Investing in Innovation: Venture Capital’s slump, and its impact on innovation

Yannis Pierrakis is Head of Investments Research at the National Endowment for Science Technology and the Arts (NESTA)

NESTA’s research shows that the 6 per cent of UK businesses with the highest growth rates generated half of the new jobs created by existing businesses between 2002 and 2008. Such young, innovative companies particularly need Venture Capital (VC) because they require significant capital up-front to develop new products in advance of sales. They tend to have intangible assets and ambitious growth plans that require large amounts of finance, show a significant delay before generating revenue and consequently entail high risk. As a result, debt finance is inappropriate – but venture capital is an alternative form of finance that is structured to address these challenges.

Creating new industries requires sustained investment over the long-term, continued commitment and long-term resources. The semiconductor and microcomputer industries are good examples of this lengthy and capital-intensive process. In both cases, it took up to ten years of continued risk capital investing before the industries properly took off. Virtually every other new industry since – biotechnology, personal computers, PC software, wireless communications, the Internet – have followed this pattern.

Downward trends

Recent trends in venture capital raised concerns that young innovative firms may find it harder to access appropriate finance; this is increasing the proportion of under-capitalised businesses, which lack the resources to grow and are at increased risk of failure.

NESTA’s latest report found that the venture capital industry has now seen an overall 40% reduction over the past two years, the number of exits has fallen by 40% and fundraising fell by over 50% (both in terms of the number of new funds and total amounts raised).

The current crisis appears to have compounded issues that the venture capital industry was already facing following the post dotcom crash. In particular:

  • Fundraising in 2009 was the lowest in a decade. Both the dotcom and financial crises resulted in a significant reduction in the number of new venture capital funds established. However current fundraising activity is considerably lower than levels seen after the dotcom crash and consequently it is at the lowest level seen in the last decade.
  • The time taken to successfully exit, through a floatation or acquisition, is getting longer . Across the world, the time taken for VC to successfully exit through floatation now averages almost seven and a half years, the longest time seen over the past two decades. This global trend is reflected in the UK market. This obviously has knock on impacts on returns which leads to difficulties in attracting more money in order to to invest in new companies.

There are no signs to suggest that a recovery will come quickly, especially for early stage companies. For a start, fundraising activity is very low and VC funds are already largely tapped out. Second, it is taking longer than ever for investors to realise returns, leading VC funds to concentrate on their existing portfolios, rather than searching for new business opportunities. Third, given low levels of stock market activity coupled with the decline in stock prices and decreasing number of mergers and acquisitions, UK VC backed companies face difficulties in identifying ways of exiting.

How can financing be fixed?

Although the government has actively supported the supply of finance to the early stage market aiming to close the equity gap, other aspects of the market have been remained unsolved or deteriorated in recent years. More particularly, initial public offerings for VC backed companies have remained low.  Without functional exit routes, the VC market will not realise its full potential regardless of the availability of investment capital.  The length of time it now takes to realise returns is holding back the whole investment chain.

Currently committed funds and much of the growth in fundraising activity that we expect to see in late 2010/11 will be government driven. Unless there are clear signs of positive returns in the UK VC market, private Limited Partnerships will continue to be reluctant to invest.

Business ‘Angels’ who were thought to be gradually taking the role of the private VC in the early stage have not yet been fully mobilised to undertake such role. Greater emphasis needs to be given to the role of gate-keepers, syndicates and organised Angel groups.

On the demand side, university and business incubators are still not well connected with the VC industry despite the emerging consensus (at least within academic circles) that Venture Capital is a key component of “new economy innovation systems”, formed by highly dynamic sets of interrelationships between VCs, market conditions and new firm incubators. A well-functioning innovation system requires the establishment of interlinked university incubators, spin-out firms, VC funds, exacting technology customers, supply chains, cluster-building programmes, science park facilities and science entrepreneurship support. Innovation finance is an integral part of a country’s innovation system – but the potential of such integration has not yet been fully realised in the UK.

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