Expert Advice

A shot in the arm for growth

Business and Innovation ambassador and NESTA CEO Jonathan Kestenbaum, takes a look at a new direction for SMEs mid-recession

Small business owners don’t need to be told about the financial challenges of the recession. But the pre-revenue businesses that typically seek venture financing have been hit harder than most.

Venture capital has been knocked for six by the financial crisis, starving high-tech and innovative businesses of an important source of cash. This is why the Government’s recent announcement of a new UK Innovation Investment Fund, which NESTA strongly argued for, is so important. It offers a powerful lifeline to the UK’s start-ups, and a shot in the arm for the economy as a whole.

Why venture capital?
A thriving small business sector depends on the availability of many types of finance, ranging from bank loans through to private investment. The government had already intervened in the banking sector, first through banking bail-outs, and then by underwriting loans through the Enterprise Finance Guarantee. Although business lending is still below pre-crunch levels, the CBI’s small business council has reported the EFG is having a material effect. Venture capital had no such help, at least until the recent announcement. But it had been even more sharply affected than bank lending. Venture funds raised 70% less capital in 2008 than in 2007, with even less expected for 2009, and their existing reserves were largely either spent or committed to existing investments.

Venture capital matters for two reasons. Firstly, the firms that rely on it have few other options. The choices for a high-tech company with a promising product but no revenues are limited: angel investment for the fortunate few, or a visit to a venture fund. But secondly, and more importantly, the firms which depend on venture finance are disproportionately important to the future of the economy. In the US, companies that were once venture-backed now represent 18% of the economy, and account for some of its highest growth sectors, from software to biotechnology.

What then does the fund offer for start-ups?
In short, better access to finance than we have seen for several years. The government plans to use its £150 million cornerstone investment to attract several times this amount in private money, raised through a fund of funds structure.

Making this work will require skillful execution. As one of its main advocates, NESTA believes three principles are particularly important. Firstly, it needs to get money to businesses fast. To do this, it must invest some of its money in existing funds that have the ability to do deals quickly. New funds take time to set up, and time, for the UK’s start-ups, is in even shorter supply than money.

Secondly, it must bring in private money effectively. Government cash is an essential catalyst for the venture capital sector, but on its own it runs the risk of being “dumb money”. The state’s chequered history of picking winners in the 1960s and 1970s suggests that the government shouldn’t act alone in deciding which businesses and funds to back. Just as importantly, leveraging outside money will mean the difference between the fund acting as a one-off stimulus, and it re-energising the venture capital sector in the long term.

There are good international precedents for this type of fund. The Yozma Group public-private venture capital fund-of-funds in Israel has invested $100m, leveraging $150m from other investors. It has led to an 85% year-on-year rise in venture capital fundraising from 1993 to 2000, and is now a fully private fund, managing $2.5bn of private money by 2001. Industry Investment, Finland’s public-private fund invests on equal terms with private investors and has outperformed other funds for the last 10 years. Similar investment vehicles in the US, New Zealand and Canada have been successful because they have all been commercially focused and structured with a degree of separation between the Government and the investment vehicles. They have avoided the tyranny of multiple objectives.

Thirdly, it needs to address the right gaps. The UK start-up sector has gaps both at the seed stage and the Series A stage. Without a holistic approach to the shortage of venture capital, we risk leaving a whole cohort of businesses struggling for survival.

All this means is that the devil is in the detail. The new fund offers a source of hope not just for today’s start-ups, but also for the businesses of the future that will hopefully benefit from a thriving venture capital sector. But to make it work will require speed, aggressive action to bring in outside funds, and attention to the full range of venture-backed firms.
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