The Supply of Equity Finance to SMES: Revisiting the "Equity ...

THE SUPPLY OF EQUITY FINANCE TO SMES: REVISITING THE “EQUITY GAP”

A report to the Department for Business, Innovation and SkillsSQW CONSULTING

URN 09/1573

The Supply of Equity Finance to SMEs: Revisiting the “Equity Gap”

A report to the Department for Business, Innovation and Skills

Acknowledgements

SQW Consulting would like to acknowledge the substantial contributions to this study made by Professor Colin Mason, University of Strathclyde, for his advice and guidance, and by Oxford Innovation, for help in engaging business angels. However, the views expressed here are those of the authors alone.

The authors would also like to thank all those who made data available to the study; those informants in the public and private sectors who participated in interviews; and the business angels who participated in a group discussion. Special thanks are due to staff in the British Venture Capital Association for advice on the use of data sources.

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Contents

Executive Summary................................................................................................................1

1 Introduction........................................................................................................................ 10

2 Methodology and definitions............................................................................................13

3 Analysis of the supply of equity finance - venture capital.............................................16

4 Venture capital funding – characteristics and processes..............................................33

5 Analysis of the supply of equity finance – informal equity (from business angels)....37

6 Publicly-backed funds in UK.............................................................................................43

7 Other public sector interventions in the equity finance market in the UK....................51

8 Equity investment and institutional investors.................................................................54

9 Corporate venturing in the UK..........................................................................................58

10 International comparisons..............................................................................................61

11 Implications of the current economic climate...............................................................73

12 Assessing the Equity Gap...............................................................................................76

13 Bibliography....................................................................................................................... 83

Annex A: Data sources and definitions............................................................................A-1

Annex B: Additional data on investment activity.............................................................B-1

Annex C: List of consultees...............................................................................................C-1

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Executive Summary

Introduction

1. This study into the supply of equity finance1 for SMEs was conducted on behalf of BIS2 (then BERR3 and DIUS4) by SQW Consulting with contributions from Oxford Innovation and Professor Colin Mason, University of Strathclyde. It was conducted during the period September 2008 to January 2009.

Research objectives

2. The research was commissioned to refresh the evidence base on equity finance and, specifically, to establish whether the existence and boundaries of the equity gap have changed since the initial ‘Bridging the Finance Gap’ research was undertaken in 2003 by HM Treasury and the Small Business Service. The latter research identified the shortage of modest amounts of risk capital – the “equity gap” – to be most acute for businesses seeking investments of between £250k and £1m, but extending up to £2m, and for some businesses it may be higher.

3. The prime objective of the current study has been to determine within which segment(s) of the SME equity supply market the structural equity gap is most acute and whether there are any differences across sectors (especially high technology), stages in business development and regional geographies. The study also provides an assessment of more recent factors affecting the supply of equity capital to SMEs including the economic downturn and Credit Crunch.

Methodology

4. The study deployed a mix of research methods, including:

desk research on:

published reports and data

data provided by public sector bodies

consultations with individuals active in the equity supply-side market

facilitated workshops with business angels.

1 Equity finance is defined as capital invested in a business for the medium to long term in return for a share of the ownership and sometimes an element of control of the businesses. Unlike debt finance, equity finance investors do not normally have a legal right to charge interest or to be paid at a particular date. Instead their return is usually paid in dividend payments and depends on the growth and profitability of the business. Equity finance is often referred to risk capital as it shares the risk of the business and equity is the last source of finance to be repaid out of any residual assets in the event that the business fails.2 Department for Business, Innovation and Skills3 Department for Business, Enterprise and Regulatory Reform4 Department for Innovation, Universities and Skills

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5. The primary research involved consultations with key private and public sector stakeholders. Consultees included finance experts, sector/industry experts, fund mangers, investors and representatives from British Venture Capital Association (BVCA), European Venture Capital Association (EVCA), British Business Angel Association (BBAA), National Endowment for Science, Technology and the Arts (NESTA), Technology Strategy Board (TSB) and Regional Development Agency (RDA) finance leads.

Key findings

Supply of venture capital

6. Out of a total of £12bn invested in unquoted equity in 2007, early stage equity accounted for 4% by value (£434m in 502 companies). Expansion capital accounted for 9% of investment by value (£1.1bn in 595 companies). Therefore, private equity (early stage and expansion stage combined) accounts for 13% of total private equity, with the remainder mainly comprising finance for Management Buy Out (MBO) and Management Buy In (MBI). Over the period 1998-2007, the level of early stage equity remained relatively constant, with peaks in 2000 (the height of the dotcom boom) and again in 2006. The supply of expansion investment has been more variable throughout the period, with prominent peaks in 2000 and 2006.

Figure 1 Investment in early stage and expansion in the UK by BVCA members, 1998-2007 (£m)

0

500

1,000

1,500

2,000

2,500

3,000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

Inve

stm

ent

(£m

)

Total early stage Expansion Total early stage and expansion

2003 2007

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity 2007; Expansion excludes refinancing bank debt and secondary purchase.

7. The bubble caused by the dotcom boom was not just a case of arguably reckless investment by VCs but also a function of their ability to raise funds from institutional investors who took an interest in the ICT sector. Many VC funds were raised just before the dotcom bubble burst and given their ten year lifespan, these funds have been suffering ever since in reported performance returns due to the aftermath of dotcom failures. The dotcom crash therefore meant not only that VCs withdrew from the sector on risk rounds, but also that

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they found it harder to raise funds for any type of investment. This led to venture capital suffering from a bad reputation with institutional investors.

8. By 2005, the worst of this problem had begun to dissipate and VCs were able to raise a good level of funds. This meant they had plenty of money to invest in 2006. By this time, new types of investor had taken an interest in the VC market, including banks and hedge funds. The decline of VC activity in 2007 may now be seen as an early warning of the current economic problems: the Initial Public Offering (IPO) market began to dry up, cutting off an important exit route for private equity.

9. Sub-£2m investments have accounted for between 70% and 80% of all venture capital investments for the period 2001 and 20075. However, investments below £2m accounted for 12% of all investments in 2001 falling 6% in 2007. The most common amount received by companies during the period 2001 and 2007 appears to have between £200k and £500k. However, the extent to which sub-£2m investments are elements in larger syndicated deals is uncertain from examination of published sources.

10. In recent years, the key sectors for VC funding (of all types) by value have been consumer-related and communications. In terms of number of deals, computer-related, medical health/biotech and consumer-related have been the highest. In terms of technology-related transactions, the key areas for early stage investment have been software, biotech and communications.

11. Since 1998, London and the South East regions dominate in terms of early stage equity provision, both absolutely and when compared to the number of VAT registered businesses in the each of the English regions.

Venture capital characteristics

12. The investment criteria of early stage funds are designed to meet the initial needs of the target client base. However, these criteria, if rigidly applied, may prevent the funds providing follow on finance, thus requiring them to pass on the deal to other providers with deeper pockets.

13. Good management is by far the most important attribute in making a company attractive to potential VC investors (more important even than the initial product or service proposition), as VCs consider it is this which will help ensure good returns. Investment readiness schemes need to take this into account as there is a perception by some fund managers that those delivering schemes are not tough enough on entrepreneurs about the need to bring in professional management.

14. The early stage VC due diligence and deal process is time consuming and expensive when compared with the potential returns and the risk that those returns will not be realised. This has contributed to the withdrawal from the market of former key players and to the syndication of deals. However, the early stage market, where the investment sizes (for non-capital intensive businesses) are relatively small, can act as a first step for new VC fund

5 Pierrakis & Mason (2008) Shifting Sands: The Changing Nature of the Early Stage Venture Capital Market in the UK. NESTA research report.

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managers with only limited resources to invest. So, whilst there are only a few VC funds at this end of the market, it is not true to say there are none.

Supply and characteristics of business angel finance

15. Business angels are playing an increasingly important role in providing early stage finance (business angels’ share of private sector investment rose from 15% in 2001 to 30% in 2007). However, the total value of recorded deals done has fallen over the period from 2005 (£47.8m) to 2007 (£29.5m). However, data on business angel investment are incomplete and hence these figures could understate the real scale of transactions. What the figures are likely to be reflecting, however, is the anecdotal evidence that a lack of market ‘exits’(e.g. IPOs, trade sales) means that business angels are having to stay involved with investees for longer, constraining their ability to invest in new deals.

16. One important investment route for business angels is through acting as co-investors for publicly backed funds, as business angels are willing to operate at the smaller end of the market. VCs are seen as less willing to be co-investors as the deals are too small to be viable (given that they would still want to undertake their own due diligence). Business angels tend to invest only in sectors in which they have direct previous experience and hence they do not need to undertake such extensive due diligence as VCs.

17. A key trend is the increasing use of angel syndicates to invest. These allow angels to share the risk and take part in larger deals (i.e. £250k to £500k). The syndication approach also allows angels to appoint a ‘lead angel’ with both financial experience and knowledge of the sector in which the investee company operates. VCs confirm that the presence of an experienced lead angel at the early stage makes the deal much more attractive to later stage investors because they take comfort from the expertise that has been involved.

18. Although business angels rate the satisfaction of their direct involvement in an investee highly, they are of course looking to generate a commercial return from their investment.

Publicly backed funds

19. There are a large number of publicly funded VC funds: Table 1 provides a summary of these by fund type.

Table 1 Summary of publicly backed VC funds

Fund type Total funds available (during investment period)6

Investment size range

End of investment period

Geographical scope

Regional Venture Capital Funds (RVCFs)

£241m Up to £660k 2007 - 2008 Regional

RDA VC funds £220m £50k - £2.5m 2008 - 2012 Regional

6 Investment period was defined as last two years i.e. 2007 and 2008. Variations in the way the data from different sources are recorded may lead to slight differences in the time period covered.

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Fund type Total funds available (during investment period)



Geographical scope

Early Growth Funds (EGFs)

£36.5m Up to £200k 2014 – 2016 Regional

University Challenge Seed Funds (UCSFs)

£60m £25k - £250k Evergreen National

UK High Technology Fund (UKHTF)

£126m Up to £2m 2006 National

Community Development Venture Fund (Also known as Bridges Fund)

£40m £100k - £2m May 2009 National

Enterprise Capital Funds (ECFs)

£185m £500k - £2m 2011 – 2013 National

Carbon Trust Funds £27m £250k - £3m Still open to investments

National

NESTA fund £50m £250k - £1m Evergreen National

Source: BERR/DIUS/RDAs/Carbon Trust/NESTA

20. It is clear from discussions with market stakeholders that publicly backed VC funds are vital for providing early stage equity capital to SMEs. Business angels do not have enough capacity by themselves to meet the financing needs of businesses seeking equity finance. Therefore, publicly backed funds help fill the gap at the early stage of the market that would otherwise exist.

21. However, there were concerns expressed by some consultees that individual publicly backed funds were too small both in terms of overall capacity (it is suggested that they need to be £30-50m to be commercially viable) and in terms of the maximum amount they could invest in any one company (initially £250k, then increased to £500k, and then increased again to £660k for an RVCF or £2m for an ECF). An example of the former would be one of the RVCFs which had total funds of only £12m. This means that they may not be able to provide all the funding the company needs and they often do not have sufficient capacity to provide follow-on funding. Hence their investees may need to find other investors to avoid growth being constrained.

22. The issue of follow-on funding highlights other concerns, including whether the fund manager of the publicly backed fund has been sufficiently tough with the investee and ensured that it is ready for the next round of investment. Also, having a public sector fund and a group of angels involved might not be attractive to some later stage investors who may only be willing to invest if they can take over the whole transaction.

23. Another problem identified with publicly backed funds was their limited time spans for investment. RVCFs and some RDA VC funds have come and gone leaving perceived gaps behind them in regional markets. However, ECFs are being made available in tranches

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and hence at present their geographical coverage is varied7. There have been a number of new VC schemes recently introduced including the Capital for Enterprise Fund and Aspire Fund. (Since completion of the research for this report, the Government announced on 29 th

June 2009 the new UK Innovation Investment Fund which will focus on providing equity finance to growing small businesses, start-ups and spin outs in digital, life sciences, clean technology and advanced manufacturing.)

24. Publicly backed funds are not generally viewed as crowding out the private sector as the private sector has commercial reasons for not being more involved in the early stage market. Co-investment arrangements were cited by stakeholders as a way of encouraging the private sector (in the form of business angels) to invest alongside the public sector. Likewise, the ECFs are seen as a way of the public sector making use of private sector fund management skills to do deals that the private sector might not otherwise consider.

Other public sector equity interventions

25. Although not a focus of this report, there are a number of tax based initiatives designed to increase the supply of equity finance to SMEs. These include Venture Capital Trusts (VCTs) and Enterprise Investment Scheme (EIS).

Venture Capital Trusts (VCTs)

26. VCTs came into existence in 1995 as a tax efficient way for High Net Worth Individuals (HNWIs) to invest (passively) in early stage companies. Funds raised/invested reached a peak in 2006 when changes in the Finance Act (FA) tightened the rules and reduced the range of companies in which VCT funds could be invested.

27. Whilst VCTs have been structured to ensure that only small companies are supported, the structure does impose constraints on the use of the vehicle. VCTs are limited to £1m on any one investment.

Enterprise Investment Scheme (EIS)

28. The EIS allows HNWIs to invest more actively in early stage companies (as business angels). The key benefits of the EIS include:

20% of the cost of the investment can be offset against income tax

Capital Gains Tax relief on any gains made on the investment if held for at least three years prior to disposal

loss relief whereby any losses made on investments disposed of after three years can be offset against income tax.

29. These reliefs make investing a tax efficient arrangement for HNWIs as well as cushioning any losses incurred.

7 It is understood that ECFs are not restricted from investing outside of their immediate geographic area and so in theory are able to invest throughout the UK. In practice, fund managers often choose to make investments closer to their geographic location to minimise costs.

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Institutional investors in venture capital funds

30. Over the period 1987-2000, unquoted equity outperformed other asset classes in terms of returns. Its reputation was however, tarnished by the dotcom crash which depressed returns for a number of subsequent years. By 2006, institutional investors were back in the market only to ease off funding again in 2007 as the early effects of the economic downturn began to cause concern. The European Venture Capital Association is stepping up promotion of VC as an asset class to try and improve its image with institutional investors.

31. In terms of funds raised in 2007, only 10% were earmarked for early stage and expansion deals (down from 15% in 2006). Also, 75% of funding came from overseas sources. Pension funds remained the largest single class of investor but their share has declined as the importance of fund of funds and banks has grown. This is a concern given that the present credit crunch has also left banks capital constrained.

International comparisons

32. Trends in VC investment in Europe between 1998 and 2007 were broadly similar to those in the UK. However, Europe recovered far more quickly from the dotcom crash than the UK. The reason may be that the UK, being by far the largest source of VC funding in Europe (40% of deals) was much more seriously affected by the market collapse than other countries.

33. The UK is also the largest angel investor in Europe (31% of volume and 44% in number of deals). The average deal size in the UK has fallen below the average for Europe between 2005-2007. It therefore appears that the UK is doing many more deals than other EU countries but the deals are smaller in size.

34. The UK is the second largest VC market in the world after the US. In terms of VC deals the UK transacted a total volume of £12bn, 56% of the volume transacted in the US (£21.5bn equivalent). It also lagged the US with regard to the percentage of deals that were early stage (on like for like definitions - 13% vs 21%). However, given the higher GDP in the US, the penetration rate in the UK was higher.

35. In volume terms, US angel investment is an order of magnitude larger than in the UK. In 2007, US angels invested US$26bn (£18.7bn) compared with UK business angels investing the equivalent of US$4m (£29.5m). Average deal size in the US in 2007 was US$455,182 (£327,527) compared with US$91,332 (£65,705) in the UK.

Implications of the current Credit Crunch

36. Fund managers state it is currently ‘too early to tell’ when the market will pick up, but recent experience from the dotcom crash suggests that downturn in the equity markets could be prolonged. The early stage end of the equity market will only pick up again when VCs can raise funds themselves. However, institutional fund raising, new early stage deals and exits are all adversely affected by current uncertainties over company valuation.

37. Most of the usual exit routes from private equity are currently restricted and hence early stage investors are staying involved in investments for longer, tying up funds that would

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otherwise be invested in new deals. In many areas business angels are less active in new deals because they need to concentrate on existing investments or have less income available for investment.

Conclusions – assessing the equity gap

38. Most consultees consider that even in normal market conditions a structural equity gap remains. However, it is clear that the boundaries of the equity gap are more complex than a single set of parameters. The parameters of the gap are believed to stretch from £250k to at least £2m (with some putting the ceiling at £5m). In the case of sectors requiring complex R&D or large capital expenditure the gap may extend up to £15m. This is generally consistent with the previous assessment presented in Bridging the Finance Gap (2003) which concluded that ‘the gap appears most acute for investments between £250k and £1m, but is also severe for businesses seeking up to £2m, and for some businesses it may be higher.

39. These equity gap parameters define the first round funding gap, but there are additional concerns relating to the possible underfunding of UK companies at each stage of the venture capital process relative to the US. This could constrain the growth of early stage companies which then do not fulfil their potential.

40. The early stage market has been changing in recent years with the growing importance of business angels, both as individuals and as members of syndicates. Business angels also constitute the most frequent source of private sector match funding in co-investment deals.

41. Whilst there is concern that VCs have abandoned the early stage market, this is not entirely true. Some new VCs have entered this market. Early stage funding can provide a stepping stone for new VC funds on the way to larger deals. The ECF structure encourages this approach.

Areas for further research

42. First and foremost, in considering the ‘equity gap’, this report has only investigated the existence of a gap in supply-side provision. When considering the overall ‘equity gap’, it will be important to consider the demand-side and the ability of firms to obtain the equity finance they need.

43. However, the report has shown that even in terms of the supply-side, there are areas where further research would be useful. These include:

investigation of the true extent of business angel funding in the UK. This would require use of the combination of techniques suggested in the recent report by Mason and Harrison.8

further examination of the funding available within each region. This would include the additional data on business angel investment and more detailed input from the RDAs (not all of which were able to provide data for the current research). This

8 Mason and Harrison (May 2008) Developing Time Series Data on the Size and Scope if the UK Business Angel Market,

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could then be used, in combination with demand-side research, to ascertain more fully how acute the equity gap is in regions outside London and the South East.

further in-depth investigation of US VC investment data to arrive at a breakdown of average deal size by funding stage. This would enable a comparison with UK average deal sizes to see if the anecdotal concerns about UK underfunding of early stage companies relative to competitor countries are justified.

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1 Introduction

1.1 This research project was conducted on behalf of BIS9 (then BERR10 and DIUS11) into the supply of equity finance12 for SMEs. The research was undertaken by SQW Consulting in collaboration with Oxford Innovation and Professor Colin Mason, University of Strathclyde during the period September 2008 to January 2009.

Background

1.2 Access to finance is essential in enabling some businesses to start up and expand. Although only a small proportion13 of businesses actually use or consider using equity finance, it is an important source of finance for SMEs, particularly those that have strong and rapid growth prospects. In addition, certain businesses are unable to obtain debt finance because they may not have sufficient cash flow to service repayments, and so equity finance is suitable for the early, pre-revenue stages of company development. SMEs can also benefit from involvement by investors in the running of the business through their expertise and personal contacts.

1.3 This research has been commissioned to refresh the evidence base on equity finance and, specifically, to establish whether the existence and boundaries of the “equity gap” for SMEs seeking modest amounts of equity finance have changed since the ‘Bridging the Finance Gap’ research undertaken by HM Treasury and Small Business Service in 2003.

1.4 The latter investigation identified the shortage of risk capital – the “equity gap” – to be most acute for businesses seeking investments of between £250k and £1m, but extending up to £2m, and for some businesses it may be higher.

1.5 Since this earlier research was conducted there have been a number of new public sector initiatives to address the issue: the introduction of Enterprise Capital Funds (ECFs) and the provision of additional venture capital funds by Regional Development Agencies (RDAs) co-financed by the European Regional Development Fund (ERDF).

1.6 The present study is being conducted against a background of mixed views. For example, research by Library House (2006) questioned whether a funding gap currently exists at all. However, the weight of other evidence appears to indicate that venture capital deals have been continually increasing in size in recent years, contributing to a gap in the supply of equity

9 Business, Innovation and Skills10 Business, Enterprise and Regulatory Reform11 Department for Innovation, Universities and Skills12 Equity finance is defined as capital invested in a business for the medium to long term in return for a share of the ownership and sometimes an element of control of the businesses. Unlike debt finance, equity finance investors do not normally have a legal right to charge interest or to be paid at a particular date. Instead their return is usually paid in dividends payments and depends on the growth and profitability of the business. Equity finance is often referred to risk capital as it shares the risk of the business and equity is the last source of finance to be repaid out of any residual assets in the event that the business fails.13 The BIS Annual Small Business Survey 2007/08 shows of SMEs seeking finance in the last 12 months (23%), only 3% sought equity finance. Similarly, the CBR Financing UK SMEs Survey for 2007 shows that of those SMEs seeking finance in the last three years (36%), only 2% sought equity finance.

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finance for smaller deals required by early stage businesses. The present study has the objective of testing and resolving the disparate views.

Scope

1.7 Building on earlier evidence, this study examines the status of supply in terms of the scale of overall supply, supply by stage of business development, regional distribution of supply and supply by industry/technology sector.

1.8 In addition to providing a snapshot of the current supply of equity in the UK to SMEs, the study also examines trends in volume, deal sizes and coverage over time.

1.9 It assesses the supply of equity from three relevant sources – from formal investment activity through venture capital institutions; from informal equity investments by business angels; and also from publicly-backed funds.

1.10 It is important to note that the current research has not revisited the underlying market failure arguments for the existence of an equity gap, as these are already evidenced in ‘Bridging the Finance Gap’ report.

Objectives

1.11 The original objective of the research was to look at structural issues affecting the existence and scale of the equity gap. Whilst this is still the case, the study also provides an initial assessment of more recent factors affecting the supply of equity capital to SMEs including the ‘Credit Crunch’ and recession.

1.12 The study has sought to determine within which segment(s) of the SME equity market is an equity gap most acute in terms of lack of supply and whether there any differences across sectors (especially high technology) and across stages in business development. The study also assess what factors cause differences in the availability of private sector finance.

1.13 The specific study objectives are to examine:

changes in VC investment over time to determine the recent and current pattern of venture capital provision to SMEs, examining data from 1998 onwards

changes in informal investment over time to determine the recent and current pattern of informal investment made through individual business angels and angel groups/syndicates

public sector backed funds to determine the pattern of investment by public sector backed venture capital funds14, including targeting of funds in relation to patterns of private sector supply and also an assessment of the strategic “fit” - the complementarity of public backed interventions in terms of rationale, objectives and investment activities

14 Including Regional Venture Capital Funds (RVCF) and Enterprise Capital Funds (ECF).

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market drivers to identify the factors that have driven recent trends and determine how these will impact on future investment behavior and supply, including specifically attitudes and likely supply of early stage high tech investments

views of institutional investors to ascertain the attitudes of institutional investors to venture capital as an asset class

corporate venturing to ascertain the current state of corporate venturing and the current attitude of larger corporates to investing in early stage third party companies.

1.14 The study also provides an insight into the following issues:

total supply of equity capital in the UK and by region for formal and informal investments by total size and number of businesses helped

the investment appraisal process which Venture Capitalists go through including due diligence before the decision to invest is given

other supply side barriers which could restrict the provision of equity finance to SMEs.

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2 Methodology and definitions

1.15 The study has been conducted using a mix of research methods including:

desk research on:

published reports and data

data provided by public sector bodies

consultations with individuals active in the equity supply-side market

facilitated workshops with business angels.

1.16 The primary research has involved consultations with key private and public sector stakeholders into the existence of an equity gap across: (a) sectors, including high technology sectors, (b) funding stages and (c) regions. Consultees included: finance experts, sector/industry experts, fund mangers, investors and others such as representatives from British Venture Capital Association (BVCA), European Venture Capital Association (EVCA), British Business Angel Association (BBAA), National Endowment for Science, Technology and the Arts (NESTA), Technology Strategy Board (TSB) and Regional Development Agency (RDA) finance leads. A list of all informants is provided in Annex C.

Data sources and definitions

1.17 The various UK and international data sources relevant to this project have important differences in the methods of data collation and analysis, and also in the definition of key terms and coverage. Full details on methodology and definitions by data source can be found in Annex A.

UK Venture capital

Data sources

1.18 The British Private Venture Capital Association (BVCA) represents over 400 full and associate members, constituting the vast majority of UK-based private equity and venture capital providers and their advisors. In analysing the supply of venture capital finance in the UK, this research relies heavily on the BVCA’s annual reporting of investment activity 15 as it is the most robust and comprehensive source of data for the UK. The data are compiled from a survey of full members16 of BVCA and attracts a very high response rate. In some years this has been 100% including the 2007 survey used in this research.

15 BVCA and PricewaterhouseCoopers (PwC) (2008), BVCA Private Equity and Venture Capital Report on Investment Activity 2007.16 According to BVCA, there are five main categories under which BVCA full members fall into, these include: private firms; partially public backed funds; captive funds; angel syndicates and listed funds. Captive funds invest their own money and/or manage or invest funds on behalf of a parent organisation.

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Definitions

1.19 There are a number of specific methodological and definitional points that need to be considered when interpreting the BVCA data. These are outlined in Annex A (see Table A-1 and Table A-2).

UK Business angels

Data sources

1.20 To measure the level of business angel activity in the UK between 1998 and 2007, the British Business Angel Association (BBAA) was contacted for data in the UK. However, no time-series data on the number and value of investments since 1998 was available.

1.21 As an alternative source, the European Business Angel Network (EBAN) survey of national and regional business angel networks (2008)17 was used to provide figures for number of deals/ investments, amount invested and the average deal size but for the period 2005-2007 only. In the UK, BBAA and LINC Scotland18 were surveyed by EBAN.

1.22 Evidence was also based on data reported by Mason19.

1.23 There are two key points to note in relation to business angel data. Firstly, any BBAA data may only be the ‘tip of the iceberg’ of angel investing because the majority of business angel investment is unrecorded20. Secondly, the data that is recorded may not be representative of the remaining angel investment activity.

Definitional issues

1.24 EBAN does not provide explicit definitions for the number of deals/ investments, amount invested and the average deal size. We have assumed the common understanding of these terms. However, it is important to highlight the difference in the definitions for ‘number of deals’ used in relation to venture capital funding (see Annex A) with that implied by EBAN. Deals for venture capital funding were counted as being equivalent to the number of companies, whereas EBAN refers to the number of investments. Consequently, the estimates for the average deal size would be measured differently.

European business angels

1.25 European Business Angel Network (EBAN) is the main source of data for European business angel investment activity, in particular its publications:

EBAN Statistics Compendium 2008 and 2007

17 EBAN (2008) Statistics Compendium, based on the information provided by business angel networks having responded to the survey conducted in 2008. 18 LINC Scotland is the national association for business angels in Scotland – www.lincscot.co.uk19 Mason (2006) The Informal Venture Capital Market in the United Kingdom – Adding to the Time Dimension, Venture Capital and the Changing World of Entrepreneurship20 Mason & Harrison (2008) identify the gap in data relating to business angel investment activity and advocate that all developed countries should produce time-series data on business angel activity, suggesting a variety of ways in which this could be achieved. This is reported in: Measuring Business Investment Activity in the United Kingdom: A Review of Potential Data Sources, Venture Capital – International Journal of Entrepreneurial Finance.

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EBAN European directory of Business Angel Networks in Europe 2008 and 2007.

European venture capital

Data sources

1.26 European venture capital statistics are available from the European Venture Capital Association21 (EVCA) Yearbook 200822. These statistics are compiled using a survey of European countries for the industry’s new database, the Private Equity Research Exchange Platform (PEREP Analytics). This represents the most authoritative source of data on European venture capital.

1.27 Some important points in relation to the methodology and definitions used in the ECVA Yearbook need to be highlighted when interpreting the EVCA data (see Table A-3 and Table A-4 for details).

US venture capital

Data sources

1.28 The only available and comparable source of data for venture capital activity in the USA is the National Venture Capital Association Yearbook 200823 (NYCA). The data come from a survey of the Association’s 741 members active in the last eight years.

1.29 Definitions used in the context of the US venture capital investment are presented in Table A-5.

21 EVCA has been established since 1983 and is based in Brussels. It represents the European private equity sector and has a membership of over 1,250 in Europe. ECVA’s activities include venture capital (from seed and start-up to development capital). www.evca.com22 EVCA Yearbook (2008) Pan-European Private Equity & Venture Capital Activity Report.23 The Yearbook includes statistics from the PwC/National Venture Capital Association MoneyTree Report based on data from Thomson Financial.

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3 Analysis of the supply of equity finance - venture capital

Key findings

1.30 The findings on the supply of formal venture capital by BVCA members are summarised below:

In 2007, venture capital comprised 13% of all private equity with total early stage funding accounting for 4% of total private equity investment and expansion stage 9% of all private equity. This led to the financing of around 1,000 companies in the UK.

Over the period 1998-2007, the level of early stage equity remained relatively constant, but with peaks in 2000 and 2006. The supply of expansion investment has been more variable throughout the period, with prominent peaks in 2000 and 2006.

The main sectors in receipt of funding (all stages) by value were consumer-related and communications. In terms of number of deals, computer-related, medical health/biotech and consumer related were the highest.

The main technology-related sectors in receipt of early stage VC funding were software, biotech and communications.

The figures for the period since 1998 demonstrate the dominance of London and the South East in terms of early stage equity provision, both in absolute terms and when adjusted for the number of VAT registered businesses by area.

Introduction

1.31 The analysis of formal venture capital investment has been subdivided into two main parts:

current supply of equity finance in 2007 – this provides a brief overview of the position of equity finance in the UK

recent investment trends between 1998 and 2007 - this is to observe the trends before and after the last global finance shock (the bursting of the “dotcom bubble” in 2001) and to refresh the evidence since 2003 and the Bridging the Finance Gap report

1.32 The key results are set out in this section with further data presented in Annex A being referenced where relevant.

16



Supply of venture capital investment in 2007

1.33 A total of nearly £12bn in private equity capital was invested in the UK in 2007 by BVCA members in companies at total early, total expansion24 and MBO/MBI stages. Of this, £1.6bn (13%) is accounted for by investment in total early and expansion stages, in 976 companies in the UK. The total investment made overseas was nearly £19.7bn, of which investment in total early and expansion stages represented £1.9bn (10%) in 186 companies.

1.34 An overview of the position in 2007 of the venture capital market in early and expansion stages in the UK and overseas is provided in Table 3-2.

Table 3-2 Investment in the UK and overseas by BVCA members, 2007

UK investment (£m)

Number of companies

financed in UK

Overseas investment (£m)

Number of companies

financed overseas

Start-up 190 207 134 23

Other early stage 244 295 115 59

Total early stage 434 502 249 82

Expansion* 1,137 474 1,645 104

VC (Total early stage & expansion*)

1,571 976 1,894 186

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity 2007. * Expansion excludes refinancing bank debt and secondary purchase.

Investment activity trends over time, 1998-2007

1.35 In nominal (i.e. non-adjusted) terms, the total investment in private equity25 in the UK by BVCA members has more than doubled (an increase of 217%), from £3,775m in 1998 to £11,972m in 2007. In real terms (removing the effects of inflation) there has been a 155% increase in supply over the same time period. The total amount invested over the period 1998-2007 was nearly £63,970m, for all financing stages.

1.36 Of this, the total amount of venture capital invested during 1998-2007 in early and expansion stages only was £15,852m (see Table 3-3), consisting of :

11% start-up investment

16% other early stage investment

73% expansion investment.

1.37 Since 2003, the total amount of investment in the UK by BVCA members was £38,422m, for all financing stages26. The total investment during 2003-2007 in early and

24 Total expansion includes: “refinancing bank debt” and “secondary purchase”. BVCA report these as separate financing stages within the expansion phase. However, the BVCA suggests these should be treated as private equity and not venture capital. Unless otherwise stated, the figures reported relating to BVCA data excludes refinancing bank debt and secondary purchase within the expansion stage.25 Total investment in total early stage, total expansion (i.e. expansion, refinancing bank debt and secondary purchase) and MBO/MBI.26 This includes: start-up; other early stage; expansion; refinancing bank debt; secondary purchase; and MBO/MBI.

17



expansion stages was £7,692m. This total was made up of almost the same split between start-up, other early stage and expansion as found during 1998-2007 (see Table 3-3).

Table 3-3 Investment in the UK by BVCA members, 1998-2007

Start-up

(£m)

Other early stage (£m)

Total early stage (£m)

Expansion(£m)

Total expansion*

(£m)

Total early stage and

expansion** (£m)

Total MBO/MB

(£m)I

Total investment

(£m)

1998 111 177 288 688 822 976 2,665 3,775

1999 128 219 347 980 1,156 1,327 4,666 6,169

2000 175 528 703 2,012 2,122 2,715 3,546 6,371

2001 163 227 390 1,339 1,636 1,729 2,726 4,752

2002 99 196 295 1,118 1,374 1,413 2,811 4,480

2003 73 190 263 477 867 740 2,944 4,074

2004 96 188 284 789 954 1,073 4,098 5,336

2005 160 222 382 1,144 1,951 1,526 4,480 6,813

2006 531 415 946 1,836 2,994 2,782 6,287 10,227

2007 190 244 434 1,137 3,817 1,571 7,721 11,972

Total 1,726 2,606 4,332 11,520 17,693 £15,852 41,944 63,969

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity 2007. *Total expansion figures include secondary purchase and refinancing bank debt. **Excludes secondary purchase and refinancing bank debt.

1.38 The data on the amount invested in early and expansion stages since 1998 (Figure 3-2) show that early stage investment has been relatively flat for much of the period, with highs in 2000 and, notably, in 2006. The supply of expansion investment has been more variable throughout the period, with prominent peaks in 2000 and 2006.

Figure 3-2 Investment in early stage and expansion in the UK by BVCA members, 1998-2007 (£m)

0

500

1,000

1,500

2,000

2,500

3,000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

Inve

stm

ent

(£m

)

Total early stage Expansion Total early stage and expansion

2003 2007

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity 2007. NB: Expansion excludes refinancing bank debt and secondary purchase.

18



1.39 Although the value of investments varies over time, investment has been relatively stable in start-up, other early and expansion stages since 1998 when measured as a proportion of the total early and expansion stage investment. Between 1998-2007 the average investment at each financing stage as a proportion of the total early stage and expansion investment was (Figure 3-3):

10% for start-ups

17% for other early stage

27% for total early stage (including start-up and other early stage)

73% for expansion.

1.40 The data for 2003-2007 show that the average investment supplied at each financing stage as a proportion of the total early stage and expansion investment was relatively consistent for start-ups but fell slightly for other early stage companies (Figure 3-3).

Figure 3-3 Investment by financing stage as a proportion of total early stage and expansion investment, 1998-2007

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007Year

Per

cen

tag

e

Start-up Other early stage Total early stage Expansion

2003 2007

Source: Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity 2007; SQW; NB: Expansion excludes refinancing bank debt and secondary purchase.

1.41 The number of companies at start-up, other early stage and expansion that received investment during 1998-2007 was 9,292 (see Table B-1), and of this population:

19% were start-ups

25% were other early stage companies

56% were companies undergoing expansion

1.42 The average amount invested (average deal size) in early stage and expansion during 1998-2007 was £1,706m (see Table B-2). The average investment in early stage and expansion since 2003 has been £1,552m. Figure 3-6 demonstrates that:

19



following the decline in average deal size between 2000 and 2003, the average expansion investment in 2003 nearly matched that of the average investment in all early stage companies in that year.

during the rising trend in average investment from 2004 onwards, the difference between the average expansion investment and the average investment in all early stage companies has been re-established.

Figure 3-4: Average amount invested (deal size) in the UK by BVCA members, 1998-2007 (£m)

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007Year

Inve

stm

ent

(£m

)

Start-up Other early stage

Total early stage Expansion

Total early stage and expansion

2003 2007

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity 2007; SQW; NB: Expansion excludes refinancing bank debt and secondary purchase.

1.43 The number of companies receiving VC funding per year has remained relatively constant since 2001 at approximately 1,000 companies a year. There has been some change in the composition with the number of expansion stage companies declining since 2003, which is off set by an increase in total early stage funding. In 2007, the number of early stage companies exceeded the number of expansion stage companies for the first time in the decade.

20



Figure 3-5: Investment in early stage and expansion in the UK by BVCA members, 1998-2007 (number of companies)

Size of investments

1.44 Pierrakis and Mason27 have compiled and analysed figures based on BVCA data for the period 2000 and 2007, investigating the number of companies and amount invested within sub-£2m investments (see Table 3-4 and Table 3-5). According to these authors, this sub-£2m category is the scale typical of early stage investments. Unfortunately, BVCA data for sub-£2m investments are not broken down by financing stage and it is not possible to distinguish between initial and follow-on investments.

Table 3-4 Number of investee companies by investment size - sub £2 m investments, 2000-2007

Investment size (£000s) 2000 2001 2002 2003 2004 2005 2006 2007Total (SQW calculation)

0-4.9 6 19 19 18 16 38 92 53 261

5-9.9 14 8 13 14 9 11 11 19 99

10-19.9 16 23 18 14 27 19 21 28 166

20-49.9 61 40 47 80 95 100 80 110 613

50-99.9 79 84 87 105 114 98 109 138 814

100-199.9 128 135 145 171 167 172 198 161 1,277

200-499.9 230 225 216 296 283 291 258 279 2,078

500-999.9 172 195 180 165 169 146 125 141 1,293

1,000-1,999 176 204 181 152 152 156 115 120 1,256

Total 0-£499.9 534 534 545 698 711 729 769 788 5,308

Total 0-£2m 880 933 906 1,015 1,032 1,031 1,009 1,049 6,847

Investments of less than £500k as a percentage of investments of under £2m

61% 57% 60% 68% 69% 71% 76% 67% Not applicable

27 Pierrakis & Mason (2008) Shifting Sands – The changing nature of the early stage venture capital market in the UK, NESTA

0

200

400

600

800

1,000

1,200

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Number of companies invested in

Total early stage Expansion VC (early stage and expansion combined)

21



Source: BVCA & PwC (2008), Private Equity and Venture Capital Report on Investment Activity 2007; Pierrakis & Mason (2008) Shifting Sands – The changing nature of the early stage venture capital market in the UK, NESTA.

Table 3-5 Amount invested by investment size by BVCA members, 2000-2007 (£m)

Investment size (£000s) 2000 2001 2002 2003 2004 2005 2006 2007Total (SQW calculation)

0-49 - - - - - - - - Not available

5-9.9 - - - - - - - - Not available

10-19.9 - - - - - - - - Not available

20-49.9 2 2 5 2 3 3 3 8 28

50-99.9 6 8 13 6 8 7 8 22 78

100-199.9 19 28 35 21 23 23 29 54 232

200-499.9 87 88 117 79 86 86 88 171 802

500-999.9 145 153 156 100 115 98 95 206 1,068

1,000-1,999 337 301 307 186 215 215 174 278 2,013

Total 0-£499.9 114 126 171 108 120 119 128 256 1,142

Total 0-£2m 596 580 634 394 450 432 397 740 4,223

Investments of less than £500k as a percentage of investments of under £2m

19% 22% 27% 27% 27% 28% 32% 35% Not applicable

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity 2007; Pierrakis & Mason (2008), Shifting Sands – The changing nature of the early stage venture capital market in the UK, NESTA. Note: - denotes value between 0 and 0.5.

1.45 The following observations can be made on this analysis of data on sub-£2m investments made during 2000-2007:

the most common amount invested measured on the basis of the number of investee companies was £200k-499k, followed by £500k- £999k and £100k-£199k

the most common investment amount in value terms was between £1.0m- £1.9m followed by £500k-£999k and £200k-£499k

1.46 During 2003-2007, the total value of investments under £2m increased by 88%, while the number of companies receiving sub-£2m investment over the same period only rose by 2%. This suggests that average deal sizes below £2m have also increased.

1.47 Research by SBS28 finds that 79% of private sector venture capital funds in England invest on a co-investment basis and that “co-investment is the norm for most funds”. Two thirds of funds co-invest on more than half of investments and more than half co-invest on more than 75%. Co-investment in syndicates allows funds to invest in larger deals and diversify their investments more effectively. Aggregate figures may overstate the true level of smaller deals.

Investment by sector

1.48 From the 2007 BVCA data it is not possible to separate investment in industry sectors by financing stage. Thus the findings presented are for all investments, including MBO/MBI

28 SBS (2005) A Mapping Study of Venture Capital Provision to SMEs in England.

22



and this limit the conclusions that can be drawn. Taking this into consideration, the aggregate investment in the UK during 1998-2007 was mainly allocated to consumer-related sectors followed by manufacturing, agriculture & other; and communications (see Table B-3). The line graph for the total investment by sector illustrates the relative success of the consumer-related sectors in attracting investment (see Figure B-1).

1.49 The number of companies (deals) by industry sector shows that computer-related, medical health biotechnology, and consumer-related are the main beneficiaries of finance (see Table B-4). However, as mentioned previously, this includes MBO/MBI deals.

1.50 The actual investment by industry sectors as a proportion of the total investment aggregated for the period 1998-2008 (Figure 3-6) shows that consumer-related; manufacturing, agriculture & other; and communications have the largest share of equity finance. Electronics, energy, construction and transport sectors have the smallest proportion of funding. It is important to note that some of these differences may be explained by differences in the size of the industry sector rather than investors willingness to invest.

Figure 3-6: Proportion of investment within industry sectors in the UK by BVCA members, 1998-2007

Energy, 2%

Transport, 4%

Construction, 4%

Financial Services, 7%

Other services, 10%

Manufacturing, agriculture & other,

12%

Consumer related, 29%

Computer related, 8%

Medical health biotech, 9%

Industrial related, 5%

Electronics related, 1%

Communications , 10%

Source: BVCA & PwC (2008), Private Equity and Venture Capital Report on Investment Activity 2007; Statistics include MBO/MBI investments.

1.51 The trend for the average amount invested (average deal size) in each sector during 1998-2007 (Table 3-8) highlights that the average investment in consumer-related sectors has increased. It is worth noting that because these figures include later stage private equity deals, they also cover sums invested in Private Finance Initiative (PFI) transactions, which may account for the peaks in investment observed in transport and construction sectors.

23



Figure 3-7: Average investment (deal size) by sector, 1998-2007

0

10

20

30

40

50

60

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Ave

rag

e d

eal

size

(£m

)

Consumer related Computer relatedElectronics related Industrial relatedMedical health biotech Communications Energy TransportConstruction Financial ServicesOther services Manufacturing, agriculture & other

2003 2007

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity 2007. The average investments include MBO/MBI deals.

Investment in technology

1.52 Although the BVCA for 2007 do not provide statistics on all industry sector by investment stage, it does provide figures on early stage technology investment deals. The aggregate investment during 1998-2007 in technology-based early stage companies was greatest in those which specialised in software, followed by biotechnology and then communications (see Table 3-6).

Table 3-6: Total investment in technology by BVCA members – total early stage, 1998-2007 (£m)

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total

Communications 13 12 59 61 33 19 15 12 3 14 241

Computer hardware 6 21 5 3 2 3 2 2 - 5 49

Internet 12 49 88 35 4 2 7 5 4 9 215

Semiconductors 1 16 32 24 9 14 12 13 8 16 145

Software 99 55 155 70 30 44 50 52 91 58 704

Other electronics related 10 7 10 17 9 8 15 17 24 13 130

Biotechnology 31 54 49 39 33 62 45 34 14 33 394

Medical instruments 0 6 2 13 6 27 10 25 24 20 133

Pharmaceuticals 14 4 4 26 20 25 22 15 41 31 202

Healthcare 10 4 3 13 7 1 4 63 7 10 122

Other 8 7 86 14 21 18 10 17 11 5 197

Total 204 235 493 315 174 223 192 255 227 214

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity 2007.

24



1.53 Data on the number of early stage technology deals also highlight the prominence of software companies amongst investees (see Table B-5).

1.54 The trend for the average amount of early stage investment (average deal size) declined during 1998-2007 overall but has been more stable since 2003 (see Figure 3-8).

Figure 3-8: Average investment (deal size) in technology – early stage, 1998-2007 (£m)

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

Ave

rag

e in

vest

men

t (£

m)

2003 2007

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity 2007.

1.55 The total number of early stage technology companies as a proportion of all early stage investees generally increased between 1998 and 2003 but has since declined to the near 1998 level in 2007 (Figure 3-9).

Figure 3-9: Proportion of early stage technology companies invested in by BVCA members, 1998-2007

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Pro

po

rtio

n o

f te

ch c

om

pan

ies

Total early stage technology companies as a proportion of all early stage companies

2003 2007

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity 2007; SQW.

25



1.56 The value of investment in early stage technology companies as a proportion of all early stage investment demonstrate a fluctuating pattern between 1998 and 2007, with a steep fall between 2003 and 2006 (Figure 3-10).

Figure 3-10: Proportion of investment in early stage technology companies, 1998-2007

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007Pro

po

rtio

n o

f in

ves

tmen

t in

te

ch c

om

pan

ies

Investment in total early stage technology companies as a proportion of all early stageinvestment

2003 2007

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity 2007; SQW

Investment by region

1.57 The total early stage investment by region29 in the UK aggregated for the period 1998-2007, shows that London, South East, East of England, North West and jointly Yorkshire & Humber and Scotland are regions with the highest level of venture capital funding (Table 3-7)30. Whereas, the highest regions in terms of the number of companies invested in (i.e. number of deals) are London, South East, East of England, North West and Scotland (Table 3-8).

1.58 When aggregating early stage investment from 2003 onwards, the regions with the highest venture capital funding are London and the South. The regions with the highest number of companies receiving investment is the same as for the 1998-2007 time period.

Table 3-7 Total investment by region – total early stage, 1998-2007 (£m)

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total

South East 65 99 128 82 72 84 69 80 142 131 952

London 87 119 286 85 99 45 73 106 278 140 1,318

South West 11 14 32 17 11 8 11 26 90 28 248

East of England 25 23 47 88 57 71 40 86 97 45 579

West Midlands 21 7 29 12 3 2 4 4 18 6 106

29 The region refers to where the investee company is located.30 Investment may be more clustered around London and South East than the figures show because the BVCA data includes some public backed funds.

26



1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total

East Midlands 10 11 18 10 2 10 17 20 105 19 222

Yorkshire and The Humber 4 15 44 7 1 2 24 12 113 12 234

North West 21 35 34 28 17 9 20 22 56 21 263

North East 3 2 9 2 2 2 3 2 7 7 39

Scotland 37 15 55 45 12 7 14 15 20 14 234

Wales 1 2 7 9 8 14 4 6 16 7 74

Northern Ireland 3 5 14 5 11 9 5 3 4 4 63

Total 288 347 703 390 295 263 284 382 946 434 4,332

Table 3-8 Total number of companies (deals) by region – total early stage, 1998-2007

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total

South East 48 60 82 56 79 98 94 104 90 88 799

London 51 75 126 82 69 66 75 75 104 110 833

South West 8 12 16 19 15 22 29 42 35 29 227

East of England 31 23 53 72 67 66 59 61 50 50 532

West Midlands 9 8 22 23 14 20 21 24 35 32 208

East Midlands 11 9 8 11 5 15 25 22 20 18 144


North West 21 12 23 34 41 42 61 65 70 77 446

North East 8 6 8 9 16 15 16 16 10 19 123

Scotland 32 33 41 49 30 22 34 36 40 34 351

Wales 5 6 4 16 26 15 14 13 20 17 136


Total 241 260 409 408 398 427 454 491 500 502 4,090


1.59 The average investment (deal size) during 1998-2007 by region shows that the largest deals were in London, Yorkshire & Humber and South East (Table B-7). Whereas, during

27



2003 -2007, the average investment is largest Yorkshire & Humber, East Midlands and London.

1.60 The key trends during 1998-2007 that emerge when calculating the total early stage investment by region as a proportion of all early stage investment in the UK are as follows (Figure 3-11):

London and East of England show more fluctuation as compared to other regions. Since 2003, London had the highest increase in investment

During 2003-2007, the greatest rise was in London, South West and Yorkshire & Humber

Scotland, West Midlands and North West experienced the sharpest decline during 1998-2007, whereas during 2003-2007 it was East of England, Wales and Northern Ireland

North East and Wales have generally remained consistently low during 1998-2007.

Figure 3-11: Total early stage investment by region as a proportion of all early stage investment in the UK, 1998-2007

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007Year

Pro

po

rtio

n o

f in

vest

men

t

South East London South West

East of England West Midlands East Midlands

Yorkshire and The Humber North West North East

Scotland Wales Northern Ireland

2003 2007

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity 2007; SQW.

1.61 To capture the full picture of venture capital funding by region, it is not sufficient just to analyse the total investment in each region because some regions may have lower levels of funding than others due to their relatively smaller business stock. For example, the North East has fewer businesses than London. Therefore, to obtain a more useful comparison, it is reasonable to use the number of VAT registered businesses for the various regions of the UK as a measure of the scale of business stock. Dividing the level of early stage investment by the number of VAT registered businesses for the period 1998-2007 provides an indication of the supply of finance relative to a region’s business activity (see Table B-8).

28



1.62 The results show that the regions attracting the most early stage investment are again London and the South East, followed by the East of England. The West Midlands has the lowest supply of early stage investment relative to the size of its business stock.

1.63 The line graph for regional early stage investment divided by the regional population size of VAT registered businesses during 1998-2007 is shown in Figure 3-12. All regions experienced a decline in early stage investment in 2007 following a peak in 2006. Based on these data, some regions experience more instability in supply than others. This graph appears to shows London, South East and East of England have less of dominance than in the unadjusted graph above. This may suggest business stock may explain some of the regional differences in the supply of equity finance.

Figure 3-12: Total early stage investment by region divided by the total number of VAT registered business, 1998-2007 (£)

0

200

400

600

800

1,000

1,200

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007Year

Inve

stm

ent

(£)

South East London South West

East of England West Midlands East Midlands

Yorkshire and The Humber North West North East

Scotland Wales Northern Ireland

2003 2007


Summary

Table 3-9 Summary of venture capital investment in the UK by BVCA members, 1998-2007

Total investment

(£ million)

Number of deals

Average deal size (£ million)

UK investment:

Total early stage 4,332 4,092 1.1

Expansion 11,520 5,200 2.2

Total early stage and expansion £15,852 9,292 1.7

Regional investment (total early stage):

South East 952 799 1.2

London 1,318 833 1.6

South West 248 227 1.1

29



Total investment

(£ million)

Number of deals

Average deal size (£ million)

East of England 579 532 1.1

West Midlands 106 208 0.5

East Midlands 222 144 1.5

Yorkshire and The Humber 234 136 1.7

North West 263 446 0.6

North East 39 123 0.3

Scotland 234 351 0.7

Wales 74 136 0.5

Northern Ireland 63 155 0.4


Underlying causes – analysis of consultee perceptions

1.64 Looking at the VC investment data over the past ten years, there is evidence of a peak at the height of the dotcom boom in 2000/2001 followed by a major falling away to a low point in 2004/5. Market supply then picks up sharply in 2006 before declining again in 2007. Stakeholders explained these trends as reflecting the ease of fund raising by VCs as well as reflecting changes to investors’ appetite for risk in investing in VC.

1.65 The bubble caused by the dotcom boom was not just a case of arguably reckless investment by VCs but also a function of their ability to raise funds from institutional investors who took an interest in the ICT sector. In the view of stakeholders, many VC funds were raised just before the dotcom bubble burst and given their ten year lifespan, have been reporting poor performance as a result of the aftermath of the dotcom failures. The dotcom crash therefore meant not only that VCs withdrew from the sector on risk rounds but also that they found it hard to raise funds for any type of investment as venture capital then suffered from a bad reputation with institutional investors.

1.66 By 2005, the worst of this problem had begun to dissipate and hence VCs were able to raise a good level of funds which meant they had plenty of money to invest in 2006. By that time, new types of investor had taken an interest in the VC market such as banks and hedge funds. The decline in VC activity in 2007 was an early warning of the current problems as the IPO market began to dry up, cutting off an exit route perceived as key by VCs. (See Section 11 for a discussion of current issues in the IPO market).

1.67 The level of IPO activity on AIM (Alternative Investment Market) is seen by many in the VC industry as an indicator for the health of the early stage VC market. This is interesting given research by Cass Business School31 that found market flotations accounted for only 3% of divestments from unquoted equity over the time period 1998-2006. This compares with nearly 25% of divestments taking the form of trade sales. As Cass suggests, the issue appears to be that flotations have become established as the preferred choice of exit for some private

31 Cass Business School (2008) The London markets and private equity backed IPOs

30



equity firms32. A tailing off in flotations therefore means VCs have had to stay involved with investee companies for longer, tying up funds that would otherwise have gone into new deals.

1.68 At the same time, some but not all of the newer investor groups (e.g. banks and hedge funds) have had serious problems of their own, meaning that VCs now have more difficulty again in raising the money they need to invest. This has led those that have the right contacts (e.g. the Carbon Trust) to look at other investor groups such as sovereign funds.

1.69 In terms of the VCs active in the early stage market, there have been a number of notable withdrawals amongst firms that were major investors in 1998 (e.g. 3i and Apax Partners). These firms have withdrawn because of less attractive returns in early stage investment compared to other investment stages. This theme is discussed further in Section 4 but appears to be part of the natural development of VC firms. Stakeholders certainly reported that the floor at which most private sector VCs were willing to get involved in early stage equity had risen over the period to a minimum of £2m (with some consultees putting the floor at £5m). However, those VCs still involved with early stage deals felt that the small amounts involved in early stage investment allowed new entrants in the VC market to get established and develop a reputation before moving on to larger deals. Thus, providing such firms are encouraged (e.g. through involvement in publicly-backed ECFs) the private sector can still play a role in the early stage market. This is confirmed by Table 3-4 which demonstrates that sub £2m deals are being done.

32 However, other evidence by Library House (2006) suggests that VC fund managers perceive trade sales to be the most likely exit route from their investments (67%) compared to 37% who thought IPO to be the most likely exit route.

31



4 Venture capital funding – characteristics and processes

Key findings

1.70 The findings are summarised below:

The investment criteria of early stage funds are designed to ensure that they meet the initial needs of their target client base. However, these criteria, if rigidly applied, may prevent the funds providing follow-on finance, thus requiring them to pass on the deal to other providers with deeper pockets.

Good management is by far the most important attribute in making a company attractive to potential VC investors (more important even than the product or service) as VCs consider that it is this which helps ensure good returns. Investment readiness schemes need to be more aware of this as there is a perception that they are not tough enough on entrepreneurs about the need to bring in professional management.

The early stage VC deal process is time consuming and expensive when compared with the potential returns and the risk that those returns will not be realised. This has contributed to the exit of former key players in the market. However, the early stage market, where the investment sizes (for non-capital intensive businesses) are relatively small, can act as a first step for new VC fund managers with only limited resources to invest. So, whilst there are only a few private sector investors at this end of the market, it is not true to say there are none.

Fund characteristics

1.71 Table 4-1 provides an example of a private sector VC fund serving the early stage market. Further examples can be found in Section 6 which looks specifically at publicly backed funds in the UK. The example fund is designed to address the needs of companies seeking seed or first round finance. However, given the investment size criteria, this begs the question of how much capacity early stage funds have to provide follow on finance on their own. Consequently there are concerns amongst some early stage fund managers that they have to step back when a business requires further funding, thus allowing the new investors to then gain all the benefits of eventual exit rather than the early stage investors who took the major risks.

Table 4-10: Example of VC fund characteristics

Name of fund

Fund size Investment size

Term of fund

Date of end of investment period

Growth stage of investee

Sector special-isations

Geograph-ical reach

OCP £40m Up to £2m (average of £750K)

N/A N/A - OCP raise £10m p.a.

Early stage Sustainable technology, healthcare devices,

UK-wide

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Name of fund


Term of fund




Geograph-ical reach

ICT

Source: OCP

The deal process

Attracting deals

1.72 VC funds use a variety of means to attract potential investments. Most of the funds consulted had developed close partnerships either with universities (through the commercialisation offices) or with local professionals (in particular accountants, banks and solicitors). Other forms of promotion included use of websites and reputation through word of mouth. In general, referrals from trusted contacts are the preferred route as each fund receives many unsolicited applications, which are generally of insufficient quality.

Criteria in investment decision

1.73 Consultees cited a number of investment criteria. The ones common to most VC funds are:

Good management. This came top with all consultees. A common issue for early stage investors is that entrepreneurs, although expert in their technological field, are often not suitable as general business managers. As a result, VCs often demand management changes or a seat on the board before they are willing to invest.

Patented technology. In early stage companies, often the only asset is the Intellectual Property of the product/service. However, one consultee admitted they would prefer a company with average technology but excellent management than vice versa.

An addressable market of sufficient size. The prospective investee needs to demonstrate that they have identified a realistic market for their product/service which is large enough to produce a good financial return.

Potential to produce an attractive financial return. Whilst VCs know that not all investments will succeed, they want to be assured that the management team is aiming for substantial profit and growth at the outset.

1.74 Beyond this core group of criteria, consultees cited others that were specific to the structure of their fund, e.g. the investment guidelines for public sector backed funds.

Reasons for rejection

1.75 The reasons for rejection were largely the reverse of the favourable criteria. The most common reasons given were an insufficiently robust business model, unrealistic expectations of market demand, and the management team lacking credibility. An unwillingness by the entrepreneur to respond by bringing in new management can break a deal for an otherwise promising company.

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1.76 On average, VCs invest in only 2% of the applications they receive. Given that in any one year a VC may receive up to 1,500 funding applications, a considerable amount of time is spent sifting through what they have received. This is why VC managers prefer referrals from trusted contacts, which often result in a far higher proportion of applications being taken forward.

Effectiveness of investment readiness

1.77 Consultees reported a low level of Investment Readiness (IR) of the propositions they received. One VC fund turns down 98% of applications received due to a lack of investment readiness. Another commented that investment readiness schemes do not appear to have had much impact on the quality of applications submitted. However, other funds reported a lack of any form of investment readiness assistance in their area and mentioned that Business Link did not seem to be able to signpost companies to suitable support.

1.78 One fund manager stated that the problem with IR schemes is that they are not tough enough on businesses about their management. The schemes are good at showing people how to prepare business plans but fail to make businesses understand the importance that VCs place on the key investment criteria (see above).

Performance expectations

1.79 With the exception of one public sector fund which stated that there was no requirement to deliver a commercial return, most funds were looking at making returns at a rate to reflect the high risk being taken. The funds measure this in one of two main ways, either as an Internal Rate of Return (IRR) where they are looking for a return of 25% - 45% or as a multiple of the amount invested (3 to 10 times). The returns need to be high to cover both the cost of due diligence and the fact that only one or two deals out of ten are likely to make a profit. In normal market conditions, investors would ideally like to realise their return in 3-5 years although most are more realistic and consider 7-8 years to be a more likely timescale.

Due diligence

Time/cost breakdown

1.80 Table 4-11 provides a synthesis of the time and costs experienced by VC consultees in structuring and closing a deal. It demonstrates that for a small investment in a technically complex company, the costs can easily account for 10% or more of the investment.

Table 4-11 Due diligence time and costs

Due diligence element Response range

Total time taken to completion:

dividing into:

6-9 months

deal structuring

due diligence

legals

2-6 months

1-3 months

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Due diligence element Response range

1-2 months

Aftercare Up to 5 years

Pre-incorporation work with spin-outs 12 months

Cost From £20k-£50k for a straightforward deal up to £70-80k for a technically complex business

Ongoing monitoring costs: £10-12k p.a.

Source: Stakeholder consultations

Charges levied

1.81 Not all consultees levy charges. Amongst those that do, up front fees of 1-3% of deal value were quoted (with 2.5% being cited as the industry norm). However, as Table 4-11 demonstrates, these fees generally only cover a portion of the costs of putting the deal in place. Consultees who did levy charges gave no indication that these amounts deterred clients from seeking equity finance.

1.82 Additional charges levied by some funds include ongoing monitoring fees of 0.5% - 1% p.a. (of investment deal size) plus directors’ fees for board attendance of £10-15k p.a.

Effect of cost/return on deal decisions

1.83 The high costs involved mean that the funds have to concentrate on the companies that are likely to produce the highest returns and/or faster exit. Hence VC funds are now more willing to invest in early stage ICT deals (a now relatively mature market with exits in 3-5 years) compared with drug development which involves a much longer time to market. Cleantech is still a relatively new sector and hence the risks and potential rewards are not fully known. As a result, early stage Cleantech funding has until very recently been unattractive to private sector VCs due to unfamiliarity. This appears to be in the process of changing as, the credit crunch notwithstanding, some private sector VCs are beginning to look at setting up funds specialising in Cleantech.

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5 Analysis of the supply of equity finance – informal equity (from business angels)

Key findings

1.84 The findings on angel activity are summarised below:

Business Angels are playing an increasingly important role in providing early stage finance (business angels’ share of private sector investment rose from 15% in 2001 to 30% in 2007). However, the total value of recorded deals done has fallen over the period from 2005 (£47.8m) to 2007 (£29.5m). Data on business angel investment is not complete and hence these figures understate the real volume of transactions.

There is anecdotal evidence that a lack of market ‘exits’(e.g. IPOs, trade sales) has led to business angels having to stay involved in deals for longer, constraining their ability to invest in new deals.

One important investment route for business angels is through acting as co-investors for publicly backed funds. They are an important source of finance for business seeking modest amounts of finance as they are willing to operate at the smaller end of the market. VCs are less willing to be co-investors as the deals are still too small to be viable (given that they would want to undertake their own due diligence). Business angels are perceived to be more flexible. Business Angels tend only to invest in companies in sectors in which they have previous experience and hence do not need to undertake such extensive due diligence as venture capitalists.

A key trend is the increasing use of angel syndicates to invest. These allow angels to share the risk and take part in larger deals (i.e. £250k to £500k). The syndication approach also allows angels to appoint a ‘lead angel’ with both financial experience and knowledge of the sector in which the investee company operates. VCs confirm that the presence of an experienced lead angel at the early stage makes the deal much more attractive to later stage investors because they take comfort from the expertise involved.

Although business angels rate the satisfaction of company involvement highly they are still looking to generate a commercial return from their investment and look to make use of the additional tax benefits to be gained through the Enterprise Investment Scheme (EIS).

UK business angel activity

1.85 The data from EBAN, which includes information from BBAA and LINC Scotland, show that the amount invested by business angels in the UK has fallen between 2005 and

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2007 (Table 5-12). In contrast, the number of deals/ investments has nearly doubled, with the average deal size becoming smaller over the same period33.

Table 5-12 Business angel activity in the UK, 2005-2007

2005 (£) 2006 (£) 2007 (£)

Total investment 47,823,639 43,407,232 29,501,722

Number of deals/ investments 226 383 449

Average deal size 211,609 113,335 65,705

Source: EBAN Statistics Compendium based on the information provided by business angel networks having responded to the survey conducted in 2008.The data includes BBAA plus LINC Scotland figures. Also, the monetary statistics provided by EBAN were originally in Euros, but have been converted by SQW into Pounds Sterling using average annual rates for the years 2005, 2006 and 2007, calculated from the monthly average rates for each year, available at: http://www.x-rates.com/d/GBP/EUR/hist2005.html, http://www.x-rates.com/d/GBP/EUR/hist2006.html, http://www.x-rates.com/d/GBP/EUR/hist2007.html

1.86 Data collated and analysed by Mason34 on business angel activity during 1993 to 2003 show that (see Table 5-13):

Between 1998/99 and 2001, there was a general increase in business angel investment followed by a decrease in 2002 and an increase again in 2003 – overall investment has risen between 1998/99 and 2003

The number of companies raising finance declined during 1998/99-2003 and the number of registered business angels increased during 1998/99 and 2003.

Table 5-13 Business angel investment activity in UK 1993-2003

1998/99 1999/00 2000/01 2001 H2 2001 2002 2003

Number of investments 192 224 217 74 186 136 161

Number of companies raising finance

185 215 211 73 182 134 159

Number of registered business angels

280 386 346 112 311 216 353

Amount invested by registered business angels (£m)

20.0 28.3 30.0 14.3 32.4 20.4 26.1

Source: Mason (2006) The Informal Venture Capital Market in the United Kingdom

1.87 Investment by financing stage during 1998-2003 is presented in Figure 5-13.

33 This is in contrast to feedback from stakeholder consultations (see later in section 5) which highlights the increasing use of business angel syndicates and thereby suggesting larger deal sizes. This maybe explained by the fact it is difficult to rely on the data from both EBAN and BBAA as it is only measuring part of the market and therefore can not be considered reliable indicators of trends. 34 Mason (2006), The Informal Venture Capital Market in the United Kingdom – Adding the Time Dimension, Venture Capital and the Changing World of Entrepreneurship.

37

http://www.x-rates.com/d/GBP/EUR/hist2007.html





Figure 5-13 Business angel investment in the UK by financing stage 1998-2003

0

5

10

15

20

25

30

35

40

1998/99 1999/00 2000/01 2001[H2] 2002 2003

Year

Per

cen

tag

e o

f in

vest

men

ts

Seed Start-up Other early stage

Expansion MBO/MBI Other receivership

Source: Mason (2006) The Informal Venture Capital Market in the United Kingdom

1.88 Business angel investment in technology sectors35 more than doubled during 1998-2003 but exhibits an erratic trend over the same period (Figure 5-14).

Figure 5-14 Business angel investment in technology sectors, 1998-2003

0

10

20

30

40

50

60

70

80

1998/99 1999/00 2000/01 2001[H2] 2002 2003

Year

Per

cen

tag

e o

f in

vest

men

t

Source: Mason (2006) The Informal Venture Capital Market in the United Kingdom.

35 Technology sectors: Communications; Computers (hardware, internet and software); Other electronics related; Biotechnology; Medical (instruments, pharmaceuticals, healthcare); Other.

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Characteristics

1.89 The key difference between business angels and VC funds is that business angels are investing their own money and hence have a personal interest in the performance of the investee company. Consultees estimate that there are about 9,000 business angels in the UK, of which around 6,000 are active at any one time (a lower number than some published figures which do not take into account double counting of angels who belong to more than one network).

1.90 Business angels can invest via a number of routes:

as individuals into companies they have become aware of through their contacts

though angel networks – which provide forums to bring investors and investee businesses together

in syndicates – small groups of business angels investing together. These can be permanent organisations or ad hoc ones for particular investments

on-line at the smaller end of the market - but this route is still too new to have gained general credibility.

1.91 Consultees report that the average individual angel investment is around £50k, with the highest amount being around £100k and the smallest as low as £5k-£10k. However, when investing as a syndicate, deals can be as large as £500k. This sum can then be doubled through the matching involved in a publicly backed co-investment scheme.

1.92 Angels have traditionally been seen by stakeholders as providers of seed capital and first round funding. However, the amounts that can now be raised through syndicates suggest that for some types of companies (i.e. those not requiring large amounts of capital expenditure) angels can carry on and invest in later funding rounds. Although in cases where an exit cannot be found, the continued involvement can become an obligation.

1.93 Many business angels are former business owners themselves and prefer to invest in the sector in which they have experience. Therefore, business angels operate in sectors as varied as farming, manufacturing, hotels and leisure, and property. However, only a relatively small proportion of angels have a high technology background. Such angels are invaluable to co-investment fund managers as they are the only private sector investors that will get involved at the seed stage of high tech developments. However, even high tech angels have a preference for software developments because they only need about £5m to reach the break even stage. This allows angels as syndicate members /co-investors to stay involved in the whole cycle rather than passing on the investment for follow on funding. Other more capital intensive high tech developments can require £10-30m to break even which is well beyond the capacity of most angels. Hence these investments will need to be passed on to other investors in the follow on funding stage who have greater financial resources.

1.94 Given that business angels wish to have a hands-on involvement in the investee business, angels have been viewed as being highly local investors. However, as demonstrated by focus group attendees, angels can belong to a number of networks in different parts of the

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country and will invest well out of their immediate geographic area for the right deal (one UK based angel had an investment in Dubai). However, their preference is not to have to travel too far. Hence, there are benefits of having angel networks in as many regions as possible.

The deal process

1.95 Any one business angel will look at between 20 and 30 projects ending up with investments in two or three, with which they will then have an active, hands-on involvement. More experienced investors may invest in four or five investments at a time but with a lower level of involvement.

Attracting deals

1.96 Individual angels are most likely to come across deals through word of mouth. However, the benefit of joining an angel network is that the network managers then organise presentations by prospective investee companies to showcase their activities. These allow angels to see a number of companies which have generally been through an initial sifting process by the network manager and hence are likely to be stronger propositions than those arising from unsolicited applications.

Criteria in investment decision

1.97 Given their personal involvement in the company’s future, business angels are looking for two main attributes. Firstly, the relationship with the company’s management is critical. Business angels are generally looking for hands on involvement in their investee company and know that this can only be done with the cooperation of the people running the business. If the management is inexperienced, business angels want to make sure that they are ‘coachable’. The business angels see themselves providing the management expertise that a VC would otherwise parachute into an investee business.

1.98 Secondly, business angels want to support a product/service they understand and that has a clear route to market. Despite some comments from VCs about business angels getting ‘hung up on the technology’, the angels attending the focus groups were clear that they wanted to be sure that the technology could translate into a marketable product.

Reasons for rejection

1.99 Key reasons for rejection include a poorly thought through business plan, a product with no clearly identified market, unrealistic expectations by the management about the value of the company and management that look unreceptive to advice. These are similar reasons to those reported by VCs.

Effectiveness of investment readiness

1.100 The angels attending the focus groups did not comment specifically on investment readiness schemes. One network manager felt that they are too focussed on ‘ticking the right boxes’ i.e. helping businesses to produce polished business plans at the expense of taking harder decisions about their businesses.

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1.101 In the case of business angels, investor readiness is the subject of more debate. Network managers consider that it is important to encourage more HNWIs to come forward as business angels and thus they need information/advice on how to become investors.

Performance expectations

1.102 A common view expressed by business angel consultees was that of any 10 investments, four will fail, three will trickle along, a couple will do alright but not provide the expected return on investment and the final one will pay for the others. As a result, angels are looking for returns of 10 times the original investment.

Due diligence

Time/cost breakdown

1.103 Focus group attendees stated they were happy to have external firms do the accountancy and legal due diligence but wanted to assess the business model themselves. Due diligence for start-up companies does not take that long. However, a company that has been in operation for some time (18 months) will be more complex and hence due diligence will take longer. Consultees felt that due diligence conducted by business angel tends to be less onerous than that undertaken by VCs. The reason given for this was that business angels know that they are going to be closer to the business on an ongoing basis and hence more likely to able to assist in mitigating risks. In comparison, VCs are more ‘distant’ investors and prefer to protect themselves with very formalised and thorough due diligence.

1.104 One angel network manager broke the process down into commercial due diligence for which the angel may rely on his/her own knowledge and technology due diligence for which the investor is likely to have to pay. Overall costs, including financial and legal due diligence, can therefore be as much as 10-12% of the investment.

Charges levied

1.105 Where no public sector money is available to finance their activities, angel networks charge investee companies membership fees (e.g. £700 per month) and success fees (e.g. 6% of money raised).

Effect of cost/return on deal decisions

1.106 Although business angels are looking for a commercial return from their investments, they are also looking for the satisfaction that comes from involvement in the companies. As one focus group attendee admitted, the time he has spent working with one of his investments has far exceeded the return he will gain.

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6 Publicly-backed funds in UK

Introduction

1.107 This section looks at the range of funds backed by public sector money. This includes:

Regional Venture Capital Funds (RVCFs)

Regional Development Agency funds


University Challenge Seed Funds (UCSF)

UK High Technology Funds (UKHTF)

Community Development Venture Fund (CDVF)


Carbon Trust Funds

NESTA fund.

Summary

1.108 Table 6-14 provides a summary of the publicly backed funds by fund type.

Table 6-14 Summary of publicly backed VC funds

Fund type Total funds available (during investment period)36



Geographical scope

Regional Venture Capital Funds

£241m Up to £660k 2007 - 2008 Regional

RDA VC funds* £220m £50k - £2.5m 2008 - 2012 Regional


£36.5m Up to £200k 2014 – 2016 Regional

University Challenge Seed Funds (UCSFs)

£60m £25k - £250k Evergreen National

UK High Technology Fund

£126m Up to £2m 2006 National

Community Development Venture Fund

(Also known as

£40m £100k - £2m May 2009 National

36 The data covers the last two years i.e. 2007 and 2008. Variations in the way the data from different sources are recorded may lead to slight differences in the time period covered.

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Fund type Total funds available (during investment period)



Geographical scope

Bridges fund)


£185m £500k - £2m 2011 – 2013 National

Carbon Trust Funds £27m £250k - £3m Still open to investments

National

NESTA fund £50m £250k - £1m Evergreen National

Source: BERR/DIUS/RDAs/Carbon Trust/NESTA* Please note data does not include figures from North West and South East Venture Capital Funds in the regions

Regional Venture Capital Funds

1.109 Regional Venture Capital Funds (RVCF) are operational in the nine English regions and provide funding for SMEs that show growth potential. The Funds are managed by professional venture capital firms and the investment in the RVCFs is through BIS, European Investment Fund, Institutional and Private Investors37. Seven of the Funds have been operational since 2002 and two since 2003. All nine Funds have come to the end of their investment period, with the majority ending in 2008.

1.110 The objective38 of the RVCFs was to create at least one viable commercial fund in each of the nine English regions to increase the availability of venture capital to SMEs, within the bounds of the equity gap at the time. It was also to show to potential investors that commercial returns are possible from funds used to invest in SMEs within the bounds of the gap, as well to raise the supply of quality fund managers working at this level.

1.111 Analysis of data provided by BIS reveals the following:

The average fund size was nearly £27m and 177 investments (deals) were made in the last two years39, with a total of 97 businesses receiving investment.

Nearly all the Funds had a general investment range up to £500k (later extended to £660k) and the overall average size of investment per company (average deal size) for all the Funds was £362,550.

The average duration of the Funds was five years and investment was made in all financing stages (including MBO/MBI). However for most Funds the dominant focus was on seed, start-up, early stage and expansion.

London was the most active region in terms of deals done followed by Yorkshire & Humber and the South West.

The smallest fund was in the North East and it made the lowest number of investments.

37 BIS; www.bis.gov.uk38 www.bis.gov.uk39 The data covers the last two years i.e. 2007 and 2008. Variations in the way the data from different sources are recorded may lead to slight differences in the time period covered.

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Regional Development Agency venture capital funds

1.112 In addition to the RVCFs, eight40 of the nine Regional Development Agencies in England operate their own venture capital funds which aim to provide investment for SMEs in their respective regions. Data are available for six41 of the eight42 regional funds. Analysis reveals the following43:

The average fund size was just over £17m44 and a total of about 800 investments (deals) were made in the last two years with over 500 businesses in receipt of investment. However, the majority (68%) of the investments were in Yorkshire & Humber.

The average size of investment per company made by five45 regional funds was nearly £423,000. This has been invested in seed, early-stage, start-up and expansion.

The average duration of most of the funds is about 10 years with the majority closing to new investments during 2008-2010.

The main sectors invested in include: life sciences, “high technology”, creative industries and manufacturing.

Yorkshire & Humber has the largest fund size followed by West Midlands and the North East.

East Midlands had the smallest fund and had one of the lowest number of investments in the last two years.

Early Growth Funds

1.113 Early Growth Funds (EGFs)46 were designed to encourage risk funding for companies in start-up and growth phase. The aim was to increase the availability of small amounts (average of £50,000) of risk capital. The main intended beneficiaries of EGFs were47:

innovative and knowledge intensive businesses

start-ups or university spin-outs

smaller manufacturers in need of new investment to pursue new opportunities

other early growth business.

40 East of England does not have a RDA funded venture capital fund in the region.41 The six RDA funds include: South West Development Agency, Yorkshire Forward, Advantage West Midlands, One NorthEast, East Midlands Development Agency and London Development Agency. 42There are no data available on the North West and South East regions.43 The investment made by the six RDA funds for which data is available includes a mixture of both public and private investment. The proportion of investment from the private sector cannot be determined based on the available data.44 This includes a mixture of equity, loan and mezzanine finance.45 Five regional funds include: South West of England Development Agency, Yorkshire Forward, One NorthEast, East Midlands Development Agency, London Development Agency.46 www.bis.gov.uk47 www.bis.gov.uk

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1.114 The EGFs came into existence during 2002-04 and all EGFs are still operational. All of the EGFs are expected to close from 2012 onwards, with the last Fund ending in 2016.

1.115 The data for EGFs indicate that the average fund size across the seven Funds was just over £5m: a total of 74 companies received investment in the last two years. The average size of investment per company for all the EGFs was nearly £153k.

University Challenge Seed Funds

1.116 The University Challenge Seed Funds (UCSFs) were set-up with the aim of commercialising research from universities. UCSFs were introduced in 1999, in 2000 and then four more in 2002/03. There are 19 Funds in all, with all but four “live” in the sense that investment and support for investees is on-going48. The total investment allocated to UCSFs was £60m49 and a total of 51 institutions are involved in the initiative. The majority of investment is in the biomedical sector (twice as many than any other sector) followed by bioscience (non-medical) and then informatics, and physics & engineering.

1.117 Although no details of the Funds as a whole were available, one consultee gave an example.

Table 6-15: Example of UCSF characteristics

Name of fund


Term of fund




Geograph-ical reach

Javelin Iceni Seedcorn Fund

£4m £25k pathfinder funding, £250k equity investment

Evergreen N/A Pre-incorporation and seed

None Proposals from partner universities only

Source: Javelin

1.118 The UCSFs were an experiment and therefore did not follow one specific path. Broadly, three approaches were taken:

concentration on Proof of Concept (PoC) – providing up to £50k

pathfinder equity investment involving a small investment as a lead into a larger investment

funds which focused on larger equity investments.

1.119 There was a hope rather than a requirement that UCSFs would be “evergreen”. The majority of the Funds have had difficulty in achieving this status.

1.120 The UCSFs were designed to plug the equity-gap for commercialisation of university research /spin-out activity beyond the point where for example Research Council funding would stop. In addition to the supply of finance, other benefits of the Funds are seen to include:

48 According to Dr Dean Patton, University of Southampton, the four Funds that are currently not investing does not mean that they will not be investing in the future. 49 www.bis.gov.uk. £45m was allocated in 1999 and £15m in 2001.

45

http://www.bis.gov.uk/



the creation of a more commercial mind set among Technology Transfer Offices (TTOs)

encouraging private fund managers to become more interested in spin-out activity.

1.121 According to ongoing research on UCSFs50, some of the UCSFs are being replaced by VC activity, with VCs becoming actively engaged with universities (e.g. Leeds University, Loughborough University). Universities have developed relationships with private fund managers and are more active in commercialising university activity. The universities have become more professional in their approach to fund managers and the fund managers themselves have become more aware of the benefits of “mining the gems” from the university research departments to find good commercial opportunities.

1.122 Although university commercialisation of research and follow-up funding will undoubtedly carry, the picture of activity and likely outcomes is patchy and difficult to assess. Funding for UCSFs directly from central Government has been replaced by the University Higher Education Innovation Fund (HEIF). The universities have the power to decide how to allocate HEIF income, including to UCSFs. In essence, funding from Government continues to be there for the purpose associated with UCSFs, should individual universities decide to use the HEIF money in this way.

UK High Technology Fund

1.123 The UK High Technology Fund (UKHTF) aimed to invest in early stage, high technology venture capital specialist companies and increase the amount of finance in these companies. It was a fund of funds which means that it invested in other funds that invest in high tech companies, rather than funding companies directly. It is no longer making investments.

Community Development Venture Fund

1.124 The Community Development Venture Fund (CDVF)51 aims to provide venture capital finance to SMEs capable of growth that are located and have economic links with the 25% most disadvantaged wards in England. It is a generalist Fund that was established in 2002 and is due to end in 2009. The total value of the Fund is £40m.

1.125 BIS data on CDVF indicate that the general investment size range is between £100k and £2m. The average size of investment per company (average deal size) is £796,412. A total of 12 businesses have received funding in the last two years. Investments made by financing stage were distributed as follows:

50% early stage

33% property-backed

8% development

8% MBO.50 By Dr Dean Patton, School of Management, University of Southampton.51 Also known as the Bridges Fund.

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Enterprise Capital Funds

1.126 Enterprise Capital Funds (ECFs) are a hybrid of Government and private sector funds for SMEs. They are aimed at addressing the equity gap for investments up to £2m52. ECFs are national, generalist funds. There are eight Funds, with the first five being launched in 2006-07 and the remaining three were launched in 2007-08. The third round competition for ECFs has been opened and further competition rounds are expected up to 2010. The end of the investment period for most of the current ECFs is 2011.

1.127 The analysis of data available for seven of the ECFs shows that:

Fund size ranges from £10m to £30m and the average fund size is just over £26m

A total of 29 businesses have received investment in the last two years and the average size of investment per company (deal size) is just over £535,270

Nearly all the Funds focus on seed, early stage and expansion phase.

Carbon Trust funds

1.128 The Carbon Trust is an independent Government-funded company which aims to “accelerate the move to a low carbon economy by working with organisations to reduce carbon emissions and develop commercial low carbon technologies53”. The Trust has its own investment arm, Carbon Trust Investments (CTI) which is responsible for two Funds54:

Clean Energy Fund – a £25m fund launched in 2002 to commercialise clean energy companies in the UK. It has invested approximately £10m in 11 companies since 2002, including both early and later investment stages. Of the remaining amount, £5m has been committed for potential follow-on investments and £10m is to be made available for new investments.

Imperial Low Carbon Seed Fund – a £2m fund launched together with the Shell Foundation in 2007, managed by Imperial Innovations. To date it has made three investments with a total value of approximately £0.5m.

1.129 According to SEF Alliance Publications (2008), CTI can only invest up to half of each round’s total value and only invest in the range £250k to £3m per investment transaction. The remaining investment is met with support from an investment syndicate involving private venture capital firms. During 2007-08, the Carbon Trust brought in a total of nearly £24m in additional private sector funding into early stage clean energy technology companies. The total cumulative private funding generated by the Carbon Trusts portfolio companies since 2002 is more than £91m.

NESTA fund

1.130 NESTA (National Endowment for Science Technology and the Arts) supports innovation through direct investment, research aimed at shaping policy and innovation

52 www.bis.gov.uk53 www.carbontrust.co.uk54 SEF Alliance Publications (2008) Public Venture Capital Study.

47



awareness programmes. In regard to the first element, NESTA runs a fund for direct investment in early stage technology companies (Table 6-16):

Table 6-16: NESTA evergreen fund

Name of fund


Term of fund




Geograph-ical reach

NESTA £50m £250k - £1m

Evergreen N/A Early stage technology

Life sciences, Cleantech, ICT

UK-wide

Source: NESTA

Analysis of stakeholder views on the role of publicly backed funds

1.131 The consultees all considered publicly backed funds to be vital. Business angels do not have enough capacity by themselves to meet all the remaining financing needs in their market and hence publicly backed VC funds help address the early stage supply gap. Many of the schemes, for instance ECFs, use private sector fund managers. However, there are some concerns expressed that publicly backed funds are too small both in terms of overall capacity (it is suggested that they need to be £30m-£50m in size to be commercially viable) and in terms of the inflexibility over the maximum amount they can invest in any one company (initially £250k, then increased to £500k, and then increased again to £660k for an RVCF or £2m for an ECF). An example of the former would be one of the RVCFs which had total funds of only £12m. This means that they may not be able to provide all the funding the company needs and they often do not have sufficient capacity to provide follow-on funding. Hence their investees may need to find other investors to avoid growth being constrained.

1.132 Whilst acknowledging the above concerns, it is also important that these schemes remain targeted at where the equity gap is most acute.

1.133 The issue of follow-on funding highlights other consultee concerns, including whether the fund managers of the publicly backed funds are sufficiently “tough” with investees to ensure that the businesses are ready for the next round of investment. Also, having a public sector fund with a group of angels involved might not be attractive to later stage investors who may only be willing to invest if they can take over the whole transaction. This not only gives later investors a more straightforward deal but also ensures that they gain the better returns to be had on exit (potentially to the detriment of the original co-investees). However, there is the counter argument that without the initial public sector investment businesses would not be in a position to gain later stage investment.

1.134 Another issue identified with publicly backed funds was their limited time spans for investment. There is a perception that RVCFs and UCSFs have come and gone, leaving gaps behind them. However, ECFs are being made available in tranches and hence at present their geographical coverage is varied. ECFs are not restricted in investing outside of their immediate geographic area and so are able to invest throughout the UK. In practice, fund managers often choose to make investments closer to their geographic location to minimise costs.

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1.135 There have also been a number of new VC schemes recently introduced including the Capital for Enterprise Fund and Aspire Fund. The Capital for Enterprise Fund is a £75m fund that aims to provide equity and quasi- equity finance to business of up to £2m. The Aspire Fund is a £12.5m co-investment fund providing up to £2m of funding55 to female led businesses looking to grow. (Since completion of this research the Government announced on the 29th June 2009 a new UK Innovation Investment Fund, which will focus on providing equity finance to growing small businesses, start-ups and spin outs in digital, life sciences, clean technology and advanced manufacturing.)

1.136 Many stakeholders consider the public sector to have learned lessons from its previous schemes as many consultees preferred the structures ECF structure. Under the RVCFs the first losses were covered by the public sector and the returns the public sector could earn were unlikely to compensate for these. However, under the ECFs the private sector covers the first losses and the public sector gains a 4.5% priority return on its share ahead of other investors.

1.137 Most consultees felt that the publicly backed funds were not crowding out the private sector as, for the reasons discussed above, the private sector had good commercial reasons for not being involved to any greater extent in the early stage market and investments below £2m. Co-investment arrangements were cited as a way of encouraging the private sector (in the form of business angels) to invest alongside the public sector.

1.138 Likewise, the ECFs are seen as a way of the public sector making use of private sector fund management skills to do deals that the private sector might not otherwise consider. However, consultees noted that in some areas (e.g. Merseyside) there is such a proliferation of public sector funds that private sector VCs avoid the market.

55 Total investment size including matched co-investment.

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7 Other public sector interventions in the equity finance market in the UK

Introduction

1.139 Although the focus of this report was primarily on Government equity schemes, this section provides a summary of indirect public sector interventions in the early stage equity market, through tax based measures mainly used to encourage HNWIs to invest in early stage companies. These include Venture Capital Trusts (VCTs), Enterprise Investment Scheme (EIS) and Corporate Venturing Scheme (CVS).

Venture Capital Trusts

1.140 Venture Capital Trusts (VCTs)56 came into existence in 1995 and aim to increase the supply of finance to high-risk trading companies that are not listed on the stock exchange. A VCT allows investors to provide finance for these unquoted companies indirectly by investing in the VCT, which itself is managed by a fund manager/ investment group. In return, investors are eligible for exemption from corporation tax on capital gains from the disposal of their investment57.

1.141 Data on VCTs from HM Revenue & Customs (HRMC) show that the amount of finance raised through VCTs has fluctuated between 2001/02 and 2007/08 (Table 7-17). Funds peaked in 2005/06 and then declined in 2007/08. This is likely to be the result of the changes in the Finance Act 2006, which tightened the rules on VCTs.

1.142 This is complemented by the number of ‘VCTs raising funds’ following a similar pattern and includes both new and existing VCTs raising funds. The trend is different for ‘VCTs managing funds’ which have risen steadily since 2001/02.

Table 7-17 Number of Venture Capital Trusts and the amount raised, 2001-2007

2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08

Amount of funds raised

(rounded to the nearest £5m)

155 70 70 520 780 270 230

VCTs raising funds in the year

(includes both new and existing VCTs raising funds in each tax year)

45 32 31 58 82 32 54

VCTs managing funds

(no. of VCTs in each tax year)

70 71 71 98 108 121 131

Source: HMRC

56 www.hmrc.gov.uk57 Cowling et al. (2008) Study of the Impact of Enterprise Investment Scheme (EIS) and Venture Capital Trusts (VCT) on Company Performance, HM Revenue & Customs Research Report 44.

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Table 7-18 Venture Capital Trusts – number of investors and amount of investment

2005-06 2004-05 2003-04

Size of investment (£)

Investors (%)

Amount of investment

(%)

Investors (%)


(%)

Investors (%)


(%)

0 5 - 6 - 27 1

£2,000 7 1 13 2 16 3

£5,000 21 4 22 5 18 7

£10,000 36 16 34 19 21 21

£25,000 12 13 11 14 9 19

£50,000 7 13 6 13 3 11

£75,000 2 5 2 5 2 14

£100,000 3 9 2 9 4 24

£100,001 7 39 5 33 - -

Total 100 100 100 100 100 100

Source: HMRC

Enterprise Investment Scheme

1.143 The Enterprise Investment Scheme (EIS) was introduced in 1994. It is designed to support small, higher-risk unquoted trading companies58. Various forms of tax relief are offered to private individuals investing in these companies. These individuals also qualify for an income tax reduction based on the amount invested59.

1.144 There is no time-series data on the EIS in terms of parameter of interest to this study. However, it is appropriate here to outline some of the main findings from research carried out by Cowling et al. (2008) on EIS (and on VCTs):

EIS investments tend to be associated with general capacity building (growth in fixed assets and employment) and increased sales

the trend for EIS in terms of number of first investments between 1996 and 2000 exhibits rapid growth, followed by a rapid decline to 200460.

58 Cowling et al. (2008) Study of the Impact of Enterprise Investment Scheme (EIS) and Venture Capital Trusts (VCT) on Company Performance, HM Revenue & Customs Research Report 44.59 According to Cowling et al. (2008), individuals are eligible for tax relief on share disposal and can also postpone the charge on capital gains tax on gains arising on the disposal of other assets at the time they make their investments.60 VCTs also follow the same general pattern.

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Corporate Venturing Scheme

1.145 The target audience of the Corporate Venturing Scheme (CVS) are companies that are seeking direct investment in the form of minority shareholding in small independent higher- risk trading companies or group of companies. In return, the Scheme provides tax incentives for investments in the same types of companies which qualify under the VCT scheme61.

1.146 Figures for CVS are also provided by HMRC. The total amount raised since 2001/02 was nearly £54m: the average amount raised was £9.0m per annum. Assuming the number of companies obtaining funds is equivalent to the number of deals then the average deal size is nearly £123,29062.

Table 7-19 Corporate Venturing Scheme – number of companies and amount invested

2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 Total

Number of companies raising funds

63 63 75 98 78 61 438

Number of investing companies

115 95 133 93 89 70 595

Amount raised (£m)

6.9 6.5 10.8 13.0 9.5 7.2 53.9

Source: HMR

1.147 Further information on corporate venturing is set out in Section 9.

61 www.hmrc.gov.uk62 SQW assumption and calculation.

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8 Equity investment and institutional investors

Key findings

1.148 The findings on institutional investors are summarised below:

Over the period 1987-2000, unquoted equity outperformed other asset classes in terms of returns. Its reputation was, however, tarnished by the dotcom crash which depressed returns for a number of subsequent years. By 2006, institutional investors were again active in the market only to ease off funding again in 2007 as early signs of the credit crunch began to cause concern. The EVCA is increasing its promotion of VC as an asset class to try to improve its image with investors.

In terms of funds raised in 2007, only 10% were earmarked for early stage and expansion deals (down from 15% in 2006). It is also important to note that 75% of funding came from overseas sources. Pension funds remained the largest single class of investor but their share has declined as the importance of fund of funds and banks has grown. This is some concern from consultees that the present economic conditions may impact on future fund raising.

Introduction

1.149 In light of consultee comments that VC has fallen out of favour with institutional investors as an asset class, this section examines investors’ views on VC over time and the reasons behind them.

Trends in institutional investors’ attitudes towards VC as an asset class

1.150 The role of private equity as an “asset class” was considered by the London Business School (LBS) in 200063. The report defined Private Equity and made the distinction between the coverage of the ‘private equity’ term as used in the UK and Europe, compared with the United States64.

1.151 At the time of the LBS report there had been a consistent positive trend in the returns produced by the private equity asset class with cumulative returns reportedly outperforming all principal UK comparator asset classes over the period between 1987 and 2000. The long-term performance of the UK private equity industry since 1980 had stood at over 14% per annum net of all costs and fees.

63 London Business School (2000) UK Venture Capital and Private Equity as an Asset Class for Institutional Investors.64 “The terms venture capital and private equity describe equity investments in unquoted companies. In the UK and much of continental Europe, the term venture capital is used synonymously with that of private equity. In the US, however, venture capital usually refers to the provision of funds for younger, early stage and developing businesses whereas private equity is mainly associated with the financing of leveraged management buy-outs and buy-ins (MBOs and MBIs)” in BVCA (2000) Private equity – the new asset class: Highlights of the London Business School report ‘UK Venture Capital and Private Equity as an Asset Class for Institutional Investors’.

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1.152 Coupled with the attractive returns, the LBS report maintained that the risks of investing in private equity funds were considerably lower than the prevailing perception, providing investments were made on the basis of a diversified portfolio. At that time (2000), the prediction was for future strong returns. UK-managed private equity funds were at the forefront of the growing pan-European market as the second largest private equity industry in the world after the USA it accounted for nearly half of all European investment. Any concerns of trustees considering investment in private equity funds regarding liquidity were presented as “more of a psychological barrier” than a reality.

1.153 However, the sources of investment were increasingly overseas, with an increasing dependence reported on funds particularly from the USA. The view was that US sources were using the experience of UK private equity managers “as an access point for attractive returns and wider pan-European private equity investment”. The LBS study reported that UK pension funds had been investing a decreasing amount in the industry over recent years.

1.154 The drive in 2000 was therefore to overcome the barriers to investing in what was identified by LBS and the BVCA as an extremely attractive investment proposition, and to obtain recognition of UK private equity as a mainstream asset class.

1.155 Despite the dotcom crash which wiped out $5 trillion in market value of technology companies from March 2000 to October 2002, UK private equity was still being promoted as a success story in early 2006 by the BVCA65, reporting that the sector was still outperforming other key asset classes. At that time, the BVCA’s most recent performance study highlighted the out-performance by private equity of both the FTSE All-Share Index and hedge funds on a three, five and ten year basis.

1.156 However, by 2007, the picture looked very different from an institutional investor perspective. The National Association of Pension Funds (NAPF) identified that “the environment in which pension funds are operating has changed significantly since 2001 … then many schemes were in surplus and the focus was on how to expand institutional investment into new areas such as venture capital … now the focus is on deficit correction, the strength of scheme sponsor covenants and scheme-specific funding”66 They attributed the deficits and the sensitivity of sponsor companies to a number of factors outside the influence of the private equity sector, in particular increased longevity of pension fund members and new accounting provisions. However, adverse market movements played a large part in the downturn and, in response; one of the consequences has been a shift in investments from equities to bonds.

1.157 Nonetheless, two surveys cited in the NAPF report identified that pension funds were taking a more diversified approach to asset allocation and the trend towards investment by pension funds in private equity/venture capital was still increasing – with 19% of respondents reporting that they make such investments (52% when weighted to asset value) compared with 15% in 2005, and up from just 6% in HM Treasury’s 2004 review. A survey in 2005 by JP Morgan Fleming67 identified that 31% of the participating pension schemes invested in private equity, with a further 26% considering investment in the sector.

65 BVCA (February 2006), Private Equity – a UK Success Story.66 National Association of Pension Funds (January 2007) Institutional Investment in the UK Six Years On. 67 JP Morgan Fleming (2005) Alternative Investment Strategies Survey of 350 pension schemes.

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1.158 However, what is not known from these data is the percentage of the total investment in the private equity sector represented specifically by UK pension funds’ investments. Compared to the importance of the overseas investors, the UK institutional investors may well still be a relatively small proportion of the total.

1.159 Latest moves by the EVCA suggest there is still an issue to be addressed concerning the confidence of institutional investors in the venture capital/private equity sector, which was dented and has never fully recovered from the dotcom crash and has been exacerbated by the current global financial downturn. It is understood to have hired a senior executive from the European Investment Fund to help promote the reputation of venture capital across Europe.68

EVCA fear that the current financial crisis “could do irreparable harm to Europe’s venture industry”. The intention therefore is to draw up policies to improve investors’ preconceptions of venture capital and ensure that institutional investors and policymakers have a clear view of the benefits of the asset class.

Sources of funding for VCs

1.160 A recent NESTA report69 using BVCA data identified that venture capital investment as a proportion of all private equity investment fell from 11% in 2000 to less than 4% in 2007.

1.161 In 2007, BVCA members raised £29.3bn, a fall of 15% from the £34.3bn raised in 2006. Stakeholders confirm that that 2006 was a “bonanza year” for fund raising and that the funding market was already easing off in 2007.

1.162 Of the funds raised by its members, 90% was earmarked for buyouts (up from 85% in 2006). Funds raised for early stage investments fell from £1.24mto £830m (although assets marked for technology companies rose). Funds raised for expansion decreased to £614m from £775m. These figures underline the investment statistics in illustrating the move from early to later stage deals.

1.163 Table 8-20 sets out the various sources of funding for VCs and clearly shows the dependence on overseas funding (already remarked upon in the LBS report in 2000). In terms of type of institution, in 2007 pension funds remained the largest class of investor but their share had declined to be replaced by increases from fund of funds and banks. In view of the credit crunch, this recent increase in the importance of banks is concerning given that they may be more likely to withdraw from this market.

1.164 The other interesting point to note is the relatively large amount of funding that comes from overseas Government agencies, compared to similar sources in the UK.

Table 8-20 Venture capital funding sources

Type of source Amount raised (£m) % of amount raised

2007 2006 2005 2007 2006 2005

Pension funds UK 1,132 2,054 1,502 4 6 5

68 www.penews.com/today/index/rss/content/3352831759 69 Pierrakis and Mason (2008) Shifting Sands – The changing nature of the early stage venture capital market in the UK.

55

http://www.penews.com/today/index/rss/content/3352831759



Type of source Amount raised (£m) % of amount raised

Overseas 5,560 7,919 7,175 19 23 26

Total 6,692 9,973 8,677 23 29 31

Insurance companies UK 635 1,080 558 2 3 2

Overseas 1,777 2,023 3,136 6 6 12

Total 2,412 3,103 3,694 8 9 14

Corporate investors UK 270 442 423 1 1 2

Overseas 370 847 928 1 2 3

Total 640 1,289 1,351 2 4 5

Banks UK 1,188 2,222 822 4 6 3

Overseas 4,380 1,307 854 15 4 3

Total 5,568 3,529 1,676 19 10 6

Fund of funds UK 2,067 1,523 1,131 7 4 4

Overseas 4,065 3,807 3,244 14 11 12

Total 6,132 5,330 4,375 21 16 16

Government agencies UK 59 470 517 - 1 2

Overseas 2,988 2,552 3,196 10 7 12

Total 3,047 3,022 3,713 10 9 14

Academic institutions UK 20 130 65 - - -

Overseas 361 1,372 1,279 1 4 5

Total 381 1,502 1,344 1 4 5

Private individuals UK 985 669 562 3 2 2

Overseas 1,486 1,352 1,019 5 4 4

Total 2,471 2,021 1,581 8 6 6

Other sources UK 931 1.132 292 3 3 1

Overseas 984 3,395 611 3 10 2

Total 1,915 4,527 903 7 13 3

Total UK 7,287 9,722 5,872 25 28 21

Total Overseas 21,971 24,574 21,442 75 72 79

Overall total 29,258 34,296 27,314 100 100 100

Source: BVCA

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9 Corporate venturing in the UK

Introduction

1.165 Section 7 provided data on companies making use of the tax breaks on offer under HMRC’s Corporate Venturing Scheme. This section provides background information on corporate venturing as a concept and illustrates this with a case study.

Background and trends70

1.166 Corporate venturing (CV) involves the creation of a formal or informal organisational team by the parent company that is responsible for investigating and developing new ventures, which may or may not reside within the group. The new venture may be an outcome of innovation that exploits new markets or new product offerings, or both.

1.167 The CV industry has a global dimension. Historically, in terms of the geographic origins of the parent company, North American companies dominated the industry, with more European and Asian companies becoming involved in the 1990s. The geographic scope of their investments has been spread over North America, Europe and Asia.

1.168 From its origins in the 1970s, CV has gone through three waves of growth and decline. The first wave ended in 1973 with the oil price shock and the consequent recession, which limited the availability of funds for investing in new venture creation.

1.169 In the 1980s, large corporations regained confidence in internal CV activities assisted by the growth reported in the electronics and computer industry. In 1984, more than $4bn was invested by almost 100 CV investors globally. The economic recession of the late 1980s adversely affected the CV industry with investments dropping below $2bn.

1.170 The third CV wave occurred in the late 1990s, in response to the “creative destruction” caused by the increased uncertainty associated with the emergence of new technologies (information and networks, media, telecommunications, biotech), the globalisation of competition, the disruption of industry boundaries, the decrease of product life cycles and the emergence of new markets. Silicon Valley became the entrepreneurial hub of start-up companies developing new services and products and the building of what is now known as the “dotcom” economy. Large corporations were keen to participate in this wave of innovation and get a stake in new business models and products which promised high returns. Reuters’ IPO of Yahoo! in 1996, for instance, returned an $848m market capitalization in the first week. In 2000, around $18bn were invested in CV funds by large corporations globally.

1.171 However, by the end of 2001 the difficult macroeconomic conditions and the collapse of the high-technology stocks had a dramatic negative effect on the financial performance of the CV funds. In 2000, Les Echos71 reported 126 CV funds globally with €15,548m raised. In contrast to this in 2004, only 11 active CV funds were reported raising €1,371m. Large 70 This section relies heavily on contributions of Dr Marina Biniari of the Hunter Centre at Strathclyde University.71 www.lesechos.fr

57

http://www.lesechos.fr/



corporations started to lose confidence in the financial and strategic performance of their CV programmes.

1.172 During the third wave, large corporations adopted primarily a corporate venture capital business model to organise their CV teams, without necessarily having the appropriate personnel, processes or experience to achieve a high number of CV deals and deliver high financial returns. Further, the focus of the corporate venture capital business model on the financial aspects of venturing neglected any emphasis on achieving tangible strategic returns for the parent companies. With the economic slow-down following 2001, companies involved in CV activities decided to withdraw from activities which were not core to their strategy and were causing financial losses.

1.173 Since 2004, a steady increase in the CV activities of large companies has been observed. Investments in Europe rose to €569m in 2006 from €430m in 2005, achieving an overall 32% increase (EVCA). In 2006, the countries targeted mostly were France and Italy, which together count for 50% of the European CV market.

1.174 In Britain, the first National Economic Development Office (NEDO) report on CV was released in 1987 promoting CV as a means of improving the international competitiveness of British industry. It promoted CV as a partnership between a large company and a small entrepreneurial firm, with the company taking a minority equity stake in the small firm in exchange for R&D, new products and markets. Media releases identified the first cases of CV activities in the late 1990s, with more British companies establishing formal CV units between 1999 and 2001.

1.175 The appearance of CV as a source of finance in the UK is aligned with the emergence of the VC industry, which in the 1980s experienced sustained growth (from £120m new VC funds in 1983 to £1.68bn in 1989) (Murray, 1994). In 1998, the British VC industry accounted for 49% of the total annual European VC investments (EVCA, 2000).

1.176 While the VC market was growing, policy makers during the late 1980s and 1990s started to recognise the growth potential of CV for small firms and became keen on promoting its benefits. The NEDO report in 1986 and the Confederation of British Industry (CBI) report in 1999 are examples of the effort undertaken to identify the misconceptions and barriers small and large firms shared in forming partnerships through venturing. In 1999, the Government announced the Corporate Venturing Scheme in an attempt to provide tax incentives (20% relief on the tax on profits) which would encourage investment in minority share holding in small, higher risk companies.

1.177 In the late 1990s, large companies started to adopt the corporate venture capital business model to invest in internal and external ventures and business ideas. Reuters Venture Capital, BAE Capital, Shell Internet Ventures, Unilever Ventures are among the best known examples. The majority of the CV investments were made in information and networks technologies, biotech and healthcare, communications and engineering industries (BVCA, 2000).

1.178 In 2002, the DTI funded the Corporate Venturing UK association to promote further networking activities between large and small firms for the formation of CV partnerships. The association was closed in 2005.

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1.179 Despite the fluctuations in the global CV industry which have inevitably affected the British market, British companies appreciate the benefits of CV in terms of innovation and growth potential. Currently, Unilever Ventures, the active collaboration between BT and New Venture Partners, and the venturing activities of BP are cases of companies which continue to have an active interest in CV activities.

Case study - UKE

1.180 As an example of corporate venturing in action, we consulted the venture team at a major UK energy company, which for the purposes of this case study we have called UKE.

1.181 The company has been involved in corporate venturing for five years. It set up a corporate venturing team 20 months ago which has six people directly involved. They are allocated an annual budget from which to make investments. However, this is flexible and they can seek further funds if good opportunities are identified. The role of the venture team is to identify investment opportunities that fit the strategic needs of the business, ‘sell’ the proposal to the appropriate internal business division and do the deal. An investment committee makes the actual investment decision.

1.182 The motive for engaging in corporate venturing is linked to having a “vision” of the future for the company and to help deliver on this vision. It is looking to invest in companies that can offer solutions and opportunities that link strategically to the core business, including energy generation, supply, IT, telecoms. It is emphasised that strategic reasons dominate investment decisions.

1.183 UKE engages in both direct and indirect investing. It has made 12 direct investments and invested in three VC funds as Limited Partners, in UK, US and Asian funds. A typical deal involves a minority stake of 20-30% but it has also done 100% deals. Amounts invested range from £50k to £15m. Investee companies can also benefit from hands-on support, contracts and project financing. UKE will do follow-on funding (up to three rounds) and will co-invest on some deals. In terms of exiting, it may divest or may buy-out the company – “all options are possible”.

1.184 Areas where UKE has invested to date include geothermal, fuel cells, active network management, smart meters, batteries, wind generation, and hydro generation. In terms of geography it has invested all over the world, as well as in several UK companies. In some cases non-UK based investee companies have opened up offices in the UK (e.g. as their European HQ).

1.185 The benefits of corporate venturing to UKE include gaining first mover advantage, betting on the right technology, and learning (e.g. an investment in photovoltaics enabled UKE to learn where the technology was going and about market opportunities).

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10 International comparisons

Key findings

1.186 The findings on international comparisons are summarised below:

Trends in VC investment in Europe over the period 1998-2007 have been broadly similar to those in the UK. However, Europe bounced back much more quickly from the dotcom crash. This may be because the UK, being by far the largest VC market in Europe (40% of deals) was therefore much more seriously affected by the crash.

The UK is also the largest angel investor in Europe (31% of volume and 44% in number of deals). However, the average deal size in the UK has fallen below the average for Europe over the period 2005-2007. It appears that angels in the UK are doing many more deals than other EU countries, but smaller ones.

As a proportion of GDP, the UK has a higher share of early stage venture capital investment than the US.

Comparing US angel investment activity with US VC investment shows that angel investments represent 86% of VC investments in terms of dollars invested but that angels make seven times as many investments as VCs.

In volume terms, US angel investment is an order of magnitude larger than in the UK. In 2007, US angels invested US$26bn (£18.7bn) compared with UK business angels investing the equivalent of US$41m (£29.5m). Notably, average deal size in the US in 2007 was US$455,182 (£327,527) compared with US$91,332 (£65,705) in the UK.

Introduction

1.187 In this section, statistics on the supply of equity in Europe and USA are presented and where possible, comparisons with the UK are made. For the comparative analysis it is important to stress a degree of caution in interpreting the trends as European/ USA statistics are not always directly comparable with the UK. This is due to differences in the methodologies and definitions used by different data sources (see Annex A).

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Europe

Venture capital

Total venture capital investment, 1998-2007

1.188 Between 1998-2007, Europe generally experienced growth in the total venture capital investment every year apart from in 2001 (Figure 10-15). The largest growth has been between 2005 and 2007 – an increase of 57%. The total investment in 2007 was €73,788m, over five times the original amount in 1998.

Figure 10-15 Europe - Venture capital investment, 1998-2007 (€ million)

14,461

25,401

34,986

24,33127,648 29,096

36,920

47,057

71,16573,788

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

€ m

illio

n

Source: EVCA Yearbook 2008

1.189 As Figure 10-16 illustrates, the value of European venture capital investment has shown similar trends to the UK from 1998 with:

both Europe and UK show a positive trend between 1998-2000

between 2000-2001 Europe and UK investment followed the same declining pattern, but from 2002 onwards, Europe experienced an upward trend, whereas UK declined further until 2003 before showing a steep increase from 2004 onwards

between 2006-2007, Europe and UK investment was levelling off at similar rates.

1.190 This suggests there are wider cross-country factors affecting the supply of venture capital to SMEs, from which the UK is not immune. For instance, the bursting of the dotcom bubble in 2001 had a widespread effect on international equity markets and the greater availability of funding in 2005 and 2006.

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Figure 10-16 Europe and UK venture capital investment, 1998-2007 (€ million and £ million)

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

Eu

rop

ean

in

vest

men

t (€

mil

lio

n)

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

UK

investm

ent (£ m

illion

)

Europe venture capital UK venture capital

Source: EVCA Yearbook 2008; BVCA; SQW; European venture capital defined as: seed, start-up, other early stage, expansion, bridge financing, rescue/ turnaround; UK venture capital defined as: start-up, other early stage, total expansion (incl. expansion refinancing bank debt, secondary purchase)

1.191 European venture capital investment by financing stage as a proportion of all venture capital financing stages72 for the period 2003-2007 (see Figure 10-17) points to seed investment being relatively steady, start-up investment showing very minor decline between 2003 and 2005, but peaking in 2006 before declining again. Expansion investment follows a gradual positive trend between 2003 and 2005, declining in 2006 before rising again in 2007.

1.192 The most relevant comparison that can be made with the UK is investment by financing stage as a proportion of total early stage and expansion investment for the period 2003-2007. This shows that:

UK start-ups follow the same steady pattern as Europe and that UK companies in expansion phase also match the European trend.

UK start-ups have a slightly higher proportion of the total venture capital supply than their European counterparts, whereas UK companies in expansion account for more or less the same proportion of the total venture capital investment as those in Europe.

The decline between 2005 and 2006 and increase in 2007 for UK companies in expansion matches the European pattern of supply.

72 i.e. sum of seed, start-up, other early stage, expansion, bridge financing and rescue/ turnaround.

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Figure 10-17 Europe - venture capital investment by financing stage as a proportion of all venture capital financing stages, 2003-2007

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

2003 2004 2005 2006 2007

Seed Start-up Expansion Rescue/turnaround

Source: EVCA Yearbook 2008; SQW; figures exclude MBO/MBI and other later financing stages

1.193 The average European venture capital deal size can be calculated from the available data (Figure 10-18). The results show that in 2007 this was €2.6m and was lower than that for the UK, which itself had the fourth largest deal size in Europe.

Figure 10-18 Europe – Average venture capital deal size, 2007

8,17

7

7,35

5

4,78

1

4,26

0

4,14

9

3,55

6

2,55

6

2,14

2

1,77

7

1,71

6

1,71

3

1,66

8

1,64

5

1,42

2

1,31

2

1,20

7

1,13

0

990

754

721

651

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

Ital

y

Rom

ania

Gre

ece

Uni

ted

Kin

gdom

Spa

in

Sw

itzer

land

Eur

ope

Pol

and

Bel

gium

Por

tuga

l

Den

mar

k

Net

herla

nds

Fra

nce

Cze

ch R

epub

lic

Nor

way

Irel

and

Fin

land

Sw

eden

Hun

gary

Ger

man

y

Aus

tria

€ th

ou

san

ds

Source: EVCA Yearbook 2008; SQW

63



1.194 In terms of venture capital deals as a proportion of GDP in 2007, the UK is above the European level and achieves the fourth highest scale of venture capital activity of any European country (Figure 10-19).

Figure 10-19 Europe – venture capital deals as proportion of GDP, 2007

0.23

%

0.21

%

0.19

%

0.18

%

0.17

%

0.15

%

0.13

%

0.11

%

0.11

%

0.11

%

0.11

%

0.10

%

0.08

%

0.07

%

0.05

%

0.05

%

0.04

%

0.03

%

0.02

%

0.02

%

0.00

%

0.0%

0.1%

0.2%

0.3%

Den

mar

k

Sw

den

Fin

land

Uni

ted

Kin

gdom

Sw

itzer

land

The

Net

herla

nds

Irel

and

Spa

in

Rom

ania

Bel

gium

Nor

way

Eur

ope

Fra

nce

Cze

ch R

epub

lic

Por

tuga

l

Ger

man

y

Pol

and

Aus

tria

Ital

y

Hun

gary

Gre

ece


1.195 When comparing the number of venture capital deals by country as a proportion of the total European venture capital deals in 2007, the UK exceeds the rest of the European countries by a large margin (Figure 10-20), accounting for 40% of all deals done.

Figure 10-20 Europe - Number of venture capital deals by country as a proportion of total European venture capital deals, 2007

0%

5%

10%

15%

20%

25%

30%

35%

40%

Uni

ted

Kin

gdom

Fra

nce

Ger

man

y

Spa

in

Sw

eden

Net

herla

nds

Sw

itzer

land

Nor

way

Fin

land

Bel

gium Ital

y

Den

mar

k

Por

tuga

l

Irel

and

Rom

ania

Pol

and

Aus

tria

Gre

ece

Cze

ch R

epub

lic

Hun

gary

Source: EVCA Yearbook 2008; SQW

64



Business angel finance

1.196 As Table 10-21 illustrates, the total EU angel investment increased between 2005 and 2006 before declining in 2007. The supply in 2007 still was higher than in 2005 by about 13%. By comparison, UK angel investment declined over the same period by 38% overall. The number of deals increased in both the EU and the UK between 2005 and 2007. However the growth in the UK was nearly 100%, whilst in the EU it was just over 60%.

1.197 Compared to other EU countries, the UK has had the highest angel investment each year between 2005 and 2007,

Table 10-21 Europe – business angel investment, number of deals and average deal size, 2005-2007(€)

2005 2006 2007

Total invested

(€’000)

(€’000)

Number of deals

Average deal size

(SQW calculation)

Total invested

(€’000)

Number of deals

Average deal size

(SQW calculation)

(€’000)

Total invested

(€’000)

Number of deals

Average deal

size(SQW calculation)

(€’000)

Austria 1,566 2 783 1,800 10 180 600 5 120

Belgium 5,704 44 130 12,111 35 346 7,006 35 200

Czech Republic

- - - - 30 - 500 1 500

Denmark 4,000 - - - - - - - -

Finland - 47 - 5,000 10 500 5,000 10 500

France 15,304 157 97 37,000 214 173 37,000 214 173

Germany 8,450 26 325 6,598 28 236 - - -

Greece - - - 30,000 1 30,000 - 0 -

Ireland - - - 550,000 5 110,000 2,200 5 440

Italy 8,050 35 230 19,500 120 163 19,500 102 191

Luxemburg - - - - - - 80 2 40

Netherlands 3,125 22 142 6,200 75 83 6,200 75 83

Poland - - - 800 4 200 - - -

Portugal - - - 412 12 34 1,662 11 151

Slovenia73 - - - 11 1 11 280 2 140

Spain - - - 2,285 18 127 2,526 11 230

Sweden 8,515 72 118 14,000 131 107 15,000 99 152

United Kingdom

69,895 226 309 63,672 383 166 43,084 449 96

EU 124,609 631 197 149,381 1,143 131 140,638 1,021 138

Source: EBAN Statistics Compendium 2008; EBAN Statistics Compendium 2007; EBAN European directory of Business Angel Networks in Europe 2008; EBAN European directory of Business Angel Networks in Europe 2007

73 Aggregate data for the Slovak Republic, Slovenia and Croatia.

65



1.198 For the EU and the UK, the average angel deal size has declined during 2005-2007 (see Figure 10-21). The UK had the greater average deal size in 2005 and 2006, but it has been overtaken by the EU average in 2007.

Figure 10-21 Europe – business angel average deal size, 2005-2007 (€)

131,000 138,000

309,000

166,000

96,000

197,000

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

2005 2006 2007

Inve

stm

en

t (€

)

Europe UK

Source: EBAN; SQW

USA

Venture capital

Total investment

1.199 The total US venture capital investment in 2007 was $30bn, in 3,200 companies. The trend between 1998 and 2007 depicts an increase from 1998 to a peak in 2000 (‘peak bubble year’) and a decline thereafter until 2003. The supply picks up again to 2007. This broadly follows the UK pattern during 1998-2007.

66



Figure 10-22 USA – Venture capital investment ($ billion), 1980-2007

Source: National Venture Capital Association, 2008

Investment by financing stage and sector

1.200 The majority of venture capital investment in the US74 was in later stage deals followed by successively lower supply to expansion; early stage and seed stage, as is the case with the UK (see Figure 10-23). The US venture capital investment by financing stage as a proportion of total start-up seed, early stage and expansion stage during 1998-2007 is shown in Figure 10-24.

74 US investment stage data uses different definitions to the UK data sources (see Annex A).

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Figure 10-23 USA – Venture capital investments by financing stage, 2007

Startup-seed, 4%

Early, 17%

Later, 42%

Expansion, 37%

Source: National Venture Capital Association Yearbook 2007

Figure 10-24 USA – Venture capital investment by financing stage as a proportion of total start-up seed, early and expansion stages, 1998-2007

0%

10%

20%

30%

40%

50%

60%

70%

80%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Startup-seed Early Expansion


1.201 The distribution by sector for 2007 identifies software and biotechnology as the main recipients of venture capital investment in the US. It is not appropriate to compare this directly with the UK because the sector definitions for the US differ substantially.

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Figure 10-25 USA – Venture capital investment by sector, 2007

Media and Entertainment, 10%

Semiconductors, 9%

Computers and Peripherals, 6%

Financial services, 5%

Software, 18%

Telecommunications, 11%

Medical Devices and Equipment, 14%

Biotechnology, 17%Industrial/Energy,

10%


US and UK venture capital comparison

1.202 Using the figures on UK market activity from Section 3 and comparing these with the US market figures above, it is possible to draw the comparison between scale of early stage investment as set out in Table 10-22. The value of US funding is higher but when set against a larger national GDP, the UK has a higher share of early stage venture capital funding.

Table 10-22 US and UK venture capital investment comparison (2007)

Amount of VC investment - early stage* (bn)

GDP (bn) GDP penetration – early stage

UK £1.6 £1,402 0.1%

US $6.3 $13,742 0.05%

Source: BVCA/NVCA/OECD;*UK: start-up plus early stage; US: start-up/seed plus early stage.

1.203 Eurostat data (Table 10-23) confirms that the UK has a higher proportion of venture capital funding as a proportion of GDP compared to the US. Differences in percentages may be explained by differences in data collation methodology and the definitions in use.

Table 10-23: Venture early stage capital investment comparison (2005)

Proportion of early stage to GDP Proportion expansion and replacement stage to GDP

UK 0.047% 0.319%

US 0.035% 0.147%

Source: Eurostat (2007) Venture Capital Investments. In Statistics in Focus, Science and Technology, no. 36/2007

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Business angels

1.204 As in the UK, gaining accurate statistics on levels of angel investment in the USA is difficult given the fragmented nature of the market. A key source of information on angel investments is the twice yearly estimate of activity produced by the Centre for Venture Research at the University of New Hampshire75. This is based on surveys of angels and angel groups, these data should still be viewed as providing an indication of angel activity rather than comprehensive and accurate statistics.

1.205 From the data in Table 10-24 and Table 10-25, the following observations can be made:

The amount invested by US angels fell sharply in the aftermath of the dotcom boom, but has increased year on year between 2002 and 2007. Other measures of investment activity (number of investments and number of investors) have also increased over the same period. Statistics for the first half of 2008 suggest this growth may have reached a plateau.

Comparing angel investment activity with venture capital investment (see Figure 10-22) indicates that angel investments represent 86% of VC investments in terms of dollars invested but that angels make seven times as many investments as VCs.

About half of angel investments are at seed and start-up (compared with 4% of VC investments) and about one-third are at early stage (compared with 17% of VC investments). Although these proportions vary year on year, it is nevertheless clear that angels invest at an earlier stage than VCs.

Around two-thirds of angel investments are new, rather than follow-on, investments.

Conversion (yield) rates, which provide a measure of how easy it is to raise finance from business angels, have fluctuated over time, ranging from 23% in 2000 and 2005 to around 10% in 2001-2003 and in the first half of 2008.

In each year for which data are available, over half the members of angel groups did not make any investments i.e. they we not active in investments made by the group – they are ‘latent angels’.

Table 10-24: Angel investment activity in the US

Year Amount invested (US$bn)

Number of investments

Number of angel

investors

% of investments in seed and start

up

% of investments in

early stage

2001 30.0 - - - -

2002 15.7 36,000 200,000 47 33

2003 18.1 42,000 220,000 52 35

2004 22.5 48,000 225,000 - -

2005 23.1 49,500 227,000 55 43

75 http://wsbe.unh.edu/analysis-reports-0

70

http://wsbe.unh.edu/analysis-reports-0



Year Amount invested (US$bn)

Number of investments

Number of angel

investors

% of investments in seed and start

up

% of investments in

early stage

2006 25.6 51,000 234,000 46 40

2007 26.0 57,120 258,000 39 35

2008 (first half) 12.4 23,100 143,000 46 33

Source: Centre for Venture Research, University of New Hampshire

Table 10-25: Characteristics of US angel investing

Year % Conversion (yield) rates

% Latent angels % Women angels % Newinvestments

2001 10.8 - - -

2002 7.1 - - -

2003 10.3 48 - -

2004 18.5 - 5.0 -

2005 23.0 62 8.7 70

2006 20.1 57 13.8 63

2007 14.0 - 12.0 63

2008 (first half) 11.0 58 13.0 63

Source: Centre for Venture Research, University of New Hampshire

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11 Implications of the current economic climate

1.206 At the time this research was undertaken (September 2008 to January 2009) it was too early for the impact of the economic downturn to be shown on investment data. This chapter provides emerging views from consultees.

Key findings

1.207 The findings on the implications of the current economic and financial conditions are summarised below:

Experience from the dotcom crash (albeit a different phenomenon) suggests that the current downturn in the equity markets could be prolonged.

The early stage end of the market will only pick up again when VCs can raise funds themselves.

Institutional fund raising, new early stage deals and exits are all adversely affected by current uncertainties over company valuations.

All the usual exit routes are currently restricted and hence early stage investors are having to stay involved with investees for longer, tying up funds that would otherwise be invested in new deals.

Business angels are less active in new deals partly because they concentrating on existing investments and partly because as individuals they currently have less tax to shelter so the benefits of the EIS have become less attractive.

Market players state it is currently ‘too early to tell’ when the market will pick up.

Observations from past trends

1.208 Figure 3-1 shows the trends in early stage equity investment over the period 1998-2007. It therefore covers the lead up to the dotcom boom and the effect of the crash. What it shows is not only the rapid decline in supply from the peak in 2000, but the long period it took before the market began to pick up again (with investment only really increasing markedly in 2005). This long slump was a function not only of a reduced appetite for risk of the VCs but also of their institutional investors on whom they rely for their own funding. The trend provides an indication of how long it might take the early stage equity market to recover from the current economic downturn.

1.209 However, whilst the dotcom boom and subsequent crash originated in one sector and then spread to other sectors, the current economic downturn is pervasive, affecting the majority of sectors. The impact of the economic downturn affects the ability of investors to raise new funds. We therefore consider it likely that there will be a marked decline in the availability of equity finance and the recovery may take longer than previously experienced.

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Impact of the economic downturn

1.210 Consultees reported a series of impacts on the market:

Some VCs are refraining from making new investments until the market settles and company valuations are clearer. They predict that it will be later in 2009 before they are likely to enter the market again. Other VCs are still investing but point out that investments will tail off when their own funds run out.

The credit crunch is making it almost impossible for VCs to raise new funds. Institutional fund managers are conserving cash and finding it difficult to make decisions on pricing, thus causing a blockage in the system.

With many VCs not investing, the economic climate has exacerbated the equity gap in terms of supply, leaving publicly backed funds and business angels as ‘the only game in town’. However, many business angel networks comment that around half their angels are currently inactive as they wait to see what will happen to the market generally but also to enable them to concentrate available resources as required by their existing investees.

However, demand for early stage equity is likely to rise as long as banks reduce their lending to small companies. Whilst equity would not normally be the preferred form of finance to cover everyday requirements, it may be the only alternative in some cases. Where VCs and angels are already investors they may be called upon on to provide this finance, using up capacity that they would otherwise use to make new investments.

Existing investors also have to stay in deals for longer as exits have almost entirely dried up. The markets (e.g. AIM) have their own liquidity issues. AIM reports a lack of liquidity at the smaller end of new offerings (defined as under £25m which effectively excludes most VC backed companies). The problem is a lack of retail investors. Even before the current economic turmoil, retail investors had been put off by changes in the tax regime (FA 2006) which removed some of the favourable tax breaks. This means the AIM market is reliant on large institutional investors. These are not interested in deals below £25m (on risk/reward grounds) and thus a gap has opened up at the smaller end of the market. AIM statistics also show that whereas until 2006, AIM did 60% new deals plus 40% follow-on deals, those percentages have now reversed, i.e. more money is going into follow-on funding than into new flotations.

In addition to the IPO problems, there is anecdotal evidence that large companies are less likely to be participating in corporate venturing at present.

Concerns over company valuation mean that trade sales have also dried up.

Taken together, there is a perception that the exit routes out of private equity are closed, which prevents existing funds being freed up to fund new deals.

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Future trends

1.211 Consultees found it hard to see past the end of the economic downturn. Most felt it was far too early to predict how the market would turn out over the next five years.

1.212 One prediction forthcoming was that there is likely to be a consolidation of business angel networks in mature markets such as the UK whilst the number of networks would continue to grow in younger markets (such as southern Europe).

1.213 In terms of new sectors such as Cleantech, it is hoped that these will begin to mature in the same way as the ICT sector with a better mix of private as well as public players in the VC market.

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12 Assessing the Equity Gap

Key findings

1.214 The findings on the equity gap are summarised below:

The parameters of the gap for most investments are believed to stretch from £250k to at least £2m (with some putting the ceiling at £5m). In the case of sectors requiring complex R&D or large capital expenditure, the gap may extend up to £15m.

These parameters define the first round funding gap, but there are additional concerns about the possible underfunding of UK companies at each stage of the venture capital process. Underfunding could constrain the growth of early stage companies which then do not go on to fulfil their potential.

The early stage market has been changing in recent years with the growing importance of business angels, both as individuals and as members of syndicates. Business angels also constitute the most frequent source of private sector match funding in publicly backed co-investment deals.

Whilst there is concern that VCs have abandoned the early stage market this is not entirely true. There is evidence of some new VC funds entering this market. Early stage funding can provide a stepping stone for new VC funds on the way to larger deals.

The increasing concentration of early stage funding in London and the South East could leave an increasing gap in other regions, although an assessment of demand is needed before a strong conclusion can be drawn.

Investment in early stage equity by type of provider

1.215 Investment by source and financing stage for the UK in 2007 is reported in (Table 12-26). This is an attempt to capture, as far as possible from the available data, the supply of equity in the UK. Due to only partial data being available for business angels76 and publicly-backed investment, it is only possible to establish a partial picture on the supply of equity from these two sources. In addition to this, some of the business angel and publicly-backed investment figures will also have been reported in BVCA 2007 data. It is not possible to identify definitively the scale of the overlap between BVCA data and the other sources of finances because BVCA’s 2007 data do not provide disaggregated investment figures attributable to survey respondents. For instance many of the public sector funds are managed by fund managers who are members of the BVCA.

1.216 Thus, venture capital investment figures reported by BVCA are not strictly only ‘pure venture capital’. As a result, the total supply of equity in the UK can only be established from multiple data sources and is open to double-counting.

76 Business angel investment figures reported by EBAN and Mason capture only part of the informal finance market.

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1.217 In view of these issues, it is important to stress that the findings in Table 12-26 should be interpreted with caution. They should be treated as representing a partial picture on the supply of equity, albeit the best that may be compiled at this time.

1.218 Table 12-26 shows that:

Venture capital is by far the largest source of investment when compared to business angels77 and publicly-backed78 finance at start-up, other early stage and total expansion stage. Even when taking into account deal sizes below £2m (associated with equity gap investments), private sector venture capital is still largest source of investment compared to Angels and publicly backed funds79.

Venture capital investment in total expansion stage is over 2.5 times greater than that at start-up and other early stage put together.

Business angel and publicly-backed investment is similar at start-up and other early stage.

Business angel investment is just over four times higher at total expansion stage when compared to investment from the public sector.

Table 12-26 Investment by source and stage (£m), 2007

Seed Start-up Other early stage

Total start-up and

other early stage

Total

Venture capital (BVCA reported) n/a 190 244 434

Venture capital (BVCA reported) deals below £2m

740

Business angel (EBAN: Mason pers. com. with SQW calculations)

0.9 7.7 8.3 16

Publicly-backed * (BERR with SQW calculations)

8.5 10.8 7.5 18.3

Source: SQW; * public includes only RVCF, ECF, UCSF, CVDF, CT.

1.219 The figures for public sector funding invested in early stage as a proportion of the overall total might suggest that the role of publicly backed funds is not significant. However anecdotal evidence from consultees highlighted the importance of the public funds in regions outside London and the South East. In regions where for instance RVCF and RDA funds have reached the end of their investment period and ECF funding has not so far penetrated, in

77 Business investment figures were distributed across each financing stage in line with percentage of investment in 2003 reported by Mason (2006): 3% seed; 26% start-up; 28% other early stage; 36% expansion; 3% MBO/MBI. 78 SQW calculation for RVCF and ECF involved taking the average size of investment per company and multiplying it with the annual number of companies that received investment. This was then allocated across each financing stage in the same proportions that actual investment occurred as reported by BIS. Calculations for UCSF and CVDF are based on BIS data. Carbon Trust (CT) investment calculated from SEF Alliance Publications (2008). Publicly-backed investments other than identified in Table 12-26 are not included because it was not possible to calculate the annual investment in 2007 based on the available data. 79 As indicated, BVCA data for 2007 may include some publicly supported and informal investments, including from co-investment schemes. However even if 100% inclusion is assumed and all these investments are stripped out from BVCA totals for start-up plus other early stage and for sub-£2m investments, pure private sector investment still contributes c. £400m and c. £697m respectively.

76



the absence of any private sector venture capital firms, business angels may be left as the only early stage funding available. Given the reduction in angel appetite for new investment (discussed in Section 5), this could be leaving early stage companies without the finding they need.

The boundaries of the equity gap

1.220 The concept of an equity gap is well established and dates back to at least the 1931 Macmillan report to the Parliamentary Committee on Finance and Industry. This results in a shortage of equity capital to viable and potentially profitable businesses seeking relatively modest amount of finance. The equity gap is often quantified as a set of boundaries relating to the amount of equity finance sought in which potentially viable and profitable businesses have acute difficulties in raising the finance they need. This does not suggest that there is no equity finance available between these lower and upper boundaries, only that there are substantial difficulties for viable businesses raising finance.

1.221 In practice the boundaries of the equity gap are not rigid. It is unrealistic to assume that the supply of equity capital suddenly increases beyond the identified boundaries of the gap and in practice there is likely to be a progressing scale of difficulty. This needs to be taken into account when designing Government policies to avoid distorting the market and creating new equity gaps immediately above the level of government schemes.

1.222 It is important to acknowledge that there are a large number of investments made in the sub-£2m investment size category (1,049 reported in 2007 by BVCA: see Table 3-3). Investments below £2m have accounted for between 70% and 80% of all investments over the period 2001 and 200780. However the extent to which sub-£2m investments are elements in larger, syndicated deals is uncertain from examination of published sources.

1.223 Pierrakis & Mason also note that the number of companies raising investment of less than £2m has risen by 20% between 2001 and 2007 (see also Table 3-3) and report that their share of total investment has varied over this period from 12% in 2001 to 6% in 2007 (see also Table 3-4).

1.224 Any full and quantitative assessment of the equity gap would require further research to assess the level of unmet demand for equity finance from potentially viable businesses. This was outside the scope of the study. In common with other research in this area, the size of the equity gap is assessed to a degree on subjective view of well informed sources, but where possible examined alongside investment trend data.

1.225 All but one of the consultees considered that an equity gap exists in early stage equity. The doubter considered that in normal market conditions (i.e. ‘non-credit crunch’) a sound business proposition would find the funding it needed. Thus, according to this view, there is no market failure only the disinclination of investors to fund unsound businesses.

1.226 Amongst all the other consultees, although one put the floor of the gap as low as £100k, most felt the equity gap started at around the £250k (below which friends and family, grants and seed money81 provided what was necessary). Responses were, however, much 80 Pierrakis & Mason, op.cit. p.1381 As defined in Annex A: Table A4

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more varied when asked about the ceiling. The majority of consultees felt that for deals involving low capital expenditure, the upper boundary of the gap was around £2m. However, a small number with particular knowledge of the formal venture capital market advised that as very few VCs now invest below £5m and since most angel syndicates only invest up to around £500k, there is a gap below the £5m ceiling.

1.227 For technically complex developments involving extensive capital expenditure the early stage gap is felt to be much larger. In the case of Cleantech or biosciences the upper boundary of the gap may be as high as £10-15m.

1.228 The evidence presented in this report is roughly consistent with the previous assessment presented in Bridging the Finance Gap (2003) which concluded that ‘the gap appears to be most acute for investments between £250k and £1m, but is also severe for businesses seeking up to £2m – and for some businesses, it may be even higher’ 82. Although it may suggest the upper boundary is higher, now at £5m, and for certain sectors may be even higher.

1.229 A number of causes were suggested by consultees for the unattractiveness of early stage equity, which is also consistent with the 2003 assessment:

the cost of due diligence relative to the returns to be made (see Section 5)

a knowledge gap on both sides of the transaction (perceived lack of business management skills in the potential investee business and a lack of understanding of the technology by ‘generalist’ VCs) which increases the perceived risk of the deal

the difficulty in raising the finance for funds to target the early stage (given the perceived risks).

1.230 Consultees also felt that the equity gap was a more complicated issue than simply defining a ‘floor’ and ‘ceiling’ for early stage deals. Concern was expressed that even where UK companies did find it possible to raise finance (at early and also later stages) they were not raising nearly enough finance. At the early stage, consultees reported that UK companies are only raising half of the amount a similar company would in the US. At later stages US funding can be 2.5 times greater than for a similar company in the UK. This suggests that growing UK companies may be seriously under-funded compared with their US peers. Unfortunately the available data on US VC investment was not detailed enough to check this by examining average deal size at each stage of investment. However, it is an area that merits further research.

Changing parameters

1.231 Most consultees commented that the equity gap had not reduced over the last few years and some felt that it had increased (due to VCs vacating the market below £5m). Therefore, the investment limit of public sector funds need some flexibility for providing additional funding to meet the financing needs of the

82 97% of consultees in the Bridging the Finance Gap Consultation agreed that SMEs continue to face a significant equity gap.

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business, although still maintaining the mandate to focus on where the equity gap is most acute.

Business angels/syndicates

1.232 Business angels have become increasingly important players in the early stage market. They are now the main source of private sector capital at this stage of financing and provide the private sector input to many publicly backed co-investment funds. Within angel finance the use of syndicates has increased significantly and the deal sizes have increased as a result.

1.233 However, angels alone are not the complete solution to the equity gap given that even their syndicates typically do not invest more than around £500k. Whilst they may meet the first funding requirements of a company, the company will soon require another funding source if it is to grow.

Co-investment funds/RVCF run-off

1.234 Given that very few private sector VCs operate in the early stage market, publicly backed funds have been the Government’s attempt to plug the equity gap. It is acknowledged that the co-investment structure encourages a doubling up of amounts raised by leveraging extra private sector funds into the market from business angels who match fund the public sector contributions.

1.235 However, the sums the RVCFs have had to offer are regarded by those involved in the high tech field as being too small (i.e. an investment of £250k plus £250k follow-on). Their absence will, according to some consultees, not have too much impact.

1.236 Others dispute this and feel that little early stage funding will be left in certain regions now that the RVCFs have reached the end of their investment period (especially given that the ECFs are being created in tranches and hence do not yet provide a full replacement). This will leave business angels as a potential source of funding.

VCs in the early stage market

1.237 Despite many comments that there are no private sector VCs left in the early stage market (the departure of Apax and 3i being quoted to demonstrate this), the consultees for this study did include early stage VCs. The explanation given is that new VCs have to start somewhere. Hence they may ‘cut their teeth’ running a VCT and then graduate to being the manager of a publicly backed fund such as an ECF. As they become more successful, they are able to raise larger sums of money and hence participate in larger (more profitable) deals. This is a natural progression and explains why Apax and 3i are no longer in the early stage market. However, it should not cause too much concern providing that there are always new VC funds coming up behind to fill the space. Whilst there is no hard evidence that new VC funds will continue to enter the early stage market especially for smaller deals, the interest aroused by the ECF bidding rounds suggests that there are fund managers out there willing to consider operating at this end of the market.

79



The dotcom effect

1.238 The dotcom crash has had a long term effect on the market. This is because funds have a ten year lifespan, so that funds established at the turn of the century, still have to report performance affected by the dotcom failures. Performance is tracked very closely by large institutional investors such as pension funds, which are cautious about investing in VC funds, particularly those focussing on the IT sector.

Minimum funding required

1.239 Consultees generally agreed that companies need around £100k at the seed stage (£2m for Cleantech seed) and an absolute minimum of £2m at early stage (£10-15m for Cleantech and biosciences). Where companies set out without sufficient funding they risk not fulfilling their growth potential. As one source in Scotland put it, there is a risk of “creating a bunch of crofters”.

Recent public sector developments

1.240 Two new funds have recently been announced by Capital for Enterprise to address perceived market gaps.

Aspire Fund

1.241 Established in autumn 2008, the £12.5m Aspire Fund is aimed at women-led businesses across the UK. It can make equity investments of between £100k and £1m on a co-investment basis to help business growth.

Capital for Enterprise Fund

1.242 This £75m fund (comprising £50m from the public sector and £25m from four banks) will make equity and quasi equity investments of between £250k and £2 m in businesses with growth potential that are currently constrained due to over gearing (i.e. their high levels of debt). The funds are to be used to restructure balance sheets and invest for growth.

Areas for further research

1.243 First and foremost, in considering the ‘equity gap’, this report has only investigated the existence of a gap in supply side provision. When considering the overall ‘equity gap’, it will be important to consider the demand side and the ability of firms to obtain the equity finance they need.

1.244 However, the report has shown that even in terms of the supply side, there are areas where further research would be useful. These include:

Investigation of the true extent of business angel funding in the UK. This would require use of the combination of techniques suggested in the recent report by Mason and Harrison83.

83 Mason and Harrison (May 2008) Developing Time Series Data on the Size and Scope if the UK Business Angel Market.

80



Further examination of the funding available within each region. This would include obtaining additional data on business angel investment and more detailed input from the RDAs (not all of which provided data for the current research). This could then be used, in combination with demand side research, to ascertain whether the equity gap is more acute in regions outside London and the South East.

81



13 Bibliography

BIS (2008) Annual Small Business Survey 2007/08

BVCA (2008), BVCA Private Equity and Venture Capital Report on Investment Activity 2007

BVCA (February 2006) Private Equity – a UK Success Story

Cass Business School (2008) The London markets and private equity backed IPOs

Colin M. Mason (2006) The Informal Venture Capital Market in the United Kingdom – Adding to the Time Dimension, Venture Capital and the Changing World of Entrepreneurship

Cosh, A, Hughes, A, Bullock, A and Milner, I(2008) Financing UK Small and Medium-sized Enterprises: The 2007 survey, Centre for Business Research (CBR)

Cowling et al. (2008) Study of the Impact of Enterprise Investment Scheme (EIS) and Venture Capital Trusts (VCT) on Company Performance, HM Revenue & Customs Research Report 44

EBAN Statistics Compendium 2008 and 2007

EVCA Yearbook (2008) Pan-European Private Equity & Venture Capital Activity Report

HMT and SBS (2003) Bridging the Finance Gap: Next Steps in improving access to growth capital for small businesses

JP Morgan Fleming (2005) Alternative Investment Strategies Survey of 350 pension schemes

Library House (2006) Beyond the Chasm: The Venture Backed Report

London Business School (2000) UK Venture Capital and Private Equity as an Asset Class for Institutional Investors

Mason and Harrison (May 2008) Developing Time Series Data on the Size and Scope if the UK Business Angel Market

National Association of Pension Funds (January 2007) Institutional Investment in the UK Six Years On

National Venture Capital Association (2008) NYCA Yearbook

Pierrakis and Mason (2008) Shifting Sands- The changing nature of the early stage venture capital market in the UK NESTA Research Report

SBS (2005) A Mapping Study of Venture Capital Provision to SMEs in England

82



SEF Alliance Publications (2008) Public Venture Capital Study

83



Annex A: Data sources and definitions

UK venture capital

Table A-1: Specific BVCA methodology

1. Investments led by overseas offices of BVCA full members (and where there has been no advice provided by the UK office) and UK deals made by non-UK based private equity firms are excluded.

2. The 2006 figures refer to investments made by both BVCA full member firms and those undertaken through an overseas office, where the UK office was the lead adviser and in spite of where the investment fund was domiciled. This was as a result of changes to the 2006 BVCA questionnaire to include investments “made” or “advised by” the office of the BVCA full member firm. As a result more cross-border investments have been included.

3. From 2005, there was a change in BVCA methodology in relation to counting the number of companies by financing stage. A company is counted once in each of the start-up and expansion categories (i.e. counted twice) but only counted once in the overall total. “This is due to some companies receiving more than one investment within the same year at different financing stages”. This does not affect “amounts invested” and applies to 2005 figures only.

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity, 2007

Table A-2: Specific BVCA definitions

Definitions

Private equity and venture capital

There is a distinction between private equity and venture capital - the latter is a subcategory of private equity which encompasses start-up to expansion stages of investment, whereas private equity covers both buyouts and venture capital

Investment According to BVCA, an “investment” is only counted and reported when “money actually changes hands” i.e. it refers to completed investments

Number of deals Equivalent to the number of companies in receipt of investment

(This is an SQW assumption because it is not possible to separate initial and follow-on investment using the BVCA data)

Average deal size Equivalent to the total amount of investment divided by the number of early and expansion stage companies. It takes into account the distribution of deal sizes as it excludes any MBO/MBI stage companies (MBO/MBI deals tend to be of large values and therefore distort the average figure).

(SQW calculation)

Investment size This is the number of companies and the amount invested within a specific range e.g. 100 companies receiving investment of between £2 million and £5 million totalling £100 million. The investment range is £2 million to £5 million.

Financing stages:

Start-up “Financing provided to companies for use in product development and initial marketing. Companies may be in the process of being set up or may have been in business for a short time, but have not yet sold their product commercially”.

Other early stage “Financing provided to companies that have completed the product development stage and require further funds to initiate commercial manufacturing and sales. They may not yet be generating profits.

Total early stage Start-up + early stage

Expansion “Sometimes known as ‘development’ or ‘growth’ capital, provided for growth and expansion of an established company. Funds may be used to finance increased production capacity, product development, provide additional working capital,

1



Definitions

and/or for marketing. Capital provided for rescue/turnaround situations is also included”.

Refinancing bank debt “Funds provided to enable a company to repay existing bank debt”

Secondary purchase “Purchase of existing shares in a company from another private equity firm, or from another shareholder or shareholders”

Total expansion Expansion+ refinancing bank debt + secondary purchase

(According to the BVCA, refinancing bank debt and secondary purchase are considered to be private equity and not venture capital. Therefore and unless otherwise stated, the figures reported relating to BVCA data excludes refinancing bank debt and secondary purchase)

Management buy-out (MBO)

“Funds provided to enable current operating management and investors to acquire an existing product line or business. Institutional buyouts (IBOs), leveraged buyouts (LBOs) and other types of similar financing are included under MBOs for the purposes of this report”.

Management buy-in (MBI) “Funds provided to enable an external manager or group of managers to buy into a company”

Total MBO/MBI MBO + MBI

Sector classification:

Consumer related “Leisure, retailing, food, products, services”

Computer related “Hardware, internet, semiconductors, software”

Electronics related “Components, instrumentation, other”

Industrial related “Chemicals and materials, services, automation”

Medical health biotech As described

Communications As described

Energy As described

Transport As described

Construction As described

Financial Services As described

Other services As described

Manufacturing agricultural & other

As described

Technology classification:

Technology The definition of technology firm used is based on a combination of Industry Classification Benchmark (ICB) and EVCA classification system.

The ICB is a new industry classification that was introduced in 2005 and is created by FTSE Group and Dow Jones Indexes. It replaces the original FTSE Global Classification System (GCS).

The definition includes ICB sector codes 9530 (software and computer services) and 9570 (technology hardware and equipment) and from the EVCA classification system, the sectors of ‘biotechnology’, ‘computers’, ‘medical’ and ‘electronics related’. Industrial companies which used innovative techniques to produce traditional goods were excluded but those companies that specialised in developing ‘cutting-edge’ materials were used in the definition.

2



Definitions

Regional classification:

Regions The regions are defined according to the Government Office Regions and regional investments relates to where the investee company is located.


European venture capital

Table A-3: EVCA methodology

1. EVCA provide investments statistics aggregated via two methods:

“industry statistics consist of aggregation of the figures by countries of location of the private equity firm in charge of the deal”

“market statistics consist of aggregation of the figure by countries of location of the portfolio company”

The figures between the two sets of statistics can vary considerably. For example, domestic investors investing abroad are accounted for in the industry statistics but not in the market statistics. On the other hand, international investors investing into the country are included in the market statistics and not in the industry statistics.

For the purposes of this study, and keeping in line with BVCA methodology, only the industry statistics have been used. This allows for a more appropriate comparison between BVCA figures for the UK and EVCA figures for Europe.

2. The overall “coverage” rate of the European private equity firms was 74% based on 1,851 eligible private equity firms.

The survey was conducted of 28 European countries but the statistics exclude seven Central and Eastern European countries (Bulgaria, Croatia, Estonia, Latvia, Lithuania, Slovakia and Slovenia), The statistics relate to the following countries:

Austria, Belgium, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Luxemburg, the Netherlands, Norway, Poland, Portugal, Romania, Spain, Sweden, Switzerland, and United Kingdom.

3. Unless otherwise stated, the European statistics includes figures for the UK.

Source: EVCA Yearbook 2008; BVCA

Table A-4: EVCA definitions

Definitions

Private equity “Private equity provides equity capital to enterprises not quoted on a stock market. Private equity refers mainly to management buyouts, management buy-ins, replacement capital and venture purchase of quoted shares”

Venture capital “A subset of private equity and refers to equity investments made for the launch, early development, or expansion of a business

Number of deals Equivalent to the number of investments

(Note: This differs from the definition used in relation to the BVCA investment data where number of deals was equivalent to the number of companies)

Average deal size The total investment divided by the number of investments

Financing stage:

Seed “Financing provided to research, assess and develop an initial concept before a business has reached the start-up phase”

Start-up “Financing provided to companies for product development and initial marketing. Companies may be in the process of being set up or may have been in business for a short time, but have not sold their product commercially”.

Other early stage “Financing to companies that have completed the product development stage and require further funds to initiate commercial manufacturing and sales. They will not yet

3



Definitions

be generating a profit”.

Expansion “Financing provided for the growth and expansion of an operating company, which may or may not be breaking even or trading profitably. Capital may be used to finance increased production capacity, market or product development, and/or to provide additional working capital”.

Bridge financing “Financing made available to a company in the period of transition from being privately owned to being public ally quoted”

Rescue/Turnaround “Financing made available to an existing business, which has expressed trading difficulties, with a view to re-establishing prosperity”

Venture capital deals The classification for venture capital deals: seed, start-up, other early stage, expansion, bridge financing, rescue/ turnaround.


US venture capital

Table A-5: USA – NYCA Definitions

Financing stages:

Seed stage financing “This stage is a relatively small amount of capital provided to an inventor or entrepreneur to prove a concept and to qualify for start-up capital. This may involve product development and market research as well as building a management team and developing a business plan, if the initial steps are successful. This is a pre-marketing stage”.

Start-up financing “This stage provides financing to companies completing development and may include initial marketing efforts. Companies may be in the process of organising or they may already be in business for one year or less, but they have not sold their products commercially. Usually such firms will have made market studies, assembled the key management, developed a business plan, and are ready to conduct business”.

Other early stage financing

“Other early stage financing includes an increase in valuation, total size, and the per share price for companies whose products are either in development or are commercially available. This involves the first round of financing following a company’s start-up phase that involves an institutional venture capital fund…The networking capabilities of the venture capitalist are used more here than in more advanced stages”.

Expansion stage financing

“This stage involves working capital for the initial expansion of a company that is producing and shipping and has growing accounts receivables and inventories. It may or may not be showing a profit. Some of the uses of capital may include further plant expansion, marketing, working capital, or development of an improved product. More institutional investors are more likely to be included along with initial investors from previous rounds. The venture capitalist’s role in this stage evolves from a supportive role to a more strategic role”.

Later stage “Capital in this stage is provided for companies that have reached a fairly stable growth rate; that is, not growing as fast as the rates attained in the expansion stages. Again, these companies may or may not be profitable, but are more likely to be than in previous stages of development. Other financial characteristics of these companies include positive cash flow”.

Source: National Venture Capital Association, 2008

4



Annex B: Additional data on investment activity

Number of companies financed in the UK by BVCA members, 1998-2007

Table B-1: Number of companies financed in the UK by BVCA members, 1998-2007

Start-up

Other early stage

Total early stage

Expansion Total expansion*

Total early stage and expansion**

Total MBO/MBI

Total

1998 115 126 241 484 561 725 320 1,122

1999 101 159 260 481 539 741 310 1,109

2000 153 256 409 498 548 907 225 1,182

2001 190 218 408 590 653 998 246 1,307

2002 165 233 398 568 619 966 179 1,196

2003 185 242 427 582 645 1,009 202 1,274

2004 190 264 454 522 580 976 267 1,301

2005 208 285 493 511 573 1,004 308 1,307

2006 245 255 500 490 573 990 365 1,318

2007 207 295 502 474 595 976 349 1,330

Total 1,759 2,333 4,092 5,200 5,886 9,292 3,811 12,446

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity, 2007. * Total expansion figures include secondary purchase and refinancing bank debt. ** Excludes secondary purchase and refinancing bank debt.

Average amount invested (deal size) in the UK by BVCA members, 1998-2007

Table B-2: Average amount invested (deal size) in the UK by BVCA members, 1998-2007 (£m)

Start-up Other early stageTotal early

stage Expansion*Total early stage

and expansion

1998 965 1,405 1,195 1,421 1,346

1999 1,267 1,377 1,335 2,037 1,791

2000 1,144 2,063 1,719 4,040 2,993

2001 858 1,041 956 2,269 1,732

2002 600 841 741 1,968 1,463

2003 395 785 616 820 733

2004 505 712 626 1,511 1,099

2005 769 779 775 2,239 1,520

2006 2,167 1,627 1,892 3,747 2,810

2007 918 827 865 2,399 1,610

Total average 981 1,117 1,059 2,215 1,706

1



Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity, 2007. * Excludes secondary purchase and refinancing bank debt

Amount of investment by investment size by BVCA members, 2000-2007

Figure B-1: Amount of investment by investment size by BVCA members, 2000-2007 (£m)

0

100

200

300

400

500

600

700

800

2000 2001 2002 2003 2004 2005 2006 2007

Year

Inve

stm

ent

(£m

)

£10-19.9k £20-49.9k £50-99.9k

£100-199.9k £200-499.9k £500-999.9k

£1,000-1,999k Total 0-£499.9k Total 0-£2m

2003 2007

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity, 2007. Pierrakis & Mason (2008) “Shifting Sands – The changing nature of the early stage venture capital market in the UK”.

Total investment by sector, 1998-2007

Table B-3: Total investment by sector, 1998-2007

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total

Consumer related 557 1,640 2,132 1,122 1,561 1,616 1,421 2,563 2,172 3,990 18,774

Computer related 253 680 892 663 284 285 316 297 816 417 4,903

Electronics related 103 93 197 62 78 62 85 49 35 31 795

Industrial related 381 431 382 124 143 104 244 102 397 894 3,202

Medical health biotech 210 288 697 481 710 213 462 540 1,081 887 5,569

Communications 506 119 510 655 260 382 125 658 576 2,607 6,398

Energy 57 63 83 45 23 11 191 299 420 231 1,423

Transport 129 320 127 294 278 79 43 182 618 304 2,374

Construction 101 291 191 356 62 45 9 75 1,119 125 2,374

Financial Services 58 104 64 173 394 236 536 762 668 1,593 4,588

Other Services 502 729 382 323 278 333 1,137 495 1,479 469 6,127

Manufacturing. 918 1,411 714 453 408 708 767 791 846 424 7,440

2



1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total

Agriculture & other

Total 3,775 6,169 6,371 4,752 4,480 4,074 5,336 6,813 10,227 11,972 63,969


Total investment within industry sectors in the UK by BVCA members, 1998-2007

Figure B-1: Total investment within industry sectors in the UK by BVCA members, 1998-2007

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Inve

stm

ent

(£m

)

Consumer related Computer relatedElectronics related Industrial relatedMedical health biotech Communications Energy TransportConstruction Financial ServicesOther services Manufacturing, agriculture & other

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity, 2007.

Number of companies (deals) by industry sector in the UK, 1998-2007

Table B-4: Number of companies (deals) by industry sector in the UK, 1998-2007

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total

Consumer related 115 112 142 161 153 120 119 138 167 218 1,445

Computer related 164 258 242 437 332 351 285 291 276 290 2,926

Electronics related 59 48 73 78 59 76 73 69 46 33 614

Industrial related 168 86 24 58 51 71 111 98 105 164 936

Medical health biotech 106 133 180 179 216 203 244 246 225 205 1,937

Communications 42 35 232 91 136 106 90 94 111 127 1,064

Energy 16 17 15 13 20 17 24 25 23 41 211

Transport 22 9 24 57 18 19 13 16 11 21 210

Construction 40 31 35 38 19 18 22 27 24 29 283

Financial Services 23 17 35 57 72 46 36 63 75 86 510

3



1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total

Other Services 126 147 71 92 87 118 123 129 143 27 1,063

Manufacturing. Agriculture & other 241 216 109 47 33 129 161 111 112 89 1,248

Total 1,122 1,109 1,182 1,308 1,196 1,274 1,301 1,307 1,318 1,330 12,447

Source: BVCA & PwC (2007), “Private Equity and Venture Capital Report on Investment Activity”. Figures include MBO/MBI.

Total number of technology companies (deals) - total early stage, 1998-2007

Table B-5: Total number of technology companies (deals) - total early stage, 1998-2007

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total

Communications 13 12 59 61 33 19 15 12 3 14 241

Computer hardware 6 21 5 3 2 3 2 2 - 5 49

Internet 12 49 88 35 4 2 7 5 4 9 215

Semiconductors 1 16 32 24 9 14 12 13 8 16 145

Software 99 55 155 70 30 44 50 52 91 58 704

Other electronics related 10 7 10 17 9 8 15 17 24 13 130

Biotechnology 31 54 49 39 33 62 45 34 14 33 394

Medical instruments 0 6 2 13 6 27 10 25 24 20 133

Pharmaceuticals 14 4 4 26 20 25 22 15 41 31 202

Healthcare 10 4 3 13 7 1 4 63 7 10 122

Other 8 7 86 14 21 18 10 17 11 5 197

Total 204 235 493 315 174 223 192 255 227 214

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity, 2007.

Table B-6: Total number of companies (deals) by region – total early stage, 1998-2007

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total

South East 48 60 82 56 79 98 94 104 90 88 799

London 51 75 126 82 69 66 75 75 104 110 833

South West 8 12 16 19 15 22 29 42 35 29 227

East of England 31 23 53 72 67 66 59 61 50 50 532

West Midlands 9 8 22 23 14 20 21 24 35 32 208

East Midlands 11 9 8 11 5 15 25 22 20 18 144


North West 21 12 23 34 41 42 61 65 70 77 446

North East 8 6 8 9 16 15 16 16 10 19 123

4



1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total

Scotland 32 33 41 49 30 22 34 36 40 34 351

Wales 5 6 4 16 26 15 14 13 20 17 136


Total 241 260 409 408 398 427 454 491 500 502 4,090

Source: BVCA & PwC (2008) Private Equity and Venture Capital Report on Investment Activity, 2007; SQW

Average investment (deal size) by region – total early stage, 1998-2007

Table B-7: Average investment (deal size) by region – total early stage, 1998-2007 (£m)

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total

South East 1.4 1.7 1.6 1.5 0.9 0.9 0.7 0.8 1.6 1.5 1.2

London 1.7 1.6 2.3 1.0 1.4 0.7 1.0 1.4 2.7 1.3 1.6

South West 1.4 1.2 2.0 0.9 0.7 0.4 0.4 0.6 2.6 1.0 1.1

East of England 0.8 1.0 0.9 1.2 0.9 1.1 0.7 1.4 1.9 0.9 1.1

West Midlands 2.3 0.9 1.3 0.5 0.2 0.1 0.2 0.2 0.5 0.2 0.5

East Midlands 0.9 1.2 2.3 0.9 0.4 0.7 0.7 0.9 5.3 1.1 1.5

Yorkshire and The Humber 0.3 1.4 3.1 0.3 0.2 0.2 4.0 0.6 11.3 0.6 1.7

North West 1.0 2.9 1.5 0.8 0.4 0.2 0.3 0.3 0.8 0.3 0.6

North East 0.4 0.3 1.1 0.2 0.1 0.1 0.2 0.1 0.7 0.4 0.3

Scotland 1.2 0.5 1.3 0.9 0.4 0.3 0.4 0.4 0.5 0.4 0.7

Wales 0.2 0.3 1.8 0.6 0.3 0.9 0.3 0.5 0.8 0.4 0.5

Northern Ireland 0.6 1.0 1.2 0.5 0.4 0.3 0.3 0.2 0.3 0.4 0.4

Total 1.2 1.3 1.7 1.0 0.7 0.6 0.6 0.8 1.9 0.9 1.1


Total early stage investment by region divided by the total number of VAT registered business, 1998-2007

Table B-8: Total early stage investment by region divided by the total number of VAT registered business, 2001-2007 (£)

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total

South East 243 361 457 296 257 297 241 270 472 427 334

London 334 443 1,037 301 348 158 254 360 921 453 463

South West 67 84 190 103 66 48 65 147 501 153 145

East of England 145 130 261 495 318 392 219 455 503 229 317

West Midlands 147 48 196 81 20 13 26 25 111 36 70

East Midlands 86 93 150 84 17 82 137 156 801 142 180

5



1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total


North West 127 209 201 167 101 53 116 124 308 113 152

North East 69 45 201 45 45 45 66 42 145 142 85

Scotland 297 120 435 359 96 56 111 113 149 102 182

Wales 13 25 88 115 101 177 51 73 191 82 92


Total 168 198 395 221 165 147 157 203 493 222 239


6



Annex C: List of consultees

Table C-1: Consultee list

Name and title of consultee Organisation

Umerah Akram, AIM Regulation London Stock Exchange

Rachel Barbour, Director of Communications BVCA

Bob Barnsley, Investment Director Advantage Business Angels

Dr Marina Biniari Hunter Centre, Strathclyde University

Anthony Clarke, Managing Director GLE Growth Capital

Ken Cooper, Investment Director Capital for Enterprise

Dr Marc Cowling IES, University of Sussex

William Dawson, Investment Manager Amadeus Capital

Stuart Down, Ventures Team Scottish and Southern Energy plc

Stephen Edwards, Co-founder Core Capital LLP

Emma Fau Sebastian EVCA

Walter Gibson, Lead technologist Technology Strategy Board

Michelle Giddens, Director Bridges Community Ventures

Sally Goodsell, Chief Executive Finance South East

Joan Gordon, Investment team Scottish Enterprise

David Grahame, Chief Executive LINC Scotland

Anthea Harrison NESTA

Richard Hepper, FD Oxford Capital Partners

Valerie Joliffe, Chief Executive Javelin Ventures

Henrietta Marsh, AIM Fund Manager ISIS

David McMeekin London Technology Fund

Howard Miller, Head of Public Affairs London Stock Exchange

Alister Minty, Director Sigma IP Limited

Professor Gordon Murray Exeter University Business School

Alex McWhirter, RDA Finance Lead Yorkshire Forward

Claire Munck, General Manager EBAN

Stuart Nichol, Director Octopus Investments

Dr Paul Nightingale University of Sussex

Calum Paterson, Managing Partner Scottish Equity Partners

Dr Dean Patton School of Management, University of Southampton

1



Name and title of consultee Organisation

Scott Sage, Research Project Manager BVCA

Nick Smailes, Director SETSquared

Liz Stevenson, Senior Public Affairs manager London Stock Exchange

Marcus Stuttard, Deputy Head of AIM London Stock Exchange

Philip Tellwright, MD SWAIN

Jenny Tooth, Business Development Director GLE Growth Capital/BBAA

Vivienne Upcott-Gill, Funds Development Manager YFM

George Whitehead, Business Development Director NESTA Investments

Adam Workman, Partner Carbon Trust

Peter Wright, Investment Director Finance Wales

Anthony Clarke British Business Angel Association

Table C-2: Business angels attending Oxford focus group

Name of consultee

Chris Baker

John Caines

John Catling

Hugh Pelton

High Smith

Michael Taylor

Table C-3: Business angels attending Leeds focus group

Name of consultee

Peter Ball

David Belford

Graham Davis

Sandy Gillan

Barbara Greaves (Manager of YABA)

Chris Redfearn

2

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