Why Governments Should Act Like Venture Capitalists

TLDR: Governments play an important role in financing companies that don’t meet the traditional returns profile an investor expects but result in some public good, but grants create misaligned incentives between governments and businesses. Equity based investments present a better alternative.

A Perfect System

In aggregate, markets are good at allocating capital to opportunities that present the best risk-adjusted return. Businesses that fit the desired returns profile, and need capital to generate growth, present a match made in heaven and a fair price can be decided by the market.

Some businesses don’t fit that desired returns profile. Whatever the reason, whether it’s lack of scalability, a small market size, or the high risk of failure not compensating the potential return, they’re not attractive opportunities to traditional investors. However, many businesses have impact which is beneficial past investor returns. It’s clearly important to fund businesses that have positive societal outcomes but aren’t attractive in a traditional capitalist system.

Enter government grants, a way to provide capital to businesses that advance a national interest but may not be viable for the capital markets. Government grants, which are often equity free, allow the government to advance their interests without creating government owned organisations that inevitably incur a bloat generally avoided by private enterprise.

An Imperfect System

Private funding and government grants work beautifully in tandem when companies fit neatly into a bucket of being attractive to public markets, socially beneficial or neither. However, often good companies fall into both. They fill a keen need from society hence why they’re financially, and socially, successful. Governments can fund these companies, count them as a success, and consider tax-payer funded grants as successful.

However, there is little to no cost to attain an equity-free government grant. Funding from private investors is a well considered process. You’re convinced, as a founder or leader, that the capital you’re looking to raise is going to return more to you than the equity you’re selling. If you don’t have the belief that you’re going to secure growth which compensates you in excess of your cost of capital, then you don’t raise money. With little to no cost of capital for equity-free government grants it is almost always worth securing them, even if that money isn’t required for growth.

Functionally, well funded private businesses can hoover up government grants by presenting the most compelling evidence for success while having very little grant funded impact and effectively subsiding current investors. The opportunity cost of not funding businesses that can’t survive in the private funding environment, and deploying capital into businesses where the incremental boost in economic activity is small, is devastating.

Building Something Better

Refactoring equity free government grants as equity-based government grants has two core effects.

[1] Creating a cost of capital makes businesses assess whether they need the government grant to operate and generate additional growth.

[2] Money is returned to the pot for future businesses.

The cost of capital, particularly when high, incentivises companies to prioritise private funding and allows an additional component to the traditional venture capital formula, social impact.

Government venture investments that prioritise social impact alongside returns takes them out of competition with private markets. Opportunities that aren’t as privately viable, but have a strong social impact, can be funded without that same allocation being soaked up by companies that are already succeeding with traditional investors.

This also potentially streamlines the government funding model. Companies which don’t meet the venture capital bar of entry but are socially interesting have a very clear path to follow. A path that exists as qualified leads from VC firms, that don’t want to back them but want them to win, into a government venture structure. Operating in this way also allows access to the experience of a class of venture professionals with private sector experience that can contribute socially.