“Nurturing the green shoots” - how do we fund the start-ups of the future?

Business angels and serial entrepreneurs, guest bloggers Ian Ritchie and Paul Atkinson urge the government to do more to support the growth companies of the future.

In the run up to the Budget there was, as usual, a ‘whole lotta lobbying’ going on.

The British Venture Capital Association (BVCA) believes there is a crisis is investment and wanted the government to channel substantial funds via the larger Venture Capital firms.

On the other hand, the CBI considers it is time to recreate the Industrial and Commercial Finance Corporation (ICFC), founded after the second world war by the major clearing banks and which later turned into the world’s largest Venture Capital firm, 3i. In the last decade 3i has moved out of this market altogether, leaving a significant gap.

These are both valid ideas, and it looks as though the proposed Strategic Investment Fund may go some way to address them but we are more worried about where the small start-up companies will actually come from – the innovative new businesses that will grow ambitious enough to seek the Venture Capital support that is proposed. Who is lobbying for them?

Start-ups, these days, are invariably supported by Business Angels; wealthy individuals who put money and effort into early stage businesses. Trouble is, the Angel market is largely supported by the Enterprise Investment Scheme (EIS), which gives substantial tax breaks to these high-risk investors. Right now, such individuals don’t have many Capital Gains to re-invest, or the resultant tax to shelter, and as trade sales and flotations have dried up, their money  is locked into their existing investments.

Scotland is relatively well served in terms of angel networks and the Scottish Co-Investment Fund and Venture Fund models support this to the tune of 25% + of all angel money being deployed. 

But one of the main issues just now is that what spare angel money there is, is being diverted to investment opportunities that would normally be served by debt provision (that is later stage investment opportunities).  As it happens, Scotland is currently outperforming the rest of the UK in terms of Angel investment - but this is probably not enough in the current environment, where debt is not easily available (no matter what the government states).

However, with the notable exception of a handful of firms like Pentech and ParEquity, Scotland is under-served by early stage VCs (ie those firms that invest £1-5m in early stage businesses and operate in a very hands on way). There are still good sources of VC funding once you get to the £10m level, whereas early stage funding, both the first £200,000, and second round finance up to £5m,  is becoming extremely difficult to raise.

There is a crying need for some more government-supported early stage risk money. It would be so much better to support 50 companies with £200,000 each, than one at £10m. This could be further helped if the banks were to provide a matching debt model aligned with Scottish Enterprise’s offerings.

From a Scottish perspective, any initiatives that support the establishment of early stage VCs would be a good thing e.g. by providing committed capital into their funds (for example using European Investment Fund monies, as is happening in the North East and parts of Central Europe).

A key area that would make a huge difference would be providing additional incentives/support for investor readiness and diligence processes as this is a key tipping point to early stage companies gaining investment support. In our experience many companies that approach us are not really investor ready. Just because the numbers add up, this doesn't mean their market strategy or business model is ready to receive financial support from the capital market. Such schemes could easily be managed by the existing SMART/SPUR teams in Government.

Of course, there are very few of us to lobby for the start-up companies because, by definition, they don’t yet exist, but unless we do something to ensure the formation of a healthy new population of businesses, the Venture Capitalists will later have nothing to invest in, and then where will the "green shoots" be ?

Ian Ritchie, Paul Atkinson

Comments

[Andy Smith]

Hi Paul & Ian

As founder of a Scottish startup I couldn't agree more with the sentiments expressed in your article. As Paul knows, I have been in fund raising mode for a while and perhaps trying to do so before we were really market proven or investor ready ... building business plans that required a £1M investment then failing to provide the evidence to back up this level of investment. Too much money, too early, based on too little. Mea culpa.

I'm as ambitious as the next man and really believe in what we are doing and perhaps niavely saw no strategic reason to take a conservative approach to going for funding that would support rapid growth.

It would be a real boost to have access to smaller but significant amounts of "risk-money", shared between say Angels, a Scottish Enterprise scheme and matched Bank investment of the type you describe.

A combination of say £100K + £100k + £100K would make a huge difference to our company at precisely this moment in time , working on the basis of "this looks like it might well succeed, the team are committed and capable and the returns could be very large indeed." Waiting until all the real "investment calamity" risks are eliminated before going back down the £1M investment route means we have to struggle by on meagre funds making compromises every day. There has to be a middle ground.

One suggestion at a structural level would be making the bank element a convertible loan in reverse - this would be an innovative way of encouraging founders to take in funds early in exchange for equity - knowing that they could "buy it back" at some future point at a level that generates a big return for the bank and returns equity to the founders. Wouldn't that improve the image of the Banks.

The quote about "crying need" definitely hit a nerve with me tonight - gald to get a forum to air my views - so thanks very much!

Andy Smith
Agenor Technology