Regional Studies, 1998, Vol.32, pp. 405-409

A Policy Response to Regional Disparities in the Supply of Risk Capital to New Technology-Based Firms in the

European Union: the European Seed Capital Fund Scheme

Gordon C. Murray

Warwick Business School, University of Warwick, Coventry CV4 7AL, England

Venture capital High technology Regional development Small firms

The European Seed Capital Fund Pilot Scheme (1988-95) was a European Commission response to two primary concerns that: i) private venture capital firms in Europe were increasingly retreating from the financing and support of start-up, early-stage and, particularly, technology-based enterprises; and ii) existing spatial concentrations in the supply of venture capital prejudiced the formation of new, innovative businesses in less economically developed regions of the Union. This paper presents the updated results of a study of this Scheme in 1992. The comparative internal dynamics of the Seed Funds are explored. The Scheme realised its goal of encouraging private investment into innovative, technology-based young firms. However, the continued ability of the funds to meet longer-term commercial and/or regional developmental objectives is questioned given scale-related problems of economic viability.

INTRODUCTION

The effective economic and social convergence of the, now fifteen, member states of the European Union was reconfirmed at Maastricht in 1991. However, a significant barrier to realising the scale and scope economies of European-wide activity remains the disparate economic development both across and within individual member states. The Commission’s commitment to ‘spatial justice’ (Giannakouru, 1996) has engendered a wide range of initiatives targeted to less developed areas of the Union.

SMALL & MEDIUM SIZED ENTERPRISES: THE ‘SPECIAL CASE’ OF NEW TECHNOLOGY-BASED FIRMS (NTBFs)

Since the late 1970s, SMEs have been seen as an increasingly important policy vehicle for economic and regional development goals within the Union. This interest has come about through an increasing recognition of the major contribution of SMEs to total employment and to the net creation of new jobs (Birch, 1979; Gallaher and Stewart; 1986; Storey et al., 1989). SMEs are now firmly established as a major

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focus of the Commission’s economic, technological and regional policies (EC White Paper, 1994; EC Green Paper on Innovation, 1995).

Within the wider corpus of SMEs, new technology-based firms represent a peculiarly attractive focus for policy makers. NTBFs are seen as offering significant potential benefits in four cardinal areas of Union interest: employment creation, innovation, export sales growth and regional development (Rothwell & Zegveld, 1982; Freeman, 1983; OECD, 1986; Oakey et al., 1988; Rothwell, 1989; Roberts, 1991; Coopers & Lybrand, 1996). Interest in NTBFs has in part stemmed from an appreciation of their critical role from the early 1970s in the economic growth of regions of high technology activity in the USA, particularly Silicon Valley, California and Route 128 around Boston, Massachusetts (Oakey, 1984; Florida and Kenny, 1988; Roberts, 1991; Bygraves & Timmons, 1992), as well as their contribution to fast growth European regions (Meyer-Kramer, 1985; Keeble, 1989) .

However, while successful NTBFs potentially offer material advantages to the economic prosperity of a location, their genesis and early years are fraught with extremely high levels of uncertainty and risk in virtually all areas of activity including financing, technology and marketing (Oakey, 1984, Roberts, 1991, Murray, 1995). For the individual NTBF, an exceptional technological offering is a necessary but not sufficient condition for economic success. Their entrepreneurial founders have also to manage organisational and product/market demands in both internal and external environments characterised by their complexity and rapid rate of change.

THE FINANCING OF NTBFs

Financing difficulties are particularly acute for NTBFs on formation and at their earliest stages of development (Roberts, 1991; Moore, 1993; Murray & Lott, 1995). Limited tangible assets reduces their opportunity for collateral based lending from retail banks, which is the predominant source of external finance to European SMEs (European Network for SME Research, 1993; Storey, 1994). The economic value of intellectual property rights created by the entrepreneur is, as yet, unproven and thus unexploitable (Rumelt, 1984). The ability of new entrepreneurs from a technology/ scientific background to attract external equity finance, ie. formal venture capital, is also prejudiced by their frequent lack of commercial experience and the absence of an established track record of successful enterprise (Tyebjee and Bruno, 1984; MacMillan et al., 1985; Goslin & Barge, 1986). In consequence, owner-managers of NTBFs are, per force, very heavily dependent on own and family personal finance for initial capitalisation (Oakey, 1983; Roberts, 1991; Moore, 1993) in addition to relying on trade credit and, to a lesser extent, government grants (Utterback et al., 1988; Moore and Garnsey, 1991).

The imperfections of capital markets have featured largely in the debates on SME developmental constraints. The proposition of the existence of an ‘equity gap’, ie. a market failure in the adequate provision of external risk capital, has been part of the economic literature for over 60 years (see The Macmillan Committee, 1931). A succession of official committees and research exercises since that date (see, for example, Bolton, 1971; Wilson, 1979; Burns and Dewhurst, 1993; Confederation of British Industry, 1993) have each cited evidence of the existence of equity gaps and their deleterious effect on the viability of smaller businesses which are generally

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characterised as having weaker liquidity, more volatile levels of profitability, an over-dependence on short-term sources of finance and an insufficiency of shareholders’ funds or equity. NTBFs are seen as particularly vulnerable to capital constraints given that initial investment costs, particularly R&D, are incurred before any prospect of consequent revenues.

THE IMPORTANCE OF VENTURE CAPITAL

It is within the context of innovative firms seeking early-stage, external finance with the potential promise of substantial returns but at a concomitant high level of risk that the potential of venture capital as a source of entrepreneurial support appears most relevant. Yet, almost without exception in the sixteen member countries of the European Venture Capital Association, there has been a declining interest in the support of start-up and early-stage investment since the mid 1980s. The European venture capital industry has metamorphosed into a development capital industry primarily occupied with the restructuring and refinancing of extant businesses (Table 1).

Table 1. Allocation of European Venture Capital Investments by Stage 1993-95

‘Fast-track’ NTBFs, with their predominant reliance on external equity finance, are particularly disadvantaged by such structural changes in the venture capital market. Even if MBO/MBI statistics are removed from the European figures, the percentage of total investment allocated to technology-based enterprises has remained largely constant over a decade of enormous technological change in the world’s developed economies (Fig. 1). The proportion of venture finance allocated to NTBFs in Europe is in stark contrast to the pre-eminence of technology-based investments in the US.

Fig. 1. Technology Investments as a Percentage of ‘Adjusted’ Total Investment (ie. excluding MBOs/MBIs and LBOs/Acquisitions) in Europe and the USA

1984-95

(note: While this paper is exclusively concerned with ‘formal’ venture capital, an exhaustive treatment of NTBF financing must necessarily address the potentially critical role played by informal investors or “business angels” particularly within a regional development context (Wetzel, 1993; Mason and Harrison, 1994)).

REGIONAL DISCONTINUITIES IN THE SUPPLY OF EUROPEAN VENTURE CAPITAL

The existence of a regional dimension to the supply and demand for equity has become a theme of increasing interest to economic geographers (McNaughton and Green, 1988; Martin, 1989; Thompson, 1989; Mason and Harrison, 1991; Mason, 1992) given the consequent implications for development in regions with poorly developed capital markets. Thompson, op. cit., argues that venture capital is a subject of particular interest for four reasons - its role in new investment processes including regional development disparities; its pivotal importance to high-technology industries; the involvement by (US) public agencies in influencing the supply of venture capital particularly to address regional ‘gaps’; and the ‘spatial choreography’ of venture capital occasioned by behavioural, institutional and distance constraints.

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Yet, as Martin, 1989, and other have noted, given that few robust analyses exist on the processes or outcomes of regional capital formation, theoretical understandings of the spatial organisation of capital markets remains unsatisfactory.

The European distribution of venture capital is highly skewed. Some five countries (in rank order: the UK, France, Germany, Italy and the Netherlands) represented 83% of the cumulative funds raised to 1995 (ECU 46.7 billion) by the membership of the EVCA. The UK is the oldest and largest centre of venture capital activity in Europe. It alone represents 45% of cumulative funds, a sum over twice the size of its nearest competitor, France (ECU 10.6 billion).

The considerable regional disparities in venture capital provision between European member states is further mirrored at the sub-country level. Venture capital firms are clustered in areas characterised by both established financial centres and high concentrations of economic activity (see, for example, Ciciotti, 1986; Leinbach and Amrhein, 1987; McNaughton and Green, 1988; Martin, 1989; Mason and Harrison, 1991; Sánchez, 1992; Minns, 1993). Critically, the information and governance advantages of a close proximity between investors and investees result in capital being primarily allocated within these clusters (Florida and Kenny 1988).

Mason and Harrison, 1991, supporting the case for a regional equity gap in the UK, further note that depressed regions in the Midlands and Northern England are also net exporters of equity finance to the more successful southern regions, such as Cambridgeshire in East Anglia (Keeble, 1989). Florida and Kenny and Leinbach and Amrhein, (ops. cit.), similarly demonstrate the migration of US finances from less developed central and mid Western states to the East and West coast areas. The empirical literature is uniform in its conclusion that venture capital availability and usage remains highly concentrated in regions of established and growing economic advantage.

A POLICY RESPONSE FROM THE EUROPEAN COMMISSION: THE EUROPEAN SEED CAPITAL FUND SCHEME

Concern at the apparent paucity and limited regional distribution of third party equity finance for European NTBFs engendered a policy response from the European Commission. In October 1988, the Commission adopted a Community pilot scheme to stimulate seed capital. The stated objectives of the Scheme were:

"...to foster enterprise creation in the Community by strengthening the financing opportunities available to new enterprises, through the creation of 24 new seed capital funds throughout the Community, and by improving the quality and survival rate of seed capital projects, through the services the funds will provide to the projects. This pilot scheme aims to stimulate private sector and start-up investment by providing financial incentives to these new funds...”

CEC document (SEC/88/1496), 1988

The focus of the pilot scheme was "new or embryonic companies that require financial and/or management support for development into companies capable of

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raising first round finance" (op. cit.). Importantly, while the Scheme was subsequently translated by the participant funds as to be primarily concerned with NTBFs, the original documentation did not specifically state a exclusive technological focus.

The sponsoring Directorates General for the pilot scheme were DGXXIII (Enterprise) and DGXVI (Regional Development). While the objectives of the Scheme did not directly allude to distributional inequalities in capital provision, the involvement of DGXVI ensured a regional dimension to the pilot scheme and the specific inclusion of new funds in Objective 1, 2 and 5b areas.

Each of the supported funds in the scheme received a reimbursable, interest-free advance of up to 50% of the annual operating costs of the fund over a three to five year period. This loan is due for repayment after ten years when it was deemed that sufficient investment realisations would have been made to enable the return of the advance. Those funds which have not achieved net investment returns above a 'hurdle' (referenced to long term treasury bonds plus five percentage points during the period of the fund's existence) are to be absolved from repaying the loan.

The operating subsidy was paid by DGXXIII to all funds. For those fourteen funds which operated in 'selected assisted areas' of the Union, DGXVI paid a further capital contribution of up to 25% of the funds under management - a minimum of ECU 125,000 and a maximum of ECU 250,000. This additional capital loan was a recognition of the likely difficulties in attracting private investors which would be faced by small regional funds. This interest-free advance is only returnable if the fund has made a capital gain at the end of the term.

Fig. 2 Location of 21 ESCF Scheme Supported Funds Surveyed in 1992

OBJECTIVES OF THE STUDY

Three years after the Scheme’s inception, the author was invited to review the progress of the Scheme to date. By January 1992, 22 funds had been created in ten countries and had started to invest in SMEs. In agreement with the Commission sponsors, the study embraced the following objectives:

1) to review progress to date of the supported funds including their ability to attract additional private sources of investment capital

2) to ascertain indicative evidence of the funds’ ability to meet desired goals of enterprise and job creation via technology-based new firms

3) to address the inter-relationship between economic and (regional) developmental objectives of the funds

4) to appraise the continued viability of the funds created after the 5 year period of Commission support

THE SURVEY METHODOLOGY

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It was decided to interview personally the senior investment manager of each of the twenty-two funds from the ten member states in the Scheme as of Jan 1992. A semi-structured interview schedule was prepared in English and French. Only one fund declined to be interviewed. (A further postal survey of the investee firms was also completed but does not form part of the present paper.)

A FUND TYPOLOGY

The two types of fund, primarily supported by DGXXIII and DGXVI respectively, were termed regional funds and commercial funds. Their characteristics are summarised in Table 2.

Table 2 Typology of Regional and Commercial Seed Capital Funds

The following results from the study, and subsequent Commission updates, address fund behaviour primarily from the perspective of the regional funds. Their actions are contrasted with the commercial funds particularly to illustrate the nature and consequences of the additional or different policy objectives placed on regional funds as vehicles for local development.

BASIC FUND CHARACTERISTICS

Size and Investment Disparities in Commercial and Regional Funds

Table 3 Statistics of Seed Capital Funds in ESCF Scheme in 1992

By 1992, the extant funds had already started to exhibit material differences based on both the resources employed and their regional or commercial logic (Table 3). The average size of investment in individual firms by the commercial funds was four times higher than their regional counterparts. Commercial funds managed their investee portfolio more intensely. Accordingly, the operating costs of commercial funds were 20% higher than their regional counterparts. However, when expressed as a percentage of funds under management, these costs were one third lower for commercial funds. This illustrates a fundamental issue for small scale investor groups of the penal effect of indivisible, fixed governance costs.

The figures suggest that regional funds were pursuing a diversified portfolio approach by making modest investments among a larger number of client firms. In contrast, commercial funds had restricted their activities to relatively few but larger investment thereby allowing for contingencies and planned ‘follow-on finance’ to existing investees. This latter strategy is consistent with the practice in private venture capital firms with a technology focus (Bygrave and Timmons, 1993; Murray, 1994). It was not possible to determine if the regional funds’ policy was purposeful or contingent on supply-side limitations, ie. fewer attractive candidates available in which to invest larger sums.

FINANCE RAISING BY THE FUNDS

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Some two years after the inception of the Scheme, the funds had raised ECU 36.2 million of new finances for equity investment. This figure excludes the capital subvention of approximately ECU 2.6 million made to regional funds by DGXVI. The small scale of this sum is put into context when it is recognised that 15 (71%) of the funds had total financing of under ECU 2 million. The average external finance raised per fund was ECU 1.72 million (range ECU 0.5-7.0 million). The importance of this figure is apparent if referenced to average operating costs of the funds. Without making any investments whatsoever, the regional and commercial funds would have exhausted their original capital in eight and twelve years, respectively.

The ‘Leverage Effect’ of European Commission Subsidy

The effectiveness of the imprimatur of the EU in assisting the process of fund raising was significant, particularly for the regional funds. Fund managers were asked to estimate the amount of finance they believed they would have been able to raise from private investors without the existence of the Scheme. Only two of the thirteen regional funds reported that they would have been able to raise any finance. The total fund raising estimate of the regional managers, in the absence of the Scheme, was ECU 2.8 million compared to the actual sum raised of ECU 13.5 million. The ‘pump priming’ role of the Commission resulted in an increase of finances raised by the thirteen regional funds of 382%. Conversely, only three of the eight commercial funds believed that they would not have been able to raise finance unaided. Their views as to the Commission’s influence was that it represented an additional ECU 4 million - a 27% increase in funds raised.

Thus, the Scheme had met initially one of its objectives of stimulating private sector financial transfers. However, the effectiveness of the Commission’s intervention, more pessimistically, may conversely be seen as an indication of private investors’ circumspection as to the economic viability of regional seed capital investment in the absence of significant EU subsidy.

Sources of Private Investment

The proportion of finance provided by private sources for the regional funds was 64%. although government agencies represented the largest category (28.9%) of contributor (Table 4). Over three-quarters (77.3%) of the commercial funds’ finances came from institutional and private investors, ie. the source from which most mainstream venture capitalists attract finance

Table 4 Types of Institutional Investors in Seed Capital Funds in 1992

Investors’ Reasons For and Against Supporting Seed Funds (Respondents’ Opinions)

However, only one quarter (27%) of regional fund managers believed that investors contributed to their funds for predominantly commercial reasons (Table 5). This makes the material contribution of venture capital firms to regional funds surprising (although several of these firms were owned by regional banks.). Conversely, nearly half (48%) of commercial fund managers believed that profit was the primary reasoning of their investors. None the less, both types of fund managers

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acknowledged the critical importance of non-economic reasons in motivating institutional investors. This has implication for further finance raising. In the absence of tangible evidence of attractive investment performance, initial fund supporters may unlikely be a reliable source of further finance. Critically, all funds are likely to require further finance raising before tangible evidence of their investment performance is available. Investors who declined to participate were, in the opinion of the fund managers, discouraged by the high risk and poor prospects for attractive returns from seed capital investment.

Table 5 Investors' Reasons For & Against Contributing to a Seed Capital Fund

Fund Performance Evaluation by Their Managers

The regional fund managers appeared to give little priority to quantitative performance variables in their own individual benchmarks for their fund’s performance (Table 6). The absence of formal monitoring/evaluation criteria for nearly half the funds in the Scheme was potentially alarming given the managers’ fiduciary accountability to their public and private investors. Particularly for regional fund managers, the interim results of substantial investment activity appeared to have received little explicit analysis.

Table 6 Primary Criterion for Fund Performance Evaluation

THE IMPORTANCE OF DEAL FLOW

A key prerequisite of success for a venture capital firm is its ability to attract a flow of attractive, potential investee businesses. Only six of the 21 funds admitted to having a formal marketing strategy for attracting deal flow. However, the funds did not appear to have suffered from a limited supply of entrepreneurial firms seeking equity finance in the period 1990-92. Collectively, the respondents’ funds had received a total of 1,410 approaches, and from which 69 investments had been made in total. While no data were collected on the quality of this deal flow, the overall acceptance rate of 5.6% accords closely to other researchers’ findings of venture capital acceptance rates (Bannock, 1991; Dixon, 1991; Roberts, 1991). For the 669 deals on which specific information was available, there appeared to be little difference in summary acceptance rates between the two types of fund.

Table 7 Sources of Funds’ Deal Flow 1992

Sources of Referrals

The apparent ease with which the funds had managed to engender interest among entrepreneurs is arguably a recognition of the strong networking skills applied by managers within often strictly defined regional locations or specific product/ technology markets.

Table 7 illustrates the wide spread of sources of referral employed by managers of both types of fund. Hustedde and Pulver, 1992, in the US have indicated that the source of the advice and referral can be an important indicator as to the likely outcome of the subsequent investment. These authors reported that public sector

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conduits tend to be associated with, subsequently, less successful investee firms in the US. If valid in a European context, these findings will be a cause for concern to the regional funds which largely employ public sector channels for prospective deal flow.

Different Fund Types, Different Networks

The close relationship between the regional funds and the Business Innovations Centres (BICs) is evident. (BICs were set up by DGXVI in 1984 and were originally designed to ‘assist areas undergoing economic restructuring and/or economically less advantaged areas of the Community.). BICs are normally represented on the board of the regional seed funds.

The limited data suggest that commercial funds employed wider and more heterogeneous sources of referral, and non-public contacts were particularly important. Bank and financial institution originated enterprises represented over one quarter of the commercial funds’ investment portfolios. In contrast, none of the 26 firms introduced by banks to the regional funds resulted in an investment. The lack of locational/developmental constraints on commercial funds may represent an advantage in deal sourcing.

PROJECT APPRAISAL AND SELECTION CRITERIA

The would-be investor has to reach a judgement on three critical sources of uncertainty - the viability of the technology; the existence of an attractive product/market opportunity; and the abilities of the entrepreneur/management team. It is in the area of project evaluation that the regional and commercial funds exhibited most commonality. Asked to cite the five most important project selection criteria, the two types of funds only differed in the importance given to the ‘nature of the technology’ (Table 8). This likely reflects the commercial funds greater focus on technology investments. Their responses also confirmed the findings of several other studies which have indicated that the essentially subjective appraisal of the entrepreneur or management team dominates more formal financial appraisals in early-stage investments (see Tyebjeee & Bruno, 1984; MacMillan et al., 1985 & 1987; Goslin & Barge, 1986; Sapienza, 1992; Hall and Hoffer, 1993).

Table 8 Fund Managers' Rating of Key Project Selection Criteria

The commonality of the two types of fund managers’ response was also reflected in their reasons for refusing a new project proposal (Table 9).

Table 9 Fund Managers' Reasons for Refusing New Projects

However, the views of the two types of fund managers did diverge markedly on the minimum level of financial attractiveness of a project proposal as assessed by the target Internal Rate of Return acceptable to the fund. Only three (23%) of the regional fund managers would impose a rate of return at >20% per annum, ie. a level significantly below the threshold of 57% imposed by UK technology investors (Murray & Lott, 1995). Half of the commercial funds stipulated this minimum IRR target. That nearly half of all managers did not have a defined financial performance target was arguably a reflection of the extreme practicable difficulty of setting an ex

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ante target given the imperfect information available for early-stage technology investments. However, this omission may also reflect, especially for regional fund managers, the subordination of financial objectives to wider developmental goals.

INVESTMENT FOCUS OF FUNDS

Targeted Stage of Investment

As noted, the history of the European venture capital industry illustrates a marked movement away from early-stage investment (Murray, 1995). The logic of the Scheme was to encourage the supply of finance dedicated to enterprise formation and growth. The actions to date of the two types of funds show that their activities remain exclusively directed to early-stage investment (Table 10). There was no evidence of a ‘creep’ to later stage, less risky development capital investments.

Table 10 Percentage of Investments Made by Stage of Investee Firm Development

Commercial funds were particularly likely to invest in young businesses before any sales had been made. That the regional funds had, on average, over one third of their portfolio in firms which had already started making sales may likely be a reflection of their close relationship to existing support agencies, eg. BICs. This relationship is also likely to explain the greater proportion of low/medium technology firms within their portfolios when compared to commercial funds. Given the geographic constraints of regional funds, it is also highly probable that the supply of early-stage NTBF opportunities was significantly more constrained than for their commercial fund counterparts.

Targeted Level of Technology Investments

Within broad definitions, the respondents were asked to ‘self code’ their portfolio of investee firms regarding the degree to which they incorporated advanced and novel/innovative technology processes or product features. Such a process of categorisation is less robust than that employed by Butchart, 1987, and OECD, 1992, but the researchers were primarily interested in a broad classification of the existing investments rather than determining the technology status of a single firm.

Table 11 Percentage Distribution of Investee Firms by Level of Technological Innovation

Two particular observations resulted from this enquiry. The regional funds espoused a greater preferred interest in advanced technology investments but it was the commercial funds which had assumed this role in practice (Table 11). This, as noted, may be a reflection of the limited supply of such investments in funds constrained by regional boundaries. Secondly, while both types of fund indicated a preference for including between a quarter and a fifth of low technology investments, in practice, these investments represented around 10% of the average portfolio. Managers observed that technology-based firms were potentially more attractive from either the perspective of job creation or capital gain.

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EXIT ARRANGEMENTS

Central to the logic of venture capital investment is the ability for the investors eventually to liquidate/realise their investment at a capital gain reflecting risk and illiquidity premia. (it has been argued that the limited role of small firm stockmarkets in Europe has been a major disincentive to potential investors in growth SMEs, see EVCA, 1993; Bannock, 1994).

Table 12 Planned Exit Route for Investee Companies (weighted by rank ordering)

Managers were asked to give their assessment of the most likely exit routes for their present and future portfolio companies. Table 12 indicates that trade sales remain the most likely source of a project exit for both types of funds. This is in line with general venture capital behaviour (Relander & Syrjänen, 1992). The two categories of funds are similar in their exit expectations. The exception is the relatively greater importance given to an Initial Public Offering by the commercial funds. However, such a route is only feasible for the commercially most successful NTBFs. The limited importance given to a stockmarket exit suggests that only a small minority of investments are regarded as being of the highest commercial potential or, conversely, the inappropriateness of existing bourses for NTBFs in several European countries.

The importance of a repurchase of the investors' equity by the original entrepreneur(s) reflected the peculiarities of investing in small businesses which were faced by several funds. These managers noted that entrepreneurs would not accept seed capital investment without the contractual right to subsequently repurchase the investor's portion of the equity. Such an exit channel is of no interest to commercial investors as the entrepreneur has a direct incentive in discouraging or delaying the growth in the value of the enterprise in order to repurchase the equity he/she does not control (an ‘agency cost’ problem, see Amit et. al., 1991). For most funds, this route remained the ‘exit of last resort’.

Venture capitalists were also seen as a potentially important source of follow-on finance as co-investors in growing enterprises needing significant increases in capitalisation. However, Murray, 1994, has noted the limited interest of UK later stage venture capitalists in providing follow-on finance for seed capitalist derived projects. It is also noteworthy that there was a negligible incidence of syndicated financing of the original investments. Mason and Harrison, 1991, have observed that inter-regional co-investment is one means by which regional equity gaps may be ameliorated.

CONTEMPORARY PERFORMANCE OF THE ESCF SCHEME

Subsequent to the original study in 1992, the Commission has provided updated statistics on both the participating funds and their investee companies on an annual basis. Two additional funds has been introduced and the non-respondent Greek fund has been removed from the Scheme.

Importantly, the author’s original classification has been refined by the Commission. Funds are now segregated into exclusively commercial, high-tech funds, and two regional categories which are defined by the nature of the predominant sources of

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finance. This re-classification serves to increase the differences cited in this paper between the commercial and the regional funds in 1992.

Commercial Funds:

Private High-Tech Funds (n=4) investment raised exclusively from private investors and directed only to high technology projects irrespective of location

Regional Funds:

i. Private Regional Funds (n=8) >50% of funds raised from private investors with investments directed to one or more well defined regions

ii. Public Regional Funds (n=11) <50% of funds raised from private investors with investments directed to one or more well defined regions

FUND CAPITALISATION AND INVESTMENT ACTIVITY POST 1992

Table 13 Growth of Total ESCF Scheme Funds Under Management

There has been relatively little additional fund raising in the three year period. However, nine funds have noted an intent to raise a further ECU 20 million, two-thirds of which will be via new shareholders. This imperative is greatest for the high-tech funds which are almost fully invested. Their average investment values and the costs associated with a ‘hands-on’ method of governance remain significantly higher than for all regional funds. Additional demands on their funds from existing, or new investees, cannot be sustained from extant resources. This places these funds and their existing investees in a position of vulnerability in the event of unforeseen problems.

Table 14 Total Investments Activity by Type of Fund by Jan 1995

The continued structural differences between regional and high technology funds is a recognition of the diversity of their respective goals (Table 14). Significantly, interim figures show the firm failure rate of commercial funds to be nearly one third of that of all regional funds. This may be a consequence of the ‘better’ stock of available investee businesses, more discriminating investment policies of commercial funds and/or their greater investee support activities. However, it is still premature to draw strong conclusions.

EMPLOYMENT CREATION

Table 15 Number of Jobs Created by Category of Fund and Technology Status 1992-94

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Table 15 serves to reinforce the importance of NTBFs as potentially attractive source of employment creation relative to SMEs embracing less innovative technologies. The degree of technological sophistication of the investee firms appears directly related to the firms’ potential to create new jobs. The figures also illustrate a paradox. The regional funds were created for developmental objectives including additional employment generation. In contrast, the high technology funds remain primarily an economic activity. Yet, it is the high technology firms which have recorded the greatest employment growth per investee firm and per fund. The Commission (DGXXIII) has drawn the conclusion from the Pilot Scheme results to date that its future policy focus should concentrate exclusively on commercial funds, which target high technology enterprises and employ finance from the private sector, regardless of their location.

Table 16 Cost of Community Support per Job and Enterprise Created

On a Commission assumption of a 30% loan default, the cost to the EC of the Scheme per job and enterprise created was ECU 1,260 and 13, 979, respectively (Table 17). These figures appear to be remarkably attractive. Storey’s (1994) analysis of the Enterprise Allowance Scheme in the UK estimated a public cost of ECU 2,600 per job and ECU 78,000 per firm. The cost per job of the Urban Development Corporations in England and Wales has been cited as ECU 28,000 per job (The Guardian 19/8/95, p.9). Statistics (1980-96) from the Massachusetts Technology Development Corporation in Boston, an arguably more relevant comparison given its NTBF focus, show similarly effective public funds leverage with a cost per job of ECU 1,055 and cost per enterprise of ECU 110,000. MTDC has created relatively fewer, larger enterprises (60 active) but with a higher average employment growth at 104 new jobs per firm.

The efficacy of the Scheme is in part a result of the leverage effect of public loans on private investment. While high tech funds created the most jobs in advanced technologies, the greater total number of jobs and enterprises created by the regional funds relative to the public subsidies given significantly increased their comparative performance. However, a more rigorous analysis of the employment impact of the Scheme will necessarily have to address deadweight arguments regarding the actions of entrepreneurs in the absence of the Scheme. Further and critically, the longer-term viability of fledgling NTBFs cannot yet be assumed.

THE THREAT OF INVESTMENT/REALISATION DISCONTINUITIES

The interim success of the high technology/commercial funds has produced one area of considerable threat. In early-stage venturing, the investment cycle is generally seen as seven to ten years (Bannock, 1991). During this period, successful investees will frequently require several rounds of finance as the business grows and develops but remains insufficiently profitable in the short/medium term to fund growth and R&D investment exclusively from retained earnings (Murray, 1994). The cycle of costs and returns are not synchronised and the fund needs to be able to have recourse to substantial finance prior to a profitable realisation of its investments. The ability of the Scheme’s high-tech funds to meet future cash demands is, at present, highly constrained in the absence of further sources of finance.

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Table 17 Fund Statistics in January 1995

Table 17 takes no consideration that the existing investments of the technology funds may require additional finance over the remaining six year average life of the funds. Nor are the substantial costs for an investee firm of a market flotation or a trade sale included in the above calculations. In short, for the most successful fund category, there is a present danger that the funds will imminently run out of operating finances before the majority of their investments can be successfully realised. In these critical circumstances, any attempt to obtain additional fund finance from investors is likely to be problematic given the parlous negotiating position of a financially weak fund.

CONCLUSIONS AND DISCUSSION

Problems in the supply of seed and early-stage venture capital remain endemic in Europe. In the absence of professional investors or the complementary, informal investor/business angel sector, prescriptions to address ‘equity gap’ issues are heavily dependent on public initiatives. The ESCF Scheme represents a European response. It is properly judged according to its objectives. Yet, as a pilot programme, its findings have their greatest import in influencing subsequent EC regional and enterprise policies.

By February 1995, at a budgeted public investment of ECU 8.76 million, twenty-three funds (and a support network) had been created and had attracted ECU 41 million of institutional finance. The 188 extant, early-stage enterprises had created 2,085 direct jobs, predominantly in technology-related activities. Failed enterprises currently represent 17.5% of investments. Under the EC’s revised fund definitions, the nineteen regional funds representing 60% of the finance raised (ECU 24.8m.) and had supported 147 enterprises. The explicit objectives of the Scheme had been successfully realised and the estimated subsidies per job and enterprise created appeared highly cost effective. EC intervention cannot be challenged on either ‘opportunity cost’ grounds, nor as displacing (‘crowding out’) established private markets for venture capital (Fisher, 1988).

However, conclusions must remain circumspect until the longer term viability of both the new enterprises and the funds as economic entities are proven. The urgent need of the high-tech funds for additional finance raises serious concerns as to future viability. Without exception, the small scale of all funds prejudices viability given the penal effect of fixed management costs. This future viability may well be conditional on the development of what Florida and Kenny, 1988, describe as indigenous ‘technology infrastructures’and by which additional finance, information and advice is efficiently provided to NTBFs and their investors through symbiotic local linkages.

All funds raised institutional finance on the basis of securing an acceptable return for their investors. This return can only be met by the subsequent, profitable sale of their portfolio companies. At the end of the 10 year funding period, if the investors do not receive a risk and time adjusted return on their capital, they have in effect subsidised the social goals of enterprise creation. This is likely to severely curtail future private fund raising in addition to increasing significantly the real cost of the Scheme.

14

There is an evident quantity/quality divide between regional and commercial (high-tech) funds. The latter actively discriminated by investing greater finance and managerial support in a smaller number of attractive (by sales and employment growth) firms. Unencumbered by developmental goals, the four high tech funds appeared demonstrably more professional in managerial behaviour. The separateness of the regional funds from private communities of finance, information and deal flow is potentially problematic if these agents are to be judged ultimately as commercial organisations.

The funds had established effective networks as evidenced by the availability of initial funding and a robust deal flow. There does not appear circumstantial support for Bennet and Krebs’, 1994, assertion of the more fractionated networks in less developed regions. However, the regional funds were not sited in the most economically and socially disadvantaged areas of the Union. The ability of the regional funds to make technology investments would suggest that a latent demand exists and is frustrated by supply side constraints of finance. However, that investees are willing to accept finance allows no observation on the quality of these enterprises. Indeed, the limited evidence from the study suggests that regional investees are smaller, grow less quickly, are less technologically intensive and are more liable to fail than the recipients of commercial fund investments.

That these funds had to be created de novo, lends support to Thompson’s, 1989, questioning of Neo-classical diffusion arguments regarding the correction of either regional or early-stage investment shortages. The steeply sloped ‘distance decay curves’ witnessed by McNaughton and Green, 1988, in Canada remain evident in Europe. Governance and information demands ensure the continued spatial concentration of venture capital activity. The materiality of these constraints present a powerful argument for the logic of public initiatives which address barriers to the local supply of additional private venture capital finance. However, such schemes are likely to be necessary but not sufficient catalysts for continued regional enterprise/ employment growth in the absence of complementary, techno-commercial networks to assist the subsequent development of the new firms.

ooOoo

ACKNOWLEDGEMENTS

The author would like to thank the European Commission (DGs XXIII and XVI) for their financial support of the original 1992 study, and David Francis whose participation in the fieldwork and subsequent analysis was invaluable. Any errors of fact, interpretation or omission remain the sole responsibility of the author.

15

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18

Table 1. Allocation of European Venture Capital Investments by Stage 1993-95

1993 1994 1995Stages of Venture Capital Investment:

ECU million

%Total

ECU million

%Total

ECU million

%Total

Seed 20.8 0.5 37.1 0.7 34.4 0.6Start-Up and

Early Stage179.7 4.4 273.3 5.0 286.5 5.2

Expansion 1,888.5 45.9 2,294.2 42.2 2,298.6 41.4Replacement 345.9 8.4 434.1 8.0 354.5 6.4MBO/MBI 1,680.2 40.8 2401.0 44.1 2,572.0 46.4Total Investment 4,115 100.0 5,440 100.0 5,546 100.0Source: BVCA 1995, EVCA 1995

19

Fig. 1. Technology Investments as a Percentage of ‘Adjusted’ Total Investment (ie. excluding MBOs/MBIs and LBOs/Acquisitions) in Europe and the USA

1984-95

0

10

20

30

40

50

60

70

80

90

100

1984

1986

1988

1990

1992

1994

Year

Per

cent

age

US Technology- % Value TotalInvestments

EUR Technology-% Value TotalInvestments

Source: BVCA and EVCA Annual Statistics 1985-96, NVCA Annual Reports 1990-1996EVCA statistics aggregate sixteen European countries including the UK.NB. The trends in Fig.1 should only be seen as indicative given broad definition of technology-based investments.

20

Fig. 2. Location of 21 ESCF Scheme Supported Funds Surveyed in 1992

C

R

R

R

RC

R R

C R C C

R

R

C RC

C

R

R

R

= Capital Cities (and Berlin) C = Commercial Funds R = Regional Funds

21

Table 2. Typology of Regional and Commercial Seed Capital FundsRegional Funds Commercial Funds

Primary Fund Objective Encouragement of New Firm Formation and Employment in location of fund

Attractive Capital Gain to Investors fully reflecting premia for risk and illiquidity

Secondary Fund Objective

Positive and Acceptable Financial Return to Investors

New NTBF Formation

Capitalisation Public Funds and 'Social' Investment by Private Sector

Primarily Commercial Investors but including some 'Social' Investors

Investee Focus New & Early Stage Enterprises with some Technology component

Exclusively, NTBFs with exploitable Intellectual Property Rights in attractive and fast growing markets

Locus of Operation Development Region Area determined by practicability of regular investor/investee contact

Support Infrastructure BICs* and other Public Enterprise Support Agencies, Public and Commercial Networks

Private, Commercial Networks & Commercial Consultants

* Business Innovations Centres

22

Table 3. Statistics of Seed Capital Funds in ESCF Scheme in 1992

ECU 000sRegional Funds

N=13Commercial Funds

N=8

Average Fund Size ECU000 1,345.4 2,341.3 Range Funds Raised ECU000 500 - 2,575 750 - 7,000Number of Investee Firms 48 31Average Investment per Firm ECU 58.922 232.777Annual Operating Costs ECU 157,176 189,162Range Ann. Operating Costs ECU000 21 - 195 87 - 406Operating Costs as a % Funds Under Management 11.7% 8.1%

23

Table 4. Types of Institutional Investors in Seed Capital Funds in 1992

Source: (ECUs)

Investment in

Regional Funds

% Total Investment

Investment in

Commercial Funds

% Total Investment

Private Banks 1,569,000 12.3 3,063,040 16.4State Banks 2,500,000 13.3Business Innovation Centres 132,000 1.0 - -Chambers of Commerce 120,000 0.9 1,000,000 5.3Churches 556,000 4.4 - -Private Financial Institutions 2,775,000 21.7 8,751,960 46.7Nat. Government Agencies 2,886,650 22.6 - -Reg. Government Agencies 805,600 6.3 750,000 4.0Private Companies 402,000 3.1 - -Venture Capitalists 2,748,650 21.5 1,480,000 7.9Universities 77,250 0.6 - -Individuals

Total Funds Raised

693,000

12,765,150

5.4 1,185,000

18,730,000

6.3

24

Table 5. Investors' Reasons For & Against Contributing to a Seed Capital FundReasons For: Ranking No. Reasons Against: Ranking No.

Regional Development /Job Creation/Social Responsibilities

1 13 Excessive Risk/ Poor Expected Returns

1 11

SME Development 2 7 Alternative Investment Opportunities

2 3

EC Financial Support for the Fund

3 6 No Seed Capital Experience/Interest

3= 2

Growth Opportunities

4 4 No Track Record by Seed Fund

3= 2

New Products/ Technologies

5= 3 Already Investing in Seed Capital

3= 2

Attractive Potential Returns

5= 3

25

TABLE 6. PRIMARY CRITERION FOR FUND PERFORMANCE EVALUATION

Fund Performance Criteria:Regional Funds

N=13Commercial Funds

N=8No. of Jobs Created - 1No. Businesses Created 1 -Return on Capital 4 5No Formal Evaluation Criteria 8 2

26

TABLE 7. SOURCES OF FUNDS’ DEAL FLOW 1992Regional Funds N=13 Commercial Funds N=8

Deal Channels: % Proposals % Acceptances % Proposals % AcceptancesBanks/Fin. Institutions 6.4 0 15.3 27.2BICs 40.5 50.0 7.6 9.1Development Agencies 0.7 0 - -Chambers of Comm. 7.3 9.1Government 8.1 0 3.1 9.1Consultants - - 5.3 4.5Fund Investors 1.2 0.7 - -European Commission - - 0.4 4.5Universities/SCI. Parks 3.7 3.3 0.1 4.5Venture Capitalists 3.9 10.0 2.7 9.1Unspecified Dealflow 24.9 30.0 57.3 22.7

Total Numbers 407 30 262 22

Acceptance Rates % 7.4 8.4

27

Table 8. Fund Managers' Rating of Key Project Selection Criteria

Key Acceptance Criteria:

Regional Funds' Ratings*

N=13

Commercial Funds' Ratings*

N=8Entrepreneur's Character 4.9 4.8Entrepreneur's Experience 4.1 3.9Degree of Expected Competition 4.0 4.1Legal Protection of Technology 3.2 3.0Nature of Technology 2.8 3.6*Rating Scale: Not important 1 - Very Important 5

28

Table 9. Fund Managers' Reasons for Refusing New ProjectsRegional Funds Commercial Funds

% Total % TotalUnprompted Reasons: N=29 N=22Entrepreneur's Lack of Experience 20.7} 13.6}Character of Entrepreneur 13.8} 34.5 22.7} 36.3Market/Growth Potential of Product 24.1 27.3Technology Potential 10.3 13.6Other 30.1 22.8

29

Table 10. Percentage of Investments Made by Stage of Investee Firm DevelopmentConceptTesting

Pre- Prodn/Sales

Initial Sales

EarlyGrowth

No. of Responses

Regional Preferred 32 32 36 0 13Funds: Actual* 12.5 52.1 33.3 2.1 48

Commercial: Preferred 20 33 47 0 8Funds Actual* 28.1 56.3 15.6 0 31*Estimated from investments made

30

Table 11. Percentage Distribution of Investee Firms by Level of Technological Innovation

Technology Innovation:

Low Medium High No. of Responses

Regional Funds: Preferred 23.1 53.8 23.1 13Actual* 11.4 61.3 27.2 48

Commercial Funds:

Preferred 25 62.5 12.5 8

Actual* 9.5 46.9 43.6 31*Estimated from investments made

31

Table 12. Planned Exit Route for Investee Companies (weighted by rank ordering)Planned Exit Routes: Regional

Funds % Exits

Number of

Responses

Commercial Funds

% Exits

Number of

ResponsesTrade Sale 34.4 21 34.3 37Entrepreneur Share Repurchase

33.3 36 31.1 19

Sale to a Venture Capitalist 30.6 33 27.9 17Initial Public Offering 1.8 2 6.6 4

32

Table 13. Growth of Total ESCF Scheme Funds Under ManagementJan

1992Jan

1993Jan

1994Jan

1995Number of Funds 21 24 24 23Total (non-EC) Capital Raised 36.2 37.7 39.9 41.0Average Capital per Fund 1.72 1.57 1.66 1.78Average Fund Operating Cost ECU 142,685 155,441 174,254 176,126

33

Table 14. Total Investments Activity by Type of Fund by Jan 1995Private

Regional Fundsn = 8

PublicRegional

Fundsn = 11

PrivateHigh Tech

Fundsn = 4

Average Capitalisation ECU million 1.3 1.3 4.06Percentage of Fund Invested 45 47 92Annual Fund Operating Costs ECU 145,997 122,618 259,762Total No. of Investments 62 85 41Average Investment Value ECU 59,736 68,836 333,576Percentage High Tech Investments 31 42 85Percentage Medium Tech

Investments45 45 15

Percentage Low Tech Investments 24 13 0No. of Business Failures 21 15 4Failures as a % of Total Investments 33.9 17.6 9.8

34

Table 15. Number of Jobs Created by Category of Fund and Technology Status 1992-94

Number of Jobs Created

PublicRegional

Fundsn = 11

PrivateRegional

Fundsn = 8

Private High- Tech Fundsn = 4

Total Jobs by

Tech. Status

No. of Firms

by Tech. Status

Jobs/Firm by

Tech. Status

High-Tech Companies 261 360 514 1,135 90 12.6Med.-Tech Companies 239 377 119 735 72 10.2Low-Tech Companies 118 97 0 215 26 8.3Total Jobs Created 618 834 633 2,085 188No. of Jobs/Fund 56.2 104.3 158.3No. of Jobs/Firm 7.3 13.5 15.4

35

Table 16. Cost of Community Support per Job and Enterprise Created

Assumption of 30% Repayment Default

OverallScheme

AllRegional

Funds

PrivateHigh- Tech

Fundsn = 23 n = 19 n = 4

Total Cost of Repayable Operating and Capital Subsidies ECU million

8.76 4.77 3.99

Estimated Real Total Subsidy Cost ECU million

2.628 1.43 1.20

Cost per job (2,085 jobs created) ECU 1,260 985 1,892Cost per enterprise (188 enterprises created) ECU

13,979 9,731 29,210

36

Table 17. Fund Statistics in January 1995Private

Regional Fundsn = 8

PublicRegional

Fundsn = 11

PrivateHigh Tech

Fundsn = 4

Total Funds Raised ECU million 10.4 14.4 16.2Percentage of Available Finance per Fund Invested

47.4 45.0 92.4

Average Uninvested Finance per Fund ECU million

0.68 0.72 0.31

Annual Operating Costs ECU 122,618 145,997 259,762Time in Years to Exhaustion of Present Finance (excluding new investment) for an Average Fund

5.6 4.9 1.2

37