Private equity funding for innovative start-ups is drying up. The cash drought threatens to hamper Britain's ability to create jobs in the vital knowledge economy

In the UK we don't really have a venture culture," says Martin Rice, chief executive of software company Erudine. "What we have is an M&A culture." Rice speaks from personal experience. His company sells a software toolkit intended to cut the cost of system development by as much as 90 per cent.

Rice calls the Erudine Behaviour Engine a revolutionary product, but until the company secured a major investment from aerospace giant EADS earlier this year, the founders were forced to finance the business largely from their own pockets.

The reason? Well, according to Rice, anyone with a truly innovative product at the pre-revenue stage is likely to have a tough time selling the concept to the private equity/venture capital community. "Investors say they're looking for innovation, but what they really want are 'me too' products, with a few variations on what has gone before," he says. "They don't really want the risk of backing something that is genuinely new."

Rice's view is far from unique. One of the most common criticisms of the UK private equity market is that funds prefer to invest in established companies rather than start-ups. And a new report from NESTA (the National Endowment for Science, Technology and the Arts) suggests the recession has made life even more difficult for cash-hungry, early-stage companies.

The report says VC funding of early-stage firms fell 70 per cent in 2008 from the previous year, with 2009 set to be worse again. A closer look at the figures reveals why. NESTA says only 13 VC funds have more than £5m in their coffers and the total available for new investment is a relatively paltry £400m. Meanwhile, the credit crunch has curbed the ability of VCs to raise cash.

It's a situation that disproportionately affects innovative, fast-growth firms that need large amounts of money for research and development. As the report points out, developing a groundbreaking technology and bringing it to market eats cash quickly, and there are no guarantees of success. As the risk is too great for banks, companies have to look for equity investment-finance that seems to have dried up.

So what does this mean for the ability of the UK to nurture innovative businesses? It would be wrong to suggest that all inventive companies need VC finance. Many accept the fact that any injection of venture capital will have to be put off until management can demonstrate sales, or at least sales potential. So they raise what they can and focus on getting a product into the market.

Certainly that was the experience of former investment banker Charles Clark, chief executive of Rosslyn Analytics. The company was founded to develop and sell what Clark describes as a "Bloomberg screen" for finance directors and procurement chiefs, providing them with a means to track spending across the organisation.

"When we launched the company, VCs wouldn't look at us, because they said we hadn't proved the concept," says Clark. "So we had to bootstrap the business, using the cash we had to get to a position where we could raise finance when strategic decisions had to be made."

Today, with clients such as law firm Clifford Chance and mining giant Rio Tinto, Clark says the company has proved that a market for its product exists, putting it in a strong position to negotiate with investors for growth capital.

It's been a similar story at Erudine. Before EADS bought a stake, the company was financed through loans, remortgaging, credit cards and a government grant for R&D. By putting the product into the marketplace, Erudine has succeeded in establishing itself as investment-worthy. "Once we could show the product being used by blue-chip clients in mission-critical environments, people were falling over themselves to invest," says Rice.

There are undoubted attractions to the bootstrap approach, not least that you hang on to a greater share of the business. In the current climate, VCs prove more risk-averse so they ask for a greater share of equity when they do invest. Companies that are already earning revenues and profits are seen as lower risk, so when they reach the stage of pitching for growth capital the equity cost isn't too high.

But bootstrapping a business towards profitability isn't always appropriate or possible. Kevin Jones, a director at Finance South East, the funding arm of regional development agency SEEDA, says: "Today's start-ups may find it hard to raise even small sums of money now. House prices have been falling, so it's more difficult to remortgage. It's also more difficult to get friends-and-family funding and angel finance because there is less money around."

Businesses that can raise cash from those sources may find it isn't enough to enable them to deliver on their potential. Steve Schlenker is managing partner of DN Capital, a VC firm that splits its investments 50/50 between pre-revenue and revenue-generating companies. He says that without substantial early-stage finance some potentially world-beating businesses would wither on the vine. "We do see a lot of companies making it to revenue under their own steam but the breakthrough companies-the ones that require a lot of R&D spend-won't be able to do it that way," he argues.

In that respect the freezing-up of VC funding has serious implications, but Schlenker says there is light at the end of the tunnel. He acknowledges that VC investment slumped in the fourth quarter of 2008 and the first quarter of this year but argues that a corner has been turned. "Valuations have stabilised and we are now seeing renewed interest in investment. In fact, the shortage of bank finance has resulted in more deal opportunities for VCs."

Government agencies are also addressing the equity gap. Finance South East has established what it calls a "funding escalator". Working with VCs and angels, it can arrange finance from proof of concept through to later stage growth capital. "We are providing more funding than at any stage in the past," says Jones.

But there's a limit to what government can do and the recession has aggravated a problem that was already hampering the creation of fast-growth companies. Early-stage finance for high-risk, high-reward ventures is in short supply and that gap compromises our potential to create jobs in the all-important knowledge economy.