Less developed country as start-up corporation: Adopting the venture capital model for development in light of global capital market realities
Sorabella, William B
I. INTRODUCTION
Many approaches have been proposed for how less developed countries (LDCs) can achieve prosperity, despite their current lack of the ingredients usually associated with growth. World consensus seems to recommend adopting a political economy that includes rapid liberalization of market regulation, privatization of state-owned enterprises (SOEs), and attempts to access global capital markets. These conceptions have been challenged in light of the recent global economic currency crisis; however, the resulting recommendations remain mostly unchanged. Recommendations, particularly those coming from influential intergovernmental lending agencies, still focus on intensifying incentives to move toward a more market-based economy, integration within limitless free trade areas, and the creation of additional intergovernmental organizations to standardize this agenda. This consensus has shaped the plans implemented by injured LDCs to assist in their recovery from crisis, as a result of both voluntary choice and coercion from external influences. This Note will propose a new perspective from which development can be viewed.
Imagine for a few moments that the citizens of an LDC are similar to the individuals that will be involved in a newly-formed corporate enterprise. Both groups are ultimately seeking to advance their utility, both individually and collectively. To be successful, both groups must adopt a comprehensive strategy that will lead them to that goal while being weary of the tremendous influence of more established competitors. Finally and most critical to any developing organization, both groups must find a way to finance their efforts while maintaining sufficient control over the enterprise.
This Note will view LDCs through the paradigm of a start-up corporation seeking to design a business plan and capital structure that will enable it to prosper in a world dominated by large corporations, global capital markets, and industrialized countries. Given the recognizable linkages between nations and corporations in theory and practice, this perspective will lend itself toward more beneficial, yet somewhat unpopular, recommendations for LDC development.
Part II will present several theoretical starting points for the discussion, including some basic elements of economics, and will bring to light potential processes for achieving the ultimate goal of development. Part III will describe the empirical problem facing many emerging markets, most notably how their struggle to attract foreign invest ment and their willingness to adopt an imposed policy agenda have produced a crippling effect on development. Part IV will suggest policy recommendations for emerging market economies that will allow LDCs to reach the theoretical goals set out in Part II while avoiding the perils described in Part III. To do so, Part IV will analyze parallels between the process of national and corporate development through the stages of business planning, venture capital financing, and eventual public offering of securities.
Il. SOME THEORETICAL STARTING POINTS: THE MISSION FOR THE EMERGING MARKET NATION
Around the globe, there is a clear divergence between developed countries and LDCs. Developed countries are industrialized production centers that offer a high quality of life to their citizens and have large amounts of capital to pursue opportunities for innovation and improvement. More often than not, these nations have relatively democratic governmental structures, liberal market based economies, and efficient capital markets. At the other end of the spectrum, LDCs produce less efficiently, use technology that is often more crude, offer a significantly lower quality of life to their citizens, and lack the capital and resources necessary to join the ranks of industrialized nations.1
Presuming that LDCs would prefer to enjoy the position of security and opportunity held by developed countries, the obvious goal is development2 Many indicators measure development, but each fundamentally attempts to evaluate the “level of living” enjoyed by a nation’s citizens.3 Two major quality of life indicators are education and health. Education indicators reflect a nation’s ability to train its citizens to understand existing technologies, design new products, and maintain a continuing dialogue of ideas with developed nations.4 Education levels can be evaluated by comparing rates of literacy, primary schooling, and secondary schooling.5 Mortality rates and the level of nutrition usually measure the health or well-being of the populations Comparisons can also be made using well-recognized financial standards such as gross domestic product, per capita income, industrial production, and purchasing power.7
Each of these standards objectively measures welfare; however, this Note is concerned with advancing the strength of the nation as a whole. Therefore, the level of dispersion of these measures (the extent to which all benefits are shared among various socioeconomic groups) is also important, not just the type of indicator used.8 While this reflects an egalitarian value judgment, the government must attempt to position its population to be competitive with more advanced nations by improving the quality of living standards for a majority of citizens. Currently, LDCs have a weak record for distributing benefits to groups other than the elite. In Brazil, for example, although the benefits from economic reform have been flowing to the elite classes, “[t]he government record on social issues, such as education, health, land distribution, employment, and security, remains weak. “9
Finally, the sustainability of development is important, as compounded growth is essential to long-term progress and meaningful improvement. Even if some elite members of the population receive benefits, the spreading of benefits to all strata of the population takes time. Therefore, an internal divide between the rich and poor is more likely to occur without sustained growth, a divide that will preclude meaningful growth in the future. Additionally, sustained growth has a positive effect on the general population’s confidence in a country’s development plan, which, in turn, will increase investor confidence.
To develop quickly, nations need access to capital to invest in industry, technology, and an educated population. However, because LDCs lack internal sources of capital, they are forced to look to outsiders. Those in control of foreign capital are primarily concerned with the risk and return of an investment. Unfortunately for developing countries, cross-border investing adds many additional levels of risk, such as sovereign risk, currency risk, and unfamiliarity with financial and market structures.10 Consequently, LDCs must either seek to minimize these additional risks by finding a way to offer greater security for these investments, or offer such exceptional returns that foreign investors are willing to bear the extraordinary risks. This choice is indicative of an important linkage between economic systems and government policy, with both affecting each other and creating an overall market tone.
First, the values underlying a governmental structure often have parallel values in the economic structure of a nation.11 For example, there is a clear link between democracy and market-based economics, as both provide broad access to the decision-making process and both, at least in theory, establish representation, opportunity, and participant leadership of the group.12 Similarly, totalitarian governments are more likely to actively control industrial decision-making. The overlap in these concepts can be seen in intermingled terms, like the use of phrases such as democratization of capital or representative corporate voting rights.
Second, governments affect economies by selecting whose rights and interests will be protected, which players within the economy will be supported, and which standards of conduct will exist by the formation of a legal infrastructure. The success and growth of an economy is therefore largely dependent on the approach taken by the government. The success of an economy similarly affects the political success of a government, as better performance reinforces the governmental policies. To the extent that the political structure is reinforced, greater stability makes for less sovereign risk for foreign investors. Therefore, for a nation to succeed, its economy and government must have unified values that establish the course and speed of development.
Market economics is based on essential elements, or assumptions, without which markets do not function efficiently. The theoretical market requires perfect information, freedom of firm entry or exit, no transaction costs, and numerous participants.13 In practice, these conditions are never fully present, but their relative presence can be viewed along a continuous spectrum.
For example, consider the level of government control of the economy and the extent to which such action enables or inhibits the existence of market assumptions. Certain governments adopt protectionist approaches that place extensive economic control in the hands of domestic officials. These approaches allow the government to direct the economy by favoring certain groups and industries, most often by limiting potential harms from external influences.14 The exhibited preference of LDCs to retain such control rather than democratizing economic influence may reflect a greater need to protect the domestic market and its citizens.15 As the spectrum moves toward a more liberal economic approach, the presence of market assumptions becomes more recognizable. Most governments, however, still exert their influence by creating incentives for growth within certain sectors, directing the development of the work force, and offering limited protection from the world economy. SOEs are one of the most common control mechanisms that act as non-profit maximizing market participants through which a country can develop vital industries and provide employment for laborers.16
Because of protectionist approaches and the absence of other influences, governments in emerging markets exert more influence over their economies than governments in developed nations. In the United States, many forces affect the market, including “a competitive product market, a reasonably efficient capital market, an active market for corporate control, incentive compensation for managers,” and oversight by large shareholders, monitoring professionals, the press, sophisticated courts, and well-financed interest groups.17 Because they are without many of these influences, emerging market governments are often solely responsible for choosing the manner and pace of development. Therefore, LDCs are particularly fertile ground for the implementation of innovative policies, as government choice faces less significant opposition.18 While this Note does not recommend recklessly using nations as the subject of experiments, it is worth noting that credible ideas likely to produce preferable outcomes can be implemented with fewer impediments. This has been recognized by groups, such as intergovernmental organizations, that willingly direct policy in emerging markets.
Part II has established concepts vital to the forthcoming analysis and alternative perspective: the need for broad-based development and capital, the role of government in influencing the climate for foreign investment, and the importance of underlying governmental and economic values for achieving development goals. Part III will consider whether these goals and theories remain viable in a world dominated by global institutional investment.
III. SOME PRACTICAL STARTING POINTS: THE CURRENT CRISIS OF THE EMERGING MARKET NATION
The rapid globalization of capital markets has significantly influenced the prospects for economic development, as capital now flows through various currencies and securities between nations with far greater ease and frequency. Technological innovations and improvements in communication allow money managers, who are seeking to realize superior returns on their portfolios, to explore previously untouchable markets. In addition, developed nations have enjoyed relative prosperity in the 1990s, resulting in a willingness by their citizens to invest their savings more actively and adventurously.19
Investors, including institutions, controlling massive amounts of liquid capital have tried to diversify their portfolios and outperform the U.S. markets by investing overseas. As will be demonstrated by the discussion in Part IV regarding the parallels between developing nations and start-up corporations, the growth rate of a successful venture is likely to be highest at early stages of development. Given this likelihood, investors looking for high returns have been willing to invest in emerging markets on the cusp of rapid growth. Huge emerging growth departments and mutual funds that target LDCs have flourished, further easing and expanding investment into these markets.20 The Institute of International Finance, for example, found that between 1994 and 1996, commercial bank and non-bank private lending to emerging market economies tripled to $178 billion.21 Much of this exuberance seems to have been rash.
A. The Risks and Dangers of Emerging Market Investments
The hope of emerging market speculators is that they will invest in emerging market securities immediately before rapid growth is indicated, maintain these positions while money pours into these seemingly attractive markets, and then sell the now highly appreciated securities.22 Many risks, however, make this strategy dangerous for both the investors and the emerging markets themselves.
The massive inflow of capital into emerging markets during the mid-1990s created substantial risks,23 especially because many of these investments could not have otherwise been supported by appropriate research into the selected securities or capital markets.24 The following four risk factors were not hidden from investors, yet the money continued to flow into these markets.
First, the extensive disclosure approach, characteristic of U.S. securities markets, did. not exist in many LDCs.25 Therefore, few of even the most informed speculators were able to truly understand the risk profile of the securities they purchased. It is accepted that ” [t] he advantages of transparency are a baseline for financial and legal development and resulting financial stability and economic success.”26 The burden of more pervasive disclosure requirements for a U.S. listing overshadows all other factors for foreign companies deciding whether or not to list on U.S. securities exchanges;27 the ease of less invasive disclosure in other markets is clearly recognized.
In Russia, for example, the Federal Securities Market Act of 1996 has been praised for introducing basic U.S. style standards for disclosure, proof of ownership, and enforcement.28 Perhaps the more appropriate question is: why did Russia wait until 1996? In the early 1990s, the capitalization of the Russian equity markets grew by 3,300% in just eighteen months.29 Fueled almost entirely by foreign investment, yet without sufficient disclosure or regulatory enforcement, such speculation could not have been supported by sound financial research.
Second, the analysts that would normally provide such research for institutional investors had a tendency to free ride off the research of others. Karacadag and Samuels note that ” [a] t work in today’s information and analysis market on emerging economies is the classic `freerider’ problem. . . . In essence, market participants attempt to `freeride’ off those that do their homework, but to the extent that everyone is doing the same thing, the market is left with sub-optimal, inadequately researched, mirror-imaged judgments as a basis for allocating capital. “30 As institutional investors gathered less information, foreign investment in emerging markets became even more risky.
Third, because foreign investors, particularly performance-conscious money managers, were taking extreme chances by speculating without sufficient research, institutional investors were more apt to have a sell-side bias-a tendency to sell large positions at the first hint of falling valuations.31 This suggests that even slight sell-offs in what were already likely to be over-valued markets would cause prices to spiral downward very quickly. Consequently, years of capital appreciation in an emerging market could be quickly eradicated, with fear in one market spreading to other similarly situated markets.32
Finally, if such sell-offs did occur, the subsequent pressure on investors to exit would affect the value of the market’s currency, further exacerbating the inclination to sell. As foreign investors left the market, the supply of the emerging market currency would far exceed demand, and its value would fall. For example, despite the relative strength of Brazil’s Real stabilization plan, commentators remained concerned about the risk of an external payments shock.33 Currency shocks affect inflation, employment, the ability to buy foreign products, interest rates, and the security of debt. They can destroy years of improvements in stabilizing macroeconomic factors and constitute an additional risk of investing in emerging market.
While the visibility and viability of risk factors appears greater in hindsight, emerging market investors knowingly dumped vast amounts of capital into under-investigated markets with extensive downside risk. Such rapid declines in the capital markets, as discussed above, introduced significant harm to the domestic market as well.
Most significantly, extensive speculation in emerging markets and the higher risk of rapid declines had a harmful effect on interest rates. Given the linkages between capital markets, higher expected returns in equity markets require higher interest rates be paid on debt offerings. Therefore, during boom times, debt-ridden nations are forced to pay higher interest rates on debt. In the event of a crash, interest rates would rise as risk is more visible and must be compensated for. Therefore, rapid appreciation in the capital equity markets was almost certain to increase the interest rates required to finance emerging market debt whether or not a crash eventually occurred.
Short-term speculation offers only limited progress, if any, toward the goal of broadly dispersed welfare improvements for an emerging market nation.34 The general population of an LDC is poor and lacks the savings to invest in securities.35 For citizens of emerging market economies to realize gain from the inflow of investment so that they have increased buying power, the few that do own securities must sell into the market during the short boom period. The implications for sovereignty are significant, as encouraging citizens to sell their securities to foreigners relinquishes control of the capital markets to short– term biased foreign speculators.36 Therefore, temporary foreign interest in a particular market is unlikely to broadly increase its quality of life. The local population is unlikely to have positions in the market, would prefer not to abandon control of the nation’s corporations, and would have disincentives against selling into such markets even if they did own securities.
Additionally, because of the difference between primary and secondary markets, those looking to raise capital are also unlikely to recognize the benefit of lower cost financing from short-term speculation. Only those that raise capital during the market boom will be able to secure financing at a discount, and offerings are unlikely to be so time flexible. Because the need for financing usually precedes the recognition of growth, most issuers will have offered their securities before the boom. As a result, the issuers would realize no benefit from higher prices being paid for their previously issued securities without further offerings. Short-term speculation, therefore, is unlikely to reduce financing costs.
B. Accepting Risks and Adopting Policies to Lure Foreign Capital
Despite the risks associated with extensive foreign involvement, LDCs encouraged foreign investment as a means of achieving development goals. This occurred primarily through a policy of adopting extensive liberalization plans, a “we’re like you, so we’re less risky” advertising approach, and laws creating favorable conditions for foreign investors. Consider some of the following examples.
In the Philippines, President Ramos adopted a “strategy of luring U.S. and European investors to the Philippines, stressing its Catholic and democratic characteristics in contrast to the corporate authoritarianism of the rest of Asia.”37 This policy involved the elimination of protectionist legislation and the endorsement of Export Processing Zones, virtual concentration camps where foreign manufacturers could use cheap labor while only providing slave-like working conditions.38 Extensive reductions in burdensome regulations were used to invite foreign investment, including the amendment of certain restrictions to allow foreign investors to own one hundred percent of the equity in all but the most prized industries.39
This policy was characteristic of the region:
[B]efore the Thai devaluation in July, the Asian so-called `tigers’ were considered exemplars of what liberalized . . . emerging market economies could achieve of [sic] rapid economic growth. The `tigers,’ while insisting on `Asian’ values’ contribution to their growth rates, had all followed the Western international economic institutions’ prescriptions for emerging market growth, including the opening of their capital markets to foreign portfolio investment.40Policies aimed at creating favorable terms for foreign investors were not limited to Asia, as shown by the example of Brazil. Brazil introduced commercial liberalization plans, privatized many industries, and dismantled bureaucratic impediments to foreign commerce.41 As general advice to practitioners, the Practicing Law Institute characterized Brazil as having “few restrictions . . . for individuals or legal entities, domiciled or headquartered abroad, to invest in Brazil. “42 In fact, Brazil has given preferential treatment to foreign investors, particularly foreign institutional investors, who are exempt from capital gains tax while Brazilian residents are taxed at a twenty five percent rate on such income.43 Brazil has also shortened repatriation limits and lessened other regulations to remedy foreigner disinterest in Brazilian privatization.44
A notable element to this trend has been the push toward speedy privatization. In principle, SOEs distort the efficient allocation of resources. Nations have privatized such enterprises to appear committed to liberal economics, as well as to pay down national debt, stimulate private sector growth, and democratize ownership.45 Due to a myriad of problems that will be discussed in Part III, particularly the difficulty of valuing these companies without established regulation or disclosure, most privatizations have failed to meet these expectations. Instead, SOEs have been sold at steep discounts and with little foreign involvement.46
C. The Resulting Financial Crisis
The stage had been set for a collapse: LDCs had invited the influence of overly exuberant foreign speculators who brought massive amounts of capital into volatile, unsophisticated markets. This continued despite growing risk and a predisposition to sell at virtually any inclination of overvaluation. Then, news of the devaluation of Thailand’s currency spurned a reassessment of risk and the recognition of conditions of low savings, export slowdowns, political uncertainty, large current account deficits, fragile banking systems, and unstable government debt.47 Amidst a panic, extensive portfolio reshuffling removed much of the foreign capital from these emerging markets, causing the Asian financial crisis of the late 1990s.48
The causes of this crisis have been widely researched and many conflicting views have been proposed.49 The two major alternative theories are those of Jeffrey Sachs and Paul Krugman. Sachs believes that panic altered investor confidence and caused a contagious selloff.50 Krugman, on the other hand, believes that the fundamental data on the economies themselves eroded such that investors could no longer maintain confidence in these markets.51 Regardless of whether the collapse was based on rational or irrational assessments of risk, the fall had crippling effects on these capital markets and their underlying economies.
In rescuing these markets, the International Monetary Fund (IMF) attempted to limit the harmful effects of the crisis by applying its own philosophy of economic liberalization to the problem. Although rescue packages differed by country, the general IMF response was to require countries to enter into austerity and debt restructuring programs with mandatory conditionality requirements. These packages gave the IMF significant control over the nation’s economy,52 much of which was used to push for even more rapid liberalization. These policies have been deeply criticized,53 but they have advanced nonetheless.
Other efforts have been made to open securities markets further and standardize market conditions around the globe. The Office of International Affairs at the U.S. Securities and Exchange Commission, for example, fosters the “encouragement of U.S. style market structures and regulatory principles,”54 by providing extensive training and recommendations to capital markets in Eastern Europe, Asia, Latin America, and Africa. Presumably, these efforts are intended to increase the level of transparency in these markets, make foreign investment in these markets less risky, and lay the groundwork for the opening of public capital markets in nations that have not yet done so. Similarly, recommendations to link underdeveloped nations together through more comprehensive intergovernmental organizations have also been supported.55 For example, moral suasion has been used to encourage standardization by favoring “emerging market economies that implement widely accepted norms.”56 These programs standardize all undeveloped nations, coerce the adoption of Western-style economic philosophy, and limit the specific risks to foreigners of investing in any one emerging market economy.
In Part II, we recognized the theories behind development and the essential role of capital in making such development possible. Part III has shown how such theories and goals have encountered significant setbacks as the emerging market economies have exposed themselves to the volatility of the global capital markets. As a result of a foreseeable financial crisis, many LDCs now have their hands tied as they must obey the IMF order of pervasive liberalization. Part IV will suggest an alternative policy approach that combines the theory of Part II and the practical risks of Part III.
IV. A POLICY WITH POTENTIAL FROM THE ALTERNATIVE PERSPECTIVE OF ENTERPRISE
A fundamental feature of market economics is the theory of competitive advantage. According to this theory, one market player can distinguish his product from that of other competitors. If the market for this product favors that modification, the market player succeeds regardless of the previous dominance of other producers. Even if not everyone views this innovation as superior, many markets have room to support niche producers. Market economies, therefore, rely on innovation and variation to advance the welfare of the market as a whole, for both producers and consumers.
Most innovative ideas, however, cannot automatically be translated into marketable products; innovative ideas usually require capital investment before being launched into the marketplace. This is the plight of the start-up business-holding an idea likely to be successful but lacking the capital to realize the goal of market introduction. Capital markets are often used to combine the spirit of entrepreneurs with the desire of investors to reap returns, resulting in the creation of a system that has shown great success in financing innovative business enterprises. Throughout the process, particular attention is often given to who will control the enterprise, which values or corporate culture will be created, and which players will be rewarded according to their level and form of risk.
Comparing this enterprise with the theories presented in Part II, the parallels between the plight of start up corporations and emerging market economies becomes apparent; each have great potential, insufficient capital to independently advance its goals, the desire to maintain some control over the enterprise, and a preference for advancing a set of values in accordance with its mission.
The push for the liberalization of all markets discussed in Part III indicates a preference for market based economic structures. The manner and speed of this effort however, has been counter to techniques proven successful for the start-up corporate enterprise. Extensive logical reasoning can support each stage in the birth of the corporate enterprise. Using that same logic, Part IV will recommend that a process similar to that used to finance a start-up corporation be used to allow an LDC to more effectively define itself by its innovation and ability to compete in its respective market. To illustrate this logic and the corresponding similarities, extensive examples of both corporations and nations will be used.
At its most basic level, the following analysis will recommend a slower, more independent process for developing the essential elements of a market based economy and capital market. First, creating a stable platform for markets requires governments to design a comprehensive liberalization policy that limits immediate exposure to capital market volatility while concurrently fostering the entrepreneurial spirit. Second, the governments of emerging markets should slowly lower barriers to foreign capital by creating incentives for particular forms of foreign investment, specifically long-term capital. Implementing a preference for venture capital and other forms of direct investment can most effectively accomplish this goal. Third, while privatization of SOEs must be delayed, a legal infrastructure to make privatization more likely to succeed must be planted. Finally, the ultimate goal must be the eventual opening of all markets to foreign participation, but not until market assumptions are more visible and the domestic population can participate in the fruits of liberalization. This policy recommends that LDCs distinguish themselves through self-determination in order to create a competitive advantage over other LDCs that are also compet ing for access to global capital markets.
A. Business Planning Stage
1. The Logic of Comprehensive Business Planning
A corporation is principally founded upon a major idea: Dell Computer chose to direct market computers and to focus on customer support, Home Depot believed that a national, discount, name-brand hardware store could replace local hardware stores, Southwest Airlines introduced low-frills discount air travel with a less-expensive, standardized fleet. Countless examples of companies exist that were founded on innovative products: the ball point pen, the paper clip, microwaveable pizza crust-the list continues seemingly without end. Further, many companies grew simply because they could improve a product that already existed or could provide a service in a better fashion than others had done before.
In order to function as originally envisioned, ideas must be supported by a well-planned, integrated strategy designed to convert the idea into a marketable product. Multiple factors must be considered in making such plans: the existing market, sales tactics and projections, methods of production, the training of workers, etc. Most notably, start-ups must consider how to finance the enterprise. A fundamental function of the business plan is to demonstrate to potential investors that risk and strategy factors have been extensively considered, helping the entrepreneur to gain credibility in the eyes of potential investors. More of the factors that comprise a business plan will be considered in the next two stages of the venture.57 At this point, it is important to remember that stability limits risk, and limited risk makes investment more attractive. Therefore, a comprehensive business plan that projects a sustainable, stable business approach is likely to become a more successful investment vehicle.
The ability to create a unified business plan early in the formation process also eases efforts to create a corporate culture of shared values and practices. The values that a corporation would like to reinforce are more likely to actually become a part of the venture’s culture as it develops if they are introduced early on in the process. Productive corporate cultures make enterprises function more smoothly and are more likely to lead to superior quality and performance. A corporate ethos that encourages a cooperative effort will lead to better products; however, value systems are difficult to change, so these values must be planted early in the development of a new enterprise.
2. The Need for Business Planning for Development
The reasons underlying the need for a credible approach to business planning can be easily compared to the challenges faced by a developing nation. An LDC also must design a credible plan by considering alternative strategies, evaluating market conditions, finding ways to finance its development agenda, and promoting values at an early stage.
This Note counsels that an LDC is more likely to produce sustainable, significant development by attempting to develop the values of liberal markets while delaying the full-scale liberalization of all markets. Many of these elements will be discussed later, most notably the need to encourage direct investment; however, the need to instill market values must be addressed at an early stage. Such values are essential if the nation is ever to adopt a free-market approach. Consider the dilemmas faced by those involved in previously state-controlled economies that were immediately liberalized. Reflecting on the process of liberalization in his country, a native Brazilian discussed how difficult the transition to a liberal mentality has been for his countrymen:
We are all (nearly all) beset by ideas that have grown with us for generations. We want steady pay (preferably as government employees), as little work as possible, many holidays, and political parties. We want our “rights” far more than we are willing to accept our “obligations.” I am convinced that this is true, but fortunately, it is not the whole truth. There are many, many people in my country that are quite different, many that consider work as being a fact of life, many that would like to earn their advancement, and many more that would support a President with the right ideas and purposes for his country. . . . No one goes out every day thinking of his or her country, saying to himself that with this in mind he will do better today than he did yesterday. These are not thoughts of the normal person, but the gut feeling that it is worthwhile to strive ahead is essential to the people of any country in the world.58
Similar problems exist in Russia. “Privatization in the sense of transferring ownership from state authorities to private owners is not enough to create a capitalist dynamic among the new owners. . . . “59 “A basic problem facing Russian economic reform is the lack of public confidence in both the market economy and the legal system.”60 Globalization makes it more difficult for governments, especially in LDCs, to protect independent national norms.61 As a result, the task of encouraging market-oriented norms will be a difficult, but one that must be accepted if sustained development is to be achieved.62
Incentives for market-oriented values can be created through a legal infrastructure that enforces practices reflecting those values. This is seen in laws requiring transparency and full disclosure. It is almost unanimously accepted that a major cause of the recent financial crisis was a lack of transparency.63 In the aftermath of this crisis, laws requiring transparency have almost universally been recommended as a way of averting future crises, typically through the adoption of U.S. style securities regulation discussed in Part III.64 Transparency is important beyond public capital markets as well. For example, transparency enhances the theoretical market assumption of perfect information and allows for greater monitoring of all involved parties. Furthermore, it promotes an ethos of methodical exploration, a more detailed analysis of contingency risks, and a preference for fair dealing.65 Therefore, this Note recommends the immediate establishment of a general disclosure regime; this regime cannot be one introduced just before, and certainly not after, capital market liberalization. By adopting such a regime early in the development process, disclosure laws reinforce efforts to create capitalist values in LDCs.
While comprehensive securities regulation beyond general disclosure requirements need not be as immediate as privatization, groundwork regulation should be established in a number of areas.66 First, as the plan includes the eventual privatization of SOEs, which are most often utilities and other core industries, regulatory schemes must be developed that will limit the profit uncertainties that have historically plagued privatization valuations. For example, in Argentina, uncertainty about how to value the potential income of privatized gas and petroleum SOEs forced the government to sell them at discounts of up to thirty-two percent;67 established utility regulations would have mitigated this problem.
Second, a general legal infrastructure must be established to create order and predictability in the society.68 In the past, under-enforcement of corruption laws often has had harmful effects in developing nations and has subverted the goal of economic advancement. The abundance of pyramid corruption scandals in Russia, for example, has undermined investor confidence in its capital markets.69 In Vietnam, the likelihood of random government regulation undermines the predictability of doing business.70 Enforcement mechanisms to limit such discretion would make investment in Vietnam more attractive.
Finally, laws that create incentives for some sharing of economic benefits among as many socioeconomic levels of the population as possible will help to reinforce the values of the development program. Economies often realize some benefit of progress but retain it solely in the pockets of the elite. Consequently, disgruntled workers feel unappreciated and are less willing to contribute to future progress. Dispersing economic benefits more broadly will increase the project’s likelihood of success and achieve a major goal of Part II-the better distribution of quality of life improvements. The decision to share benefits is quite similar to corporate-level policies of employee profit sharing or sales commissions in that they recognize everyone’s contribution and create a spirit of progress. Recognizable rewards are more likely to foster the market spirit of “doing better,” discussed by the Brazilian above.71
The business planning stage must establish a unified approach to advancement and begin the process of creating a framework in which the enterprise can succeed. Instilling market values, establishing a credible legal regime, and setting a tone of stability will all assist in this endeavor and make the next step, obatining capital to finance the proposal, more succesful.
B. Venture Capital Stage
1. The Logic Underlying the Need for Venture Capital
Few great ideas can be converted into marketable products without financing. Consider the following examples: Oracle created software for network computers, but the idea needed extensive financial support to pay programmers to write the code, implement marketing promotions, employ a sales force, and to fund many other expenses that arise from the regular business operations. Coca-Cola needed to build bottling and distribution facilities before it could sell sodas. Likewise, most service-oriented businesses, with the possible exception of hang-up-your-shingle professionals, need capital to translate an idea into earnings. 1-800-FLOWERS, for instance, links consumers with flower shops. However, they would be unable to provide this service without established relationships with local shops, communications equipment, and extensive advertising. Even less innovative ideas need capital to begin operations: farms need tractors, restaurants need tables, clothes companies need sewing machines, and home builders need wood.
Ideas without a proven background, however, generally cannot acquire start-up capital by offering securities to the general public; individual public investors are unwilling, or unable, to research the business proposal and model projections for its growth and profit potential, as this would be an inefficient use of time given the size of the potential investment.72 Therefore, start up enterprises often look to venture capitalists, who are frequently willing to finance new ideas when they are confident the start-up is credible and likely to be successful.73
Another financing strategy is the joint venture. A joint venture is formed by an alliance of two or more groups, each with different specialties or comparative advantages that they contribute to a project, who then share in its success. For example, one group may provide the idea and the other the financing, personnel, or equipment.
An alliance between a start-up company with an idea and an established corporation capable of financing the enterprise through retained earnings also allows the start up to develop its idea. Note that this arrangement demonstrates the distinct advantage that established corporations hold over the start-up enterprise.
Venture capitalists and those considering joint ventures evaluate the idea as developed in the business plan. They consider profit potential and the extent to which they would be willing to invest capital in the enterprise. In exchange for this investment, venture capitalists will receive a percentage of the corporation’s equity, often about thirty percent. This allows the entrepreneur to maintain significant control over the corporation, establish its value system, and focus on idea development, but has the effect of allowing the venture capitalist to reap extensive returns from a primarily passive investment. The capital markets admire those that are able to do this effectively, and firms serving this function are expanding in number.74 An interesting example is the publicly traded firm CMGI, which was originally formed as a direct-marketing business in 1968 (well before the popularity of the Internet) and which now essentially acts as an Internet venture capital firm.75 The ideas underlying the ventures in which CMGI has invested have been strong and CMGI’s investors have been fruitfully rewarded-a clear recognition of the power of the venture capital form of financing.
2. The Need for Venture Capital for Development
Despite the logic and proven success of the venture capital stage of enterprise development, this stage is most often overlooked or altogether skipped by LDCs, making the resulting recommendations the most vital to LDC success.
Venture capital and joint venture arrangements allow for a careful balancing of the benefits and risks of foreign capital investment. While some control is ceded to foreign investors, in return the LDG receives long-term, non-speculative investment capital that contributes to the development process. The government can institute limits to guarantee that this balance is achieved. For example, governments can gain control over financing terms by instituting repatriation limits and limitations on the allowable percentage of foreign ownership. These controls force long-term investment by slowing the removal of capital from an enterprise. Unfortunately, the trend is in the opposite direction, towards the lowering of such restrictions.
Two additional features of direct investment also make it more advantageous for development. First, closer linkages between investors, either venture capitalists or joint venture corporations, lead to exchanges of expertise. The developing nation thereby learns as well as produces.76 Through such exchanges, LDCs eventually become more capable of independent progress. In contrast, public shareholders rarely offer guidance to the enterprise they own.
Second, closer relationships can facilitate the drafting of investment agreements with more complicated features, such as special clauses for various contingencies, more complicated financial instruments, or radically altered structures. For example, companies can invest in collective enterprises where laborers are paid in the form of sustenance for themselves and education for their children. While it may seem somewhat counterintuitive to recommend more complicated financing for less complicated players, tailored arrangements can be used to encourage investment, allay concerns about contingencies, and encourage more fundamental development.
As mentioned earlier, LDCs often skip the venture capital stage and attempt to privatize early in the process-a critical flaw in the LDC development plan. Early privatization opens the market to the risks of short-term capital flows discussed in Part III but offers no benefits to the indigenous population. This is despite the fact that “one of the most important determinants of how privatization programs will fare in developing countries is the extent to which they have developed mature competitive markets and strong private sectors prior to privatization.”77
Surprisingly, the rapid liberalization of weak, unstable economies with little protection for local populations is exactly the policy endorsed by most LDCs, a policy encouraged by self interested developed countries. Consider the difficulties confronting the start-up enterprise discussed in Parts II and III leading to the venture capital stage. Start-up corporations are unable to tap the public capital markets because the uncertainty risk is too high for general investors. Instead, the enterprise must establish a track record by convincing specific players in the market to participate in the enterprise. For these players-venture capitalists and joint venture partners-investment is safer because they have more thoroughly evaluated the business proposal and they will have increased influence over its early development.
The unsuccessful track records of many LDCs are likely to scare capital markets. The public will, therefore, significantly discount any offering made to the market, as exemplified by the steep discounting suffered by SOEs during privatization efforts mentioned in Part III. Delayed privatization gives the government time to enact needed utility regulation schemes and standards for public securities disclosure, enabling eventual privatization to avoid valuation and credibility pitfalls. Applying the underlying logic of the venture capital stage to the struggles for economic development shows the error in LDCs’ policies– they rush privatization.
Because global capital markets have little interest in premature privatization, development goals cannot be achieved. While the purpose of privatization is to raise capital to pay down crippling levels of government debt, the predictable lack of foreign interest has forced governments to privatize by selling further debt instruments. Only four percent of the $6.57 billion raised from privatization in Brazil has come in the form of cash payments. This means that ninety-six percent has come in the form of privatization “currencies,” a misnomer for various debt securities targeted to development goals.78 Furthermore, it is difficult to provide the poor, who lack capital to invest in such enterprises, access to capital. However, without democratized ownership, no meaningful dispersion of eventual benefits from appreciation can occur.
Despite being the best way to achieve development goals, LDCs rarely focus on attracting direct investment. Furthermore, foreign investors are generally unwilling to consider direct investment when the nation has made easier means of investing through public securities markets available. Although Brazil has been heralded for having significant direct investment, the actual amounts are paltry. In 1996, only twelve percent of total foreign capital inflows were in the form of direct investment, whereas portfolio investment made up over thirty one percent of inflows.79 In Vietnam, where there is no public securities market, investors are forced to consider direct investment if they wish to be involved in the potential development of the national economy.80 Although Vietnam has not been praised for its meteoric growth, it has likewise not been trashed for its susceptibility to shortterm capital market flows. The policy of the Vietnamese government has been characterized as “struggling with the tension between a market-oriented economy and command and control policies.”81 Though the ability to straddle the line between protecting citizens from the volatility of capital markets and embracing market values is admit tedly difficult, the principle that such a delicately balanced policy may ultimately produce the desired result of sustainable development is not challenged. Indeed, maintaining the tension by blocking portfolio investment but encouraging direct investment might strike the appropriate balance between the harms and benefits of market and protectionist approaches.
While recognizing its benefits, many LDCs have been timid in pushing for more controls on capital and in creating incentives for venture capital and joint venture-type arrangements. This has been true despite the fact that LDCs have significant advantages that distinguish them from developed countries and make them particularly attractive to foreign corporations and investors.
First, the greatest strength of developing countries is the immense size of their internal market for products, most of which is fundamentally untapped. Access to this vast market makes direct investment in emerging markets attractive.82 Whereas portfolio investments can reap satisfactory returns, building a factory that manufactures and sells a name brand product is more likely to lead to long-term market access and sales profits. In the process, consumers are able to enjoy the consumption of additional products and other advantages associated with increased direct investment. For example, Brazil’s large consumer market has attracted many investors: “Brazil’s size makes it inherently attractive for investors and therefore permits much more policy flexibility and unorthodoxy.”gs Consequently, a large, untapped market may mitigate inhibitions to proposing unconventional financing.
Second, emerging markets are poor and yet populous; therefore, they offer cheap labor to foreign companies looking to lower production costs.84 Such policies have been criticized for endorsing slave labor, and many companies have received negative publicity when stigmatized with such accusations.85 A nation that endorses this treatment sacrifices the goal of dispersed economic benefits. The cost of labor, however, is so cheap in these nations, relative to the cost of labor in developed nations, that even the additional cost of providing workers with a higher standard of living would not make tapping the market for cheap labor significantly less desirable.
Finally, individuals who are excited by the dynamic spirit of change that comes with progress and lies at the heart of market competition have great passion for improvement. Those that have been willing to invest and form long-term relationships in arenas fueled with this capitalist spirit will be rewarded handsomely. While there are conflicting reports, many have said that the spirit of change in China since the conversion of Hong Kong back to the Chinese has created a mood of change and progress. While China does not have an extensive market for securities, preferring instead to maintain as much sovereignty as possible, China’s rate of growth exceeds that of most other emerging market economies.86 It has also attracted nearly twenty-one percent of all foreign direct investment from the period of 1982 to 1994.87
The benefits of a more methodical policy toward privatization are not novel. Protectionist policies have often been used by nations to protect their citizens from the risks of the capital markets.88 Unfortunately, protectionist policies have often been used for ulterior motives, such as reinforcing a military dictatorship. This Note’s recommendations, however, already exist in practice in various nations committed to more progressive goals. For example, many corporations have shown a willingness to form joint ventures in Latin America, and Russia has many cooperatives for commercial products that incorporate elements of joint ventures.89 Government policies can influence the form of capital desired for the enterprise of development. Furthermore, the logic underlying the venture capital system supports a methodology that entails (1) a comprehensive plan designed around development by direct investment, (2) policies to establish longer-term relationships, and (3) delayed full-scale liberalization of capital markets until market conditions can safely support global competition.
C. Public Offering Stage
1. The Logic Underlying the Need for Market Liberalization
The high point of capitalism may well be the initial public offering, the stage when a corporation’s status and recognized potential cause the general investing public to want to own a part of the enterprise. The public offering represents a validation of the principles and ideas on which the corporation was founded. However, a public offering also gives the corporation dynamic tools to become even more profitable: additional financing to further growth, the ability to finance synergistic acquisitions with stock, and the added publicity that comes from public listing and analyst coverage. For examples, simply consider the wealth and prestige of the entrepreneurs who developed companies around ideas and realized incredible wealth when those companies went public: Bill Gates of Microsoft, Michael Dell of Dell Computer, Larry Ellison of Oracle, and a growing list of Internet billionaires like Jeff Bezos of Amazon.com and Jerry Yang of Yahoo!.
Public capital markets have proven to be an extremely efficient means of allocating capital. When supported by full disclosure and comprehensive, enforceable securities regulation, market credibility is high and many investors are willing to assume the risks of market volatility. These risks also create incentives for more extensive research to verify market valuations, and industries develop to support such markets. For example, in New York and London, lawyers, bankers, brokers, accountants, reporters, and analysts earn a living tied to the existence of financial markets.
Furthermore, the public offering often represents a venture capitalist firm’s chosen exit strategy. Such firms invest capital in exchange for equity securities that are easily liquidated in a public market. This strategy is especially favorable if the shares are sold following a public offering that has presumably resulted in a rapid appreciation in the value of the investment. CMGI, for example, is positioned to realize astronomical returns on its investments as its ventures continue to result in public offerings.90
Finally, when the general population has a base level of wealth, the existence of public capital markets allows for the democratization of capital investment. Once a company’s securities are publicly available, ordinary citizens can assume the risks and potential benefits of an enterprise, and returns on growth will be shared broadly.
2. The Need for Market Liberalization for Development
Emerging markets must plan to eventually open their capital markets as a deliberate component of their development plans. As for the entrepreneur, the act of opening domestic capital markets to public trading and foreigner investors should be a high point in the development process. Like the ensuing validation of a start-up corporation, so too should a developing country find praise at this stage if it is successful, as success reflects a proven ability to design a plan and meet the intended goals. However, the timing of the move is vital to the success of development, as evidenced by the risks of premature privatization.
Before this goal can be accomplished, many issues must be resolved. First, the assumptions underlying market economies must be recognizable, especially the free flow of information. The act of opening the markets will advance other assumptions, such as minimal transaction costs for financing and easy entry into and exit out of markets. Second, the necessary legal infrastructure must be in place to make trading in the market and general business in the nation credible. Third, and largely supported by a legal infrastructure, the values of a market-based system must be developed in the population to allow them to embrace the dynamic spirit of change that is essential to market economics.91
To the extent possible, the opportunity to buy into the market must be available to as much of the population as possible to allow for the dispersion of benefits. Whereas previous plans for privatization have included efforts to encourage employees and citizens to become involved,92 such goals are more realistic if privatization is delayed to give these groups time to establish at least small savings. As with any legislation, governments can pick who will win and who will lose. During the venture capital stage of development, the government was advised to reward those who took a chance on the plan, and similarly, during the public offering stage, the government should reward those who have toiled for progress. If this is successful, the ability to improve the population’s quality of life will be recognized, a central goal of the development effort that has characteristically been unsuccessful.
Worth noting is the difficult position of those nations that have accelerated privatization and already liberalized their capital markets. Closing these markets to foreign investment entirely would be too rash, as future credibility would be seriously jeopardized. However, to the extent that controls can be implemented and future privatization discouraged, the economy will be better positioned to enjoy more healthy maturation.
The eventual full liberalization of the market is important. Without it, the ability to acquire venture capital financing is severely handicapped. The existence of a credible exit strategy is essential to those taking a chance by investing early in the plan of development.
Perhaps an overall example to illustrate the potential for this business model would be helpful. Few foreign traders would consider India within the typical group of emerging markets, perhaps because India has followed a steady plan of development that has led to sustainable, recognizable, though not earth-shattering development. Therefore, while this process has received few headlines, it has succeeded, at least along some measures, at achieving the goals of development. For quite a while, India followed a policy of self reliance, limiting its exposure to the risks of the global economy.93 When it finally decided to open many of its securities markets to foreign capital and influence, the exchanges were model examples of functioning securities markets having comprehensive disclosure and other securities regulation, resulting in high levels of confidence in the market.94 Much of the population has been able to comfortably invest its savings in the market.95 Furthermore, the markets were not opened without limitation; only twenty four percent of equity and thirty percent of debt can be held by foreign institutions.96 While many nations that were previously coveted by foreign institutional investors are now suffering, India’s economy is growing by five percent per year and has significant industrial growth as well.97
The efficient liberalized capital market is unquestionably the desired end result, and a model that, if healthy, can produce an environment capable of financing good ideas. This Note, however, has proposed a different manner for reaching that end, one that allows LDCs to slowly mature before reaching the pinnacle of full liberalization.
V. CONCLUSION
Markets are dynamic platforms for progress and innovation. Fundamentally, they rely on participants distinguishing themselves by having a competitive advantage, a base level of legal infrastructure, and a comprehensive system of values. Markets, however, require high levels of sophistication to provide decision-makers with credible information about the products being offered. In seeking to financing innovative ideas, corporations must establish their credibility by creating cohesive business plans that will lead to progress and profit for those who assume the risk of the venture.
Despite the demonstrated success of the sequence involved in the financing of corporate ventures, key elements of this sequence have been left out of most recommendations for how to develop economies. Rather than achieving market results by creating credible markets, rapid liberalization is most often either adopted or imposed, exposing the prospects for development to the whims of the global capital markets. Nations, like corporations, should be able to distinguish themselves as niche players in the market for financing as long as their business model is one that will lead to success. In doing so, a nation that (1) resists immediate liberalization, (2) retains some sovereignty, (3) disperses benefits to a larger percentage of the population, (4) stands willing to form closer relationships, (5) advertises its relative strengths and desirable qualities, and (6) continuously advances the values and framework of markets, should be able to produce more meaningful development and a higher quality of life for its citizens.
Any nation, regardless of the stage of development at which it finds itself, can adopt the plan of the start up corporation. This Note sets forth the theoretical starting point-the comparison between nations and corporations. The careful design and implementation of the recommendations suggested by this comparison present a surmount able, outstanding challenge for each nation that is seeking to develop. Therefore, these recommendations remain valid for Brazil, Russia, China, the Philippines, India, and Vietnam, as well as for Africa, Eastern Europe, and other parts of Latin America and Asia. Nations must be willing to distinguish themselves and set their own course for development. Nations should not succumb to the coaxing of the global capital market to engage in a race-to-the-bottom, which will result in imperialist control. An emerging market that follows the path of the corporate enterprise in its desire to balance its individual needs with those of the global capital markets is more likely to achieve healthy, comprehensive development.
WILLIAM B. SORABELLA* B. Soy
* J.D., Georgetown University Law Center, expected May 2000; A.B., Bowdoin College, 1997. This Note is adapted from a paper prepared for a seminar in Corporations in Modern Society in the Spring of 1999. The author would like to thank Professor Lawrence Mitchell for his comments and guidance. The author would also like to thank Michael Volpe, Cali Tran, Andrew Chvatal, and the late George Malko for showing him the entrepreneurial spirit’s tremendous potential for progress. Finally, the author would like to thank his parents, Philip and Janice Sorabella, his brother, Robert Sorabella, and his sisters, Laurie and Jean Sorabella, for inspiring him to dream great dreams.
Copyright Georgetown University Law Center Winter 2000
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