The SEVEN Fund $50k VINE Project: Developing
Investment Indicators for Emerging Market SMEs

Submit an Idea To The VINE Competition

What indicators can outside investors measure to help them predict the
potential success of emerging market SMEs?

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Quick Links:
• Overview
• FAQ
• Background
• Lack of Knowledge, High Perception of Risk Limit Investments in Emerging Market
• The Challenge
• The Process of Open Innovation
• The Process & Contributions Competition Stages
• Terms and Conditions

Overview

The VINE (Virtual Integrated Networking Experience) Project will award $50,000 in prizes to individuals or teams of contributors for developing investment indicators for emerging market SMEs (Small and Medium–sized Enterprises). We will do this through a five–month long online competition that invites anyone with ideas to submit, collaborate, and refine them. The end result will be an index of factors that the SEVEN Fund will release to the public to assist in broader analysis of investment opportunities for emerging market investment.

Background

Entrepreneurs in emerging markets frequently cite a lack of access to investment capital as a barrier to starting and growing their businesses. In the US, Europe, and other mature markets, SMEs benefit from an inflow of capital from venture capitalists, private investors, and banks. However, early–stage investments in emerging markets are limited by a lack of information and therefore a high perception of risk. The SEVEN Fund is sponsoring a competition designed to engage diverse thinkers from around the globe to develop a set of investment indicators and processes that can be used to assess emerging market SMEs potential. The goal of the competition is to provide a new set of metrics that can be used to help improve investor confidence and stimulate investment in promising emerging market firms.

Lack of Knowledge, High Perceptions of Risk Limit Investments in Emerging Markets

Barriers to commercial financial investment in emerging economies, particularly in early–stage ventures, fascinate us at the SEVEN Fund. Most OECD countries have flourished from high levels of financial investment flowing into SMEs. Outside of a few major hotspots, such as China, Brazil and India, there is almost a complete lack of such activity in developing countries¹. We seek to further explore the causes and possible solutions of this limited financial investment.

Different investment vehicles exist for companies at different stages of size and development. In emerging market economies, there exists a vehicle for very small micro–firms through the various micro–finance and micro-loan offerings and a vehicle for large, established corporate entities through the banking and global financial markets. The firms that have the most difficult time accessing capital are the for–profit, small to medium–size enterprises (SMEs) that need more funds than microfinance can offer and do not qualify for investments from banks or the world financial markets. Although each country identifies a SME differently, the most commonly–held definition, held by the EU, is that a SME is a firm consisting of between 10 to 250 employees².

Investment level is a function of risk perception: the higher the risk perceived by most investors, the lower the actual investment made. Risk, on the other hand, is a function of knowledge and familiarity: the more an investor knows about an investment opportunity, the lower the perceived risk to the investor. Venture capital firms (VCs) in the US and Europe work within this spectrum, in markets where they have more information and knowledge than the average investor. General investors use evaluation methods such as financial ratios to help them determine the risk of their investment in equities. These financial ratios are of very little to no use when looking at SMEs with limited revenue history. Therefore, VCs specialize and become experts in certain industries or sectors. Their acquired pattern recognition about the potential for success in a specific industry allows them to recognize winning ideas and entrepreneurs. This expertise in turn lowers the risk of investment for them.

However, rather than using the financial ratios of general investors to evaluate companies, many VCs develop their own indicators (sometimes known as proxies or analogs) that help them to measure the future success potential of SMEs. These indicators serve to reinforce the decisions made based on their pattern recognition. Such indicators might consist of the time it takes a company to hire top technical talent, the values and attitudes of the management team, or the speed at which a company produces its first prototype. Others include the amount of self-funding capital put into the start-up by the founders, the growth potential of the market, or the number of potential routes to exit the investment. The possibilities are endless. These indicators allow the VCs to quantify and reinforce their pattern recognition by looking at non-traditional, but crucial, markers of success. Venture capitalists are able to take risks that the average investor is not by spreading the risk over multiple investments in the hopes that just one returns a substantial payoff. VCs have developed sophisticated and useful systems and tools for managing risk and predicting success that can benefit other investors. We believe there is much that can be learned from VCs, and many of their findings apply particularly to emerging markets.

We define emerging market economies to broadly encompass all lower–income countries with a growing entrepreneurial class. Therefore, investors are challenged to find a model that functions in different environments for a wide range of SMEs. For example, one Chinese manufacturer of solar photovoltaic panels needed to raise $40 million to reach its ambitious growth plan, and was able to access global venture funds and management talent. One the other side of the spectrum, an African horticulture company that processes and exports vegetables to Europe needed $800,000 to expand its operations, but had little access to funders outside of its home country. The challenge that we pose to you is to find a model that can address the needs of both types of firms.

Small and medium-sized companies are important for growth and prosperity for two reasons. SMEs can spur greater innovation than traditional legacy firms hampered by bureaucracy, corruption, and an incentive to protect the status quo. Indirectly, a strong base of SMEs also indicates cultural and economic vibrancy, as this sector is typically where employment growth is highest, the best ideas originate, and economies learn to compete globally.

The Challenge

The SEVEN Fund is putting out a challenge, a question to be answered by anyone and everyone. Recognizing that traditional financial ratios and assessment metrics are not sufficient for identifying promising emerging market firms, we therefore pose the following question:

"What indicators can outside investors measure to help them predict the potential success of emerging market SMEs?"

The Process of Open Innovation

In building our index, we could have taken several approaches. We could engage top academics – economists and business strategists – working in developing markets, or we could ask investment bankers and venture capitalists already investing in these markets; we could go straight to entrepreneurs themselves. We believe, however, that stimulating a dialogue among all these groups – and anyone else who is inspired to participate - will generate the most powerful insights. We especially welcome contributions from non-traditional participants in these discussions.

Our Process of Open Innovation is inspired by several sources, including a story featured in Bill Taylor’s and Polly Labarre’s book Mavericks at Work³, that recalls how a Canadian gold–mining company organized an open-source challenge—inviting engineers and scientists from around the world to submit their best ideas for where to drill for gold. The contest caught the eye of an Australian engineer by the name of Nick Archibald, who had developed much-admired technology for oil-and-gas exploration. Archibald believed that his technology could also work for minerals such as gold, so he entered (and won) the contest, earned a huge prize, and became an instant celebrity—the Paul Potts of mining.

A second inspiration comes from Eric Raymond’s paper "The Cathedral and the Bazaar",4 which describes the differences of a structured (formally organized) versus a collaborative development model (open environment) in the software industry as advocated by Linux inventor Linus Torvalds. Finally, we believe in the idea that the group knows more than any one individual, and that innovation often comes about when an expert from one field looks at and tries to solve problems in a different domain. As discussed at length in the recent book Wikinomics,5 collaborative development is being used across industries to expand the pool of ideas developed to solve complex problems. By tapping into the world’s collective intellectual capital, proposed solutions are more effective than if informed by only one domain.

This competition is a challenge prize, paying homage to the X–prize and other challenge prizes. We wish also to recognize the roots of this process, used so effectively in the Open Source Software movement, by engineers, computer programmers, and scientists. We are pleased to be among the early experimenters using the same process to seek solutions in other domains.

This competition is the ideal situation to think differently, to innovate, to look at an old problem in a new way and that is what we‚re inviting you to do. We are opening up this competition to contributors who want to engage and pave the way forward to stimulate exciting investment opportunities in emerging market entrepreneurs. We will take the winning ideas and test them in rigorous academic ways later. For now, we‚re interested in your most wildly innovative ideas. The contest runs on the SEVEN website www.sevenfund.org. First round submissions are due by November 30th, 2008 and the second round of collaborative development runs from December 1, 2008 to January 7, 2009. The winner will be announced in January 2009 and receive $50,000. The funds will be awarded to all those who contribute to the winning idea, starting with the originator and continuing to nodes along the vine.

The Process & Contributions Competition Stages

Phase I –Initial Submission: July 15 – November 30, 2008

The first step to participating in the competition is to submit an idea. Participants may submit their ideas using the form at http://www.sevenfund.org/vine-form.php. Submitted ideas can take any form individual indicators, a complete framework for evaluation, an equation that can be used to input indicative information, anything you can come up with (see sample submissions below). We welcome your most innovative ideas!

Registrants may submit more than one idea. A word on the style in which submissions should be made: this is not an academic exercise. Submissions will be judged on clarity and conciseness. Initial submissions are limited to a maximum of 750 words, and should include a 100 word abstract. Submissions that are brief, address just one aspect of the discussion, or not comprehensive are also encouraged. Please provide brief citations for any sources you reference.

Phase II –Collaboration: December 1, 2008 – January 7, 2009

After November 30, 2008, all submitted ideas will be posted to a wiki and everyone who has submitted an idea will receive a username and password. During this period of collaboration, new and existing contributors can:

• Post new ideas
• Comment on an existing idea
• Combine ideas
• Refine and change ideas

Although new contributors are encouraged during this phase, the bulk of the financial reward will be dedicated for participants that submitted original ideas in Phase I. However, we hope that the teams that are formed during this phase will develop richer, more comprehensive models for evaluation. Final submissions of these combined, refined ideas will be submitted by January 7, 2009.

Phase III –Voting and Awards: January 2009

After January 7, we will close the wiki to further edits and close off registration. $50,000 in prizes will be awarded. The online community will be asked to select the top five finalists. From there, an expert panel of judges will make the final selection of awards.

Frequently Asked Questions

Where does the name VINE come from? Vines are growths based on long flexible stems; they possess nodal points of energy–absorbing leaves, are often opportunistic and light seeking; they are an adaptation to life in areas where small patches of fertile soil are adjacent to exposed areas with more sunlight but little or no soil; many require rock exposures and other supports, rather than investing energy in their own supportive tissue, to enable them to climb toward the sun, and flower. SEVEN aims to be a kind of rocky support to emerging market investments.

How will the funds be awarded? The $50,000 will be awarded to participants at critical nodes along the "vine" of the evolution of the winning idea; for example, the originator of the winning proposal might receive $20,000, with $10,000 each for two key editors/future contributors, and $2,500 each for the other four finalists.

What does a successful submission look like? Submitted ideas can take any form – individual indicators, a complete framework for evaluation, an equation that can be used to input indicative information, anything you can come up with. Below are two samples that provide examples of the wide diversity of styles that we encourage for submission:

Sample Submission A (word count 80):

EVALUTION CRITERIA	WEIGHTING
High integrity of entrepreneur	15%
Market growing at greater than fifteen percent annually	15%
Entrepreneur familiar with target market	10%
Little threat of competition in first three years	10%
Highly likely that venture can be acquired or go public	10%
Proprietary or high-tech product	8%
Entrepreneur attention to detail in materials and presentation	8%
Entrepreneur demonstrated leadership ability in past	8%
Entrepreneur philosophy compatible with VC culture	8%
Expected return of over 25% within five years	8%

Sample Submission B (word count 396):

VCs must refine their underlying model in order to take advantage of emerging market talent of smaller–sized businesses. The emerging market model should add three elements that differ from traditional funding models: low-cost screening, diverse sector expertise, and patient capital.

A typical VC is able to complete six to eight deals per year, due to the lengthy process of search, screening, and due diligence. Since the average investment size can be 2-10 times smaller in emerging markets, VC managers find themselves unable to leverage their time to earn comparable returns to developed markets. VCs should seek to hire university graduates in target markets to act as low–cost screens. Their job is to actively cast as wide of a net as possible, and to travel and meet entrepreneurs in person. With salaries ranging as low as US$5,000 per year, VCs can thus access a wider investment pool without wasting managers time. In addition, VCs should utilize an online business acumen test to further vet possible entrepreneurs. This will create a more robust short-list of investment opportunities than traditional models allow.

The vast majority of VCs are focused in the high-tech and clean–tech sectors, while the majority of emerging market SMEs are focused on agriculture, manufacturing, and services. VCs should therefore develop expertise in these areas, again using local, lower-cost talent. Many of these investments will require risk management, such as understanding climate risk or commodity price hedging, that competing VCs do not have. This will allow VCs to access investments in emerging markets with little competition from other funders

Finally, many emerging market SMEs struggle to offer a likely IPO or acquisition exit option. This has proven a major barrier to VC investment. One solution is for VCs to offer a "patient capital" fund that expands the return on investment horizon beyond the traditional Five and Seven years. Instead of a quick buy-sell model, VCs should target long-term sustainable ownership. As long as the investment is profitable, the VC can recoup its investment through dividends or smaller ownership sales. This will require more "patient" investors that have a similar longer-term horizon. Fortunately, there are a growing number of investors with this profile, including national development banks, private high–net worth individuals, and foundation investment funds. By specifying up front that an emerging market fund has a different investment horizon, VCs can access a wider range of attractive emerging market investments.

Who can participate in this competition? This competition is open to anyone who wishes to participate. Participants must register at http://www.sevenfund.org/vine-form.php.

Can I submit my ideas on behalf of an organization, or do I need to submit them as an individual? Both individuals and organizations are welcome to submit their ideas to the VINE competition.

Can I submit social metrics? Can I submit metrics on social impact? I am thinking about how to evaluate the impact of small businesses or social enterprises on poverty, development, or other social indicators.While social metrics are important and a worthwhile discussion, VINE is focused on determining a set of investment metrics to effectively assess Small and Medium Sized Enterprises. SEVEN Fund plans to hold a future competition that specifically addresses the need for a framework surrounding social metrics.

Can I submit metrics based on my experience working with SMEs in the United States or Europe? I think they would be applicable. Absolutely. We welcome submissions based on experience in any industry, geography, or pulled from any intellectual domain.

Who can I contact for more information? Questions about this competition can be directed to info@sevenfund.org.

Terms and Conditions

The SEVEN Fund has sole and absolute discretion to determine which submission entries, if any, merit an award. The SEVEN Fund reserves the right, in its sole and absolute discretion, to change, modify, extend or reduce the terms, dates and conditions of, or to suspend or terminate, the competition without prior notice. SEVEN will endeavor to inform participants of any such change, modification, extension, reduction, suspension or termination, as the case may be, through any media outlet deemed appropriate by SEVEN in its sole and absolute discretion. SEVEN further reserves the right to nullify and/or cancel any part or all of the competition if it appears that any fraud or malfunctions have occurred in any form whatsoever. Each participant undertakes to indemnify and keep SEVEN harmless from and against any loss, damage, claims, costs and expenses which may be incurred by or asserted against SEVEN as a result of such participant's participation in the competition. SEVEN is not responsible for the content of proposed ideas or submitted contributions.

12008 Global Venture Capital Survey, Deloitte and National Venture Capital Association).
2 http://rru.worldbank.org/Documents/other/MSMEdatabase/msme_database.htm
3 http://www.mavericksatwork.com/
4 http://catb.org/~esr/writings/cathedral-bazaar/
5 www.wikinomics.com