The authors borrow their explanation from a clever application of standard trade theory and finance theory. In the modern world, there are two things that drive the global economy; entrepreneurial ideas and financial capital. By financial capital they do not mean money, or simply investible capital. They describe this resource as high risk capital, i.e., capital searching for high-risk (but high return) investment. Very simply put, this is what most people mean when they talk about venture capital and/or private equity.
Consider two countries A and B. Country A has a comparative advantage in ideas and B has a comparative advantage in high-risk capital. Comparative advantage is a term in trade theory; in the current example it means that country A loses less capital when it produces an idea while country B loses more capital when it produces an idea. Trade theory tells us that in such cases country A should export ideas and country B should export its high risk capital. To fix matters, let us say that country B is the US and country A is a developing country like India (or Israel in the original paper). So, the US has the venture capital and India has the entrepreneurial ideas. The US should export its capital to India and India can export some of its ideas to the US. (Strict and pure trade theorists may object to such a characterisation since no one consumes ideas or capital but we will pass on that.)
How does finance theory come into the picture Both the countries have valuable assets; the US has high risk capital and India has ideas. Ideas are yet to be proven and, hence, are considered risky by ordinary investors who, therefore, stay away from them. Venture capitalists, on the other hand, through their risk exposure, and ownership strategies act as intermediaries between the investors and the holders of ideas. They can fund the risky ideas that an ordinary investor would want to avoid funding. How do they do this
They buy shares in the new start-up that is set up with the entrepreneurial idea and the finance they bring in. By buying shares, they transfer their current asset (low, or no, risk cash) to the future (risky returns). Entrepreneurs, on the other hand, transfer a part of their high risk asset to the venture capitalists in exchange for low risk cash today. Most venture capital in these start-ups acts as commitment to fund employment of highly skilled labour for a period of time in the new company. This, in turn, transfers skilled labour from traditional industries to high paying new sectors. Higher incomes generate demand for other goods and a multiplier effect in the economy that fuels growth in the economy that brings in the venture capital.
To allow venture capital to play this role, it is essential to make it easy for them to enter. This has been well recognised. However, what needs to be emphasised is that it must also be made easy for them to exit. Venture capitalists have no interest in owning companies; they want to get out of these companies when they have become successful and that is how they make their money. If this is prevented, or difficult, they will not enter in the first place and the various benefits discussed above will not be realised.
I guess the telecom sector is a good example of what we mean by new ideas in developing countries being more valuable for them than old traditional methods that have succeeded in other countries. Not only has mobile phone changed much of the realities in rural India, it has also generated large amounts of employment and income in much of the country. And, the path followed by the telecom sector in India is very home-designed and quite different from what advanced countries did in their context. Indeed, the rapid growth of mobile telephony in developing countries has opened up entirely new possibilities of addressing developmental issuese.g., the mobile wallet has huge implications for fighting the current and topical issue of exclusion of the poor from formal, or institutional, financial services.
In short, we should stop searching for tried and tested ideas and encourage our own hitherto untried, and obviously untested, ideas. Making it easier for venture capital to come in means we need not spend any of our own resources!
The author is research director, India Development Foundation