Reshaping the UK economy

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Research report: June 2009

Reshaping the UK economyThe role o public investment in nancing growth

Yannis Pierrakis and Stian Westlake


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Reshaping the UK economy

The role o public investment in nancing growth

Foreword

There has been much discussion this week around public investment in high-growth start-ups.

The key challenge now is how to structure this type o investment and make sure it gets into thesystem eectively. Above all, public nance at this stage must lever private capital towards start-upbusinesses otherwise it will be a wasted exercise.

NESTAs position as the UKs largest portolio investor in pre-revenue companies, alongside ourresearch expertise, means we are uniquely placed to gain an insight into this area. This report

considers the most eective models o public nance supporting growth businesses.

Execution and implementation are all, and are what the market will be looking to.

Jonathan KestenbaumCEO, NESTA

June, 2009

NESTA is the National Endowment or Science, Technology and the Arts.

Our aim is to transorm the UKs capacity or innovation. We invest inearly-stage companies, inorm innovation policy and encourage a culturethat helps innovation to fourish.


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Executive summary

High-growth, entrepreneurial businessesare essential to the UKs emergence romrecession. But their success is dependent onseveral actors, one o which is the availabilityo appropriate nance. The availability ogrowth nance has declined drastically in the

credit crunch, and too little has been doneto revive it. It will be impossible to transormand rehabilitate the UKs economy without anequivalent change in our sources o capital.

This shortage will not resolve itsel. I letunchecked, it will undermine the innovativesectors on which the long-term growth o theUKs economy depends. Government has animportant role to play. Although there havebeen a large number o ailed attempts bygovernments to stimulate the nancing o

high-growth businesses, there have also beennotable success stories.

By drawing out the principles o theseexamples, this paper sets out a proposal thatoers a timely, ecient and smart way orthe Government to support and stimulateinvestment in high-growth companies.

The challenge or the UK is not to createnew high-growth start-ups, but how tosupport the continued growth o thesebusinesses. Doing so could provide avaluable economic stimulus.High-growth, innovative companies oer apotent answer to the economic challenges theUK aces.

They generate a disproportionately largeshare o net new jobs.1 Research suggeststhat between 2 to 4 per cent o all rms areresponsible or the majority o employmentgrowth. Their combination o high productivityand employment growth means that high-growth rms are also responsible or a

substantial proportion o economic growth.2

Innovative businesses will only thrive wherethe right nancial architecture is in placeThese high-growth rms require signicantcapital up-ront. And this is dicult to obtainthrough conventional sources o debt nance.These rms tend to have intangible assets

and ambitious growth plans that require largeamounts o nance, show a signicant delaybeore generating revenue and consequentlyentail high risk. As a result, savings areinadequate and debt nance is inappropriatebut venture capital is an alternative orm onance that is structured to address thesechallenges.3

Venture-backed businesses aredisproportionately important or growthThere are between 800 and 1,100 venture

capital-backed businesses in the UK. Theirhigh growth potential makes them vital to oureconomic uture. Over the ve-year period to2006/7, venture rms increased worldwideemployment by 8 per cent a year comparedwith the 3 per cent growth achieved by FTSEMid-250 companies. Their UK employmentgrew by 6 per cent, compared to a national riseo 1 per cent a year.4

Early-stage nance has been neglected andis sueringThe credit crunch has hit the venture capitalsector hard. Most UK investors in early-stagetechnology companies have already investedmost o their unds and are keeping mosto whats let or the ollow-on investmentsin those rms. And very little new moneyis coming into the market, since the rate atwhich new venture unds are raised has sloweddramatically. In 2008, VC undraising was down70 per cent on the previous year; 2009 looksset to be even worse.

What should the Government do?

The case or government support or venturenance is greater now than ever: private capital

4

1. Henrekson, Magnus andJohansson (2008) Gazellesas Job Creators a surveyand interpretation o theevidence. IFN Working PaperNo. 733.

2. BERR (2008) BERR EconomicPaper No. 3 - High GrowthFirms in the UK: lessons roman analysis o comparative UKperormance. London: BERR.

3. NESTA (2007) Makingmoney at the early-stage: thechallenge or venture capitalin the UK. NESTA PolicyBrieng. London: NESTA.

4. BVCA (2007) The EconomicImpact o Private Equity inthe UK 2007 Report: a surveyo 1,000 recipients o riskcapital. London: BVCA.


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is hard to come by and the uture o this vitalcohort o 1,000 growth rms is threatened.

Although there is a clear shortage onance or high-growth companies in thecoming years, and a gap that public supportcould ll, the Government should proceed

with cautionMany past interventions have allen oul o aew common problems: trying to achieve toomany goals; being sub-scale; limiting the poolo potential investments, being too generouswith public money. They have also sueredrom unrealistic time horizons. Avoiding thesepitalls is a prerequisite or any credible policyin this area.

The role o government is not to makesmart investments, but to make sure smartinvestments get made.

Six decades ater the rst governmenteorts to support nance to small andmedium-sized enterprises, there is stillno consensus as to what constitutes aneective model o government interventionThe report seeks to provide some light into thisissue by addressing the ollowing questions:

1. What should the Government do topromote nance to high-growth companiesand what choices does it ace in supporting

early-stage investments?

2. How can the Government create theconditions or investments in high-growthentrepreneurial rms?

3. How much money is currently needed inthe early-stage market? What orm shouldany investment take? Should governmentinvest directly or indirectly? Should anythird-party investment be in existing ornew unds? How should private capital beleveraged?

We address these questions in turn,highlighting the main issues and providingrecommendations, along with internationalcase studies o attempts to stimulate theventure market.

Finally, we propose the establishment o apublic-private und o unds, making useo the best o private sector experience andavoiding many o the pitalls o excessive directintervention. The proposal could be put into

action with an investment o 150 million opublic money, and would begin stimulatinggrowth businesses within a matter o weeks.


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Acknowledgements

We would like to thank a number o people or their contributions made to this report.

Francis Carpenter, the ormer CEO o the European Investment Fund (EIF) and senior advisor to

NESTA Investments, reviewed the report and provided helpul comments on drats.

Gilles Duruf, the President o the Public Policy Forum at North American Venture Capital Summit,provided us with inormation and material or the Canadian and other international case studies.

Yigal Erlich, the ounder and now chairman o Yozma, provided us with inormation about theYozma case study in Israel.

About the authors

Yannis Pierrakis is Head o Investments Research and Stian Westlake is Executive Director o Policyand Research at NESTA.


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Contents

Reshaping the UK economyThe role o public investment in nancing growth

Part 1: Overview 8

Part 2: The importance o growth businesses 9

Part 3: Small but mighty: the place o venture capital in the UKs nancial 11architecture

3.1 High-growth businesses have limited access to debt 11

3.2 The vital one thousand 13

3.3 New industries and venture capital 14

Part 4: The role or government in early-stage investment 15

4.1 The role o government 15

4.2 The impact o the global nancial crisis on UK growth nance 16

Part 5: Cautionary tales: the risks o public venture capital investment 19

Part 6: Eective public investment in venture capital 22

6.1 What works? A ramework or what the government should do 22

6.2 A proposal: the UK und o unds 29


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Part 1: Overview

This report addresses the question o how toencourage and support growth businesses to

lead the UK out o recession. In particular, itocuses on the nancial architecture necessaryto support growth, and demonstrates theimportance o a unctioning early-stage nancesector to the real economy. Although therehave been many misadventures in governmentattempts to nance early-stage businesses,global experience suggests that public supporthas an indispensable role to play, and that it ispossible to provide this support in a way that islimited, timely and eective.

We believe that:

a. it is impossible to achieve a transormationo the UK economy without an equivalentchange in our sources o capital;

b. there is a vital but limited roleor government in enabling thistransormation.

High-growth, innovative companies oer apotent answer to our economic challenges. Butsuch rms have oten had diculty obtainingnance, and these diculties have increasedconsiderably in the recession. The Governmentis now considering whether and how tostimulate investment in these businesses.

There are positive examples rom around theworld o how government can encourage early-stage investment, leveraging private capitaland helping high-growth rms grow aster. Butthere are also many examples o ailure. Thenal section o the report sets out principlesor how the Government can eectively

support the nancial underpinnings o a high-growth economy, concluding with a specicproposal that incorporates UK and international

lessons with NESTAs own practical experienceo venture capital investing.


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Part 2: The importance o growth businesses

Innovative, ast-growing companies are avital source o long-term economic growth

and job creation.5 They are also central to thevision o new industries set out in the WhitePaper New Industry, New Jobs. The UK willcontinue to be an economy driven by thecreation and exploitation o knowledge. Overthe last 15 years the contribution o high-technology manuacturing and knowledge-intensive services to UK gross value added hasincreased steadily to over 40 per cent.6 Thenature o these sectors is likely to change asglobal demand changes, and many o the bigprizes will be won by new rms rather than

incumbents.

High-growth rms are relatively rare in the UKeconomy. In 2005, there were 11,369 high-growth rms in the UK, representing 6.3 percent o all rms employing ten employees ormore.7 However, the impact o high-growthrms in the UK economy is very signicant.New evidence8 suggests that high-growth rmsin the period 2002-2005 created more thantwice the number o jobs than slower-growingbusinesses.9 The UK share o high-growthrms in 2005 is higher than in the UnitedStates 6.3 compared to 5.2 per cent. Indeed,it has the highest share o all other developedindustrial economies or which data is available.But only a minority o rms in the UK manageto sustain high levels o growth or more thana short period o time. The biggest challengeor the UK is not the supply o promising rms,but how to help them succeed.

A number o actors are important to thegrowth o innovative rms:

Access to knowledge. Proprietaryknowledge (whether o new technologies,business processes, or other know-how) is

requently a basis or rapid growth. Eectiveresearch universities with competent

technology transer oces are requentlyidentied as important sources o thisknowledge. Just as important is the ability togenerate breakthrough knowledge throughinterdisciplinary academic collaboration,or by eective models o open innovationamong rms and between rms anduniversities.

Skilled workorces. The skills agendaas highlighted in the Leitch Review10 isvital to the ability to build high-growth

businesses. Growing rms, especially inhigh-tech sectors, are prodigious consumerso talent. But technical skill alone is notenough. The mindset o the entrepreneuris equally important: the UKs ability tonurture entrepreneurs who think acrosstraditional disciplines and industries is vitalor innovation.

Eective inrastructure. Eectiveinrastructure or innovation is in some casesphysical; superast broadband supportingdigital media, or proximity to Stanstedairport helping Cambridge-based stem cellcompanies fy their bespoke products todistant hospitals. But more importantly,innovation is also driven by the networksand relationships that bind companiestogether. Take the role o eective supplychains. Toyotas supply chain is structuredin such a way that suppliers have strongincentives to innovate (they are oereda share in the savings); GMs traditionallywasnt, and is suering the consequences.Eective linkages between businesses and

organisations (such as universities, basicresearch laboratories, applied researchlaboratories, technology transer agencies,

9

5. NESTA (2008) Unlocking

the potential o innovativerms. NESTA Policy Brieng.London: NESTA.

6. Work Foundation (2006)Dening the knowledgeeconomy. London: WorkFoundation.

7. NESTA (orthcoming)Mapping rm growth inthe UK. London: NESTA.The denition o high-growth is that used by theOECD, reerring to rms thatincreased revenues 20 percent or more in each o thepast three years.

8. Ibid.

9. In act, in 2005-08 the gap

between these two groupswas less marked but high-growth rms still managed tocreated almost a quarter o amillion more jobs.

10. HM Treasury (2005) LeitchReview o skills in the UK:The long-term challenge.London: HMT.

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governance organisations, banks and venturecapitalists) are an important contributor toinnovative capability.11

Demand or innovation. Companies aremore likely to innovate successully i theycan count on deep markets or new products.

This is partly a question o simple marketsize: better access to local and internationalcustomers through strong supply chains andoreign trade helps. But even more importantis the extent to which customers demandinnovative products. The importance oAmerican consumers hunger or new goodsand services has been cited as an importantactor or the USs economic growth.12

Availability and access to nance. Manyo the most innovative rms have longstart-up phases. During this time, rms

incur development costs but little revenue.They also lack signicant assets that couldbe used as collateral or loans.13 This isparticularly true o high-tech businesses,which have oered some o the best growthopportunities over the past 30 years. Thismakes the question o nance central tothese rms ability to get started and tothrive.

The nancial element is particularly crucial,and it is on this actor that we will ocus in this

report. Public policy has dedicated signicantenergy to opening regional and global marketsor trade, attempting to ll skills gaps,promoting academic science and technology,and developing inrastructure. The provision onance or high-growth start-ups is a tougherchallenge. As the White Paper, New Industry,New Jobs, states: For this reason, access tonance is an important barrier or business todevelop their ull potential and the governmentclearly states that any constraint on the abilityo UK-based businesses to exercise comparativeadvantage on the basis o high levels o skillsor knowledge must be regarded as a seriousimpediment to the UKs economic success.14

11. Cooke, P. and Morgan, K.

(1998) The AssociationalEconomy: Firms, Regions,and Innovation. Oxord:Oxord University Press.

12. Bhide, A. (2008) TheVenturesome Economy.Princeton: PrincetonUniversity Press.

13. Oakey, R. (1984) Innovationand regional growth insmall high technology rms:evidence rom Britain andthe USA. Regional Studies.18, pp.237-251.

14. HM Government (2009)New Industry, New Jobs.White Paper. London: TSO.p.10.


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Part 3: Small but mighty: the place o venture capital inthe UKs nancial architecture

To understand how the UKs nancial systemneeds to change to support innovation and

growth, we need to consider the UKs nancialarchitecture as a whole.

There are three main sources o nanceavailable to business:

Debt nance most commonly the provisiono a loan o some orm that is subsequentlyrepaid at a pre-agreed interest rate. Thesemay be available rom a High Street Bankor specialist nance providers. There aremany sources o debt nance: the corporate

bond market or the largest rms; banknancing acilities; small business loans; andsmall-scale entrepreneurs nancing theirbusinesses through remortgaging or creditcard debt.

Equity nance whereby capital is providedto the company in return or a shareholdingin the business by corporate investors,business angels, venture capital/privateequity or public sector schemes. There area wide range o services provided by thepublic markets, accessible through fotationsor other share issues by the largest rms,through private equity, leveraged buy-outs,management buy-outs and buy-ins.

Sot capital typically associated withgrant unding or nancial subsidies providedrom the public sector through grants, R&Dtax incentives, innovation vouchers or othermeans. Such nancial support is typicallyavailable through Regional DevelopmentAgencies, government departments anddevolved administration departments in

Scotland and Wales.

New high-growth rms need dierent kindso support depending on their stage o

development. They thrive i there is a smoothprogression rom one type o unding tothe next.15 Figure 1 (page 10) illustratesthe journey o company growth rom ideageneration to protability. Dierent sources ocapital are relevant at dierent stages o therms development. The ormer Departmentor Innovation, Universities and Skills describedthis as an escalator o nancial support orinnovative businesses at dierent stages otheir growth.16

The red boxes in Figure 1 represent thosesteps where nance is hardest to obtain. Theyneed particular attention rom policymakers.Most investors and entrepreneurs observethat an equity gap exists or investmentsrom 250,000 to 2 million; others haveidentied a second equity gap that stretchesup to 5 million (especially or the medical andpharmaceutical sector).

3.1 High-growth businesses havelimited access to debt

At rst glance, nance or growth businessesappears to present only a limited problem. Arecent European Commission report17 showedthat only 19 per cent o UK small and medium-sized enterprises saw limited access to nanceas a constraint. Although this gure was higherthan that in other European countries (it wasjust 7 per cent and 9 per cent respectively inFinland and Denmark), it at least implied thatthe vast majority o the UK rms are able to

secure external nance.

11

15. CBR (2009) Start-upnance: The role o MicroFunds in the nancing onew technology-basedrms. Cambridge: CBR.

16. DIUS (2008) InnovationNation. White Paper.London: DIUS. p.38.

17. European Commission(2009) DG Enterprise andIndustry, Interim Evaluationo the entrepreneurship andinnovation programme.Final Report. Brussels: EC.


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18. CBR (2008) Financing UKSmall and Medium-sizedEnterprises: the 2007Survey. Cambridge: CBR.

Figure 1: Business nance architecture

Figure 2: External sources o nance percentage o business using various nancial products

100k

500k

50k

10k

2m

100m

10m

5m

1m

Concept and

seed stage

Start-ups Early-stage Later-stage Expansion

Amounts

invested

PrivateEquity

Banks

Grants

Idea

generation

Idea

evaluation

Product

development

Product

launching

Expansion &

marketing

Profit

generation

Main sources of capital Gaps

Private Venture

CapitalBanksPublicly backed

Venture Capital

Private VentureCapital

Banks

BusinessAngels

VentureCapital

Banks

30

20

10

0

50

60

40

2004 2007

Creditcards

Overdrafts

Commercial

loans

Leasing/HP

Grants

Factoring/

invoice

discounting

Equityfinance

55

43

53

42

24

19

27

18

65

34

3

1

Percentage

Source: CBR 200818


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However, this gure conceals a dierencebetween dierent types o rm. As Figure 2shows, the majority o rms accessing nancerelied on small-scale debt nance: credit cards,overdrats and commercial loans.

The high-growth rms described in Section 2

oten do not t into this category, especiallyin their early years. These companies requiresignicant capital up-ront. And this is veryhard to obtain rom conventional sources odebt nance. They tend to have intangibleassets, and show a signicant delay beoregenerating revenue making than a high riskinvestment.

These rms are, o course, some o the mostattractive growth prospects, and include start-ups in the inormation technology, lie sciencesand advanced engineering sectors. They rely on

early-stage equity nance: venture capital andangel investment.

Only a small proportion o businesses seekor receive venture capital nance.19 But iwe are concerned about the oundation onew industries and the delivery o dramatic,transormative growth, we should ocus onthese particular companies.

Creating new industries also requires sustainedinvestment over the long-term, continued

commitment and long-term resources. Thesemiconductor and microcomputer industriesare good examples o this lengthy and

capital-intensive process.20 In both cases, ittook up to ten years o continued risk capitalinvesting beore the industries properly tooko. Virtually every other new industry since biotechnology, personal computers, PCsotware, wireless communications, the Internet have ollowed this pattern.21

3.2 The vital one thousand

Dierent estimates put the number obusinesses in the UK that are reliant on venturecapital at between 880 and 1,100.22 These rmsplay an important role in economic growth andjob creation.

The largest recent survey showed that over theve years to 2006/7, rms backed by venture

capital increased their worldwide employmentby 8 per cent per year, a much higher rateo growth than the 3 per cent reported bymost mid-sized companies. Venture-backedrms UK employment also grew by 6 percent, compared to a national annual rise inemployment o 1 per cent.23

The evidence rom the US, where ventureactivity has a longer pedigree, is even morecompelling. The largest study showed thatAmerican companies that received venture

capital rom 1970-2006 accounted or 10.4million jobs and $2.3 trillion in revenues in2006.24 The total revenue o venture capital-

13

19. European Commission

(2009) DG Enterprise andIndustry, Interim Evaluationo the entrepreneurship andinnovation programme.Final Report. Brussels: EC;and CBR (2008) FinancingUK Small and Medium-sized Enterprises: the2007 Survey. Cambridge:CBR.

20. Bygrave, W. and Timmons,J. (1992) Venture Capital atthe Crossroads. Cambridge,MA: Harvard BusinessSchool Press.

21. Timmons, J. and Spinelli,S. (2003) New VentureCreation: Entrepreneurship

or the 21st Century. NewYork: McGraw-Hill.

22. Dow Jones as per January2009.

23. BVCA (2007) The EconomicImpact o Private Equityin the UK 2007 Report: asurvey o 1,000 recipients orisk capital. London: BVCA.

24. Global Insights, NVCA(2007) Venture Impact:The Economic Importanceo Venture Capital BackedCompanies to the U.S.Economy. Arlington, VA:NVCA.

25. Bygrave, W. and Timmons,J. (1992) Venture Capital at

the Crossroads. Cambridge,MA: Harvard BusinessSchool Press.

Figure 3: Semiconductor Industry: Cumulative Number o Venture Capital Investments andIndustry Shipments

40

30

20

50

10

0

4

3

2

5

1

0

1960 1962 1964 1966 1968 1970 1972 1974 1976 1978

Investments Shipments

Shipments($ billion)

Cumulativenumber of

investments

Surge ininvestments

Surge inshipments

Intel 1968

Source: Bygrave and Timmons 199225


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nanced companies comprised 17.6 per cento the nations GDP and 9.1 per cent o USprivate sector employment in 2006. Venturecapital-backed companies outperormed

their non-ventured counterparts in jobcreation and revenue growth. Employmentin venture-backed companies jumped by 3.6per cent between 2003 and 2006 as nationalemployment grew by just 1.4 per cent. At thesame time, venture capital-backed companysales grew by more than 11.8 per cent,compared to an overall rise in US companysales o 6.5 per cent during the same period.

High-growth rms that rely on venturecapital also have an important impact oninnovation. A variety o studies have shownthat venture-backed rms are responsible ora disproportionate number o patents andnew technologies, and bring more radicalinnovations to market aster than lower-growthbusinesses that rely on other types o nance.27This is partly because high-growth rms aremore likely to rely on venture unding becauseo their unique nancial needs, and partlybecause venture capitalists use their infuenceas shareholders and business networks toencourage rapid growth and proessionalmanagement.

3.3 New industries and venture capital

High-growth, venture-backed rms are alsomore likely to generate new industries.28

Examples include personal computers, cellularcommunications, microcomputer sotware,biotechnology, and overnight delivery.29 Inthe words o one US survey, their eectshave included the creation o hundreds othousands o new jobs, new expenditures orresearch and development, increased exportsales, and the payment o hundreds o millionso dollars in state taxes. By mobilizing and laterrecycling scarce risk capital and entrepreneurialtalent, venture capital rms have transormedthe economy.30

Some venture capital-backed companies createproducts so revolutionary that they gavebirth to new industries; others bring aboutevolutionary change in existing industries.31Venture capital has played an important rolein the development o some o the mostsignicant scientic inventions and importantindustries o our times. It is one o the crucialingredients in the mix o scientic discovery,entrepreneurial talent and nance that drivesnew industries, and has sometimes createdideas and inventions powerul enough to

transorm society.

26. Ibid.

27. Kortum, S. and Lerner,J. (2000) Assessing thecontribution o venturecapital to innovation. RANDJournal o Economics. Vol.31, No. 4, Winter 2000,pp.674692; Hellman,T. and Puri, M. (2002)Venture capital and theproessionalisation o start-ups: Empirical Evidence.Journal o Finance. 57,pp.169-197; Kaplan, S.and Stromberg, P. (2001)Financial contracting meetsthe real world: an empiricalanalysis o venture capitalcontracts. Review oEconomic Studies. 2002,pp.1-35.

28. See Ibid; and Timmons,J. and Spinelli, S. (2003)New Venture Creation:Entrepreneurship or the21st Century. New York:McGraw-Hill.

29. Bygrave, W. and Timmons,J. (1992) Venture Capital atthe Crossroads. Cambridge,MA: Harvard BusinessSchool Press.

30. Ibid. p.2.

31. Ibid.

Figure 4: Minicomputer Industry: Cumulative Number o Start-up Companies and IndustryShipments

80

60

40

100

120

20

0

1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980

Startups Shipments

1.5

1

0.5

2

2.5

0

Dec. 1957

Surge instartups

Surge inshipments

Shipments($ billion)

Cumulativenumber of

startups

Source: Bygrave and Timmons 199226


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32. Lerner, J., Moore, D. andShepherd, S. (2005) Astudy o New Zealandsventure capital marketand implications or publicpolicy. Report to theMinistry o Research Scienceand Technology. Wellington:LECG Ltd.

33. Pierrakis, Y. and Mason, C.(2007) Shiting sands: The

changing nature o the earlystage venture capital marketin the UK. London: NESTA.

Part 4: The role or government in early-stage investment

I the story were as simple as this, the messageor policymakers would be clear: stand back

and give venture capital unds ree rein toinvest, delivering prot or themselves andgrowth and innovation or the rest o theeconomy. However, the situation is morecomplex.

As Josh Lerner o Harvard Business Schoolremarked: It is instructive to observe that allventure capital markets o which we are awarewere initiated with some orm o governmentsupport. These markets do not appear toemerge without some orm o assistance.32

This section will outline the role o publicmoney in the UK early-stage nance market,and how the credit crunch has exacerbated themarket ailures that public intervention sets outto address.

4.1 The role o government

The existence o an equity gap the inabilityo small rms to access the nance they needto grow has been a long-term challenge orUK governments. Successive administrationshave acknowledged the importance o theventure capital industry and implementedvarious initiatives in support o early-stageventure capital investment, including seed andstart-up unding. But six decades ater the rstgovernment intervention in support o nanceto SMEs, there is still no consensus as to whatconstitutes an eective model o governmentintervention.

Around the time o the Second World War,government thinking ocused on plans toinstitutionalise business nance, by creating

new organisations to provide unding to smalland medium enterprises (the Industrial and

Commercial Finance Corporation, ICFC, whichlater evolved into 3i). Tax incentive schemesto promote investments and the availabilityo external nance to business were originallyintroduced in 1983 and were replaced in the1990s by the Enterprise Investment Schemeand Venture Capital Trusts. Towards the end othe 1990s, a number o new initiatives wereintroduced, targeting dierent sub-segmentso the early-stage market, namely the regionalVenture Capital markets (Regional VentureCapital Funds), university spin-outs (University

Challenge Funds) and very small businesses(Enterprise Guarantee Funds).

The introduction o Enterprise CapitalFunds (ECFs) in the new century saw theGovernments ocus shit to incentivisingprivate investors to co-invest with publiclybacked venture unds, in the case o ECF byproviding 2:1 matching o private capital. Theeect o this and other policies has been toshit public sector investment rom stand-alonepublic sector unds to co-investment withprivate investors.33 This includes both ad hocco-investing by ree-standing public sectorunds with private investors as well as co-investment unds which are required to investalongside private investors.

The public sector has become considerablymore important as an investor in both absoluteand relative terms. Investments involving publicsector unds, both as sole investors and withprivate investors (unds and individuals), haverisen rom 18 per cent o all venture capitalinvestments in 2001 to 43 per cent in 2007. In

short, private sector unding has become lesssignicant, although still important, and publicsector venture capital unds are becoming


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34. Ibid.

35. See Eurochambres (2009)at: HYPERLINK http://ec.europa.eu/enterprise/e_i/news/article_8750_en.htm http://ec.europa.eu/enterprise/e_i/news/article_8750_en.htm

36. CBI (2009) Access tonance survey. January2009. London: CBI.

37. Pierrakis, Y. and Harrison,A. (2009) Venture CapitalFundraising Activity Slows in2008. London: NESTA.

38. Ibid.

39. Pierrakis, Y. and Mason, C.(2007) Shiting sands: Thechanging nature o the earlystage venture capital marketin the UK. London: NESTA.

more important but changing their approachrom investing on a ree standing basis toco-investing with business angels and privatesector unds.34

The credit crunch has made government actioneven more relevant to the nancing o early-

stage businesses. As we shall see below, ithas made private capital or venture nance ascarce and dwindling phenomenon.

4.2 The impact o the global nancialcrisis on UK growth nance

Many small businesses ace nancial challengesin the recession, as banks (the main source ocredit or most smaller rms) become morerisk-averse. In early 2009, some 30 per cent o

small rms aced liquidity problems,35 and theCBI36 predicts that the availability o nancewill worsen or UK businesses: 28 per cent orms that took part in their survey expect thatexisting nance availability will tighten urtherwhile 60 per cent expect availability o new andrenewed credit to decline.

But the eect on high-growth rms and theequity capital on which they depend has beeneven more damaging. NESTAs research hasshown that existing venture unds have very

little money remaining to invest, and that therate at which new venture unds are raised hasslowed dramatically.37 All o this raises severechallenges or the cohort o 1,000 high-potential rms, most o which will require newnance in the next 12-18 months.

We will look rst o all at the causes o thisunding collapse, and then at its eects.

The parlous state o nance or early-stagerms in the UK is a unction both o the directeects o the credit crunch and o longer-term trends. As we shall see, venture capitalinvestment in the UK has paradoxically beenhit both by the prolonged availability o cheapdebt beore the crunch, and by its suddenevaporation.

The eect o the credit crunch and theaccompanying downturn is the most obviouscause. Falling stock markets and poorer tradingenvironments make it harder or unds tosell or foat their existing investments, whichthen require urther investment to keep them

running, severely limiting the amount availableor new investments. In addition, some undslimited partners (nancial investors) are

suering in the current liquidity crisis; there isanecdotal evidence that this too is aectingtheir ability to und urther investments.38Finally, some observers have also noticed atrend or institutional investors (who providethe money or some venture capital unds) toreduce the amount o money going into private

equity o all kinds, which makes it harderto raise venture capital unds (even thoughthe bulk o the asset class is dominated byleveraged buy-outs, a very dierent type oinvestment).

The eect o the credit crunch on othersources o venture unding, such as angelinvestors, has not been studied in depth, but itseems likely that the poor perormance o mostasset classes in recent years will leave theserich investors with less money to invest in high-growth rms.

The recent alling o o venture capitalunding is particularly damaging because itcomes on the back o a long-running period odisinvestment in UK early-stage nance on thepart o many unders.

Although equity investments in unquotedcompanies trebled between 2003 and 2007rom 4 billion to nearly 12 billion, thisexpansion in investment activity has been inprivate equity rather than venture capital,

propelled by a huge increase in undingor leveraged buy-outs. Large, leveragedinvestments are nancially attractive to unds,particularly i they generate ees based on theirtotal assets under management: a 1 billionund doing leveraged buy-outs will generatemore income than a 75 million und backing asimilar number o early-stage businesses.

This has had the eect o driving up theaverage (mean) size o investment to 9million in 2007, more than twice its 2001value.39 This trend has gone even urther inthe credit crunch, with entrepreneurs reportingventure unds taking equity stakes in revenue-generating technology rms in return orworking capital eectively lling the rolenormally played by banks rather than thetraditional role o early-stage investors.

Early-stage investments have allen since2000 as a proportion o total private equityinvestment (apart rom in 2006) and their shareo total investment activity has been less than5 per cent in recent years (Figure 5).

The variability o returns on ventureinvestments has also limited levels o


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1717

40. Venture capital und returns

or the period 1980-1997were positive with 13.3 percent Internal Rate o Return(IRR). During the periodater the bubble burst,the returns were negativewith an average IRR o-6.6 per cent. This negativeperormance brings downthe overall IRR. The vastmajority o investment inthis area 3.3 billion or60 per cent o total venturecapital investment intothe UK by independentunds was in this particulartimerame (1998-2001). Itappears as though venturecapital is starting to break

through the J-curve on2002/2003 vintages witha pooled return o 0.3 percent on these still immatureunds. See BVCA (2009)Benchmarking UK VentureCapital to the US andIsrael: what lessons can belearned? London: BVCA.


investment. Much o this has been caused bythe very poor returns on investments madeduring the 1998-2001 technology bubble:given the long-term nature o venture capitalunds, the eects o these deals continued tobe elt through the 2005. Although there issome evidence that perormance is beginning

to improve, it will take longer or und returnsto rise signicantly, since the rst unds raisedater the bubble (the 2002-03 vintage) areonly just beginning to show returns, andeven these may be too early to iner overallperormance.40

The consequence o all o this is a dramaticshortall in the unds available or venturecapital investment. As Figure 6 shows, 2008saw a sharp drop in the amount o moneyraised or venture capital investment.

At the same time, existing unds are largelytapped out. Thirty-nine unds have been

actively investing in the early-stage space overthe last ve years. NESTA research suggeststhat there are only 13 that have over 5 millioneach let to invest and the total remainingcumulative unds available or investment arein the region o 400 million.41 In many cases,these unds are being reserved or unplanned

ollow-on investment in portolio companies,and are unavailable to und new growth.

These and other actors aecting the widerinvestment market have led us to conclude thatunding or early-stage technology companiesis already extremely low. The trend is likely tobecome more evident in 2009 as ewer undsare closing and signicantly less money isavailable to rms. This underlines the need oremergency support to ensure that some o theUKs most promising technology can surviveand thrive.

Figure 5: Early-stage investments as a percentage o total investments, 1984-2008

20

15

10

25

30

5

0

1984

Percentage

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Years

Early-stage investments as percentage of total investments

Source: Data rom BVCA Investment Activity Reports various years


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8

42. Ibid.

Figure 6: Early-stage undraising

800

600

400

1000

1200

200

0

2004 2005 2006

Years

2007 2008

50

45

40

35

30

25

20

15

10

5

0

Amount raised (m) Average size of fund (m) Number of funds closed

38

31

44

26

7

16

612

21

2322

1010

649

29

646

179

Source: NESTA 200842


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Part 5: Cautionary tales: the risks o public venturecapital investment

Although there is a clear shortage o nanceor high-growth companies in the coming

years, and a gap that public support could ll,the Government should proceed with caution.Governments attempts to stimulate the early-stage nance market have a chequered history.It is important to take on board the lessons opast policies when considering how the statecan create a supportive environment or growthcompanies.

Many past interventions have allen oul o aew common problems: trying to achieve toomany goals; being sub-scale; limiting the pool

o potential investments; being too generouswith public money; and having unrealistictime horizons. Avoiding these pitalls is aprerequisite or any credible policy in this area.

The tyranny o multiple objectivesMany publicly backed unds (e.g. RegionalVenture Capital Funds and University ChallengeFunds) have multiple objectives: they mayseek to deliver both a commercial and a socialreturn, or to encourage regional development.43NESTAs experience o running and investing inunds suggests that it is very dicult to makesuccessul investment while also pursuing otherobjectives. Indeed, the more objectives a undhas (either explicitly or tacitly), the less likely itis to satisy any o them. Explicit non-nancialobjectives also make it harder to recruit anappropriate team: at present, investmentproessionals with the skills to undertakeeconomic development work are rarely thosewith the best track records o backing anddeveloping protable companies.44

Size matters45

Public unds also requently suer romproblems o size. Firstly, they can be too smallto operate eectively, either not being able

to invest enough to justi y their operatingcosts, or not spending enough on sta

and operations to make good investments.Secondly, small unds are particularly likely tomake small investments, which can oten besel deeating, as investees spend too muchtime looking or their next unding round andnot enough time building their business. Thedrip-eed model o nance, which is otenjustied as allowing investors to keep a closeeye on company perormance, oten has theopposite eect, ocusing management teamson nancial issues that have nothing to do withthe operations o the rm.

In a typical venture capital und, the generalpartners receive an annual management eeo up to 2 per cent o the committed capital,which is applied to the rms operations.Thereore, a venture capital und should havea minimum 30 million under managementwhich will provide a 600,000 operating annualbudget. This could sustain the unds entireoperations, including salaries, overheads,marketing, investor management and meetingregulatory requirements.

But a 5 million und (such as the UniversityChallenge Funds) would not have this ballast.At this level annual income would be just100,000, barely sucient to cover basicadministrative costs, let alone recruit the talentnecessary or success.

Geographical limitations constrain returnsA number o publicly backed unds aregeographically ocused, with a requirement toconcentrate on certain English regions or UKnations. Although venture capital certainly

has a role to play in stimulating regionaleconomies, limiting unds to regions hassignicant risks. Firstly, it is oten associated

43. NESTA (orthcoming)Lessons Learned Booklet1: On Building a SuccessulEarly-Stage Fund. London:NESTA; and CBR (2009)Start-up nance: The role oMicro Funds in the nancingo new technology-basedrms. Cambridge: CBR.

44. NESTA (2008) StimulatingVenture Capital. London:

NESTA.

45. From NESTA (orthcoming)Lessons Learned Booklet1: On Building a SuccessulEarly-Stage Fund. London:NESTA.


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46. Mason and Pierrakis(orthcoming) VentureCapital, the Regions andPublic Policy: The UnitedKingdom since the Post-2000 Technology Crash.

47. Extracted rom NESTA(orthcoming) LessonsLearned Booklet 1: OnBuilding a SuccessulEarly-Stage Fund. London:

NESTA.

with being sub-scale and having mixedinvestment objectives, as outlined above.Secondly, it constrains unds ability to sourcehigh-quality investments: economic activityrequently crosses the borders betweenregions, which in the UK are relatively smallin geographic terms. This means that a und

that can only invest in its local region is likelyto turn down many potentially attractive butnon-local investments it encounters, reducingits chances o striking good deals.

Geographically bounded unds are also aactor in a wider and potentially troublingphenomenon: the predominance o publicunding in particular UK regions. Figure 7below shows that the overwhelming majorityo early-stage venture capital investmentsin many UK regions and nations are publiclybacked. This in itsel is not necessarily

a cause or concern: i the alternative issensible investments not being made, publicintervention may be justied. But combinedwith the other concerns about public unds(in particular, the vitiating eect o mixedobjectives and small und size on investmentquality), this becomes more problematic.

Over-generous public support weakensincentivesCash-strapped entrepreneurs unsurprisinglywelcome public investment when privateinvestment is scarce. But it is possible toinvest too much public money into a und. TheCanadian Labour Fund programmes made a

disproportionately large contribution throughtax credits into public-private unds. This over-generous contribution allowed private investorsto borrow the contribution that was required othem, and use the unds management ee tooset part or all o the cost o borrowing. Thusthey were ahead even beore the und beganto make returns, which severely weakened theirincentives to make smart investments, anddeeated the object o involving the privatesector in the rst place. There is a strong caseor requiring a signicant private investmentinto unds to ensure incentives are well aligned.

Many early-stage unds grosslyunderestimate how long it takes to exit aninvestment47

Public investors should be aware that ventureinvesting is a long-term proposal, unlikelyto deliver returns to politically convenient

Figure 7: Publicly backed early-stage investments as a proportion o all early-stageinvestments in the UK regions, 2000-2008

Wales

North West

Yorkshire

West Midlands

Northern Ireland

North East

Scotland

East Midlands

South West

East of England

South East

London

0 20 40 60 80 100

PercentagePublicly backed deals in early-stage

Source: Mason & Pierrakis 200946


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timetables. The average time required or aventure-backed company to exit has morethan doubled in the last ten years, rom 4.2years in 1999 to 9.6 years in 2008. Even highlysuccessul technology-based companies cantake seven to eight years rom seed-stage toexit. It is not uncommon or lie sciences start-

ups to conduct ve to seven years o trials; thecompany may not generate revenue until yearsater the initial investment, let alone providea return when the investor wishes to sell hisstake.

With meaningul realisations or a und unlikelyto occur until its sunset years, any early-stageunds that expect to achieve exits (and initialreturns) within a ew years are destined orailure. This can pose a challenge or publicly-backed unds, which can be subject to theshorter time horizons and resource constraints

demanded by politics and external events.With perormance management commonin public policy, publicly-backed unds areoten required to measure and report theirperormance within years o their launch. Doingso is both inappropriate and counterproductive:a und may be perceived to be a ailure i ithas not achieved any exits or return ater aew years o investing. At best, this will be adistraction; at worst, it may compromise theunds ability to make its existing investmentspay o.

The shortcomings o many publicly backedschemes to stimulate early-stage investmentoer valuable lessons or the uture. We cannotaord to waste our limited resources and ignorethe hard-earned lessons o previous unds andpolicies. Just as important is identiying whatdoes work. This is the ocus o the next section.


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Part 6: Eective public investment in venture capital

6.1 What works? A ramework or whatthe government should do

In the previous sections, we identied thecase or public intervention to help ll thegap in nance or growth companies. We alsoexamined some key ailings o past policiesintended to encourage early-stage investment.

So, what should the Government actually do?How can the Government create the conditionsor investment in high-potential entrepreneurialrms?

Public investments are essential to ll thecapital gap48 and may serve a bridgingunction to acilitate external privateinvestments in early-stage business.49 Throughits programmes, the Government ought tocomplement rather than compete with theprivate sector.50 Its role should be to create thenecessary conditions to attract private investorsthrough incentives, lower risks and guaranteedrewards.

This chapter begins by setting out threeprinciples or intervention, continues byillustrating the various choices that agovernment has to make when choosingwhat to do, and concludes by illustrating theproposed design and structure o investment.

Principles or interventionGiven the challenge acing high-growthbusinesses in the UK, the constraints that therecession is putting on public budgets, andthe diculties o previous public investmentprogrammes that sought to pick winners, thereare three principles that should guide public

support or early-stage investment:

1. TimelinessProgrammes that take several months or

years to deliver investment to businesses willnot meet the needs o todays growth rms. Inthe words o James Foster, Chie Executive oXMOS, one o the UKs leading semiconductorstart-ups: The recession has severely cutventure unding or innovation, and new ideasare not getting unded. This industry willbe dead in a years time unless something isdone51 about investment. This means that theset-up time o any proposed intervention isvitally important.

2. DiscernmentEarly-stage investment depends on the abilityto identiy good investments and managethem well. The role o government is not tomake smart investments, but to make suresmart investments get made. Any interventionrelying on public money must ensure that itnds its way to companies most likely to growand prosper regardless o how the investmentis allocated.

3. EciencyGiven the increasing pressures on governmentspending, any proposed solution must makethe best possible use o government money.Each pound o public money should leverageas much private money as possible. Anyintervention should be as time-limited aspossible, encouraging private investment totake its place.

The choices acing the GovernmentGovernment aces a number o choices insupporting early-stage investment. Any schemethat aims to help ll the nance gap and

encourage a unctioning market to emergemust address the ollowing questions:

48. Pierrakis, Y. and Mason, C.

(2007) Shiting sands: Thechanging nature o the earlystage venture capital marketin the UK. London: NESTA.

49. Toole, A. and Turvey, C.(2009) How does initialpublic nancing infuenceprivate incentives or ollow-on investments in earlystage technologies? Journalo Technology Transer.2009, 34, pp.43-58.

50. For urther readingsee: Lerner, J. (2002)When bureaucrats meetentrepreneurs: the designo eective public venturecapital programmes. The

Economic Journal. 112:F73F84; and Cressy, R. (2002)Funding gaps: A symposium.The Economic Journal.112(477) (February),pp.1-20.

51. In an interview with NESTAresearchers conducted inJune 2009.


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52. We used the Library Housedatabase (which has nowbeen acquired by DowJones, Venture Source)to obtain these data. Theamounts invested in someo those companies areundisclosed and thereorethe total amount invested ishigher than 354 million.

53. The amounts invested in

some o those companies areundisclosed and thereorethe total amount invested ishigher than 620 million.


How much money is needed?

What orm should the money take?

Should government investment be direct orindirect?

Should indirect investment be in existing ornew unds?

How should private capital be leveraged?

We address these questions in turn,highlighting the main issues and providingrecommendations, along with case studies oattempts to stimulate the venture market inIsrael, New Zealand and Canada that cast lighton the issues.

How much money is needed?

As described earlier, between 2007 and 2008the amount invested in venture capital undsell by over 450 million.

In 2008, 190 companies received at least52354 million in venture capital unding round1 investment with a median investment o850,000. In addition, 234 companies receivedat least53 641 million in urther unding(unding rounds 2, 3 etc.). In this case, themedian investment is 1.7 million.

In general, between a quarter and a third oall venture capital amounts are invested innew companies each year (Table 1) and theremainder goes in ollow-on investments.

In section 4.2, we saw that the total remainingcumulative unds available or investment are inthe region o 400 million.54 We also illustratedthat in 2008, only 179 million new moneywas raised. Consequently, the total investableventure capital is in the region o 580 million.

Based on previous practice evident in Table1 and on the assumption that all investableamounts currently available will be invested

this year, we anticipate that between 150and 200 million o the 580 million wouldbe invested in unding round 1 companiesand the remaining 390-440 million wouldgo in ollow-on investments. I 2008 levels oventure capital activity are to be sustained, anadditional amount o 100 million needs to be

dedicated to unding round 1 companies andan extra 200 million is required or ollow-oninvestments.

Recommendation: an injection o 300 millionto 350 million (whether o public unds aloneor public and private unds) would meet thechallenges o early-stage rms.

What orm should investment take?Previous policies to promote ventureinvestment have included both governmentinvestment and tax breaks. Both have a cash

cost to the Government, but the two optionshave a dierent time prole. Money investedcan, with the right channels, nd its wayquickly to businesses in need o investment.Tax incentives will generally take longer toaect the system, not least because they relyon infuencing the behaviour o investors. Andi the tax benet does not accrue immediately,the incentive to act will be urther delayed.

Recommendation: Government involvementshould take the orm o investment rather than

tax credit, in order to meet the principle otimeliness.

Direct or indirect investments?I Government intervention is to take the ormo investment, should this be done directly orindirectly? Direct investment, along the lines oICFC or other government-run unds, involvesthe government setting up a body that investsmoney with businesses; indirect investmentrelies on using an intermediary to invest themoney.

The concept o direct venture capitalinvestments to individual rms was rst

Table 1: Proportion o unding round 1 investment, 2003-2008

* In 2008, two unding round 1 investments were reported or 50 million each

Source: Figures calculated using the Library House database which has now been acquired by Dow Jones, Venture Source

Proportion o Funding Round 1 investments 27% 26% 15% 24% 23% 36%

2003 2004 2005 2006 2007 2008*


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55. Lerner, J. (2002) Whenbureaucrats meetentrepreneurs: the designo eective public venturecapital programmes. TheEconomic Journal. 112.

56. The Yozma Program Policy and Success Factors.Presentation by Yigal Erlich.Available at: http://www.insme.org/documenti/

Yozma_presentation.pd

57. In an interview with NESTAresearchers conducted inMay 2009.

introduced in the UK with the creation o ICFC,which later evolved into 3i. Venture capital wasvirtually non-existent in the UK in the mid-1940s and the model o direct investments incompanies was seen as a way o adding valuecreation to the companies and initiating avibrant venture capital market in the UK.

In general, the model o direct investmentsrequires the creation o new organisationalinrastructure. This can be appropriate i acountry entirely lacks venture capital skillsand expertise and sees no way o importingthem as in post-war Britain, when the ICFC wasestablished: the country lacked not just smallbusiness nances, but also the skills to invest itand the wherewithal to administer the process.

The direct approach has its drawbacks. It takestoo long to set up such a large organisation.

On average, an individual investment managerneeds three months to complete a singleinvestment. I a venture capital portolio is tobe executed properly, a lengthy due diligenceprocess is required. Technology specialistsneed to be identied and consulted. Careulinvestigation o the market is needed withinthe ramework o the pre-investment process.Thereore, it will take 50 to 100 investmentmanagers to invest 100 million in a year(based on 250,000 500,000 per deal andthree months or each deal). The creation o a

und with such a large number o investmentmanagers takes a long time to establish.

Secondly, there is the question o investmentskill. A large public und will ace the dilemmao either hiring a large number o sta romprivate unds (which will be expensive,arguably deeating the purpose o establishinga public und, and risking crowding out privateinvestment) or deploying a large number o

relatively inexperienced investment managers,which is likely to make or poor investments.55

The alternative lies with delegating thedecision-making though a public und ounds, which could then invest in privately rununds, taking advantage o their expertise.This has been the approach o a number osuccessul programmes in other countries,including Yozma in Israel (see box), FinnishIndustry Investors and The New ZealandVenture Investment Fund (see box).

Recommendation: Unlike in 1945, the UKtoday possesses a large number o ventureunds and investment proessionals. The caseor creating a venture under rom scratchseems weak, particularly as setting it up couldtake years, limiting the likelihood o astinvestments.

Instead, we propose putting public money intoa und o unds to invest in private ventureunds, taking advantage o their expertise,and meeting the principles o timeliness and

discernment.

Yozma is one o the most powerul exampleso how investment can oster the innovationsystem. This public-private und o undswas established in Israel in 1993 and thenprivatised in 1997. Yozma was a new parto the Israeli innovation system with thespecic aim o stimulating venture capital.The government established a $100 millioninvestment company and co-invested innew venture capital unds alongside privateinvestors, typically providing 40 per cent othe unds capital. This led to the creation oten drop-down unds. Each und received$8 million investment rom Yozma and $12million rom strategic private investors.

The und also made a small number o direct

investments to stimulate the market at thisvery early stage o its development.

Predetermined exit conditions wereintroduced as an incentive or private co-investment: Yozmas partners had a ve-yearoption to buy out the governments shareat predetermined conditions. Eight out oten investors exercised their option andbought out the government.56 Yigal Erlich,the ounder and now chairman o Yozma,argues57 that the private unds were moreinterested in the return they could make thanthe possibility o loss, hence the decisionto provide upside incentives rather thandownside protection.

Particular attention was given to unds romthe US aimed at establishing links with theUS venture capital community and Yozma

actively encouraged the involvement othe US in its drop-down unds. As a result,

Israel


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58. BVCA (2009) BenchmarkingUK Venture Capital to theUS and Israel: What lessonscan be learned? London:BVCA.

59. Ibid.

60. Cooke, P., Davies, C. andWilson, R. (2002) InnovationAdvantages o Cities: FromKnowledge to Equity inFive Basic Steps. EuropeanPlanning Studies. 10(2),pp.233-250.

61. Ibid.

most o the early-stage investments inIsrael will not be sold to Israeli companiesbut to US companies, or will trade on USstock exchanges and some 70 per cent oinvestment in Israeli venture unds at the endo the 1990s came rom the US.58

Thanks to a number o successul exits byYozma unds in 1996-1998, the venturecapital industry networks in Israel wereextended, multinational companies enteredthe Israeli market and collective learning bythe Israeli venture capital industry emerged.59By 2005, $10 billion was raised by venturecapital unds and 60 venture capital undswere operating.

According to Erlich, the governmentintervention was the turning point or theventure capital industry in Israel. A high-

tech development nance system withglobal and local links had been established.Private venture capital became abundantending Yozmas role as a pump-priming body.Yozma was deemed ready to join the market,its public animator unction successullyullled.60 As Cooke says, perhaps this isthe apotheosis o the successul innovation

support policy, whereby it achieves thedemise o its own public-sector venturenancing body.61

The Israeli government intervention wasrelatively short Yozma was privatised ouryears ater its inception. Erlich believes

that interventions such as Yozma need tobe temporary and they should not replacethe role o the private unds: when thereis a need, the government has to takeaction by intervening in the market but thisintervention has to be temporary.

Yozmas example shows that careullydirected government interventions can provevery successul. However, Yozmas successwas not solely a result o its organisationalstructure or re-structure. It beneted romthe creation and re-enorcement o suitable

conditions or interactive learning betweenstart-ups and the venture capital community,and the vital establishment o close linkswith American venture capital. Policymakersshould urther investigate the example oYozma when considering suitable models orpublic intervention.

Figure 8: Total amount raised by Israeli high-tech companies ($m)

Israeli VC F unds Other entities

1997

240

190

1998

340

260

1999

436

576

2000

1,270

1,822

2001

812

1173

2002

480

650

2003

421

589

2004

665

800

Source: IVC Research Center, cited in Early-Stage Investments The Israeli Perspective, Yigal Erlich


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62. The material o this analysis

is drawn rom the NZVIFwebsite: http://www.nzvi.co.nz


64. Ibid.

65. NZVIF (2008) Fundingboost or VC backed growthcompanies. Media Release,December 2008. Auckland:NZVIF.


The New Zealand Venture Investment Fund(NZVIF)62 is a venture und that managesund o und investments as well as makingdirect investments. NZVIF was establishedby the New Zealand government in 2002 to

create a vibrant venture capital market. Priorto its establishment there was no dedicatedventure capital operating in the country.

NZVIF currently has $200 million o undsunder management and it is invested througha $160 million Venture Capital Fund o Fundsand a $40 million Seed Co-investment Fund.NZVIFs investments are made either throughprivately managed venture capital unds oralongside experienced angel investors whoare investing into New Zealand-originated,high-growth potential companies.

The NZVIF Venture Capital Fund o Fundsonly invests in unds which have beensuccessul in raising matching capital romprivate investors. The amount that NZVIFinvests is dependent on the overall und sizeas well as its investment stage and ocus.However, the maximum amount that NZVIFis able to invest in any venture capital undis NZ$25 million (9.7 million). It investsin the Funds on the same terms as privateinvestors, except that other investors in each

Fund are provided with an option that isexercisable up to the end o the th year othe Fund to buy out the NZVIF investmenton the basis o capital plus interest only (i.e.other investors can access any upside abovethis amount) and the Fund must operatewithin the investing prole across seed/start-up/early expansion as set out by NZVIF. Itparticipates in investor governance decisionson the same terms as private investors, withthe same voting rights. Investor governancearrangements refect current marketpractice.63

To date six such Funds have beenestablished, with ve Funds currently active.$232 million has been invested throughthe programme (NZVIF plus private sectormoney) in 48 high-growth innovativecompanies.

The NZVIF Seed Co-investment Fund is anearly-stage direct investment und investingin early-stage high-growth companies.Established in late 2005, the und provides

$40 million o matched investment alongsideselected Seed Co-investment partners on

a 1:1 basis into seed and start-up high-growth companies. To date $21 million hasbeen invested together with nine Seed Co-investment Partners to 26 companies.64

The latest commitment o the NZVIF und o$20 million has been made to an Annex Fundto support existing venture capital-backedportolio companies which are seekinggrowth capital. NZVIF chie executiveFranceska Banga said the Annex Fund isdesigned to assist companies which havepreviously received investment rom NZVIF-backed venture capital unds and are lookingor ollow-on unding or their next stageo growth, such as establishing an exportbase oshore and developing internationalmarkets.

A number o highly promising venture

capital und portolio companies are at

the stage o needing more capital to und

urther growth. At the same time, our

o the six venture capital unds which

NZVIF has backed are close to ully

invested. The Annex Fund will provide

urther capital which the und managers

can draw on to und the next stage o

growth or their companies. In the current

investment climate, it is difcult or any

company to raise capital. It is especiallydifcult or young g rowth companies.

In the past they might have attracted

unding rom US investors at this stage

o their growth, but in the current market

that source o capital has dried up.65

Since the inception o the NZVIF, therehas been a strong and steady increase inthe amount invested in the equity market.However, this increase is most apparent atthe expansion stage. The venture capitalstage has not yet seen strong growth similarto that experienced by other small economiessuch as Israel and Singapore.

The NZVIF programme and the VIF SeedFunds have contributed positively to thedevelopment o a larger pool o individualswith the necessary skills and expertise inseed and start-up investment.66

The NZVIF example illustrates a very soundapproach to government intervention insupport o establishing and sustaining the

venture capital market. It has delegatedthe decision-making to commercial unds,

New Zealand


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67. Ibid.

68. CVCA (2009) Why VentureCapital is Essential to theCanadian Economy: TheImpact o Venture Capitalon the Canadian Economy.Toronto: CVCA.


70. This analysis is includedin Lerner, J., Moore, D.and Shepherd, S. (2005)

A study o New Zealandsventure capital marketand implications or publicpolicy. Report to theMinistry o Research Scienceand Technology. Wellington:LECG Ltd; and its materialis drawn rom Carragher,A and Kelly, D. (1998) AnEvaluative Comparison othe Canadian and AmericanPrivate Equity Markets.Journal o Private Equity.Vol. 1 No. 3; and OECD(2003) Venture CapitalPolicy Review: Canada. STIWorking Paper 2003/4.Paris: OECD.

71. Ibid.

Existing unds versus new undsAssuming that public money will be invested inprivate unds, it needs to be decided whetherthese will be existing or new unds. New undsoer the possibility o leveraging more externalcapital; they are also likely to be able to absorbmore government unding than existing undsthat had not been planning to make largenumbers o new investments. Existing unds

oer the ability to invest money quickly, withno set-up period.

Recommendation: Both proposals havetheir merits (investing existing unds oerstimeliness, investing in new unds oersmore eciency through greater leverageopportunities). Our proposal is to do both,reserving part o the und or immediateinvestment, and the remainder or investmentinto new unds.

it requires private co-investments and itsupports the establishment o a vibrantmarket structure.

Despite NZVIFs positive role in catalysingthe venture capital sector67 and its soundprinciples, the New Zealand venture

capital market is still at an early stage odevelopment is not yet sel-sustaining.This highlights the act that venture capitalmarkets take several years to evolve andshould not be considered as one-oapproaches.

In 1983, the rst Labour Sponsored VentureCapital Corporation (LSVCC, also knownas Labour Fund) was created in Quebec.LSVCCs and PVCCs (Provincial Venture

Capital Corporations) raise their capital romindividuals this is why they are also calledretail unds who receive signicant taxcredits as incentives to invest in small andmedium-sized companies.68

Labour unions were involved in thegovernance o labour unds through board odirector representation. However they werenot involved in the day-to-day management.They were created to allow workers accessto investment in venture capital and tound businesses that would add jobs to theeconomy. Most o their investments in the1980s were in the orm o developmentcapital in traditional sectors.69

The Labour Funds had a number oproblematic incentive issues.

The incentives o the Labour Fundmanagers were not closely aligned to theincentives o their retail investors.

The costs associated with the reporting

requirements o being publicly listedsecurities were onerous.

The high number o retail investorsincreased the cost o administration andthe xed period or holding could lead tomass exodus o retail investors at the end

o the stipulated period once all o the taxincentives had been accrued.

They provided retail investors withront-end tax credits. These incentivesled to retail investors having incentivesto invest in these unds or tax benetsthat could be accessed irrespective othe perormance o the und, and thusdistorted ecient investment behaviour.70

The Canadian early experience withgovernment interventions provides anillustration o the counter-productiveeects o poorly designed policies. Theoverwhelming eect o the Labour Fundswas to dramatically increase the size ocapital invested in venture capital unds inCanada. The tax incentives or the LSVCCsprogramme led to an infux o inexperiencednew investors. The excess competition orpotential investment-ready rms crowdedout private sector investment.71

The Canadian venture capital market has

now recovered rom the earlier problemsassociated with the Labour Funds. However,

Canada


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72. CVCA (2009) Why Venture

Capital is Essential to theCanadian Economy: TheImpact o Venture Capitalon the Canadian Economy.Toronto: CVCA.

73. See http://www.nancialpost.com/news-sectors/story.html?id=1583306

74. In an interview with NESTAresearchers conducted inMay 2009.

75. Duruf, G. (2009) FacingHead Winds: the CanadianVC industry in the presentcrisis. Presentation at theCVCA Annual Conerence,28 May 2009.

its problems are not limited to LabourSponsor Funds and are more complex. Theseunds have been restructuring during therecent years, as the rest o the industry, andthe industry people are thinking more interms o complementarily than crowdingout the private investors.

Canada wishes to evolve rom a resource-based economy to a knowledge-basedeconomy. To achieve this, it has massivelyinvested in publicly unded R&D. Bymeans o a series o policy actionssuch as tax credits and governmentventure capital unds, both ederal andprovincial governments have supportedthe development o the venture capitalindustry.72

Recently, many unds o unds have been

set up in various provinces, such as BritishColumbia and Alberta, which both have aund o unds established with $90 millionand $100 million respectively. The unds havespecic attributes, minimum size and ocuson technology. They also have to establishlinks with the best US unds. In June 2008,the Ontario government announced anew $205 million Ontario Venture CapitalFund. The und is comprised o $90 milliongovernment investments and a $115 millioninusion by institutional players. Later this

year, a $250 million co-investment undwas created by the Ontario governmentto support companies operating in clean

technology, lie science, digital media andICT. In Quebec, a new $700 million undwas created with a matching $250 millioncontribution rom the Caisse de depot etplacement du Quebec and the SolidarityFund QFL and $200 million rom the Quebecgovernment. A urther $100 million rom

other investors may be added to the und.

73

Gilles Duruf rom North American VentureCapital Summit argues74 that ten years agothe Canadians were in avour o havinggeographical limitations: There was a earthat the best companies will be taken by theAmericans. It is a strong belie that neitherCanadians nor Europeans are willing to bethe incubator or the Americans. Canadianshave now changed the way they see thingsand believe that in order to build strongcompanies they need to be more open. There

is still a ear that the best companies willmove to the US, but you have to balancethat with the act that you also need to beopen to get the right people on board.

An exciting piece o inormation o theCanadian case is the act that the undsthat receive backing rom the BusinessDevelopment Bank o Canada (BDC) areallowed to invest 80 per cent in Canada,with 20 per cent able to be invested in otherNorth American companies as a means o

generating enhanced returns and osteringthe transer o best practices.

Table 2: Latest government responses to the VC market in Canada

Source: Gilles Duruf 200975

BC Gov FoF $90m $90m

AB Gov FoF $100m $100m

ON Private FoF $90m $115m $205m$455m

Co-inv und $250m $250m

QC Private FoF $200m $500m $125m? $700m$800m

FoF $50m $50m $25m? $100m

Fed. Invt in late $75m $75mstage und

Total $855m $550m $115m $1,520m

Government Other Private sector Totalallocation anchor LPs LPs (incented)

}

}


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76. HM Government (2009)New Industry, New Jobs.White Paper. London: TSO.

77. An eective subordinategovernment role could implythat:

PrivateLPsgettheirmoney back rst plus apreerred return

Governmentgetsits

money back secondAnyremainingcapitalis

split

How to leverage private capital: At the undo unds level, the government has the optionto either act alone or leverage its contributionwith private capital. Clearly, leveraging privatecapital is better value or the Government.The challenge is to provide terms on whichprivate capital will be willing to invest. The low

returns in the venture capital market makesthem unattractive or private investments as itentails high risks and small rewards. The risk isinherent and it will always remain in this area othe market but market proessionals and high-skilled venture capital investors can reduce it.The issue o small rewards to private investorsis something that government can eectivelydeal with by providing the appropriatestructure to diminish low returns.

Recommendation: Our proposal is toencourage private co-investment into the

und o unds on a matching basis, with thepublic upside being subordinated to theprivate one by accepting a capped return. Amore modest co-investment into new undscan then be accepted (perhaps on a 1:3 basis,since signicant private money will alreadybe invested rom the und o unds. This willensure the und o unds plays a catalytic rolein encouraging private money into the market.The aim should be (as it was in Israels Yozmaprogramme) to encourage the private sectoreventually to buy out the public sector.

6.2 A proposal: the UK und o unds

Early-stage venture capital is importantbecause its activities have been shown togenerate signicant spill-over benet to rms.However, the returns in the UK are low and notencouraging the creation o a venture capitalindustry as vibrant as that in the US. Thereore,the government needs to support this industryin several ways.

First, by injecting money into existingunds that are in immediate need o cash tosupport their portolio companies.

Second, by increasing the availability omoney in the early-stage market by settingup public-private matching schemes.

Building on lessons learned rom successulmodels implemented elsewhere (such asIsrael, New Zealand and Canada) and on some

basic elements o the existing governmentinterventions that have worked well, the

interventions should complement rather thancompete with private venture capital unds.

The analysis in Section 5 shows that the newunds should be based on three principles:

1. In order to avoid the tyranny o multiple

objectives, the unds should only ocus onnancial returns.

2. The new unds should be large enough at least 40 million in order to operateeectively, be sustainable and make ollow-on investments.

3. The created unds should not have anygeographical restrictions on where they caninvest within the UK.

Based on the principle o public-private

partnership, the aim o the proposed und willbe twoold:

To provide much needed unding to existingventure capital unds that are struggling toraise additional money to ollow-on theirinvestments.

To oster private venture capital investmentsin the early-stage market.

The und o unds could provide a major

boost to high-potential growth sectors.Separate unds could be created to providevital early-stage equity unding to innovativerms, particularly in the areas identied bythe government as promising ones: advancedengineering, electronics and biosciences.76

Main und150 million o government commitmentshould be used to leverage 150 million romprivate investment creating a und o unds o300 million. To assist und managers to attractprivate sector investors, the government shouldsubordinate its investment position in the undo unds by putting a cap on its investmentreturn, thereby boosting the anticipated returnto private sector investors and agreeing to bearrst losses (similar to existing regional venturecapital unds).77

This structure will help reduce the high risksthat early-stage investments contain. This isbased on the same principle as the EnterpriseCapital Funds model which requires approvedunds to raise matching unding rom the

private sector.


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The main und would invest in two ways inunds operating in the early-stage technologyventure capital space: existing unds and newunds.

Existing undsOne third o the und (100 million) should

be used to support existing venture capital-backed companies that are in desperate needo investments in order to survive the turmoil.This capital will provide a signicant injectionto the market which only managed to raiseless than 200 million last year compared withover 600 million the year beore.78 There arecurrently hundreds o companies undraisingbut due to the limited investable moneyavailable in the market it is very likely thatthese ventures will collapse.

Existing unds which are privately managed and

have a track record o success should receiveup to 20 million each rom the und o undsto invest in existing promising companies romtheir portolio. The und o unds will matchthe value o their existing portolio (in order toavoid state aid).

New undsThe remaining 200 million should be used tostimulate new ventures through the creation osix unds that will receive 30 million each.

100 million should be invested this year andthe remainder over our years.

In addition to the 30 million, each newund will attract a urther 10 million romprivate investors bringing the total capital o

each und to approximately 40 million andleveraging the government money by 40/60.

By attracting urther private investments,new unds will raise the total leverage oprivate money to 220 million (150 millionat the und o unds level plus 70 million at

the new unds level).

Due to their size, these unds will be ableto make ollow-on investments without thedanger o dilution.

The unds should be directly targeted atinvesting in early-stage companies that arealling into the equity gap. As such, it shouldmake investments in companies seekingless than 500,000, with a target level orrst investment o between 250,000 and500,000. The unding limit on the amount

that can be currently invested in a singlecompany by public sector unds constrainsollow-on investing in a co-investmentssituation. Very oten, publicly backed undportolio companies cannot be ollowed up inthe unding ladder and are abandoned beorethey are ready to attract private investment andas a result collapse. Thereore, the new undsshould have the ability to make ollow-oninvestments through to exit.

We believe this proposal oers an aordable,

ecient, immediate way to provide nance toUK high-growth businesses. It should kick startour wider early-stage investment market.

It is needed urgently. And there are hugepotential rewards in growth, new jobs and newindustries.


Figure 9: Proposed structure o the und o unds

300 million public

early-stage

fund of funds

20 million

investment

into 5 existing

funds

100 million

for immediate

investment

200 million

for new funds

30 million

co-investment

into 6-7

new funds

10+ million private

co-investment

per fund

Existing VC fund Existing VC fund x5 x6-7New VC fund New VC fundNew VC fund

150 million government investment

150 million private investment


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