With the announcement in the Union Budget of a ₹10,000-crore fund for start-ups, the possibilities of and prospects for early-stage financing appear to have received a further boost.

Three observations are relevant in this regard. One, this is not the first time that State and Central governments have attempted such initiatives.

Second, for decades now governments elsewhere in the world have attempted similar interventions to kick start or boost entrepreneurship. Third, it is perhaps useful to step back and see what can be learnt from those experiences before working out the details of the government’s programme.

I intend to address each of these questions in some detail. Before I embark on that process it would be useful to understand what is it about venture capital that has made it so effective in financing early-stage enterprises.

Higher risks Financing start-ups is known to be a more challenging task than providing capital to established enterprises. An obvious aspect about early-stage enterprises is that they are more likely to fail than an established enterprise. Economists describe this higher likelihood of failure as higher uncertainty or risk.

There are two other challenges that investors who have funded early stage enterprises would readily appreciate.

The first of these is that start-ups are more challenging to evaluate. Central to the evaluation process is finding out as much as possible about the venture and the people behind it. Entrepreneurs know more about their business than investors can ever find out or know. Economists refer to this gap as information asymmetry.

The second problem is the difference in motivation between the entrepreneur and the investor. The investor is interested in achieving a return on investment in a time-bound fashion. Entrepreneurs set up ventures for multiple other reasons. Pursuing a passion, owning and managing a venture and realising personal wealth are the more commonly known among these reasons.

A third set of issues arises from doing business with other people’s money. It is referred to as the problem of moral hazard, a term borrowed from the insurance industry. The insured party tends to be less careful about avoiding accidents when he knows that a property is protected from damage by insurance. In the same way entrepreneurs can be potentially less diligent when their business is substantially funded by an investor.

A related problem is that of the entrepreneur taking decisions that will serve his purpose even though it may not be the right thing to do for generating a financial return. For example, an entrepreneur who is an inventor could potentially pursue an invention indefinitely even in the face of compelling evidence that it does not make economic sense to do so simply because he is passionate about it

These problems exist in the case of larger and more established enterprises too. But they tend to be more pronounced in the case of start-ups. Again, it is not as if every entrepreneurial venture is fraught with this problem.

Evaluation process Venture capitalists address these problems through intensive effort in evaluating an enterprise. They could spend between two and six months evaluating a proposal. This is on top of the specialist knowledge of industries or technologies that venture capital investment managers bring to the business.

After they write the funding cheque they also engage with the enterprise to continue to learn about the venture. Through this engagement they seek to ensure that the entrepreneur does not behave opportunistically, to his benefit.

Academics and practitioners believe that venture capitalists produce many successful businesses out of entrepreneurial ventures because of this ability of theirs in tackling the challenges in financing start-ups. It is further believed that the structure and incentives of the venture capital fund motivate them to be successful. In the next piece, we will examine how the structure of the fund indeed incentivises the investment manager.

The writer is Chairperson, NS Raghavan Centre for Entrepreneurial Learning at IIM-Bangalore. Views expressed are his own.

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