COMMERCIALISATION FORUM AND FAIR OF IDEAS.
ADDRESS BY DAVID MURRAY, CEO, COMMONWEALTH BANK ON FINANCE AND GOVERNANCE IN EMERGING COMPANIES.
It's a great pleasure to be here. This is a very important topic for a number of reasons. I did mention to David that my schedule today requires me to leave after my presentation and after we've had a chance for some questions if there are any so I'll be on my way after that, David, but I'm sure the other speakers will provide valuable insights as well.
The fundamental position that we're in is that we have an economy which is less than 2% of the global economy, we have a tiny fraction of the world's population, we have some significant natural endowments that give a small number of industries a natural competitive advantage. On the other hand we have a population that already has, by world standards, a high per capita income, a strong standard of living and a history of very strong education and a history of fantastic innovation for such a small part of the world's population.
It follows naturally from that, that the only path that we can follow from here to add value to our succeeding generations is that of a much higher value-added economy in which brain power becomes a natural earner and we contribute to our succeeding generations and contribute through know-how to the rest of the world as well.
In doing that we have to remember one of the fundamental economic principles that guides human beings and that is that not only do human beings create value for one another by trading with one another - that follows because we all bring different skills to bear on production - but that in trading with one another we will only ever trade if we produce, if each party to a trade produces value for themselves.
And the production of value, as Vernon Smith recently said on his tour here, that production of value or attainment of value to one another, when we trade, can only be determined by reference to the individual attributes of each person. If I intend to do something, even if it looks silly, like having a game of golf, I do so because it has value to me. I do not need a piece of legislation or a government or anybody else to help me work that out. I can do it all by myself.
On the other hand, I do need or should have, if I want to sign up as a member of this society, I should be expected to comply with certain standards of behaviour. That is, I can't create value for myself by stealing something from somebody else. So there are certain fundamental rules of behaviour but apart from that there is no room for heavy regulatory intervention in the process of trading, if we're to maximise value.
Now, what I want to go through today is how this value process proceeds as companies start and emerge. I want to talk a little bit about finance but the critical issues are that during this evolution there is always a dilution of value or dilution of ownership through development of companies. I want to examine that at different stages of development and governance and then make some observations about the economic and regulatory framework that we need to keep an eye on to make sure it's not inhibiting this process.
Let me start, then, with this question of dilution.
There are, on one way of examining it anyway, nine generic assets that any firm requires to be in business. There is one that's bundled around money called capital. There are three that relate predominantly to people: management; know-how, whether it's public domain, secret or patented and skilled labour.
There are four more that relate to the fundamental infrastructure of the firm: raw materials, intermediate product used in production or final product for a market and the fourth is the equipment and tools that make up the production process.
And lastly, there's one asset related to the market which we call acquired market access. That is, how do you distribute what you produce, what is it that establishes you in the market, either a distribution contract, an established brand, an owned distribution system, such as a bank has.
Now those nine assets make up all the moving parts that are required to be put into process to make the firm work. Generally, no one business has all nine assets in its own right and, therefore, there is a process of negotiation required to get access to those assets to make something work.
It follows from that that a change in the business, at any point of its development, requires a remixing of the assets. For example, we often think that it's fantastic to be growing fast. I can tell you from experience as a corporate banker that a company in a very fast state of growth can be as difficult to deal with as a company that's actually having significant difficulty because the growing pains bring a lot of unexpected, sometimes unplanned, stresses on financing.
Some more examples help. Capital to underpin growth is an obvious area. If it's necessary to sign distribution agreements the distributor will require some sort of guarantees about the volume. If those guarantees are not available, the distributor might start asking questions about the timeliness of that distribution agreement or, in fact, wanting some access to the technology or rights to the technology to underpin value to the distributor, depending on bargaining power.
Different changes in the market, for example, a significant expansion of demand, will require new tooling up so the refresh rate, or the age of the equipment and tools, will be a significant factor in negotiating a fresh stage. So whichever way you look at it, any changes in the business require remixing and renegotiation of value with each party.
The important issue here in finance is that in the very early stages a new business essentially consists of know-how, particularly closer back to the pure research stage. Therefore, in determining how to move from pure research to start-up, it is almost fundamental that some sort of dilution of ownership will occur and this is usually a very, very painful time but if we look at the prospects of a new piece of technology, it is better to face up to that at that point and understand that a smaller piece of a larger ultimate pie is better than holding onto ownership for the sake of holding onto ownership.
Other negotiations will require a change in the pattern of economic rents paid to service providers or the present value of assets. For example, if in negotiating the technology one has to give up rights to future derivatives of the technology then the present value in the equation has changed.
So emerging companies go through these stages of development and each one affects the redistribution of value. Now, in that light, I think we need to understand something very fundamental. The Cambridge economist, Nicholas Caldor, defined the business owner as the coordinating ability of the firm. This coordinating ability is really what I've just been discussing.
But it's better to think of, at the time the prospects or shape of a company changes, the firm doesn't so much go through a change as becoming a completely different entity. In doing all these negotiations, firms will enter into strategic alliances, changes in share ownership, changes in distribution agreements, changes in joint venture arrangements, admission of new partners in all sorts of ways and it is better to regard each of those changes as the construction of a new entity than to regard it as just a minor change in the firm.
This approach will mean that the company or the firm will think much more clearly about the consequences across all of these nine generic assets that are deployed in the business.
We can think about this in relation to these stages of development and how they affect the mix of assets and their values. At the pure research stage, the know-how is the starting point and there will already have been arrangements around financing of that know-how, whether it's within a university or part of a public grant or a private grant. Those grants are never given usually without some conditions and those conditions will impose limitation on direction of research or ultimate commercialisation and ownership.
The start-up phase is probably the most difficult. As I mentioned, at that point some dilution is inevitable and needs to be thought through but, at that point, the firm has to consider all of those nine assets and how they're going to negotiate to get them in addition to their financing.
The early stage of development is characterised mostly by significant growth pains and this is where classically solid examination of cash flows can - the absence of an examination of cash flows can cause a lot of difficulty.
Then development through ultimately to listed public company status brings to bear a number of very significant new demands on the company, mainly because the process of asking individuals for capital is very different from the process of making offers to the public at large and our public listed company system brings to bear a whole lot of new rules and compliance arrangements for anybody making offers to the public at large, to protect individual investors.
As a fundamental proposition, those rules and compliance arrangements are necessary. They can, however, be taken to ridiculous levels of compliance and reporting that can be very, very limiting for smaller companies emerging compared to larger companies that have the resource and the experience to undertake all of those compliance arrangements but I'll talk about that in a moment.
In dealing with finance and governance at this point, the particular issue is that we need a dynamic financial system to be able to provide the different types of finance that are relevant to the different stages of development.
The classic position for banks is that they effectively offer a capital guarantee to their depositors. For this reason they have not, in our history, have not generally been involved in development finance or venture capital to any degree whatsoever. A highly leveraged bank with a capital guarantee to a depositor is actually not the logical place for venture capital.
It wasn't until we deregulated the financial system that we developed a venture capital industry of any substance in Australia. The early attempts at the development of a venture capital industry relied on tax incentives which always have a problem that we like tax incentives to be put in place but then we have to diarise for their inevitable withdrawal and doing that means that we just don't have true continuity in venture capital.
So even though venture capital now is a small proportion of total managed funds in Australia and it's necessarily small, it is nevertheless a very significantly different position from that which we had before deregulation of the financial system.
If we move then to whether or not our systems support these stages of development in terms of regulation and governance, I just want to first make a key point.
The philosopher, David Hume, said that there are three fundamental laws of human nature: the right of possession, in our case I think we're talking mostly about intellectual property; its transference by consent, which means the operation of contract law; and the performance of promises, where we talk about the rule of law.
Each of these fundamental foundations is influenced by government actions, particularly by regulations and I just want to go through some issues related to those.
The first is the difference between public and private capital where there's been some debate. I mentioned that in dealing with the public we make offers to the public at large and there must be some rules about that but there are differences in behaviour and differences in approach. Some people say that if we have public companies that have these compliance arrangements on them, then we should only make that onerous for big companies and not so onerous for little companies. I think that approach is very limiting.
Firstly, it's the same as saying that over-regulation of big companies isn't such a bad idea and over-regulation of anything is a bad idea. Importantly, though, it basically assumes that small companies can stay small and stay away from these compliance arrangements whereas I would have thought we should set our sights on a bigger objective, that small companies succeed and become large companies.
So it is better to argue for a minimalist approach to regulation rather than having differences between small companies and large companies.
Where we have differences between public and private companies we should be very careful always to understand that we need flexibility. For example, last year, as part of our own governance review, we took a decision that while shares, restricted shares might be a good form of long term incentive for our executives, that we no longer wanted to deal in share options for certain governance reasons.
At the time I had to make it abundantly clear that I nevertheless thought that stock options are a very, very valuable source of incentive for emerging companies and start-ups, where there's limited liquidity and capital but there can be fantastic incentives with share options to starter-owners.
In terms of compliance cost and regulation, there are some interesting examples. One is the operation of share options. Under our tax law, the exercise of options immediately crystallises tax on income even though the whole point of putting the options together was to share the capital fabric of the firm with the owner, not to provide income. So there are discontinuities in tax and other areas that I think we need to watch very carefully.
Another on that we particularly hear from the small business sector is that we have very complex structures of business. One reason why banking for small enterprises requires so much skill is not just because of the banking skill but because of the complexity of structures.
The reason that complex structures are presented to us is because an owner of a small company necessarily has to deal with a number of things: tax planning, family estate planning, limitation of liability. This causes company structures to be put in place, complex groups of companies, complex family trust structures and, by the time we deal with all of our requirements, and some of them regulated requirements for dealing with these structures, we need very, very sophisticated people that are hard to employ in large numbers.
And we've agreed already to take on, in the Australian Bankers' Association, a program of examining why these complex structures are necessary to plan for tax, to plan for families and to have limitation of liability to protect emerging companies.
I mentioned the rule of law and I just want to raise a couple of important things. The most innovative, one of the most innovative things we've ever seen that supports an innovative economy is the concept of common law and precedent because every time we have a new technology we fracture something in the system, we change something and a system of common law, that underpins contract law, enables us to make continual changes to the way we do business without having to go back to the legislature and rewrite codified law.
That is a very, very powerful thing and it only takes the occasional precedent and testing in a court for everyone to know which direction to take in the formation of their new contracts.
So whenever we start moving away from English or common law towards codified Roman law, we are actually making it more difficult to innovate and to get on and get the value of that innovation. Yet time and again now, we see new pieces of regulation that are hundreds of pages long and that require guidance notes in the regulators that are also hundreds of pages long.
We also see the introduction into laws of significant ambiguity like, for example, tests of fairness and tests of social responsibility. These things are the ambit of elected government to determine how to distribute wealth and by including them into laws which affect business and small business and start-ups, they really are almost putting those business in a system of entrapment.
The other area of law which I think we have to be particularly careful about is that the rule of law is broken down whenever we have judicial activism that says, look, I don't think the legislature should really have passed a law this way, I think differently therefore I'll rule this way. That, or rulings which are over-complex and go into points of law that are not necessary, just give us more uncertainty about our future contracts not more certainty about those contracts. So dealing in intellectual property, commercialisation and governance requires us to get active about the rule of law and make sure that we have good laws and the enforcement through good rule of law.
As we move forward it seems to me that Australia needs its research desperately because we need the development from that to add value to our economy and to add a pace of growth that we would not otherwise get from our other endowments but we are not like the rest of the world. We have a smaller population but we have incredibly talented people.
In terms of the fundamental research, so much of it in Australia comes out of universities compared to other parts of the world where a lot more comes out of private research or company-based research and for that reason we have to get the value out of our university research.
Our universities, in turn, need funding. They rely on government funding for their student work. They do not have the sort of massive endowments generally that universities around the world have and, at the same time, Australia does not have a large market so if we're going to exploit our know-how in markets, it's very often going to be in foreign markets, therefore we have to negotiate.
We know also that we can't rely on silver bullets, just the occasional significant invention that will bring home the bacon. It's a matter of continuous process of examination.
So, for that reason, we have to be the best at commercialisation out of our universities and, to the extent there's other research, using that as well.
So I think, for that reason, we have to focus on our universities as a source of research, we have to develop commercialisation potential with our universities and we have to remove statutory obstacles to commercialisation whether it's tax impediments, legal structure costs or the operation of the rule of law.
We have to minimise regulatory intervention and, in relation to the financial system, we want to maintain a deregulated, dynamic system that has all the sources of different types of finance and a large pool of venture capital to support the emergence of new ideas and new companies. Thank you very much.