Let’s start with the good news. According to a survey published in June by Barclays Business Banking, 110,300 new companies opened for trade in the first three months of this year—an increase of around 25 per cent on the same period in 2005. The survey provides evidence that Britons are stepping out of the nine-to-five comfort zone in favour of entrepreneurship. Even allowing for a rising failure rate—the Barclays survey shows a 50 per cent increase year-on-year—it is a trend that bodes well for the economy. But such figures mask an uncomfortable truth; entrepreneurial activity may be on the rise, but the UK still lags far behind the US in terms of company creation, and venture capital—or the lack of it—is seen as the problem.
The language of lucre
Angels
Individuals who invest in start-up companies, either directly or through loose syndicates. Investments usually amount to a few hundred thousand pounds. Those investing directly often play an active role in the company and join the board.
Venture Capital Trusts
Launched in 1995 as part of a government strategy to encourage investment in young companies. The government offered an income tax relief on all money put into VCTs. In 2006, relief was reduced from 40 to 30 per cent and the gross asset value of investee companies was halved (to £7m). These will be young, but not necessarily start-up, companies. VCTs are quoted companies usually set up and managed by private equity houses.
Enterprise Capital Funds
Government-backed vehicles providing seed and early-stage funding for innovative businesses. The government supplies two-thirds of the money for each ECF but takes only one third of the profits. Private Equity A generic term for investment in private companies, usually. PE backs early-stage companies (often through the management of VCTs or ECFs), but the investment trend is towards bigger, and more established, businesses. PE houses have taken controlling stakes in household-name companies such as Debenhams and the AA. Many private equity deals are management buy-outs. Total PE investment came in at £11.7bn in 2005. Investment in early stage and start-up companies totalled £382m (BVCA figures).
MiFID
The EU’s Markets in Financial Instruments Directive broadly replaces the Investment Services Directive. It is an attempt to standardise financial services in order to create a single European market for investment bankers, stockbrokers, corporate finance firms, banks and any other organisations selling investment products to customers. Under the current schedule, companies have until November 2007 to comply.
This is particularly true in the technology sector, where Britain has yet to match the success of the US in turning ideas into world beating companies. Even VC-friendly hotspots such as the “Silicon Fen” around Cambridge University fail to compare for entrepreneurial dynamism with the original Silicon Valley in California.
According to Jonathan Kestenbaum, chief executive of the National Endowment for Science, Technology and the Arts (NESTA), it is now vital that the UK closes the gap. NESTA was founded to provide funding and advice for new ventures and he is adamant that unless Britain creates more innovative companies, UK economic competitiveness will suffer. “We can’t compete on efficiency anymore,” he says. “Today we have to compete in areas where we have a competitive edge—the arts and media sector, and our science base.”
But, while banks may be happy to finance the launch of a sandwich chain or recruitment agency, speculating on the success of a prototype microchip is less appealing—they are not in the risk business.
Isn’t this where VCs come in? Venture capital trusts and private equity houses are awash with cash at the moment, having raised £27.3bn in 2005 compared with just 3.3bn a year earlier, according to British Venture Capital Association (BVCA) figures. Yet relatively little of that is finding its way to the technology sector or early stage projects.
Research published this year by Global Entrepreneurial Monitor (GEM) indicates that only around 20 per cent of European VC cash was directed into technology companies last year, compared with 84.1 per cent in the US. Meanwhile, figures from Venture One research company show that UK investment by VCs in early-stage companies dropped to just £300m in 2005, a tenth of the amount recorded in 2000 (which was, admittedly, the height of the dotcom boom.)
Amy Mokady, vice-president of sales and marketing at Cambridge-based start-up Light Blue Optics, says the simple reality behind the statistics is that fledgling technology start-ups find it incredibly difficult to raise cash. Mokady helped orchestrate a successful pitch to VCs that netted the company a £1.3m injection of seed capital through a consortium led by 3i to develop its micro-projector products. But she is aware that investors tend to be sceptical about businesses yet to generate income. “They are very cautious about pre-revenue companies,” she says. “Once you can demonstrate that you can produce an income it becomes a lot easier.”
Within the VC/private equity industry there are those who concede there is insufficient cash available for innovative start-ups. “Not enough money is being applied at the seed stage,” says Laurence John, chief executive of Amadeus Seed, an enterprise capital fund established to provide new ventures with development cash. “Most VCs are only interested in first and second-round funding.”
It’s not hard to see why a VC might resist providing development capital. According to John, taking a start-up and turning it into an investment-ready company can cost upwards of £1m in seed capital.
It’s not just product development that needs to be addressed. The founders also have to build a corporate structure good enough to reassure future first and second round investors they are backing a viable concern, with a decent business plan and a strong management team.
Finding investment gets easier as the company develops, according to Kestenbaum. “You have to think of funding a company as walking through a desert from one oasis to the next,” he says. “At the seed stage, there aren’t many oases around. As you progress, you find there are more of them.”
Even then, the investment criteria may prove problematic. Most VCs expect to see demonstrable potential for rapid growth. In the tech sector, that tends to equate to global sales potential. Increasingly, VCs are looking to invest in ventures with multi-territory aspirations, rather than putting smaller sums into businesses with a localised focus. “We want companies that have ambition and that think globally,” explains Simon Cook, CEO of early-stage investor Esprit Capital Partners. “For a good technology firm, we would want to put in about £10m. That’s the kind of sum required to take that technology to the American market.”
Gary Robins, chief executive of private equity investment group Hotbed, agrees that start-ups needing the most cash tend to get a more sympathetic hearing from the VC community. “It’s difficult to imagine how a venture that is seeking to raise £200,000 or £300,000 could be built into anything significant,” he says. “Unless a venture is seeking to raise at least £1m, it is unlikely to become a business of substance.” As the BVCA sees it, few UK start-ups have the potential to justify that kind of investment. It boils down to a deficit of suitable candidates that can boast a magic combination of ambition, quality management and a strong, defensible product. “It isn’t so much an investment gap as an ‘opportunity to invest’ gap,” says BVCA vice-chairman Wol Kolade.
Despite the protestations of the BVCA, several investors to whom Director spoke maintained there is also a finance gap, at least at the seed capital stage. But equally, the supply of good, new companies is not as plentiful as it could be.
In an attempt to mitigate investor risk, the government has set up the Enterprise Capital Fund (ECF), to mixed reviews. John from Amadeus Seed, an ECF, sees it as a way of widening the pool of potential investors. “Angels traditionally don’t like putting money into funds,” he says. “What the government has done is incentivise the private investor.”
But, while Gary Robins agrees that private investors can play an important role in backing early- stage businesses, especially if they are brought together through funds or syndicates, he believes inequalities in the tax system remain a disincentive to individual private investors. He points to the experience of Hotbed, which currently invests in fast-growth companies on behalf of around 400 members.
“We look for EIS (Enterprise Investment Scheme) companies to invest in,” he says, citing another government scheme. “At the moment, the income tax break on an EIS investment is just 20 per cent. We think the EIS tax break should be raised to the 40 per cent level enjoyed by venture capital trusts (VCTs). While the ECF is a positive step, he adds, relatively few funds are up and running at the moment.
VCs also raise concerns about the apparent trend towards heavier-handed regulation. The BVCA has welcomed the government’s commitment to modernising the law on limited partnerships, which should make VCTs easier to set up and run. But Kolade cautions that the “direction of travel” is often towards a tightening of the regulatory screw. He cites the impact of the European Union’s imminent MiFID (Markets in Financial Instruments Directive, see sidebar) regulations as one example. “We’re being regulated as if we are investment banks,” he says. “And clearly we are not.”
New enterprise directors, too, face regulation. But this is equally true of the US. “No-one wants another Enron,” explains Dr Rebecca Harding, executive director of GEM. “Different countries are addressing this in different ways and the US appears to be taking the regulatory route to prevention.”
Arguably, the greatest difference between US and UK start-ups lies in the national psyche. In the US, the culture of entrepreneurship is more deeply rooted in than in the UK.
It’s a difference that cannot be wiped away by the stroke of a policy-maker’s pen. But there are ways of addressing the issue, as Michael Synder, senior partner at accountancy Kingston Smith, contends. “Business should play a much more central role in schools,” he says. “There ought to be more financial and practical business education.”
Entrepreneurs also require support structures. Kestenbaum says that more must be done to create the informal and formal networks of academics, investors, managers, business advisers and mentors that characterise the Silicon Valley ecosystem. “If innovation is to flourish you need collaboration,” he says.
Mokady adds: “One of the big differences in the US is that there are more experienced people who are prepared to run start-ups,” she says. “These are professional managers who join a company and take it from early stage to exit. You don’t really get that here, because it involves a lot of risk.”
Which feeds directly back to the investment issue: innovation may be a wonderful thing, but companies won’t get VC backing unless they have strong and experienced management. Mokady believes that investors tend to back teams ahead of technology. “Light Blue Optics was formed by four research postgraduates from Cambridge,” she says. “Their initial attempt to secure backing from VCs failed because the team didn’t have the necessary business experience.”
None of this should disguise the fact that Britain is perfectly capable of building strong technology companies. The management expertise, the technical know-how and the corporate finance are all there, as is the perfect vehicle for IPOs in the form of the Alternative Investment Market. As for creating an entrepreneurial ecosphere on a par with the US—that remains a work in progress.
