC funds were considered too risky; relaxing tax rates (on capital gains tax and ‘carried interest’– profit sharing among VC equity partners) for VCs; creating favorable policies towards Merger & Acquisitions (M&A) and Initial Public Offering (IPO) activity; increasing the R&D budget with focus on commercialization of R&D (rather than just publications) to augment entrepreneurial ventures emerging out of educational institutions; and facilitating establishment of business angel networks’ across Pakistan.

“… increase the R&D budget with focus on commercialization of R&D (rather than just publications) to augment entrepreneurial ventures emerging out of educational institutions.”

He then concentrated on the overall role of public policy in influencing the rules of the game to nurture entrepreneurship in the country. He pinpointed “ease of doing business” as the most crucial policy lever to support entrepreneurship; Additionally, taxation, environmental regulation and healthcare liability regulation also impact it; With only 60%-70% chance of success, protection through functioning bankruptcy laws would be beneficial. But he specifically concentrated on the significance of intellectual property rights (especially in areas such as computer software development) and anti-trust enforcement for fostering entrepreneurial growth.

“… lack of strong enforcement of patent laws discouraged the entrepreneur to spend time in research, as the product could not later be defended to make profit.”

In the West, most entrepreneurial ventures emerged as an outcome of R&D activities in universities. Patenting this research assisted in commercialising the product as the patent system essentially granted temporary monopoly to the innovator to reap economic benefits while increasing societal welfare. But lack of strong enforcement of patent laws discouraged the entrepreneur to spend time in research, as the product could not later be defended to make profit. Similarly the goal of anti-trust laws was to prevent monopolies from forming, inhibiting entrepreneurship in the concerned sector. In Pakistan though, in the context of patents, no ‘practical’ implementation of Intellectual Property Protection rights existed. In addition, certain types of patenting were not possible as these were listed in the “UnPatentable Inventions” (Intellectual Property Organisation of Pakistan, 2009). Rather surprisingly, computer software, being a pure outcome of intellectual effort, was included in this list.

Lastly Khalid delved into the impact of overall macro-level policies on entrepreneurship. He argued that Pakistani economy had traditionally been ‘centrally planned’ accruing economic benefits on the basis of influence and contacts. Instead of developing a competitive marketbased economy, this incentive regime created a rent-poseeking businessman rather than a professional manager or a productive entrepreneur. Thus competitiveness, risk taking and innovation never took root in Pakistan leading to a general lack of entrepreneurial outcomes. Additionally professional managers were not trusted given that legal system could not prevent fraud, theft and outright misuse of business information because of a lack of contract enforcement and property rights. Consequently, the cost of doing business increased and the entrepreneur ended up getting involved in everything, including some of the tasks that could be deliberated to professional managers, resulting in the stagnation of growth in SMEs, the sector that most entrepreneurs started from. He thus argued for deregulation and a free market economy with strong antitrust, intellectual property rights, contract and property rights enforcement.

“the incentive regime created a rent-seeking businessman rather than a professional manager or a productive entrepreneur.”

Khalid stated that establishment of Small and Medium Enterprises Development Authority (SMEDA), SME Bank and SME Business Support Fund were steps in the right direction, and additionally welcomed the formation of Competitiveness Support Fund (CSF) and the Agribusiness Support Fund (ASF), both providing matching grants to small entrepreneurial businesses interested in value addition. He promoted the idea of setting up a secondary market (such as NASDAQ) for listing of smaller firms. However, he argued that awareness regarding these initiatives remained low and most entrepreneurs had difficulty understanding and utilizing these facilities because of a lack of literacy and awareness. Education thus remained the most critical factor of them all.

1 Haque, N. U. (2007). PIDE Working Paper # 29: Entrepreneurship in Pakistan. Retrieved December 20, 2009, from Pakistan Institute of Development Economics (PIDE) – Working Papers: http://www.pide.org. pk/index.php?option=com_content&view=article&id=69&Itemid=94.

2 Akhtar, S. (2008, April 17). Venture capital in Pakistan. Retrieved December 20, 2009, from Competitiveness Support Fund: http://www. competitiveness.org.pk/downloads/Venture%20capital%20in%20Pakistan. pdf.

3 Akbar, U., & Bashir, N. (2010). Entrepreneurial Environment In Pakistan For Start-Ups. In Z. Haqq (Ed.), Proceedings of the 12th International Business Research Conference (pp. 710-722). Dubai, United Arab Emirates: World Business Institute. Available at: http://www.wbiconpro. com/table_of_contents_manage_apr2010.htm.