Money makes the world go around

David Bott, Director of Innovation Programmes at the Technology Strategy Board.

I got to musing about it all recently during the debate about how the UK’s proposed Green Investment Bank should be funded. What is the best financial support mechanism for a government to use? In industry we used to worry about three main types of money. Since becoming a public servant, I have learnt that there are two other types. There may be more.

The first (and best) type of money is the stuff you get from customers in exchange for products and services. This is the goal of all companies – to sell their output for more than it cost to produce, and to sell lots of it.

This money is rightfully yours and what you do with it is totally up to you. Unfortunately, it is hard to get. You have to make or supply something that people want, and be better or cheaper than other companies that make similar things.

To be in a position to get this most desirable type of money, you tend to use the two other types. The first is debt. This type of money usually comes from a conventional bank. It is a strict business deal. You borrow an amount of money for (often) a fixed period of time and for a specific purpose, and as well as paying back the money, you pay extra for the privilege of having had it.

The money generates an income for the provider, and has hopefully been used by the company to make even more money than the amount borrowed and the interest paid. The rate of interest is often varied to take account of the risk involved in the loan, based on the specific use to which the money will be put, or the strength of the company borrowing it – but mostly, this is low risk money for the lender. Those who lend know a lot about money, but their assessment of risk, and therefore the interest rate, is based on financial factors.

Growing with equity

The second type of money is equity. This is where someone provides money to a company in exchange for a share in the ownership. The company pays a dividend (which is equivalent to interest) to the lender and the amount of money grows as the company grows. Thus the lender gets an additional benefit when a company is successful.

In the case of large companies, this money is provided by shareholders who are either individuals or companies that manage funds on behalf of others. For smaller companies, the money is likely to come from venture capitalists or business angels.

Equity funding is more risk-tolerant than debt, but in consequence, a higher rate of return is expected. Large companies that invest in other companies do a fair amount of analysis of the market, the standing of an investee company in the market, comparison with competitors, the people involved, and so on.

Venture capitalists are even more engaged in due diligence and often provide human resources at senior management level to try to maximise the chances of success. Overall, this sort of money requires a larger return and stronger interaction between company and money source, but it does tolerate more risk.

Two other types of money

Since joining the Technology Strategy Board, I have discovered there are two other types of money. The first is usually called subsidy. This is provided to companies and sectors to try to affect economic activity at an international level. Having large multinational companies resident in a country provides jobs, drives supply chains and has all sorts of positive impacts – and so is seen as a good thing.

Thus it is normal for governments to make it financially attractive for such companies to operate in their country. The money can be provided in the form of loans with low interest rates, or grants with implied long-term economic returns, or it may be provided through other fiscal means.

Not surprisingly, it is the sort of financial support that government-sponsored organisations like the Technology Strategy Board provide that interests me most – at the moment. This money is often awarded as a grant for part of a specific project. It is “invested” against the specification of the project.

Although there are provisions in most contracts I have seen, money is rarely taken back if the project is unsuccessful. That is because it is (mostly) invested in riskier projects. The logic is easy – if the government can encourage companies or groups of companies to take on high risk projects, then – if the projects are successful – those companies will be more profitable in the future, and therefore employ more people and pay more taxes.

How to deal with transgression

At this point it is necessary to introduce a distinction between organisations, which I was taught a long time ago. It is best summed up as the difference between policemen and doctors. There are some groups which, if you step outside the rules of society, are there to punish you for the position you find yourself in. There are others which, if you find yourself outside the normal states of society, are there to help you get back inside. One punishes transgression, the other helps reverse it.

Both of these types of response exist in the “money business”. If you cannot pay back the money you take as debt, would the lender punish you, or work with you to help you pay it back? Most lenders just charge more and leave it as your problem.

If you cannot pay back money you take in exchange for equity, then the lender is more likely to help you, because they share the liability.

In the case of grants, it would be possible to punish those who don’t deliver by cancelling the grant and even requiring repayment, and if you wanted to be a simple funding agency, that is probably what you would do.

If on the other hand, when those who take grants try - but fail - to deliver, you could give them support, add to their expertise and help them understand what they did wrong. Then - next time - they may well do better. Sounds like a plan to me!