OPTIMAL CAPITAL STRUCTURE FOR SUCCESSFUL COMMERCIALIZATION OF INNOVATIONS

Ģirts Brasliņš
University of Latvia, Latvia

Aleksis Orlovs
University of Latvia, Latvia

Introduction

'Innovations' by the definition is the process of creating of new products, business forms, new forms of any action in any field - both social, culture or technology. Esko Aho, former Finnish Vice-President formulated Innovations as - the science  which converts knowledge into money (Stabulnieks 2009).

Innovation is not just a new product or process development, but a whole set of actions from an initial idea to its implementation on the market including technology transfer, market research, business management, employee education and training and so on (Stabulnieks 2009). An individual will start using his brain power if he is encouraged morally (with advice and support) and practically (by means of law and fundraising). However, it is not enough as there should be a desire, a different perspective used daily. True for those who say that they need only a desire and everything will happen. But to create something new and unprecedented that will be competitive not only on the Latvian market, but also well beyond it, you definitely need a creative and innovative touch. 

There is no longer any doubt about the immense importance of innovation in economy and business competitiveness - the European Innovation Scoreboard 2010  inexorably shows that Latvia is in the last place in the list of Innovations, while  Sweden is at the very top (Innovations Union Scoreboard 2011). Successful entrepreneurship and competitiveness, especially, in a tough economic situation, mostly depends on persistence and willingness to act. As says an old Arab quote: "The one who wants to do something will find the tools to do it, but one who does not want to do anything will find the reasons for not to do it" (Stabulnieks 2009).  To change this situation, society should be accustomed to innovations already starting from kindergarten. 

There has been a long discussion about the positive economic development scenarios for  Latvia since the year  2000. Additionally, several documents were developed to improve the state`s position, for example - National Innovation Program for Latvia (2003- 2006), but without any positive results so far.  As it usually happens in Latvia, we repeat the same mistakes again and again. Everything goes directly contrary to the plans - most talented Latvian scientists continue to depart to foreign countries, and the inventions and research results of the Latvian scientists for low compensation are acquired by foreign companies.

To study the above mentioned issues the authors have defined the following goals : 

1. to identify the problem areas of the recently founded innovative companies
2. to double-check the findings about the problem areas when compared to the financial performance data of the start-ups;
3. to develop practical recommendations for the innovative companies to improve their commercialization potential.

The four basic objectives of the research were as follows:

1. to identify Innovative companies founded during the last 3 year period in the medical industry in order to perform the research   
2. to conduct interviews with innovative business founders to map the problem areas in successful commercialization of innovative ideas
3. to analyze financial statements of innovative companies to prove the link between the capital structure and the success of innovation commercialization
4. to provide recommendations to improve the potential of innovation commercialization.

The article has the following structure:

• Section 1 identifies the problem areas of the start-up innovative companies and defines the field of research.
• Section 2 introduces methodology for the financial data analysis and provides the results.
• Section 3 describes the main conclusions and provides recommendations for the improvement of the commercialization of the potential Innovations

1. Problem areas of the start-up innovative companies

To analyze the reasons that prevent the Latvian innovative start-up companies to be successful - to commercialize their innovations, the authors have studied the previously done research, as well as conducted  interviews with venture capital experts and start-up founders.

As it is concluded in the “Central Baltic Innovation Tools for Practice 2009-2011” report prepared by Christer Lindström / Lunic Oy, one of the major barriers to innovation is the lack of financing.  Lack of financing as an essential factor for start-up development, was mentioned in the interviews with “Latvian private equity and venture capital association” members. While not every small business turns into a multinational one, they all face the same issue in their early days – finding   money to enable them to start and build up their business and test their product or service (European Competitiveness Report, 2011). Financing is necessary to help them set up and expand their operations, develop new products, and invest in new staff or production facilities.

The authors have interviewed innovative business founders of the last 3 year period, identifying the problem areas in successful commercialization of innovative ideas.

The key findings from the interviews were as follows:

1. for successful commercialization of innovations, founders and managers need to dare to conduct business and commercialize innovation
2. sufficient funding is needed for the successful commercialization.

As an ability to dare is mostly a psychological problem, the authors decided to investigate the problem of sufficient funding for successful commercialization of innovation.

Many small businesses started  as just an idea of one or two people who invested their own money and, probably, turned to their families and friends for financial help  in return for a share in the business. But if they are successful, there comes a time for all developing SMEs when they need new investments to expand or innovate further. That is where they often run into problems, because they find it much harder than larger businesses to obtain financing from banks, capital markets or other suppliers of credit.

This “financing gap” is all the more important in a fast-changing knowledge-based economy because of the speed of innovation. Innovative SMEs with a high growth potential, many of them in high-technology sectors, have recently played a pivotal role in increasing productivity and maintaining competitiveness. But innovative products and services, however, need investments to flourish.

There is neither a register of innovative companies in Latvia, nor any standard classification criteria. Associations and business clusters mostly unite the “old” businesses and through these organizations “old” businesses realize their market strategies and lobby. Therefore, no data on new innovative start-up companies are available in the associations or clusters. There are competitions organized by the Latvian Investment Agency  for innovative companies in order to get funding or mentoring, such as “Pre-Seed Capital” or “Ideju Kauss”, from which the authors of the article were able to get data on innovative companies, though without any confirmation of successful innovation commercialization. 

The only official criterion for the possible innovation commercialization in Latvia is the Patent register, as one may assume that since the patent is registered, there is a higher probability of the commercialization of the  patented innovation.

Unfortunately, this approach has some limitations: 

1. not all businesses decide to patent their inventions
2. no evidence for patenting a service was found; however, according to the interviews, a large number of innovations are made in the service industries as well.

Thus, the authors have conducted the research on the registered patents of the last 3 year period in three industries – IT, wood industry and medical industry.

Figure 1. Source Latvian Patent Office data.

The results showed that most of the registered patents were in the medical industry. This allows the authors to conclude that the medical industry might be the most innovative industry and the capital structure of start-ups doing business in medical industry should be researched.

To conduct the research, five innovative companies in the medical industry were selected using the information provided by the Latvian Investment and Development Agency about the companies founded during the last 3 year period, which have successfully commenced operations on the Latvian or conquered export markets. All the other attempts to find out the information about the companies to meet the goals of the research did not succeed. Neither various professional associations, nor experts were able to name start-up companies in the field of medical industry, which could classify for further research.

The companies were selected for in-depth interviews with their owners, as well as for a detailed analysis of the financial data in order to test the authors' hypothesis on a link between the optimal capital structure and  successful commercialization of innovation.

All the respondents clearly identified that a company operating solely with a limited owners’ equity, is limited in its ability to commercialize the innovation. Due to the market globalization and information availability on any innovation, company with limited financial resources is not able to pursue a rapid market acquisition strategy, thus giving possibility to potential competitors to commercialize the same innovation on the markets the company was not able to reach. On the other hand, with sufficient financial resources a start-up is able to pursue more aggressive innovation commercialization strategy and acquire a significant market share on the chosen markets before the completion.

2. Financial performance data analysis

To double-check the results of the interviews, the authors conducted financial statement analysis of the five selected companies.

Financial statement analysis is the process of understanding the risk and profitability of a company through the analysis of the reported financial information, particularly, annual and quarterly reports. Financial statement analysis consists of reformulating reported financial statements, analysis and adjustments of measurement errors, and financial ratio analysis on the basis of reformulated and adjusted financial statements (Bhattacharyya, Kindersley 2011).

The researched companies were tested against 10 ratios, and, afterwards, divided into two groups - “Successful” and “Unsuccessful”, in terms of innovation commercialization (see Table 1). 

“Successful” companies are defined as companies  which were able to triple turnover year over year, during the last 2 financial years.

The data analysis resulted in the following findings:

A. Turnover dynamics (increase times) 2010/2009.

The ratio measures the company's ability to increase its turnover during the first operating years. The authors measured the 2  last financial years (2010/2009) of the compared companies. The results showed that the successful companies were able to increase turnover on average 4.8 times, but the unsuccessful  - only two times. This means that the successful companies realized their commercialization potential in a better way.

B. Assets turnover (revenue/assets, 2010)

The asset turnover measures the company's efficiency in using its assets in generating revenue - the higher the number, the better. The authors measured the last financial year (2010) of the compared companies. The results showed that the successful companies generated on average 1.59 LVL for each asset's LVL, but the unsuccessful - only for 0.43 LVL. This confirms that the successful companies are more efficient in deploying their assets.

C. Capital turnover (revenue/statutory capital, 2010)

The capital turnover measures the company's efficiency in using its statutory capital in generating revenue - the higher the number, the better. The authors measured the last financial year (2010) of the compared companies. The results showed that the successful companies generated on average 205.45 LVL for each capital LVL, but the unsuccessful - only for 0.88 LVL. This proves that the successful companies were able to realize their commercialization potential in a much better way.

D. Gross profit

Gross profit is the difference between revenue and the cost of making a product or providing a service, before deducting overhead, payroll, taxation, and interest payments. The authors measured the last financial year (2010) of the compared companies. The results showed that the gross profit of the successful company was positive, but the unsuccessful companies had negative figures. This proves that the successful companies were able to realize their commercialization potential in a much better way.

E. Shareholders, number

The authors compared the average number of shareholders in “Successful” and “Unsuccessful” companies in order to understand whether the number of shareholders influences the success of innovation commercialization. The results showed that the successful companies on average had 3 shareholders (mixed private and legal persons), but the unsuccessful companies on average had 1.5 shareholders (private). This shows that the successful companies have a larger number of shareholders, thus, getting a better team, expertise and access to investments.

F. Acquisition of external bank capital

The authors compared the balance sheets of “Successful” and “Unsuccessful” companies in order to understand whether the acquired external bank capital influences the success of innovation commercialization. The results showed that the average successful company acquired external bank capital, but the unsuccessful - didn't.

G. Acquisition of loan from owner

The authors compared the balance sheets of “Successful” and “Unsuccessful” companies in order to understand whether the acquired loan from the owner influences the success of innovation commercialization. The results confirmed  that both the average successful and unsuccessful companies acquired loan from the owner.

H. Acquisition of external investor

The authors compared the balance sheets of “Successful” and “Unsuccessful” companies in order to understand whether the acquired external investor influences the success of innovation commercialization. The results showed that the average successful company acquired an external investor, but the unsuccessful - didn't.

I. The number of employees  

The authors compared “Successful” and “Unsuccessful” companies (2010) in order to understand whether the number of employees influences the success of innovation commercialization. The results showed that successful companies had on average 13 employees, but the unsuccessful - 1.5. This proves that the successful companies were able to realize their  commercialization potential in a much better way.

J. Investment financing ratio ((equity + loans)/non-current assets)

The so-called golden rules of the balance highlight the funding status of the company's investments. The first rule states that long-term investments have to be financed from equity. Since the equity is held by the company for an unlimited time, it should finance the long-term investments of the company. If equity is less than the sum of the long-term investments, it  means that private equity does not cover all long-term investments. This characterizes a rational use of the capital. But if equity is used for working capital financing, it is considered to be an an irrational use of equity.

The second rule states that long-term investments have to be financed from equity and long-term loans. Since the long-term loan has to be repaid after one year or longer, so this capital can be used to finance  long-term investments (Finanšu analīze, 2011).

The results showed that the average successful company had a ratio of 3.77, but the unsuccessful - 36.46. This  proves that the successful companies use the capital in a more rational way than the unsuccessful ones.

The analysis of the financial performance data provides sufficient evidence about the link between the capital structure and successful commercialization of innovations.

Conclusions and recommendations

The interviews showed that for innovative start-up founders, the main barrier in successful commercialization of innovation is insufficiency of financial capital.

In the very start-up phase the company is mostly  funded by the owners’ capital, as  investment in a start-up is considered to be  a very high risk investment.

Due to the limited capacity of the owners’ capital, the further development of an innovative start-up is under the risk of a failure of innovation to stay in the “pilot” phase.

The analysis of the financial performance data of the last 3 year period of the start-up companies in the medical industry allows categorizing them into successful and unsuccessful.

The successful companies, besides a positive gross profit figure, had a different capital structure model. The successful companies were able to acquire external capital in a form of bank loans or financial investment from the external investor.

Additional capital acquisition ensured  successful commercialization of innovation, and it was confirmed in the  interview  findings that the main problem for innovative start-ups is an insufficient financial capital.

The overall conclusion is that the successful innovation commercialization is possible in the environment where start-up companies can acquire and have access to the financial capital in a form of bank development loans, government grants, high risk venture capital and business angels.

The authors recommend to increase the information flow towards the new start-up founders about the availability of the above mentioned capital acquisition tools, as all the financing tools are already available in Latvia.

The authors recommend innovators to be more active in capital acquisition and choose appropriate financial tools, as additional capitalization leads to successful innovation commercialization.

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