SE BOARD PERFORMANCE COMMITTEE SEBPC(09)1
INVESTMENT TEAM FOR DISCUSSION
THE STRATEGIC ROLE AND CONTRIBUTION OF THE RISK CAPITAL MARKET TO THE DEVELOPMENT OF SCOTLAND’S ECONOMY
1. INTRODUCTION
The purpose of the paper is to provide an overview of the strategic role and contribution of the early stage risk capital market to the development of Scotland’s economy, describe the key features of the Scottish market, and provide evidence on the contribution made to the Government Economic Strategy (GES) growth targets. The paper is timely given the recent agreement by the Cabinet Secretary to progress feasibility work to consider adoption of JEREMIE in Scotland.
The primary focus of SE interventions, is on:
· young/early stage technology ventures, where;
· financial and technical risk is high, and;
· investment requires to be risk-taking, patient and smart, and;
· risk capital is relatively scarce and can be difficult to access.
2. THE ROLE AND SIGNIFICANCE OF RISK CAPITAL IN STRATEGIC ECONOMIC
DEVELOPMENT
The Scottish Government has set ambitious long-run growth and productivity targets for the Scottish economy[1]. To meet these targets and close the productivity gap with our competitors, the Scottish economy must permanently raise the level of productivity. The number and quality of businesses and the quality of the business environment are key determinants of productivity.[2] The challenge facing the Scottish economy, therefore, is not only to see the number of businesses increase in an expanding private sector, but to see the quality of those businesses improve significantly in terms of their potential for high growth in international markets – and to develop a local business environment which can support and accelerate this process.
The importance of high-growth businesses to economic performance is emphasised in a recent publication by BERR[3], which indicates that high growth firms are found to contribute a disproportionate amount to employment growth. It is estimated that between 2 to 4% of all firms are responsible for the majority of employment growth. High growth firms also display higher levels of productivity than average. This combination of high productivity and employment growth implies that high growth firms are responsible for a substantial proportion of economic growth.
The most recent evidence available[4], indicates that Scotland:
· has a low number of businesses relative to population
· outperforms the UK average for fast-growth[5] and high-growth[6] businesses (as a proportion of the existing stock of businesses); and
· has a lower proportion of ‘no-growth’ businesses than the UK average.
This suggests that Scotland has a smaller but higher quality pool of growth-orientated businesses compared with the UK as a whole. Any issue of a lack of entrepreneurial capacity in the general population, reflected in our lower business birth rate, may therefore not be applicable to our stock of existing businesses, which appears to be performing relatively well. However, Scotland does have a lower stock of businesses.
With respect to new technology ventures, the challenge for Scotland is especially acute: relatively few indigenous technology ventures tend to succeed and those which do often become acquisition targets for larger businesses based elsewhere. Moreover, while Scotland has re-focused its inward investment efforts with some success, the scale and value which such projects add directly to the output of the economy has significantly declined by historic standards.
Thus, the relative decline in cross-border direct investment as a source of international technology-businesses of scale in combination with Scotland’s growing need for such businesses places greater onus than ever on indigenous new firm formation and business building processes. Early-stage risk capital is clearly a key enabler and driver of these processes and as such Scotland’s future growth prospects are inextricably linked to the health and dynamism of the early-stage risk capital market.
Historically, due to the relatively high risks and costs involved, the banking system has proven reluctant to support the start-up and early-stage development of young technology ventures through debt finance. Going forward, the role of the banking system in Scotland and the UK is likely to diminish further due to the effects of the credit crunch. The need to rebuild balance sheets to meet statutory capitalization requirements in the UK and the general on-going problem of liquidity within the international banking system are continuing to seriously constrain the availability of debt finance – even to well-established quality businesses.
Under these exceptional conditions, there is more pressure on businesses, especially new/young technology ventures, to pursue equity-based solutions to their funding requirements. And from an investor perspective, the early-stage risk capital market by its very nature tends to be counter-cyclical: clearly, cash-rich investors which are dynamic, sophisticated and risk taking will want to take advantage of any downturn (e.g. more favourable valuations). Consequently, as supply and demand-side pressures intensify, the strategic role of the early-stage risk capital can be expected to grow commensurately in importance in terms of the stimulation and support of the start-up and early-stage growth of indigenous technology ventures.
From the investor perspective, compared with other asset categories, equity stakes in new/young technology ventures are somewhat less attractive because of the inherently high levels of risk and uncertainty and the relatively poor average returns[7]. It is unsurprising, therefore, to find for the economy as a whole that risk capital is relatively scarce and a small component of the private capital mix. Estimates for Scotland suggest that the supply of risk finance serves as little as 3% of start up businesses. Historically, this has been significantly lower than in Europe than in the United States.
Moreover, this inherent scarcity is further compounded by the non-homogeneous nature of the early-stage risk capital market which is associated with the following dominant features:
· The early-stage risk capital market comprises a number of inter-connected and interdependent stages/phases associated with start-up and follow-on funding requirements;
· Moreover, risk levels, investment costs, expected returns and investment time frames vary significantly by industry sector/technology domain and by company stage of development.[8]
At the regional level, the degree of variation can be very high and this can further accentuate the scarcity of certain types of risk capital, especially larger quanta of capital which requires investment over long periods and has especially high risks attached to it. This is evident in the Scottish experience and is perhaps exemplified by the continuing absence of a recognised specialised lead-investor for any of the industry sectors/technology domains which SE has identified as high priority, especially biotechnology within life sciences.
The risk capital market provides much more than early-stage funding: key know-how and expertise embedded in the extended networks of the main investment supply-side actors and agents can be harnessed, mobilised and deployed in a focused manner through the agency of the market to stimulate and support business start-up activity and early-stage business building. In particular, this complementary know-how and expertise can often be in scarce supply locally but is vital to the would-be technology entrepreneur as it can help to:
· Validate the business model and better define an appropriate businesses architecture and related businesses processes;
· Identify and develop and/or acquire the resources, assets, competences and capabilities which are core to the development of the business; and
· Identify and to gain access to the specialized complementary assets needed to support successful innovation.
3: FEATURES OF THE SCOTTISH RISK CAPITAL MARKET
(a) Capacity and Capability
Though the capacity and capability of the early-stage risk capital market in Scotland has developed in a number of significant ways, especially over the last 5 years, the market clearly can not yet be regarded as fully scaled, well formed and fully functioning. The 2005-07 Scottish Risk Capital Market report identified total investment of £114m in 2007, equating to 144 investment deals. Investment reached a peak of around £250m in 2001 and has since fallen back to around £100m from 2002 onwards. Business Angels[9] dominate the Scottish market, and were involved in 42% of all deals in 2007, with Venture Capitalists (VCs) involved in 30% of deals and SE involved in 24%.
The weaknesses associated with the partial and incomplete nature of the Scottish risk capital market include:
· Relatively high start-up costs for new investors wishing to enter (e.g. legal and accountancy fees, and costs of finding and hiring an experienced gatekeeper to identify and broker deals);
· Relatively high transaction costs for existing investors due to the continued existence of information and coordination failures (e.g. weak forward linkages between Angel and later stage VC investors which impairs efficient market co-ordination) and some irrational pricing (largely associated with the cost of accessing high value business and marketing intelligence required as part of investment due diligence); and
· Returns which remain uncertain and increasingly difficult to realise – largely because of the growing difficulty which early-stage investors face in defining appropriate exit routes.
Another pronounced feature of the Scottish risk capital market is its continuing inability to generate and sustain rapid long-term growth unaided: the scale, mechanisms and dynamism associate with critical mass have yet to evolve. Though investor portfolios have expanded and matured, only a modest number of successful exists have been achieved so far. Moreover, most of Scotland’s Business Angel Syndicates are young[10] and are still in the process of building their portfolios. As such, the market has yet to produce a strong pricing signal which clearly indicates the level and type of returns which investors can reasonably expect to receive from this type of investment. The scaling and development of the market is not just about the adequacy of supply and demand, it is also linked to important qualitative factors related to world class capability and competency building. For example, superior supply side capabilities have potential to attract investors and entrepreneurs into a region from elsewhere.
Times of economic downturn tend to expose the weakness of incomplete risk capital markets, especially at the regional level. This was the case, for example, in the period following the burst of the dot.com bubble and the shock of 9/11 when Scotland’s best established Business Angel syndicates, Braveheart and Archangel, would almost certainly have collapsed without European funding support. Leading economic indicators suggest that the current economic downturn is likely to be deeper and more extended. Accordingly, the structure of Scotland’s relatively small and developing risk capital market is likely to face unprecedented pressures which could have the power to undermine the progress of the last 4-5 years and perhaps permanently damage future growth prospects in the absence of suitably powerful and supportive interventions by the public sector.
In terms of its overall development, there are number of key issues and challenges which the Scottish risk capital market currently faces. These include:
· The risk capital market remains relatively small scale and highly segmented compared with other successful economies. As illustrated in the 2007 Risk Capital Market Report, the market segments along a number of important dimensions: e.g. by technology/product/market/domain; by stage of development; and by capital structure preferences (debt vs. equity);
· There have been relatively few company successes in the key technology domains and quite a number of high profile failures;
· Exit routes are becoming increasingly difficult to define for investors. Public markets remain difficult, especially for new technology ventures where IPOs have dwindled to a trickle; VCs have moved closer to market which means early-stage investors have to stay in longer; and trade sales are demanding that such investments are more market ready which again means that early stage investors are having to stay in longer;
· A consistent track record of attractive returns to private investors has still to be established;
· The strength and quality of future demand in the key technology domains is increasingly difficult to anticipate at this time, especially the needs of technology start-ups. Starting and growing New Technology Ventures is a high risk activity, which we have struggled to incentivise successfully. Under current market conditions (the international credit crunch and deep international recession) these risks are even greater and returns even more uncertain. It is difficult to predict how these conditions will impact on the motives and intentions of potential technology entrepreneurs, and the level of future start-up activity; and
· Moreover, the follow-on funding needs of existing young and growing technology ventures could dominate throughout the period of the downturn; consequently the funds available to assist riskier new ventures could reduce ability to invest in new companies.
(b) Equity Gaps
The trend amongst large international venture capitalists to concentrate on deals above £10m has been well documented[11]. Moreover, as noted already, the early-stage risk capital market in Scotland is still developing and is not yet well scaled, fully formed or fully functioning. The interplay of these two trends and features inevitably give rise to significant gaps in funding provision at different stages throughout the business development cycle (from start-up, through early-stage development to full scale-up). In the Scottish context such gaps can seriously:
· Constrain start-up activity, early-stage business building and progress to full scale up from a company perspective, and
· Reduce the availability of exit options, from an investor perspective.
Moreover, the nature and extent of these gaps can vary significantly over increasingly short time spans as capital markets have become more volatile. Accordingly, Scottish Enterprise has regularly commissioned research to establish where the key funding gaps exist and to inform the design of appropriate interventions to address such gaps.
The 2005-2007 Scottish Risk Capital Market report has identified continued market polarisation and the existence of two increasingly separate risk capital markets emerging in Scotland: one supporting the expansion and development of more established ventures, with transaction values in the £2m-£7m plus range where venture capitalists and the larger business angel syndicates are the main fund providers; and the other supporting the start-up and early-stage expansion of young ventures where the public sector and informal private investors (Business Angels) are the main fund providers. The analysis shows that these markets have continued to separate, with a number of implications: