Minding the gap?

7 March 2007

Government funding initiatives such as Enterprise Capital Funds are designed to plug the equity gap for growing businesses. But do they go far enough?

The Capital Fund's recent event in London was a cause for celebration. TouchClarity, a website marketing technology company funded in its early stages by a ₤750,000 investment from the Fund, had just been acquired by Nasdaq-listed Omniture in a largely cash deal worth up to $51.5m. The investor returns were going to be substantial.

'The Capital Fund is not only doing the deals,' said David Meakin, chairman of YFM Venture Finance, which manages the Fund. 'We are [also] enjoying some success.'

TouchClarity is not alone in being given a leg up by an initial investment from the Fund. As London's Regional Venture Capital Fund (RVCF) - a ₤50m pot part-funded by the DTI's Small Business Service - the Capital Fund has invested in 50 companies so far, 70 per cent of the time alongside business angels. Like any investment strategy, to a certain extent it's a numbers game: most of these businesses are now benefiting from their first rounds of serious VC investment, although eight are in receivership.

Operating on a six-year cycle since 2000, similar funds exist for the other eight English regions. In essence, they are a source of joint private/public venture funding: the amount of government money put in is linked to the level of private angel or VC investment committed, and there are strict rules about how the funds invest in businesses. Although differing in their regional outlook, the RVCFs are comparable to the Enterprise Capital Funds (ECFs), which were announced in last year's budget and are designed to help plug the notorious equity gap that exists for companies seeking funding between around £500,000 and £2m.

But while these twin efforts at bridging the equity gap are making an impact, some are now questioning whether they go far enough and whether their approach to supporting the investment community is the right one. They argue that the funds are not attracting enough larger VC firms - many of which prefer later stage deals - largely because the government doesn't provide a big enough incentive for these firms to get involved. This is in stark contrast to the US, where the government's Small Business Investment Companies (SBIC) initiative hands out much larger sums and seems to successfully encourage VCs to pump money into start-ups.

The British Venture Capital Association, in its recent submission to the UK government's wide-ranging Sainsbury Review on science and innovation, gave voice to these concerns: 'The new ECF Scheme, while useful, has been directed mainly at niche managers, not the early stage technology specialists which are seeking to compete with US Venture Capital firms to build UK derived international businesses and need larger fund sizes in the £100 million range to achieve critical mass.'

An ECF spokesman defends the scheme, pointing out that the government makes no restrictions about who can set up a fund and contesting the notion that they are aimed at niche managers. 'We don't stipulate they should be niche in any way. They are not sector or geography specific.' He says fund managers set the parameters for funds when they put together a bid, although the government does have some stipulations on how they pay out.

'The equity gap exists because investors pay the same amount of due diligence whether it's a large or small deal,' adds the spokesman. 'Investor costs are fixed. So if funds invest in the larger deals, they'll get a larger return on their investment.' ECFs are designed to plug that gap by providing government funding alongside other investment.

The spokesman argues that ECFs differ from their US counterpart in that the UK scheme is designed to maximise returns to investors, whereas the US system is more about protecting capital in case funds turn out to perform poorly. The difference in ethos is significant, since having the government act as guarantor effectively encourages US firms to take more risks.

Perhaps the reality is that without a mechanism like the US SBIC, most VCs are simply not suited to early-stage deals. That's certainly the view of Laurence John, manager of the Amadeus and Angels Seed Fund, a £10m ECF set up with £6.5m government funding. 'In the technology business, how you build a company which can one day get to be a £100m turnover concern is relatively capital intensive. But VCs are not set up to do early-stage investments. They need the deals, but they rely on different people to bring them the deals.'

So do the ECFs and RVCFs need to provide greater amounts of bridge funding? After all, RVCFs are only allowed to invest £250,000 in a business at a first stage, followed by a further £250,000 six months later. In total, over several years, the largest initial investment The Capital Fund has made was £1.1m, which is exactly the figure John estimates a fast-growing technology company needs to make it to its first institutional round of investment. For ECFs, the limit is currently ₤2m, although there are plans for this to be raised in special circumstances.

The funds' backers argue that partnerships help overcome these funding restrictions. As Stuart Nicol, investment manager at The Capital Fund, says: 'We are happy to act as a catalyst to a larger institutional round. As long as you structure it sensibly, it's not too much more effort to raise finance in two chunks rather than one.' He gives the example of TXT4, initially supported by The Fund's £250,000 but quickly enhanced with a further round of £1.5m. The Capital Fund is also keen to invest alongside other sources of finance such as angel investors or the National Endowment for Science, Technology and the Arts (NESTA).

In addition, the funds help prepare entrepreneurs to get further investment and effectively provide some level of endorsement. Kids Planet secured £250,000 funding from The Capital Fund alongside £320,000 from angels, and is now on the point of securing another tranche of up to £500,000 from angels. Speaking at the London event, Neil Fullman, CEO, said the key to its current funding success has been the support of a funding partner like The Capital Fund. 'It's very easy for any entrepreneur to stand up and say how great their business is - and they should do that. But it's important to get that external validation too and it helps give you a level of credibility.'

By David Longworth, Webster Buchanan Research