Creating Risk Capital

A Royalty Fund Solution to the Ownership and Financing of Enterprise

Ian Whalley

• Publisher: Harriman House
• Year: 2011
• ISBN:
  9780857191540
• Edition: 1
• Topic: Business
• Subtopic: Entrepreneurship
• Index: Business

Private enterprises are essential to a nation's economy and society - yet without finance, or risk capital, they may never get off the ground. Lack of risk capital on suitable terms thus frustrates entrepreneurial ambition, and checks economic growth. And, just as damaging, the search for finance can lead companies and businesses into unsuitable funding arrangements - such as bank loans or equity deals with external investors - that burden them with excessive debt or limit the ability of managers to run the business. This book proposes a fresh solution to the search for risk capital that should suit enterprise and investor alike.Ian Whalley begins by describing the rich inheritance of private enterprises and the financial systems which support them in major market economies. He looks at some serious problems which afflict many enterprises when they seek funding through conventional methods: from small and medium-size firms to major companies, providers of public services and diverse enterprises such as mutual and non-profit organisations. A common theme emerges - enterprises of all types struggle to obtain risk capital without taking on debt or compromising effective management control. The capital is necessary but the drawbacks are potentially fatal.The book shows how the dual functions of equity - risk capital and ownership capital - can be separated and thus how risk finance can be raised without affecting the ownership or control of a company, and without traditional borrowing. The model for achieving this is royalty funding, a system grounded in the proven and familiar practice of licensing. Under this system enterprises pay for the invested risk capital by means of royalties on the sales revenues they achieve, rather than become debtors or partners to those who provide the funds. Royalty funding will benefit both those who own and manage enterprises and also the investors who receive a contractually committed return whilst maintaining the security of asset ownership in the event of a failure of the enterprise.Whalley explains how royalty funding could be put into practice for a range of different enterprises, and draws some broad conclusions about the impact that royalty funding could have if used to finance business in the future.Offering a compelling alternative that complements current financial models this is an essential read for anyone involved in establishing, running or investing in successful enterprises, as well as policymakers and academics.

PART I. A RICH INHERITANCE

It should not be forgotten that England is enjoying a higher standard of living to-day because of the efforts of the nineteenth-century industrialists to open up vast tracts for settlement… and create risk capital. All of us… are living upon the riches that they made possible.

Bryher, The Heart to Artemis: A Writer’s Memoirs (Paris Press, 2006), p. 312.

The novelist and poet Bryher was the daughter of an outstanding industrialist, Sir John Ellerman, and was herself a pioneer in publishing, literature and film, and a brave benefactor of refugees escaping Nazi persecution in the 1930s. Ellerman, whose father came to England from an emerging Germany in the mid-nineteenth century, built a shipping and property empire which helped to make him the richest man in Britain. His merchant fleet played a key role in the Boer War and then in World War I, when Britain faced a deadly submarine threat from an Imperial Germany.

It is the builders of enterprises, like Sir John Ellerman, who create risk capital in its classic form: the ownership capital, or equity, which serves as the core financing of private enterprise and represents much of our wealth. Equity, in this specific sense, is pure risk capital, but in a wider sense it conveys fairness and moral justice: key elements of the bedrock which all societies need in order to flourish.

Due in no small measure to the efforts of these enterprise builders and their supporters, an immense number and variety of enterprises enrich our civilisation. A broad view of the historical origins of enterprise, and of some entrepreneurs, founders and builders, provides useful background to the ideas which follow in this book. Further background comes from the different ways in which enterprises are organised, the diverse forms of ownership adopted, and the various ways of running them.

Enterprise, capital and credit are interdependent, so it is just as important to look at the evolution and development of capital and credit institutions as to look at enterprise itself. The interface between enterprise, capital and credit is to be found in the various capital structures adopted by individual enterprises, revealing the rich variety and depth of current financial systems.

1. Enterprise and its Origins

An institution is the lengthened shadow of one man.

Ralph Waldo Emerson ^[1]

Great industries are usually born of banal concerns in humble circumstances.

William Bernstein ^[2]

The enterprise

One of the key features of a country, and a measure of its strength and diversity, is the number and quality of enterprises to be found there. Thus, in the major market economies, such as those of the UK, USA and mainland Europe, there is an immense number of enterprises and there is also much diversity in their nature, scale, form and quality.

In the UK, for example, the number of private sector enterprises has been estimated at over 4.8 million, employing an estimated 22.8 million people. ^[3] Alongside business firms there are many non-profit enterprises, mutual and co-operative organisations, such as building, friendly, industrial and provident societies, and credit unions; insurance societies; housing associations; colleges and universities; trusts and charities; societies and clubs; and employee-owned enterprises such as the John Lewis Partnership, the department store and supermarket group. There is also a very substantial public sector with enterprises ranging from schools and hospitals at one level to larger organisations like the BBC and, the largest of all, the National Health Service (NHS).

The position is similar in other major countries. In the USA, for example, there are literally millions of small, private sector business firms and a few very large ones. Alongside these, co-operative, mutual, employee-owned and non-profit enterprises play a major role in mainstream industries. To these may be added official federal or state-owned organisations, often set up for specific purposes, like the Small Business Administration (SBA).

Enterprises are rooted in social and civic life, as is clearly shown by the origin of the terms which describe their main forms: in medieval Florence, for example, the societas and the compagnia, whose members took bread together, from the Latin cum and panis; ^[4] and in Venice the fraterna and colleganza. Similar terms, like société and compagnie in France, and Gesellschaft (society) in Germany, are still used for the company today.

The vast majority of enterprises are small and local, but a few develop over time into major national and world enterprises, like Unilever, Shell and Microsoft, and sometimes even into whole industries. The financial theorist and historian William Bernstein quoted an example of a group of dairy farmers in Hjedding in Denmark, who in 1882 organised a co-operative to buy expensive machinery and jointly sell their cream and butter. This model was widely copied and became hugely successful, forming the cornerstone of Danish prosperity in the following century. ^[5]

In Britain, enterprises have begun in many different ways: for example as individual business initiatives; in persecuted and refugee communities like the Quakers, the Huguenots, and more recently the Asians from East Africa; as self-help mutual clubs and societies; as trusts and charities; and as initiatives of the state.

Business enterprises

Many business enterprises start as a sole proprietorship, when the owner of the business trades on his own account, often as a livelihood. He may enter into partnership with others in order to gain access to more resources as the business grows. He may also form a company to take advantage of limited liability, or to raise more capital. This company may become quoted, with its shares listed on a stock market; and a very few such companies may develop or merge into large investor-owned groups. A famous example of such a progression is Rolls-Royce. ^[6]

Rolls-Royce

In 1884, at the age of 21 and with savings of £20, Henry Royce set up an engineering and electrical business in Manchester: F. H. Royce & Co. Some months later he took in a partner, who invested £50. The business remained precarious for many years, the partners living in a room over the workshop, until demand for dynamos, then electrical cranes, brought a period of prosperity. In 1893 the partnership was converted into a limited company, which became Royce Ltd. in 1899, when a successful flotation raised £30,000 for a new factory and additional working capital.

In the early 1900s, with trade depressed, Royce turned his attention to motor cars, producing his first in 1904. A month after its first run, he met the aristocratic car enthusiast and salesman, the Hon. Charles Rolls, and began discussions which led to an agreement in December 1904 under which Rolls contracted to take all the cars manufactured by Royce Ltd. and sell them under the name Rolls-Royce. In 1906 Rolls-Royce Limited was formed and further capital was raised from the public to enable the company to move into new premises in Derby for the production of ‘the most perfect cars’, notably the legendary Silver Ghost.

In 1914 Rolls-Royce turned its attention to aero engines and became a leading manufacturer during the Great War. In 1931 the Rolls-Royce ‘R’ engine powered the Supermarine S6 seaplane which won the Schneider Trophy competition and established a new world air speed record. This led eventually to the Merlin engines which powered the Spitfire, Hurricane, Lancaster, Mosquito, Mustang and other aircraft of World War II, an achievement which Sir Henry Royce did not live to see. Rolls-Royce also took over the development and manufacture of gas turbines, initially for aero engines during the war, and subsequently for ships and power stations as well.

After the successful development of engines like the Dart, Avon and Spey, the company was overstretched by its far-sighted effort to bring the innovative RB211 engine to the US civil airliner market and specifically to the Lockheed TriStar aircraft. This proved to be beyond the company’s financial resources, bringing it into receivership in 1971, and subsequently into government ownership.

The RB211 and its derivatives in the Trent family of engines eventually proved very successful. The motor car division prospered and was floated off, and the company broadened its activity by providing gas turbine power to navies and the oil and gas industry. These developments helped the recovery of the company, enabling it to return to the private sector through a flotation on the Stock Exchange in 1987. Since then, the company has reached a position where it supplies engines to most major airlines and many smaller ones too; aided by strategic partnerships and acquisitions, it has grown into a major operation in the civil and military aerospace, marine and energy markets of the world.

Diverse enterprises

Some private enterprises established as trusts, charities or provident associations have become very large indeed with the passage of time. In Britain, examples include the charity Wellcome Trust, established in 1936, which funds research to improve human and animal health; the National Trust, formed in 1895 to look after places of historic interest or natural beauty; Oxfam, founded for the relief of famine in 1942; and the health and care company BUPA, which can trace its origins to the British Provident Association established in 1923.

Some co-operative and mutual organisations are also substantial, like The Co-operative Group in Britain, part of a worldwide movement modelled on a small store which opened in Rochdale in 1844; and the Mondragon Cooperative, started in 1943 in Spain’s B...