British inventors have left an indelible legacy. Yesteryear’s giants of invention – such as William Kelvin, Alexander Graham Bell and Isambard KingdomBrunel – led international revolutions in refrigeration, maritime safety, communications, transport and engineering.
Today’s inventors – like Trevor Baylis, of clockwork radio fame or Tim Berners Lee, father of the World Wide Web – have similarly transformed lives. Yet British innovation historically has depended too much on breakthroughs from lone inventors, struggling to commercialise ideas without access to sufficient resources. As the now hugely financially successful inventor, James Dyson, once put it: ‘Engineers aren’t trusted with money. I couldn’t get anyone to finance my ideas and I could only get a loan by using my house as security’.
A succession of government reports has drawn attention to investment in innovation, especially high-tech, as Britain’s route towards competing with growing industrial economies. But they have also identified funding gaps for early-stage businesses that threaten such future competitiveness unless government takes steps to address them.
The funding gap problem
Successfully commercialising scientific and technological brilliance takes skilled investment and appropriate funding. What currently occurs is described in a recent City funding report, The City’s Role in Providing for the Public Equity Financing Needs of UK SMEs, as ‘the funding escalator’: the well-trodden route from personal, family and friends’ startup capital to business angels to venture capital and finally to public listing.
The situation creates two identifiable funding hurdles. The first is that new product or high-tech innovators are at the bottom of the funding escalator. It typically takes anywhere from three to five years to bring products to market. These companies need seed funding to cover lengthy periods of negative earnings and further staged funding to bridge the gap between early adoption and mainstream customer use. Business angels tend to avoid investing in such precommercial and pre-revenue businesses, not least because Enterprise Investment Scheme tax rules can disadvantage them, and institutional investment funds are simply reluctant to provide seed capital.
Second, there is an equity gap in early-stage venture capital between £2m and £10m, which neither banks nor VCs are likely to fill. VCs prefer later-stage, larger transactions that carry lower risks, while banks might require unreachable levels of collateral for SMEs that might be poor in traditional assets but rich in intangibles.
Coupled with the financial crisis, is the situation really as grim as it sounds? ‘Well-established sources such as business angels, corporate investors and government-backed “hybrid” funds are still looking for the right project,’ says Marc Fecher, a member of the ICAEW’s Corporate Finance Faculty board and Director of Devonshire Corporate Finance Ltd. ‘But they’re more sceptical in their assessment of a business’s prospects due to the condition of the economy. We’ve seen the number of exits reduce and, consequently, less capital available for reinvestment. Even in large corporations, investing [internally or externally] in new innovation has been less of a priority.’
Specialist help to bridge the gap for high-techs does exist in the form of government-backed investors, such as the London Technology Fund, Rising Stars Growth Fund and NStar. These fund managers form syndicates by matching UK and EU funding with private third-party finance. The LTF, for example, currently achieves well over £2 from co-investors for every £1 of investment from its fund – showing a high degree of investor confidence in these early-stage investments. Such targeted government-backed help, however, is limited within the UK despite the relative success of networks of Regional Development Agency and university-supported high-tech incubators.
Intervention needed for 'patient capital'
David McMeekin, LTF chairman, says that for the positive impact of funds such as his to continue, ‘higher quantities of public backing are desperately needed’. Clive Lewis, ICAEW head of enterprise, agrees. ‘The ICAEW has called for more effective and long-term equity-based finance – in particular “patient” public-based capital – and better information about funding types and sources.’ But more needs to be done. ‘Equity-based funding solutions are often more appropriate than debt finance for high-tech companies,’ continues Lewis. ‘To spur demand for VCTs, and so promote growth in the longer term, the government should reinstate more generous tax relief for equity finance.’
Government seems to be moving, but is it in the right direction? Its review, The Provision of Growth Capital to UK Small and Medium-Sized Enterprises, published in November 2009 and led by former 3i business executive Chris Rowlands, concluded that government intervention will be needed to bridge the funding gap. But the report focused on growth capital measures rather than start-up or pre-equity. A month later, government announced an additional £175m from Hermes Private Equity and the European Investment Fund on top of the £150m of its own money in the much-vaunted UK Innovation Investment Fund. Hermes and the EIF are the fund-of-fund managers remitted to invest in companies ‘with high growth potential’. What level of interest they will have in start-ups is uncertain.
Restrictive rules on the Enterprise Investment Scheme, reinforced in the latest Budget, are themselves barriers for high-techs. The ICAEW view is that restricting the size of eligible companies to the scheme to those with gross assets of £7m is self-defeating to government objectives: it should be raised to £25m to allow for further equity funding rounds.
Developing a globally-competitive high-tech, lowcarbon and advanced manufacturing base has become central to government industrial strategy. Cross-party support for innovation suggests that this strategy is likely to remain a core component of industrial strategy in the new government. Key challenges remain, however, to match enthusiasm with entrepreneurial flair, and appropriate funding with start-up needs. Government intervention required? For once, yes please.
