Abstract: This article explores how to allocate resources to scientific and technological innovation based on the reality of China's financial system. It presents two major roads: a multi-level direct financing market and the innovation of indirect financing models.
Competition in technological innovation is one of the determinants of the profound changes that the world is undergoing. As a national strategy, technological innovation requires all-around support from the government and the financial market. Indirect finance dominates China's financial system. It determines the direction and structure of resource allocation, shaping the present and future of the economic structure.
However, studies show that a direct-financing-based financial system could be more conducive to sci-tech innovation, though the construction of the direct financing market is more time-consuming. To allocate more resources to innovation and based on the reality of China's financial system, the government should 1) develop direct finance and build a multi-level capital market, as well as 2) innovate indirect finance models. Meanwhile, industrial policy makers should also work to guide and give full play to the market’s role.
Ⅰ. THREE BASIC CONDITIONS OF VC
Sci-tech innovation needs support from a multi-level capital market, but venture capital, or VC, is more crucial.
VC has three primary conditions: patient investors, professional managers, and mature and diverse exits.
VC in technological innovation is highly risky and time-consuming. Such an investment calls for some idealism, but eventually, there have to be rewards. Because of this, patient investors only invest a small portion of their total funds in VC for sci-tech, a portion that is both sustainable and too little to seriously harm the investors with a loss.
VC fund managers are more than just investors engaged in the financial sector; they are part of the entrepreneurial group. VC is not only delivered to the bank account of a sci-tech company, but should also be used to enhance its management, decide how to industrialize technology, and grow the market and industrial chain. Therefore, VC fund managers should gain the trust of both investors and entrepreneurs and have a good grasp of both the technology and the business management they invest in.
Over the years, China has witnessed a rapid development of venture capital, but most of the investment went to areas that feature short cycles and quick earnings, and rely on Internet-enabled new business models, rather than science and technology innovation that require enduring patience. As a result, contracts that involve valuation adjustment mechanism which demands high valuation in the short term are often signed, leading to a disrupted pace of R&D of startups, blind expansion of the scale, and even practices of fraud and deception. With everyone pursuing sudden wealth, patient investors and managers find it hard to survive. Therefore, although many funds have been established over the years, very few of them have actually invested in the commercialization of sophisticated technologies. Therefore, there is a great need to discover new private investors and fund managers for science and technology venture capital.
After more than 40 years of reform and opening up, a large number of high-net-worth individuals have emerged, most of whom are entrepreneurs and many business talents, many of whom have reached the age of 50 or above. Many of them start from scratch, and some of them are still running businesses, but now they are confused about the future. Some of them are not confident about the future of traditional industries, some are unfamiliar with new industries and technologies, some not able to understand new business models, and some fail to adapt to some new policies and practices of local government departments. On the one hand, they have the demand for continued development and innovation, and on the other hand, they assume a wait-and-see approach, which leads to the condition of maintaining the status quo or even contraction or withdrawal of businesses.
Nowadays, financial institutions are vigorously developing wealth management businesses, targeting the above-mentioned group; and it is also this group that is particularly interested in wealth management, especially family asset allocation. For family assets, asset owners are more concerned about asset safety and value preservation despite the hope for asset appreciation. They also have the impulse to invest in new technologies and industries but are deterred by the lack of knowledge. In the process of developing wealth management products, considerations should be given to encourage this group of people to invest a certain percentage of their total assets in private equity funds that are designed to support technology start-ups. In this way, while the risk is tolerable to the investors, the investment in new technology and industries may bring them good returns and also provide stable funds for venture capital investment in science and technology start-ups. To bolster such practice, full income tax refunds for investment in sci-tech innovation venture capital funds and income tax deductions for investment income are recommended.
In terms of investing in tech startups, most of the investment-oriented managers of venture capital funds that have been doing very well in China over the years are no longer suitable. In a sense, they are financiers and capital players who are used to the model of investing in Internet platforms and game companies in previous years and have formed a path dependence on investing in projects of fast growth and high valuation. In the long run, venture capital fund managers who have patience for technology startups, understand the technology, and are willing to witness the growth of startups may be the young generation of post-80s or even the post-90s, whose knowledge structure, way of thinking and behavior are more compatible with the entrepreneurs of technology startups. In addition to improving their investment capabilities, they also have to assume a spirit of contract along with the construction of a market featuring the rule of law, to win the trust of the investors on the one hand, and become a trusted partner of the entrepreneurs on the other.
It is said that direct financing is more suitable for science and technology innovation, and the stock market is certainly important. However, the stock market alone is not enough, especially for technology startups. Venture capital needs to have more types of exit channels. Therefore, in the process of building a multi-level capital market, efforts should be stepped up on the construction of the equity exchange market and the M&A market.
II. GOVERNMENT GUIDANCE SHOULD PLAY ITS ROLE
The so-called "science and technology innovation" refers to the process of industrializing and marketing new scientific research results, which ultimately must rely on market forces. However, it is still unknown what kind of environment the new scientific research results can be applied to, what kind of products can be manufactured, and whether the efficiency generated by the application of the new research findings can be recognized by the market, and all these issues require a long process of trial and error and continuous optimization, which generates large uncertainties. And because of the role of the market, capital often shrinks from such uncertainty.
Although we say that entrepreneurs have the spirit of risk-taking and innovation, it is for the sake of making profits. Only when there is a great possibility of gaining profits, entrepreneurs will take risks and be willing to innovate. However, they will never take risks for the sake of risks themselves and innovate for the sake of innovation. Therefore, at the strategic level of science and technology innovation, it is essential to have the government play its role.
By saying that, I do not mean that the government should be directly involved in the work of science and technology innovation, but that the government plays a role in stimulating the entrepreneurial spirit of adventure and innovation, and guiding the market to allocate resources to science and technology innovation projects effectively.
First, it is important to recognize the role of various government subsidies. To some extent, various government subsidies have the same effect as venture capital. The extensive subsidies eventually foster successful leading enterprises in the relevant technology fields. However, since fiscal revenue and expenditure are separated, , the success or failure of various subsidies and the comprehensive benefits generated by the subsidies cannot be directly reflected in the corresponding accounts.
It is because investment and return cannot be reflected in direct correspondence that subsidies have often been criticized for lack of effectiveness in the past. Here are two shortcomings of government subsidies. First, subsidies are often given in a broad scope and usually target an industry as a whole, such as new energy vehicles. It is not targeted at a specific technology, which sees many visible failures and gives the impression of causing a lot of waste. Second, moral hazard is easy to emerge once there are design loopholes. However, the impression of subsidies creating massive waste is exactly the characteristic of venture capital. A relatively broad scope of subsidies can encourage technological competition and market competition among different technological paths, ultimately producing real winners. New energy vehicles would not be where they are today if there were no subsidies in the early stage that created the momentum of crowding in, nor the competition between various technical paths.
Second, we should continuously improve and bring forth new ideas about the forms of subsidies based on past experience. There are different forms of subsidies, such as direct subsidies, incentives, tax rebates, tax reductions, tax exemptions, interest subsidies, etc. Subsidies in different forms produce different effects for enterprises or industries at different stages.
In the case of the new energy vehicle industry, the effects of direct subsidies to manufacturers and subsidies to buyers are different. Generally speaking, in the early stage of industry development, it may be more direct and effective to subsidize manufacturers, which can attract social resources to invest in the field to the greatest extent possible; when the industry is mature enough, subsidies to car buyers can help the market pick up, which is conducive to accelerating the technological investment of enterprises through market forces, improving technical performance and reducing costs. Therefore, it is necessary to sum up past experiences, and optimize the existing subsidies to make them more targeted. At the same time, it is also necessary to bring new ideas about the forms of subsidies.
Finally, government-led funds should be operated more effectively in market-oriented ways. In the past 20 years, the government-led fund has played a great role in promoting China's scientific and technological progress and industrial development since the establishment of Zhongguancun Venture Capital Fund in 2002, but there are also problems to be solved.
Government-led funds indicate that the government is also involved in market operations and has the following shortcomings.
First, administrative supervision and assessment. Government-led funds normally require value preservation and appreciation, and some even forbid the loss of state-owned assets. This leads to a limited investment target, often relatively mature projects, and loses the characteristics of venture capital, a phenomenon not conducive to the competition of different technological paths
Second, simplistic assessment. The lack of understanding of the long-term nature of venture capital leads to short-term investment behavior.
Third, excessive and inefficient management. Fund managers fail to invest and manage projects in market-oriented ways.
Fourth, multi-layered and unprofessional issuing body. Some local government-led funds have become a means of traditional business soliciting to some extent, deviating from the direction of supporting science and technology innovation.
Fifth is the lack of the ability to leverage market capital.
The above-mentioned problems lead to the lack of market-oriented operation of government guidance funds. Despite the government’s efforts to leverage more social funds to invest in science and technology innovation enterprises, most of them are indirect funds raised by some policy rent-seeking institutions through financial products, etc. In other words, with shadow banking, investors do not know whether they are investing in general financial products or risky investment projects. Under the influence of the new asset management regulations coupled with economic downward pressure, such fundraising channels have basically dried up.
We can consider to clearly dividing government-led funds into two types: one focuses on business soliciting concerning more established projects; the other focuses on venture capital investment in tech start-ups. The second type could adopt a fully market-based operation and management approach:
? Reducing hierarchy and improving professionalism: the hierarchy of fund issuers should be reduced properly to pool talents and enhance professionalism in fund management;
? Establishing a management system and assessment method for the fund team by the operating logic of venture capital;
? Sticking to market-based operation without intervening in the daily operation of sub-funds or designating specific projects or enterprises for their investment;
? Coordinating issuers, government regulators, etc. to establish a regulatory system that conforms to the logic of venture capital and to conduct regulation, audits, etc. in accordance with the logic.
? Establishing multiple uses for the funds including guarantees, debt financing, etc. in addition to investment.
III. BUSINESS MODEL YET TO BE INNOVATED
In terms of the financing form, direct financing which includes all kinds of equity finance can satisfy the need for technological innovation at all stages. In particular, various types of venture capital are more capable of supporting nascent tech start-ups, whereas traditional credit is not.
China’s economy is dominated by direct financing. Although building a multi-level capital market has become a consensus and a development strategy for China’s financial sector, we still have a long way to go to establish a sizable market for direct financing, especially for all types of venture capital. Currently, we need to innovate business models to find new ways to effectively enable credit financing to support the cause of independent innovation in science and technology.
The key differences between credit finance and equity finance lie in 1) as the source of credit is customers’ deposits, banks must ensure that the principal and interests will be paid and therefore cannot tolerate loss of investment; 2) since the returns of bank loan are contracted interests, banks cannot share the returns from the high valuation of successful business innovation, nor can they cover the loss of other investments with such high returns. Therefore, to support technology startups, credit finance must address this weakness by creating new return models to cover the losses of high-risk investments in start-ups.
1. Developing a new product- “technological innovation loan”
In April, Zhang Xiaohui, a Nonresident Senior Fellow of China Finance 40 Forum (CF40) released a report (?detail) on Finance in Support of Technological Innovation and proposed the idea of “new specialized loans”, which is very creative. Based on the idea, this article made more specified proposals as a response to Zhang and a call to society’s attention.
For tech start-ups, we first need to set up the identification standard and method to define the scale, industry, and stage of development of the company, to promote the industrialization of technology. Built on that, banks can grant credit lines to the companies. Due to the high risk of start-up failure, banks should be allowed to charge a certain amount of incremental revenue in addition to interest revenue.
Furthermore, given the special nature of “technological innovation credit”, banks need to make special institutional arrangements accordingly:
First, incremental returns can be negotiated based on the specific condition of each company and can take various forms. For example, a return equivalent to a certain percentage of equity at IPO price (listed); a certain percentage of the valuation of the equity after a funding round; a certain percentage of the operating revenue during a particular period (like 5 or 10 years); a combination of different types of returns.
Second, the regulatory authority approves and designates commercial banks to handle the business upon their applications. The designated commercial banks should set up a specialized agency to deal with this type of loan at their head office. The business is not only a new model but also a new management challenge with great risks, and therefore should not be rolled out at full scale for a certain period.
Major banks and large joint-stock banks as well as city commercial banks can be considered to launch this business. But not all of their branches can be granted the right. Initially, the regulator can limit the number of branches that can start this business. Branches handling the business need to set up departments and teams specialized in the business.
Third, banks need to develop detailed management methods for relevant departments and businesses: asset quality should be assessed separately; information about asset quality should be a separate item to be released; loan interest is booked as general interest income.
In terms of the accounting of incremental return: as the backup fee for the potential loss of the loan, incremental return should not be included in the income statement. It could be listed as a temporary receipt or a new item. When the loss incurs, it could be first offset by the return; if the balance is not enough, the loss can be written off by general loss reserves. When the incremental return accounts for a considerable share of the loan (like 100%), a certain percentage of the incremental return (for example 10%) can be booked as operating revenue. Or drawing from the principle of first in first out in warehouse management, the loss can be written off in the chronological order of the return; the return not used to write off the loss can be deferred for 5 years and recorded as operating income over 10 years.
As for post-loan management, the method should be determined according to the conditions of different enterprises. The assignment of board directors, participation in decision-making, and business management should all be included in the loan contract.
When the incremental return is cashed in as agreed in the contract and the loan has not yet matured, the loan can be included in the general loan for accounting and management after evaluation.
Fourth, a reasonable scale of the “technological innovation loan” should be set. Given the affordability of risks, commercial banks must limit the scale of the loan. Even in a worst-case scenario, i.e., the loss rate of the loan is 100%, banks should still be able to manage the risks within a controllable range. For example, they can set the proportion of the loan at 1% of their total loans, or if more aggressive, 1% of their total assets.
Fifth, different departments within a commercial bank should coordinate and design supporting policies. Relevant departments need to jointly discuss how to select high-tech companies, and to prevent bank employees from tunneling or directing the assets in the wrong direction; they should also prevent regulatory arbitrage, malicious debt evasion, or default of some enterprises; more importantly, they should prevent the administrative intervention of local governments in this new type of business.
Concerning incremental return, as it is a major innovation for banks to charge the fee, different departments need to identify the item and coordinate their policies jointly, The central bank can take the lead and cooperate with the China Banking Regulatory Commission (CBRC), China Securities Regulatory Commission (SEC), the National Development and Reform Commission (NDRC), Ministry of Finance, Price Bureaus and other departments to formulate trial measures on the collection of the return, and the design of accounting item, bookkeeping rules, accounting principles, loss write-off, etc.
The creation of technological innovation loan offers the following merits:
1. The loan charts a new path of enabling credit to support scientific and technological innovation. Although banks must explore the combination of loan and investment and realize integrated operation, their practice is still confined to equity financing in support of start-up companies, leaving huge credit funds unable to be invested in equity and posing the problem of risk isolation between equity investment and credit business. Supporting start-up companies through wealth management subsidiaries also deviates from the risk appetite of these subsidiaries.
2. While obeying the laws of credit, the loan also helps start-up companies solve the problem of lack of funds in their initial stage, and at the same time addresses the issue of high-risk coverage for this type of business.
3. The loan offers the fund for the early development of start-up companies without diluting the equity owned by the founders or the founding team, and therefore the founders will welcome this practice and are willing to pay a reasonable price for it.
2. Developing pilot M&A loan and capital loan
Currently, a major obstacle for venture capital to fund start-ups lies in a single exit channel -IPO is basically the only channel. It takes a long time for many small start-ups to go public, and meanwhile, the market is not capable of absorbing all of them. Therefore, we need to develop an active M&A market and, accordingly, an M&A loan business.
For various reasons, China’s banking industry rarely handles M&A loan business and is not experienced in systematic evaluation and management of M&A of traditional enterprises, let alone the M&A of start-ups. However, everything needs to start with trying. We can select several banks with sound operations to conduct pilot projects through sandbox supervision to gain experience, cultivate talents, and gradually promote the business in an orderly manner based on successful cases.
Recently, the central government granted a special line of credit for policy banks to provide capital loans for major projects. This is a great policy innovation that can help boost market sentiment and expectations during this special period and promote the construction of major projects. Due to the special nature of major construction projects, the business is confined to policy banks.
Could capital loans also be provided for tech startups in the commercial sector? The author believes it is worth a try. This would of course still require the use of a sandbox regulatory mechanism:
? 1. The number of institutions eligible for capital loan business should be limited. For example, these institutions could include divisions of large banks, and some departments of joint-stock banks (in principle, they should not be county-level institutions);
? 2. The borrower must settle all the legal formalities as an enterprise, except for the lack of some part of the capital, and must have more than 50% of its own real capital;
? 3. The borrower is required to provide credit enhancement measures, such as guarantees, mortgages, and individual joint liability guarantee;
? 4. Government-led technological innovation fund should provide guarantees for such loans;
? 5. Banks should be allowed to charge excess interest on such loans or a certain percentage of excess earnings in addition to interest. The fee is treated as a risk provision for such loans for a certain period and is exempt from VAT.
This article was first released by Caijing-Mayflower on October 18, 2022. It is translated by CF40 and has not been subject to the review of the author. The views expressed herewith are the author’s own and do not represent those of CF40 or any other organizations.
