EC Project IFISE Venture Capital as a Policy Instrument: the European Challenge (or should Governments intervene?) Dr. Gordon Murray Entrepreneurship Department

EC Project IFISE

Venture Capital as a Policy Instrument:

the European Challenge

(or should Governments intervene?)

Dr. Gordon Murray

Entrepreneurship Department

London Business School

Dr. Gordon Murray: London Business School 2

But first, how do investors see the recent history in

high-tech venture capital?


Aaaaaaaaaaagggggghhhhhh!


In 2002, International Venture Capital is still on a roll(er coaster)

- re funds raised

- re finances disbursed

- re fund performance by sector

- re early-stage technology investments

- re the ability to exploit the IP of the European research base?


Going Up, or Going Down?


$0

$5, 000

$10, 000

$15, 000

$20, 000

$25, 000

$30, 000

$35, 000

1999_1 1999_2 1999_3 1999_4 2000_1 2000_2 2000_3 2000_4 2001_1 2001_2 2001_3

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

VC CVC x10 NASD Ind

Boom & Bust in the US: VC & CVC Investments 1999-2001

Mkt. shock


U.S. Venture Capital Investing & Fundraising

-20,00040,00060,00080,000

100,000120,000140,000

$'00

0

Invested Raised


European Venture Capital Investing & Fundraising

-5,000

10,00015,00020,00025,00030,00035,00040,000

$'00

0

Invested Raised


One Consequence of all this …

A flight to later-stage deals in Europe.

Especially very large MBOs

High tech is ‘out in the cold’ except life sciences


Example: UK MBO/MBI Deal Growth

0

100

200

300

400

500

600

700

800

0

5

10

15

20

25

30

35

40

45

No MBOs/MBIs Avg Value (£m)


Later-stage is …

a completely rational move for the profits- seeking venture capitalist


Larger the better: UK mature funds

Investment Stage

Number of funds

Pooled IRR

Mean IRR

Median IRR

Minimum Maximum Range Standard Deviation

Early Stage 17 8.2 6.9 8.1 -9.6 18.9 28.5 8.7

Development 34 9.1 4.6 4.8 -17.7 32.9 50.6 11.6

Mid MBO 27 16.4 15.7 14.9 -6.6 40.6 47.2 9.8 Large MBO 26 17.8 22.3 20.5 -3.0 67.3 70.3 15.3

Generalist 30 12.0 8.1 7.9 -9.9 32.0 41.9 9.8

All Funds 134 14.3 11.3 10.8 -17.7 67.3 85.0 13.1

Technology Funds only

26 9.8 10.2 9.1 -0.2 20.2 20.4 6.2

Source: LBS calculations Note: The table shows IRRs since 1980 for mature funds started before 1995.


Seed/Start-up remains a tiny part of VC Industry

European VC Investment, 1995-2001: Yearly Percentage Distribution by Stage

-10.0020.0030.0040.0050.0060.0070.00

1995 1996 1997 1998 1999 2000 2001

Startup/Seed Early Stage Expansion

Later Stage Buyout/Acquisition Other


However, Europe is getting more technology oriented …


High-Tech Investment as Percentage of Total Venture Capital Investment nb excludes MBOs

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

U.S.

Europe

U.K.


Not a bad recent European Investment record …

19.923.9

27.825.6

31.4

0

5

10

15

20

25

30

35

1996 1997 1998 1999 2000

Year

Perc

enta

ge T

otal

Inv

estm

ent

High Tech Investments

ex EVCA


and how do high tech entrepreneurs see the

current situation?

High-Tech Entrepreneur in finance raising mode 2002


and Governments’ view?


the World took seven days – this might take a little longer


“Spot the difference?” It has been represented to us that great difficulty is experienced by the smaller and medium sized businesses in raising the capital which they may from time to time require, even when the security is perfectly sound The expense of a public issue is too great in proportion to the capital raised, and, therefore, it is difficult to interest the ordinary investor

Less progress appears to have been made in meeting the needs of those requiring relatively small amounts of money or seeking seedcorn and early stage finance

The major commercial banks in most countries are reluctant to get involved in innovation financing...SMEs often suffer from both financing difficulties, at least at critical stages of their development, and structural weaknesses in their management capacity...


plus ça change (1931-1997) It has been represented to us that great difficulty is experienced by the smaller and medium sized businesses in raising the capital which they may from time to time require, even when the security is perfectly sound The expense of a public issue is too great in proportion to the capital raised, and, therefore, it is difficult to interest the ordinary investor

Less progress appears to have been made in meeting the needs of those requiring relatively small amounts of money or seeking seedcorn and early stage finance

The major commercial banks in most countries are reluctant to get involved in innovation financing...SMEs often suffer from both financing difficulties, at least at critical stages of their development, and structural weaknesses in their management capacity...


The funding of high potential ideas and young firms in technology remains a persistent European problem

- this is not going to be a quick fix


Firm’s Equity Financing needs over time

Ideas Business Business Industrial Mass

Dev. Creation Dev. Production Production

CAPITAL NEEDS

Family/own equity

Business Angels

Seed Capital

Development Capital

Pre IPO Funding

Stock Exchange Listing

TIME

}Equity

Gap


The reasons why early-stage is unattractive to most investors …


Start-Ups: The Cash Chasm


the skewed returns to three early-stage UK VC portfolios (N=42)

35.7%

7.1%

14.3%

7.1% 7.1% 7.1%

2.4%4.8%

2.4% 2.4%2.4%

7.1%

0%

5%

10%

15%

20%

25%

30%

35%

40%

-100/75 -50/-25 0/25 50/75 100/125 150/175 200/225 250/275

Achieved IRR % p.a.

Number of Investments

Project IRR = 0


-20

-15

-10

-5

0

5

10

15

20

25

30

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Years since firstinvestments

Annual Net Cash-Flows

Waves of private equity investments Total

Cash-flow profile of 10 waves of private equity investments (ex Burgel 2000)


Storey (1995) cites four problems which can make NTBFs a ‘special case’:

difficulties of the assessment of demand in highly

immature markets - risk

added uncertainties as investment covers both

development and marketing phases – (more) risk threat of accelerated redundancy in rapidly

changing technology-based sectors - (more)2 risk lack of managerial skills among entrepreneurial

scientists/technologists - (more)3 risk


Is Venture Capital a solution?


Not for Everyone: ex European Research Reports

• 1997-99, 1.3% of the external finance raised by UK SMEs came from venture capital

Bank of England “Financing of Technology Based Small Firms”2001 p9

• “Despite the rising trend and the increase in the share

of innovative companies, the number of enterprises financed by venture capital (in the Community) remains marginal”

The European Observatory for SMEs (6th Report) 2000 p163


VC is ‘exceptional’ even in the USA

EQUITYPrincipal owner 31.33%Business Angels 3.59%Venture Capital 1.85%Other Equity 12.86%

TOTAL EQUITY

DEBT FROM FINANCIAL INSTITUTIONSCommercial banks 18.75%Finance companies 4.91%Other financial institutions 3.00%

TOTAL DEBT FROM FINANCIAL INSTITUTIONS

TRADE CREDIT 15.78%

OTHER DEBTOther business 1.74%Government 0.49%Principal owner 4.10%Credit card 0.14%Other individuals 1.47%

TOTAL OTHER DEBT 7.93%

49.63%

26.66%


While VC is not the whole solution, it is important and needs to be more available

We know that Italy has limited VC finance compared to several other Western economies


Copyright © 2001, Paul D. Reynolds, S. Michael Camp, William D. Bygrave, Erkko Autio, Michael Hay and Kauffman Center for Entrepreneurial Leadership at the Ewing Marion Kauffman Foundation. All rights reserved.

Domestic Venture Capital Investmentas a Percent of GDP


Copyright © 2001, Paul D. Reynolds, S. Michael Camp, William D. Bygrave, Erkko Autio, Michael Hay and Kauffman Center for Entrepreneurial Leadership at the Ewing Marion Kauffman Foundation. All rights reserved.

Number of Companies Receiving Venture Capital in 2000


But Europe is starting to get serious


EC Work Programme 2000-2005

Entrepreneurs need finance to translate ambitions into reality. They need access to the right finance, at the right time throughout the entire life cycle of the enterprise. Yet … equity finance is still largely underdeveloped in Europe …

The US experience in seed capital, early stage finance and going public will be examined with a view to establishing benchmarks to identify shortcomings within Europe

Towards Enterprise EuropeCommission Staff Working paper

2000


and the reason why...

“Diversity is America’s strength. New ideas flow from its open

culture, superior university system, immigration and elsewhere.

Ideas are turned into innovations in many institutions including

large corporations, swarms of start-up companies and thousands of

public and private research labs. Funding for innovation is also

diverse with investments from thousands of venture capitalists,

angel investors and other sources of capital”

Joint Economic Committee Staff Report

“Entrepreneurial Dynamism and the Success of U.S. High-Tech”, 1999


A LONG WAY TO GO: Total Venture Capital Start-Up Funds and Informal Investments [US$]

0

200

400

600

800

1,000

1,200

1,400

1,600

SouthAfrica

Finland Sw eden Germany Denmark Ireland Norw ay Canada Australia UnitedKingdom

Korea Israel NewZealand

UnitedStates

Annu

al A

mou

nt p

er P

erso

n 18

-64

Year

s O

ld

Venture Capitol Start-up Informal Funds


Governments are starting to form much closer relations with Venture Capitalists.

In the case of the UK – very close …


Model of Government and VC Industry relations?


Relevant UK Legislation and Support

Present UK government has introduced reforms to the legal and tax structures of the UK which make Britain one of the most entrepreneur friendly countries in the world.

The government has been 100% supportive


Tony ‘one of us’ Blair - The Guardian, 1999


Contemporary UK Government Equity Initiatives for Small Business (list not exclusive)

• Enterprise Fund

• Community Development Venture Fund

• Regional Venture Funds

• Viridian Fund

• Coalfield Enterprise Fund

• Phoenix Fund

• Business Incubation Fund

• English Cities Fund

• National Business Angel Network


Business Angels – a private sector answer?


• The US has around 250,000 business angels investing

between $10-20 billion

• The UK has approx 18,000 investing around £500 million

• In continental Europe we have no reliable figures

• UK likely to be the biggest BA activity in Europe

Angels have pivotal role at the earliest stages:– No angels, negligible early-stage– Negligible early stage, less innovation– Less innovation, slower economic growth


ergo in Europe … The Seed/Start-Up Capital Supply

• At the earliest stages of investment – the sums

invested are trivial

• Europe does not have sufficient Business Angels to

substitute for formal VC at early-stage

• Even if entrepreneurs are prepared to pay, seed

capital is not forthcoming

a MARKET FAILURE in the supply of seed/start-up capital


Given the attractions of NTBFs –

this is not an acceptable situation for any developed European economy …


The Putative Attractions of New Technology

Based Firms

(Quality) Employment Growth

Efficiency of Innovation

Export Intensity

Regional Development

Reciprocal Relationship with Large Firms

Increase Industry Competitiveness


NB

It is not just high tech young firms which are desirable


1995-96 NET JOB GROWTH by Age and Type of Establishment(Acs and Armington, 2000)

150%

-15% -15% -12% -12% -10%-18%

143%

-7%-19%

-14% -15% -20%

-36%

-75%

-50%

-25%

0%

25%

50%

75%

100%

125%

150%

175%

200%

225%

250%

275%

300%

0-1 years 2-3 years 4-6 years 7-9 years 10-13 yrs 14-18 yrs 19 or older

Years of Age in 1996

multi-unit locations

single unit firms


Government is obliged to intervene

Venture Capital is too important to be left (solely) to venture capitalists


Venture Capital has ‘ubiquitous’ attractions to the State

A source of private investment for capital rationed

businesses (i.e. an alternative to banks & debt)

A means of supporting technology businesses

An additional financing source for fast growth young firms

An agent for industry restructuring via MBOs & MBIs etc.

A possible means of correcting regional developmental

disparities

VC is very seductive to policy makers


Classification of EUR Technology Support Schemes 2001

(ex TREND database)

Broad 69

(37.5%)

59

(32.1%)

Focused 33

(17.9%)

23

(12.5%)

Direct Indirect


Examples of ‘Direct’ support programmes

• Incubators

• VC early-stage funds

• NTBF grants & subsidies

• NTBF loans & guarantees

• Other schemes ( often, training, operations and

network promotion)


Channels of Policy ‘Delivery’

Several agencies are used to act as a medium for the transfer of resources to NTBFs including:

• Incubators• VC funds• Technology Transfer Organisations• Universities• Banks• Information networks and exchanges


Equity based Government programmes

Have the advantage of:

• Allows support directly and via intermediaries

• Addresses directly the SMEs’ financial constraint

• Can be targeted relatively precisely

• Government can take a different attitude to risk


However …

VC programmes may:

• Not go to those most needing the financial support• Risk programmes have uncertain outcomes• The existence of resources does not ensure effective

selection per se• Government support may still not make early-stage

investments attractive to experienced VC managers

NB There a presently few state supported VC exemplars outside Israel


A Number of Realities to Consider I

• Good management at the earliest stages of VC is very scarce

• Good projects to invest in are also very scarce• Ergo, attractive returns from seed and very early-

stage investments are rare exceptions, especially at the fund level

ooOoo

• It may be that a VC early-stage publicly supported fund needs to be relatively unprofitable if it is to do its job


A Number of Realities to Consider II

• The fixed costs in early-stage funds are penal• The opportunities to save costs are largely

illusory• It is not possible to do less due diligence and it

is not possible to save on quality management• Leverage of subordinated public funds will

assist but not resolve• Fund size addresses the fixed cost problem at

the expense of increasing minimum deal size.


Finally, some personal observations as a VC researcher and government adviser since 1990 …


Re Entrepreneurial Policy

• Specialist VC policy instruments without compatible tax &

company legislation will always be ineffective

• Whatever it is, do not make it complex to understand, apply

or administer for the entrepreneur

• Government should support, never actively invest

• Put in a review/monitoring facility immediately a new

programme is started

• Experiment with pilot programmes – be prepared to change

• Bring entrepreneurs & VCs into the discussions early


re Seed VC Funds

• Insist on private VC financial involvement

• Pay for quality VC management

• Ensure adequate capital rewards are available

• Recognise the best managers will not stay

• Require a fund strategy prior to funding

• Be careful of side-effects of guarantee schemes

• Model the returns and compare to VC’s plans

• Ascertain how follow-on funding is to be provided – before you need it

• Big is beautiful

• Regional funds are often political sense and commercial nonsense


re the Techi/University Entrepreneurs

• Insist on proper entrepreneurial training for scientists

• Concentrate on the hungry, not the established

• Talk about benefits not technology

• Place in tandem with professional managers

• Familiarise them with VC processes, inc. exit

• Educate the university’s senior management

• Don’t let universities gamble

• Think in terms of 10 year programmes


ITALY & the University of Pavia:

the very best of luck!

Documents

EC Project IFISE Venture Capital as a Policy Instrument: the European Challenge (or should Governments intervene?) Dr. Gordon Murray Entrepreneurship Department