Venture Socialism

This is the article written by David and John in 1997 for Renewal

Stakeholder capitalism via venture socialism

A role for regional development banks under Labour?

David Bailey and John Clancy

How do we get to a stakeholder economy?

The debate on stakeholding has highlighted two key issues that need to be addressed by Labour. Firstly, despite disagreement over to what extent short-termism in the British economy is generated within companies, or by the financial system, or as a result of macro-economic instability, what seems beyond doubt is that short-termism exists. This is manifested, for example, in British industry suffering from higher rates of return being demanded over shorter payback periods than in competing countries, thus crippling industry's ability to invest, and - crucially - handicapping fledgling firms through the lack of start-up capital. Labour has promised a stakeholder economy and needs to explore in detail both what that means and how it will deliver. Cutting through that debate over where blame lies, we aim to link these two issues, examining a modest yet realistic proposal for both stimulating change in the British financial system from within, and for spreading stakeholder principles amongst British firms. We argue that the establishment of Regional Development Banks (RDBs) could provide a catalyst for change in the banking system towards longer-term lending and a closer relationship, as well as taking a strategic interest in encouraging firms to follow stakeholding principles - such as facilitating worker participation in management, recognition of unions, adherence to a legal requirement on a minimum wage, and encouraging networking with other small firms in webs of collective activity in R&D, training and marketing.

Such an approach does bring with it a particular concept of stakeholding, and we need to be clear as to what form we advocate. Like Hutton, as well as Gamble and Kelly, we advocate reform of corporate governance structures, in our view to promote greater openness and democracy as well as longer-term thinking and commitment. Unlike Metcalf (1996), we don't believe that this needs to be imposed, or that it

would reduce managers to being 'mere referees between interest groups'. To accept the latter would be to blind oneself to the success of alternative systems (such as the J-form organisation in Japan, the Mondragon cooperatives in Spain, or a host of other successful organisational forms). Our proposal picks up on Gamble and Kelly's arguments last year in Renewal, where they argued that to encourage private sector stakeholding firms 'Labour needs to take its enabling role seriously, considering if institutional or regulatory innovation would assist in facilitating change' (Gamble and Kelly, 1996). They also point to the successful role played by 3i in providing venture capital, which might 'provide the model for a series of regional development banks which could pioneer new financial relationships between banks and small firms on a strictly commercial basis'. This was echoed by Stuart et al (1996) in a later issue of Renewal. It is to this which we turn first.

Lessons from 3i?

The relevance of 3i is in some ways obvious. Most notably, it is a provider of capital to small and (mainly) medium sized firms on a long-term, loan and equity basis; this is an example of the commitment missing from much of Britain's banking sector which is dominated in the small firm sector especially by overdraft financing. The equity aspect is important in reducing the risk of customer firms going under through increased interest payments; through the shareholding, the interest rate on the loan can be kept at 'normal' levels as well as the investment being more secure (Coopey and Clarke, 1995). The success of the firm itself determines the return to 3i; a successful firm may well pay back more than under a straight bank loan. Capital gets repaid as the firm redeems shares over a certain timescale, and dividend payments in effect represent the profit flow to 3i.

In addition, 3i was established as a private-sector institution, but through government initiative, and with public bodies as shareholders for much of its history. The Industrial and Commercial Finance Corporation (ICFC) was set up in 1945 despite the five clearing banks being reluctant shareholders, and from its inception was perceived 'to have a distinct socialist aroma' (Coopey and Clarke, 1995). That the clearing banks were compelled to participate 'under threat of sterner action' meant that the ICFC had to be set up with freedom from interference by its shareholders - including the Treasury and the Bank of England - paving the way for it to carve out its own role, later merging with the Finance Corporation for Industry and eventually being floated as 3i. There is a clear message (and precedent) here, namely that government has an enabling role in facilitating change in the banking sector, and that the institutions it creates can, if need be, go their own way as private or public-private organisations.

3i is itself regionally based, in sharp contrast to the trend in banks towards increasing centralisation of decision making over lending outside the region, in their head offices (Cowling and Sugden, 1994), which has exacerbated the gap between small firms and banks. Furthermore, in taking a long-term shareholding in a firm, 3i both rewrites the articles of association (thus restructuring the constitution of the firm) to provide a legal framework for the protection of its investment, and may impose conditions such as appointing 'special' directors to the firm (with the power for them to be made managing directors). This is where an RDB has much scope to spread stakeholding principles amongst those firms borrowing from it, by learning from and extending 3i's approach.

Injecting stakeholding

Venture capitalists force firms to comply with a structure and a system which protects their investments: they intervene in the market place and change the way firms work. Thus, in rewriting articles of association there is the potential to redefine the corporate governance arrangements within firms, for example by giving workers real stakes in the form of shareholdings, as well as retaining power for the bank over key financing decisions. This can be taken further through the conditions placed on loans; in return for the provision of long-term finance, firms might have to commit themselves to certain stakeholder principles. The exact form of such commitments is in itself another issue to be examined elsewhere, one really concerning how we define 'efficiency' under the stakeholder concept; here it is the mechanism for establishing such commitments which we aim to highlight. However, stakeholder goals for established small and medium sized firms might include such commitments as:

• Adherence to a minimum wage. Whilst this will be a legal requirement under a Labour administration, it will be difficult to police, especially amongst small firms. Breaking such a commitment would not only mean the firm breaking the law, but would bring the added danger of breaching the contract with the RDB.
• An employee share in the profits of the firm, through worker shareholdings.
• Worker representation on the board of directors.
• A right for all workers to join a trade union perhaps with the quid pro quo that workers agree to a dispute settlement procedure.
• Minimum levels of training and education (perhaps arranged in conjunction with revamped, democratically accountable TECs).
• A minimum level of investment in R&D. The exact figure may vary by sector, but it is crucial that such investment is raised generally. An added advantage

here is that Labour intends to introduce a tax credit for R&D investment, which unfortunately is likely to benefit large rather than small firms. If this commitment formalises the R&D spend in small firms then they may also benefit from the credit.

• Networking with other small firms in appropriate and systematic joint R&D (as well as marketing and export) initiatives. Evidence from home and abroad suggests these are crucial in helping small firms both to reduce costs and in technology diffusion.
• Sourcing. Commitments could be made concerning minimum local (i.e. European) sourcing (especially important if loans are made to incoming firms from outside the region) as well as paying debts within a specified period.
• Consumer protection, recognising that consumers are also stakeholders in the firm.

Failure to comply with the stakeholder commitments would be a fundamental breach of contract. Remedies may come in three forms: legal (as in the case of the minimum wage); contractual (with enforcement in the courts); and constitutional (with the RDB having the power to dismiss directors and appoint special directors to rectify the situation). It needs to be stressed that firms would not be forced to take on such stakeholder commitments, but that if they wish to borrow from the RDB the quid pro quo is agreeing to them. They can of course decide not to do so and to go elsewhere for financial assistance. However, we expect firms operating such principles to be more successful in the long run than firms operating along more 'traditional' lines, as the commitments would trigger off a virtuous cycle between small firms and banks that is in the interests of both. The long-term equity stake held by the RDB would itself offer the firm a degree of protection from takeover, allowing it to concentrate on planning and investment for the long-term.

There is clearly a need to differentiate between small and medium sized firms employing non-family members, which have formal internal relationships, and the very small, often family, entrepreneur firms. A comprehensive range of commitments may not be attractive or appropriate to such firms, which would not wish to be 'overloaded'. For the more established firms, though, these commitments would be appropriate and feasible, and there is some experience to back up this claim. In the 1980s, Enterprise Boards established by the metropolitan councils invested in small firms, with firms agreeing to such things as minimum wage commitments, health and safety, and trade union recognition. As Gouge (1996, 200) notes, firms rarely found the conditions difficult.

In any event, we do not claim that the above model (or whatever the exact nature of commitments sought) is optimal. Rather, we argue that it has the potential to

promote competition, in two senses. Firstly, what we term 'econo-diversity' would be encouraged - the fostering of a greater variety of corporate organisational forms. This is in itself desirable, for example in benefiting workers by giving them greater choice over which type of organisation to work for. Furthermore, the firms reorganising on the above principles (which might be called 'stakeholder limited companies' or SLiCs) would have to compete with conventional Limited Liability firms, partnerships, cooperatives and quoted companies. As Gamble and Kelly note, new forms of corporate governance need to show that they are superior to the old in economic performance, but that at the moment we do not have the knowledge to say they are. We feel that SLiCs will succeed, but we recognise that this is uncertain at this stage. Inter-organisational competition can only be healthy in this respect; over time the relative performance of different forms will become clear. Rather than regulating for a certain organisational form, why not instead encourage organisational diversity and see which come out best?

Secondly, competition in banking will be improved. At the moment there is only limited competition between the clearing banks for small firm customers. These, as well as 3i itself, would have to respond to the added competition from the RDB; 3i may have to cut loan rates and the clearing banks may be forced to get closer to their customers and to begin operating locally and over a longer time-frame.

Why Regional Development Banks?

Britain cannot import elements of Germany or Japan's economic systems, such as Germany's (more regionally based and long-termist) banking system, as Kay and Hutton (1996) note, as attempts at transferring institutions across systems rarely work. Instead we have to look for ways of reforming the British system from within. Establishing RDBs could act as such a catalyst for such evolutionary change from within, as other banks will be forced to respond, to become more local and more long-term. The RDB rooted in the regions could also provide advantages in terms of lower information costs, accelerated bank-learning after recessions, the avoidance of high collateral demands, and assisting the development of clusters or webs of local firms (a point stressed in the earlier stakeholder commitments) (Kelly et al, 1995). For example, it is envisaged that the RDB itself would have a number of stakeholders, perhaps including regional chambers of commerce, regional government (the proposed chambers or Parliaments where appropriate), Regional Development Agencies, TECs, central government, and the European Commission if funding comes from Europe. Being part of such a network of agents appears to help banks in overcoming information asymmetries within loan contracts, thus reducing screening, monitoring and enforcement costs. In other words, they have a richer resource base to draw on, with a wider set of recipes. There might also be a positive feedback from the RDB, in contributing to the 'organisational capacity' of

the region, that is the ability of a region as a whole, including all its key institutions, to work together in coping with rapid economic change, a capacity in which British (and particularly English) regions are seen as weak given the centralised system of government (Mawson, 1996).

As noted in our introduction, the lack of start-up capital is a key gap in the market at the moment. The City and venture capital institutions do not like start-up capital, being 'frightened of it because they have had bad experiences and (because) it is very expensive to maintain and to support with high overheads' (Stoddart, 1996). The cost savings envisaged above for an RDB, for example in being part of a network, could enable it to undertake such activity. At the moment even 3i, which has done so much, finds lending £200,000 and below difficult. Firms coming to it need a track record behind them. A number of local and regional organisations are presently trying to plug this gap, including Lancashire Enterprise's 'Rosebud Fund' as well as similar efforts by Yorkshire Enterprise and GLE Development Capital. However, coverage is limited and patchy. The RDB could plug this gap. It is highly doubtful whether commercial banks would be prompted into doing this through further extension of the Loan Guarantee Scheme (LGS), as they would probably take the benefit without necessarily expanding their portfolio of investments to include riskier investments (interestingly, 3i anticipated such problems, and lobbied vigorously against the introduction of the LGS in the early 1980s (Coopey and Clarke, 1995)).

Whilst recognising 3i's remarkable success, a final and crucial point to note from its experiences is that it could have done much more in promoting industrial development. As Coopey and Clarke (1995) point out, 3i's 'economic impact has been limited by comparison with its continental and Japanese equivalents'. This is a cause for regret because 3i's uniquely successful experience as a capital market substitute could have been the basis for a much more significant national strategy of encouraging and funding stable industrial growth. RDBs, by acting as channels for low-cost, perhaps fixed-interest loans to finance regional industrial development, could play such a role, one which 3i itself was not allowed to develop, through a lack of resources relative to its continental equivalents.

Where would the money come from?

For starters the government could redirect money going into Regional Selective Assistance (RSA) via the RDBs. This would channel assistance to local start-up and small and medium sized firms, on a longer-term basis and with better scrutiny of the effectiveness of the investment- something Britain has had problems with (see Bachtler, 1990). Secondly, the regional development agencies which Labour proposes establishing should be able to issue local bonds, with some of the proceeds channeled via the RDBs into local small firms. Thirdly, the RDBs might also

be able to attract institutional funds. When tighter central government control deprived the Enterprise Boards created in the 1980s of local authority funding, the Boards themselves began to act as Venture Capital agents, using money from pension funds and elsewhere, and actually led the development of private-sector regional venture capital funds (Brunskill and Minns, 1989). Whilst the level of investment involved was modest, it does suggest that the Boards were successful in identifying a funding gap, and that investment opportunities can be created by pro-active funding bodies armed with new forms of finance, support and strategy (Eisenschitz and Gough, 1993). A pro-active RDB could feasibly create such opportunities and similarly attract institutional funding.

Furthermore, resources could become available from Europe. The Regional Policy budget will need to expand considerably when EMU goes ahead, in order to support regions which would otherwise suffer from the withdrawal of the safety net of currency devaluation. The Director of Regional Policy at DGVXI, Graham Meadows, speaking recently in Birmingham, gave a highly relevant example of recent policy, where DGVXI had helped create an investment fund in Merseyside to lend on a long-term basis to local small firms because it felt no other assistance was forthcoming. There are precedents for this kind of involvement. 3i's predecessor, the ICFC, administered loans under an agreement with The European Investment Bank, and 3i has itself used finance from the European Coal and Steel Community (ECSC). The latter involved over £46 million being lent between 1977 and 1982 alone, creating 9,000 jobs (Coopey and Clarke, 1995).

Labour's policies

Labour has previously proposed the creation of regional banks, but dropped the idea in its 1990 policy statement Looking to the Future (Wickham-Jones, 1995). Despite this, there has remained a recognition of the difficulties faced by small firms in the regions and a desire to do something to help. In New Opportunities for Business, for example, Labour outlines plans for establishing Regional Development Agencies, one task of which could be in raising investment capital and supporting small firms and innovation in the region. Winning for Britain noted that such agencies would 'act as catalysts for new regional investment banks dedicated to mobilising savings generated in each region focusing particularly on the needs of small and medium sized enterprises'. This document also proposed a self-financing Business Development Bank for small businesses. In addition, Labour has been in talks with 3i, Nat West and venture capital companies, looking at the idea of a national investment agency. This would underwrite a certain proportion of the equity invested in fledgling firms by the venture capital firm, with repayment through profits, with the government retaining an interest in the firm (The Guardian, 28 August 1995). More recently, the Policy Handbook (1996, 2.7) states:

we are keen to encourage a wide variety of forms of partnership and enterprise, including cooperatives, and will empower regional development agencies to work with venture capital funds to provide small business finance through public/private partners.

Why not go one step further and create RDBs to fulfil such a role? Such an idea would fit in with the recent evolution of Labour's polices on small and medium sized firms, regional development and corporate governance, we feel. In establishing such initiatives to promote investment, we would like to see Labour pay particular attention to creating a regional investment infrastructure (which could also help avoid the blunders of the centrally-run NEB under the last Labour government), as well as injecting stakeholder principles amongst firms lent to. This would also link with ideas contained in the recently published Renewing the Regions (the report of the Regional Policy Commission chaired by Bruce Millan). One of its recommendations was that Regional Development Agencies should ensure that venture capital for small firms is available, and if it is not, to establish appropriate mechanisms for its delivery.

Again, why not tie this in with commitments to stakeholder principles in the firms being helped? After all, we do need to find ways of promoting values of trust and long-term commitment in corporate governance arrangements, as Blair himself argues in New Britain: 'The debate about corporate governance in Britain is still in its infancy.. .We cannot by legislation guarantee that a company will behave in a way conducive to trust and long-term commitment, but it is surely time to assess how we shift the emphasis in corporate ethos from the company being a mere vehicle for the capital market- to be traded, bought and sold as a commodity- towards a vision of the company as a community or partnership in which each employee has a stake, and where the company's responsibilities are more clearly defined'.

Political attractiveness

There are political attractions to the development of RDBs fulfilling these functions. It could establish stakeholder capitalism in the marketplace per se and could promote what might be called Venture Socialism: a new model for invited intervention in the marketplace to foster economic growth based on the principles of economic and social justice. Invitation, that is, by entrepreneurs themselves; no one is being forced to take the money. We suspect many will be happy to have it even with the presence of the commitments outlined here.

In addition there is some measure of'social ownership' under the equity aspect of the intervention. The RDB holds shares in the firm on behalf of the funding sources, be they local or regional government, central government or the EC. Thus there is some measure of indirect state involvement (this is not carte blanche involvement; it is on an invitation basis and solely in relation to a set of commitments) in firms which means that the working lives and livelihoods of by far the largest group

of workers in the economy- those in small and medium sizes firms - can be bettered. Under previous forms of socialism only those workers fortunate enough to work in the commanding heights of the economy benefited. In practice, the huge monolithic nationalised industries monopolised state involvement, reserving it for only a limited segment of the working class.

The left and the right can thus both find attractions in the project. For all sides the commitment is to the creation of sustainable, long-term jobs in the economy. Others might also be welcoming to the idea. Unions would welcome the new corporate-constitutional and contractual safeguards of their position in these (often new) firms, as well as the extension of their ability to organise in areas where they presently find obstacles - in the small and medium sized firm sector. The European Commission might welcome a new model for promoting long-term regional development patterns in the more far-flung regions of a post-EMU Europe, where subsidiarity has a real and practical force in regional development (indeed in applying subsidiarity, the Commission already looks for regional level actors to implement industrial development initiatives). The Social Chapter could also be integrated into the SLiCs framework (or other econo-diverse models), again with firms 'opting-in' to the system by accepting the investment. Chambers of Commerce and local authorities might welcome their new role in assisting regional development, and the firms themselves might use the SLiC label as a marketing logo, for example in emphasising the commitment to consumer protection or, as with Investors In People, in attracting high-quality staff.

The most intriguing political attraction, however, might be for a second term Labour government. Just as venture capitalists have to wait for their investment risks to mature later in the investment term ('lemons ripen before peaches') - through the dividend stream from the equity and preference stakes and by the firm redeeming such shares - so too venture socialists will reap a dividend stream and redemption flow from successful firms in the latter part of their investments. Having had the original capital investment returned through loan capital repayment and equity redemption, the loan interest and dividend stream is the profit flow from the SLiC to the RDB. This becomes, quite literally, what might be called the 'social dividend'.

If we're thinking about a ten year investment, this would begin to come onstream say six years after the initial investment. Some of these funds should be available for re-investment by the RDB, but part of the social dividend could be channelled into the Exchequer. Whilst privatisation 'family silver' sales were one-off receipts, the SLiC social dividend stream would, over time, become a steady, on-going flow, for use as the government saw fit.

Conclusion

If stakeholding is to mean anything to ordinary people, it has to impact at the level of their lives; in the communities they live in, through the welfare system that supports them, and at the places where they work. Recognising that stakeholding principles need to be actively fostered in such firms, linking this with the need to plug the gap in the provision of long-term finance (especially start-up finance) for small firms, and learning from 3i's experience over the last fifty years, we identify a constructive role for Regional Development Banks under a Labour government. Such an approach could act as a spur to the spread of stakeholder values, and as a catalyst for change in the banking sector. Competition would be intensified, both between banks and between different corporate organisational forms. Such greater 'econo-diversity' is itself desirable. In addition, it might inject a dynamic element into corporate evolution. If we don't know whether new forms of corporate governance are superior to old ones, let's encourage such econo-diversity and see which ones win out. Such an approach, using regionally based institutions to overcome market failures and to accelerate industrial development, should be seen as just one example of a proactive industrial policy, one which is responsive, enabling and supportive, and one based at a regional rather than a national level.

David Bailey is at the Research Centre for Industrial Strategy, University of Birmingham Business School.

John Clancy is Chair, Edgbaston Constituency Labour Party, and a former venture capital solicitor.

We are grateful for comments and suggestions made by Lisa De Propris and Denis Emms-Moss on an earlier version of this paper.

References

Bachtler, J (1990) 'Grants for inward investors: giving away money?', National

Westminster Bank Quarterly Review, May, 15-24

Blair, T (1996) New Britain. My Vision of a Young Country, London, Fourth Estate

Brunskill, I and R Minns (1989) 'Local financial markets', Local Economy, 3, 295-305

Coopey, R and D Clarke (1995) 3i. Fifty Years of Investing in Industry, Oxford, OUR

Cowling, M and R Sugden (1994) 'Small firms and lending contracts: Do banks

differentiate between firms?'', Journal oj Small Business Finance

Eisenschitz, A and J Gough (1993) The Politics of Local Economic Policy, Basingstoke,

Macmillan

Gamble, A and G Kelly (1996) 'Stakeholder capitalism and one nation socialism',

Renewal, Vol.4, No.l, 23-32

Gouge, Ed (1996) 'Local and regional development' in David Coates, (ed), Industrial

Policy in Britain. Basingstoke, Macmillan

Hutton, W (1995) The State We're In, London, Jonathan Cape. Hutton W and J Kay (1996) 'Only working together will save the economy', The Observer, 13/10/96, 26

Kelly, G et al (1995) 'Banking on the regions', New Economy, Vol.2, 4 The Labour Party (1994) Winning for Britain, London, The Labour Party The Labour Party (1996) New Opportunities for Business, London, The Labour Party The Labour Party (1996) Policy Handbook, London, The Labour Party Regional Policy Commission (1996) Renewing the Regions, Sheffield, Sheffield Hallam University

PAVIC Publications. Stoddart, M (1996) 'A venture capitalist's view' in S. Milner, (ed), Could Finance do More for British Business ? London, IPPR

Stuart, G, D.Bailey and R.Sugden (1996) 'Industrial economic policy under Labour: 'What is to be done?', Renewal, Vol.4, No.4, 19-27

Wickham-Jones, Mark (1995) 'Anticipating Social Democracy, pre-empting anticipations: economic policy making in the British Labour Party, 1987-1992', Politics and Society, Vol.23, No.4, 465-494

Back to the 5th Way