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Regional Studies, 1998, Vol.32, pp. 405-409
A Policy Response to Regional Disparities in the Supply of
Risk Capital to New Technology-Based Firms in the
European Union:
the European Seed Capital Fund Scheme
Gordon C. Murray
Warwick Business School, University of Warwick, Coventry CV4 7AL, England
Venture capital
High technology
Regional development
Small firms
The European Seed Capital Fund Pilot Scheme (1988-95) was a European
Commission response to two primary concerns that: i) private venture capital firms in
Europe were increasingly retreating from the financing and support of start-up, earlystage and, particularly, technology-based enterprises; and ii) existing spatial
concentrations in the supply of venture capital prejudiced the formation of new,
innovative businesses in less economically developed regions of the Union. This
paper presents the updated results of a study of this Scheme in 1992. The comparative
internal dynamics of the Seed Funds are explored. The Scheme realised its goal of
encouraging private investment into innovative, technology-based young firms.
However, the continued ability of the funds to meet longer-term commercial and/or
regional developmental objectives is questioned given scale-related problems of
economic viability.
INTRODUCTION
The effective economic and social convergence of the, now fifteen, member states of
the European Union was reconfirmed at Maastricht in 1991. However, a significant
barrier to realising the scale and scope economies of European-wide activity remains
the disparate economic development both across and within individual member states.
The Commission’s commitment to ‘spatial justice’ (Giannakouru, 1996) has
engendered a wide range of initiatives targeted to less developed areas of the Union.
SMALL & MEDIUM SIZED ENTERPRISES: THE ‘SPECIAL CASE’ OF
NEW TECHNOLOGY-BASED FIRMS (NTBFs)
Since the late 1970s, SMEs have been seen as an increasingly important policy vehicle
for economic and regional development goals within the Union. This interest has
come about through an increasing recognition of the major contribution of SMEs to
total employment and to the net creation of new jobs (Birch, 1979; Gallaher and
Stewart; 1986; Storey et al., 1989). SMEs are now firmly established as a major focus
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of the Commission’s economic, technological and regional policies (EC White Paper,
1994; EC Green Paper on Innovation, 1995).
Within the wider corpus of SMEs, new technology-based firms represent a peculiarly
attractive focus for policy makers. NTBFs are seen as offering significant potential
benefits in four cardinal areas of Union interest: employment creation, innovation,
export sales growth and regional development (Rothwell & Zegveld, 1982; Freeman,
1983; OECD, 1986; Oakey et al., 1988; Rothwell, 1989; Roberts, 1991; Coopers &
Lybrand, 1996). Interest in NTBFs has in part stemmed from an appreciation of their
critical role from the early 1970s in the economic growth of regions of high
technology activity in the USA, particularly Silicon Valley, California and Route 128
around Boston, Massachusetts (Oakey, 1984; Florida and Kenny, 1988; Roberts,
1991; Bygraves & Timmons, 1992), as well as their contribution to fast growth
European regions (Meyer-Kramer, 1985; Keeble, 1989) .
However, while successful NTBFs potentially offer material advantages to the
economic prosperity of a location, their genesis and early years are fraught with
extremely high levels of uncertainty and risk in virtually all areas of activity including
financing, technology and marketing (Oakey, 1984, Roberts, 1991, Murray, 1995).
For the individual NTBF, an exceptional technological offering is a necessary but not
sufficient condition for economic success. Their entrepreneurial founders have also to
manage organisational and product/market demands in both internal and external
environments characterised by their complexity and rapid rate of change.
THE FINANCING OF NTBFs
Financing difficulties are particularly acute for NTBFs on formation and at their
earliest stages of development (Roberts, 1991; Moore, 1993; Murray & Lott, 1995).
Limited tangible assets reduces their opportunity for collateral based lending from
retail banks, which is the predominant source of external finance to European SMEs
(European Network for SME Research, 1993; Storey, 1994). The economic value of
intellectual property rights created by the entrepreneur is, as yet, unproven and thus
unexploitable (Rumelt, 1984). The ability of new entrepreneurs from a technology/
scientific background to attract external equity finance, ie. formal venture capital, is
also prejudiced by their frequent lack of commercial experience and the absence of an
established track record of successful enterprise (Tyebjee and Bruno, 1984;
MacMillan et al., 1985; Goslin & Barge, 1986). In consequence, owner-managers of
NTBFs are, per force, very heavily dependent on own and family personal finance for
initial capitalisation (Oakey, 1983; Roberts, 1991; Moore, 1993) in addition to relying
on trade credit and, to a lesser extent, government grants (Utterback et al., 1988;
Moore and Garnsey, 1991).
The imperfections of capital markets have featured largely in the debates on SME
developmental constraints. The proposition of the existence of an ‘equity gap’, ie. a
market failure in the adequate provision of external risk capital, has been part of the
economic literature for over 60 years (see The Macmillan Committee, 1931). A
succession of official committees and research exercises since that date (see, for
example, Bolton, 1971; Wilson, 1979; Burns and Dewhurst, 1993; Confederation of
British Industry, 1993) have each cited evidence of the existence of equity gaps and
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their deleterious effect on the viability of smaller businesses which are generally
characterised as having weaker liquidity, more volatile levels of profitability, an overdependence on short-term sources of finance and an insufficiency of shareholders’
funds or equity. NTBFs are seen as particularly vulnerable to capital constraints given
that initial investment costs, particularly R&D, are incurred before any prospect of
consequent revenues.
THE IMPORTANCE OF VENTURE CAPITAL
It is within the context of innovative firms seeking early-stage, external finance with
the potential promise of substantial returns but at a concomitant high level of risk that
the potential of venture capital as a source of entrepreneurial support appears most
relevant. Yet, almost without exception in the sixteen member countries of the
European Venture Capital Association, there has been a declining interest in the
support of start-up and early-stage investment since the mid 1980s. The European
venture capital industry has metamorphosed into a development capital industry
primarily occupied with the restructuring and refinancing of extant businesses (Table
1).
Table 1. Allocation of European Venture Capital Investments by Stage 1993-95
‘Fast-track’ NTBFs, with their predominant reliance on external equity finance, are
particularly disadvantaged by such structural changes in the venture capital market.
Even if MBO/MBI statistics are removed from the European figures, the percentage of
total investment allocated to technology-based enterprises has remained largely
constant over a decade of enormous technological change in the world’s developed
economies (Fig. 1). The proportion of venture finance allocated to NTBFs in Europe
is in stark contrast to the pre-eminence of technology-based investments in the US.
Fig. 1. Technology Investments as a Percentage of ‘Adjusted’ Total Investment
(ie. excluding MBOs/MBIs and LBOs/Acquisitions) in Europe and the USA
1984-95
(note: While this paper is exclusively concerned with ‘formal’ venture capital, an
exhaustive treatment of NTBF financing must necessarily address the potentially
critical role played by informal investors or “business angels” particularly within a
regional development context (Wetzel, 1993; Mason and Harrison, 1994)).
REGIONAL DISCONTINUITIES IN THE SUPPLY OF EUROPEAN
VENTURE CAPITAL
The existence of a regional dimension to the supply and demand for equity has
become a theme of increasing interest to economic geographers (McNaughton and
Green, 1988; Martin, 1989; Thompson, 1989; Mason and Harrison, 1991; Mason,
1992) given the consequent implications for development in regions with poorly
developed capital markets. Thompson, op. cit., argues that venture capital is a subject
of particular interest for four reasons - its role in new investment processes including
regional development disparities; its pivotal importance to high-technology industries;
the involvement by (US) public agencies in influencing the supply of venture capital
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particularly to address regional ‘gaps’; and the ‘spatial choreography’ of venture
capital occasioned by behavioural, institutional and distance constraints. Yet, as
Martin, 1989, and other have noted, given that few robust analyses exist on the
processes or outcomes of regional capital formation, theoretical understandings of the
spatial organisation of capital markets remains unsatisfactory.
The European distribution of venture capital is highly skewed. Some five countries
(in rank order: the UK, France, Germany, Italy and the Netherlands) represented 83%
of the cumulative funds raised to 1995 (ECU 46.7 billion) by the membership of the
EVCA. The UK is the oldest and largest centre of venture capital activity in Europe.
It alone represents 45% of cumulative funds, a sum over twice the size of its nearest
competitor, France (ECU 10.6 billion).
The considerable regional disparities in venture capital provision between European
member states is further mirrored at the sub-country level. Venture capital firms are
clustered in areas characterised by both established financial centres and high
concentrations of economic activity (see, for example, Ciciotti, 1986; Leinbach and
Amrhein, 1987; McNaughton and Green, 1988; Martin, 1989; Mason and Harrison,
1991; Sánchez, 1992; Minns, 1993). Critically, the information and governance
advantages of a close proximity between investors and investees result in capital being
primarily allocated within these clusters (Florida and Kenny 1988).
Mason and Harrison, 1991, supporting the case for a regional equity gap in the UK,
further note that depressed regions in the Midlands and Northern England are also net
exporters of equity finance to the more successful southern regions, such as
Cambridgeshire in East Anglia (Keeble, 1989). Florida and Kenny and Leinbach and
Amrhein, (ops. cit.), similarly demonstrate the migration of US finances from less
developed central and mid Western states to the East and West coast areas. The
empirical literature is uniform in its conclusion that venture capital availability and
usage remains highly concentrated in regions of established and growing economic
advantage.
A POLICY RESPONSE FROM THE EUROPEAN COMMISSION:
THE EUROPEAN SEED CAPITAL FUND SCHEME
Concern at the apparent paucity and limited regional distribution of third party equity
finance for European NTBFs engendered a policy response from the European
Commission. In October 1988, the Commission adopted a Community pilot scheme
to stimulate seed capital. The stated objectives of the Scheme were:
"...to foster enterprise creation in the Community by strengthening the
financing opportunities available to new enterprises, through the
creation of 24 new seed capital funds throughout the Community, and
by improving the quality and survival rate of seed capital projects,
through the services the funds will provide to the projects. This pilot
scheme aims to stimulate private sector and start-up investment by
providing financial incentives to these new funds...”
CEC document (SEC/88/1496), 1988
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The focus of the pilot scheme was "new or embryonic companies that require
financial and/or management support for development into companies capable of
raising first round finance" (op. cit.). Importantly, while the Scheme was
subsequently translated by the participant funds as to be primarily concerned with
NTBFs, the original documentation did not specifically state a exclusive technological
focus.
The sponsoring Directorates General for the pilot scheme were DGXXIII (Enterprise)
and DGXVI (Regional Development). While the objectives of the Scheme did not
directly allude to distributional inequalities in capital provision, the involvement of
DGXVI ensured a regional dimension to the pilot scheme and the specific inclusion of
new funds in Objective 1, 2 and 5b areas.
Each of the supported funds in the scheme received a reimbursable, interest-free
advance of up to 50% of the annual operating costs of the fund over a three to five
year period. This loan is due for repayment after ten years when it was deemed that
sufficient investment realisations would have been made to enable the return of the
advance. Those funds which have not achieved net investment returns above a
'hurdle' (referenced to long term treasury bonds plus five percentage points during the
period of the fund's existence) are to be absolved from repaying the loan.
The operating subsidy was paid by DGXXIII to all funds. For those fourteen funds
which operated in 'selected assisted areas' of the Union, DGXVI paid a further capital
contribution of up to 25% of the funds under management - a minimum of ECU
125,000 and a maximum of ECU 250,000. This additional capital loan was a
recognition of the likely difficulties in attracting private investors which would be
faced by small regional funds. This interest-free advance is only returnable if the fund
has made a capital gain at the end of the term.
Fig. 2 Location of 21 ESCF Scheme Supported Funds Surveyed in 1992
OBJECTIVES OF THE STUDY
Three years after the Scheme’s inception, the author was invited to review the
progress of the Scheme to date. By January 1992, 22 funds had been created in ten
countries and had started to invest in SMEs. In agreement with the Commission
sponsors, the study embraced the following objectives:
1) to review progress to date of the supported funds including their ability to
attract additional private sources of investment capital
2) to ascertain indicative evidence of the funds’ ability to meet desired goals
of enterprise and job creation via technology-based new firms
3) to address the inter-relationship between economic and (regional)
developmental objectives of the funds
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4) to appraise the continued viability of the funds created after the 5 year
period of Commission support
THE SURVEY METHODOLOGY
It was decided to interview personally the senior investment manager of each of the
twenty-two funds from the ten member states in the Scheme as of Jan 1992. A semistructured interview schedule was prepared in English and French. Only one fund
declined to be interviewed. (A further postal survey of the investee firms was also
completed but does not form part of the present paper.)
A FUND TYPOLOGY
The two types of fund, primarily supported by DGXXIII and DGXVI respectively,
were termed regional funds and commercial funds. Their characteristics are
summarised in Table 2.
Table 2 Typology of Regional and Commercial Seed Capital Funds
The following results from the study, and subsequent Commission updates, address
fund behaviour primarily from the perspective of the regional funds. Their actions are
contrasted with the commercial funds particularly to illustrate the nature and
consequences of the additional or different policy objectives placed on regional funds
as vehicles for local development.
BASIC FUND CHARACTERISTICS
Size and Investment Disparities in Commercial and Regional Funds
Table 3 Statistics of Seed Capital Funds in ESCF Scheme in 1992
By 1992, the extant funds had already started to exhibit material differences based on
both the resources employed and their regional or commercial logic (Table 3). The
average size of investment in individual firms by the commercial funds was four
times higher than their regional counterparts. Commercial funds managed their
investee portfolio more intensely. Accordingly, the operating costs of commercial
funds were 20% higher than their regional counterparts. However, when expressed as
a percentage of funds under management, these costs were one third lower for
commercial funds. This illustrates a fundamental issue for small scale investor
groups of the penal effect of indivisible, fixed governance costs.
The figures suggest that regional funds were pursuing a diversified portfolio approach
by making modest investments among a larger number of client firms. In contrast,
commercial funds had restricted their activities to relatively few but larger investment
thereby allowing for contingencies and planned ‘follow-on finance’ to existing
investees. This latter strategy is consistent with the practice in private venture capital
firms with a technology focus (Bygrave and Timmons, 1993; Murray, 1994). It was
not possible to determine if the regional funds’ policy was purposeful or contingent
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on supply-side limitations, ie. fewer attractive candidates available in which to invest
larger sums.
FINANCE RAISING BY THE FUNDS
Some two years after the inception of the Scheme, the funds had raised ECU 36.2
million of new finances for equity investment. This figure excludes the capital
subvention of approximately ECU 2.6 million made to regional funds by DGXVI.
The small scale of this sum is put into context when it is recognised that 15 (71%) of
the funds had total financing of under ECU 2 million. The average external finance
raised per fund was ECU 1.72 million (range ECU 0.5-7.0 million). The importance
of this figure is apparent if referenced to average operating costs of the funds.
Without making any investments whatsoever, the regional and commercial funds
would have exhausted their original capital in eight and twelve years, respectively.
The ‘Leverage Effect’ of European Commission Subsidy
The effectiveness of the imprimatur of the EU in assisting the process of fund raising
was significant, particularly for the regional funds. Fund managers were asked to
estimate the amount of finance they believed they would have been able to raise from
private investors without the existence of the Scheme. Only two of the thirteen
regional funds reported that they would have been able to raise any finance. The
total fund raising estimate of the regional managers, in the absence of the Scheme,
was ECU 2.8 million compared to the actual sum raised of ECU 13.5 million. The
‘pump priming’ role of the Commission resulted in an increase of finances raised by
the thirteen regional funds of 382%. Conversely, only three of the eight commercial
funds believed that they would not have been able to raise finance unaided. Their
views as to the Commission’s influence was that it represented an additional ECU 4
million - a 27% increase in funds raised.
Thus, the Scheme had met initially one of its objectives of stimulating private sector
financial transfers. However, the effectiveness of the Commission’s intervention,
more pessimistically, may conversely be seen as an indication of private investors’
circumspection as to the economic viability of regional seed capital investment in the
absence of significant EU subsidy.
Sources of Private Investment
The proportion of finance provided by private sources for the regional funds was
64%. although government agencies represented the largest category (28.9%) of
contributor (Table 4). Over three-quarters (77.3%) of the commercial funds’ finances
came from institutional and private investors, ie. the source from which most
mainstream venture capitalists attract finance
Table 4 Types of Institutional Investors in Seed Capital Funds in 1992
Investors’ Reasons For and Against Supporting Seed Funds (Respondents’
Opinions)
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However, only one quarter (27%) of regional fund managers believed that investors
contributed to their funds for predominantly commercial reasons (Table 5). This
makes the material contribution of venture capital firms to regional funds surprising
(although several of these firms were owned by regional banks.). Conversely, nearly
half (48%) of commercial fund managers believed that profit was the primary
reasoning of their investors. None the less, both types of fund managers
acknowledged the critical importance of non-economic reasons in motivating
institutional investors. This has implication for further finance raising. In the absence
of tangible evidence of attractive investment performance, initial fund supporters may
unlikely be a reliable source of further finance. Critically, all funds are likely to
require further finance raising before tangible evidence of their investment
performance is available. Investors who declined to participate were, in the opinion
of the fund managers, discouraged by the high risk and poor prospects for attractive
returns from seed capital investment.
Table 5 Investors' Reasons For & Against Contributing to a Seed Capital Fund
Fund Performance Evaluation by Their Managers
The regional fund managers appeared to give little priority to quantitative
performance variables in their own individual benchmarks for their fund’s
performance (Table 6). The absence of formal monitoring/evaluation criteria for
nearly half the funds in the Scheme was potentially alarming given the managers’
fiduciary accountability to their public and private investors. Particularly for regional
fund managers, the interim results of substantial investment activity appeared to have
received little explicit analysis.
Table 6 Primary Criterion for Fund Performance Evaluation
THE IMPORTANCE OF DEAL FLOW
A key prerequisite of success for a venture capital firm is its ability to attract a flow of
attractive, potential investee businesses. Only six of the 21 funds admitted to having a
formal marketing strategy for attracting deal flow. However, the funds did not appear
to have suffered from a limited supply of entrepreneurial firms seeking equity finance
in the period 1990-92. Collectively, the respondents’ funds had received a total of
1,410 approaches, and from which 69 investments had been made in total. While no
data were collected on the quality of this deal flow, the overall acceptance rate of
5.6% accords closely to other researchers’ findings of venture capital acceptance rates
(Bannock, 1991; Dixon, 1991; Roberts, 1991). For the 669 deals on which specific
information was available, there appeared to be little difference in summary
acceptance rates between the two types of fund.
Table 7 Sources of Funds’ Deal Flow 1992
Sources of Referrals
The apparent ease with which the funds had managed to engender interest among
entrepreneurs is arguably a recognition of the strong networking skills applied by
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managers within often strictly defined regional locations or specific product/
technology markets.
Table 7 illustrates the wide spread of sources of referral employed by managers of
both types of fund. Hustedde and Pulver, 1992, in the US have indicated that the
source of the advice and referral can be an important indicator as to the likely
outcome of the subsequent investment. These authors reported that public sector
conduits tend to be associated with, subsequently, less successful investee firms in the
US. If valid in a European context, these findings will be a cause for concern to the
regional funds which largely employ public sector channels for prospective deal flow.
Different Fund Types, Different Networks
The close relationship between the regional funds and the Business Innovations
Centres (BICs) is evident. (BICs were set up by DGXVI in 1984 and were originally
designed to ‘assist areas undergoing economic restructuring and/or economically less
advantaged areas of the Community.). BICs are normally represented on the board of
the regional seed funds.
The limited data suggest that commercial funds employed wider and more
heterogeneous sources of referral, and non-public contacts were particularly
important. Bank and financial institution originated enterprises represented over one
quarter of the commercial funds’ investment portfolios. In contrast, none of the 26
firms introduced by banks to the regional funds resulted in an investment. The lack of
locational/developmental constraints on commercial funds may represent an
advantage in deal sourcing.
PROJECT APPRAISAL AND SELECTION CRITERIA
The would-be investor has to reach a judgement on three critical sources of
uncertainty - the viability of the technology; the existence of an attractive
product/market opportunity; and the abilities of the entrepreneur/management team.
It is in the area of project evaluation that the regional and commercial funds exhibited
most commonality. Asked to cite the five most important project selection criteria,
the two types of funds only differed in the importance given to the ‘nature of the
technology’ (Table 8). This likely reflects the commercial funds greater focus on
technology investments. Their responses also confirmed the findings of several other
studies which have indicated that the essentially subjective appraisal of the
entrepreneur or management team dominates more formal financial appraisals in
early-stage investments (see Tyebjeee & Bruno, 1984; MacMillan et al., 1985 &
1987; Goslin & Barge, 1986; Sapienza, 1992; Hall and Hoffer, 1993).
Table 8 Fund Managers' Rating of Key Project Selection Criteria
The commonality of the two types of fund managers’ response was also reflected in
their reasons for refusing a new project proposal (Table 9).
Table 9 Fund Managers' Reasons for Refusing New Projects
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However, the views of the two types of fund managers did diverge markedly on the
minimum level of financial attractiveness of a project proposal as assessed by the
target Internal Rate of Return acceptable to the fund. Only three (23%) of the regional
fund managers would impose a rate of return at >20% per annum, ie. a level
significantly below the threshold of 57% imposed by UK technology investors
(Murray & Lott, 1995). Half of the commercial funds stipulated this minimum IRR
target. That nearly half of all managers did not have a defined financial performance
target was arguably a reflection of the extreme practicable difficulty of setting an ex
ante target given the imperfect information available for early-stage technology
investments. However, this omission may also reflect, especially for regional fund
managers, the subordination of financial objectives to wider developmental goals.
INVESTMENT FOCUS OF FUNDS
Targeted Stage of Investment
As noted, the history of the European venture capital industry illustrates a marked
movement away from early-stage investment (Murray, 1995). The logic of the
Scheme was to encourage the supply of finance dedicated to enterprise formation and
growth. The actions to date of the two types of funds show that their activities remain
exclusively directed to early-stage investment (Table 10). There was no evidence of a
‘creep’ to later stage, less risky development capital investments.
Table 10 Percentage of Investments Made by Stage of Investee Firm Development
Commercial funds were particularly likely to invest in young businesses before any
sales had been made. That the regional funds had, on average, over one third of their
portfolio in firms which had already started making sales may likely be a reflection of
their close relationship to existing support agencies, eg. BICs. This relationship is
also likely to explain the greater proportion of low/medium technology firms within
their portfolios when compared to commercial funds. Given the geographic
constraints of regional funds, it is also highly probable that the supply of early-stage
NTBF opportunities was significantly more constrained than for their commercial
fund counterparts.
Targeted Level of Technology Investments
Within broad definitions, the respondents were asked to ‘self code’ their portfolio of
investee firms regarding the degree to which they incorporated advanced and
novel/innovative technology processes or product features. Such a process of
categorisation is less robust than that employed by Butchart, 1987, and OECD, 1992,
but the researchers were primarily interested in a broad classification of the existing
investments rather than determining the technology status of a single firm.
Table 11 Percentage Distribution of Investee Firms by Level of Technological
Innovation
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Two particular observations resulted from this enquiry. The regional funds espoused
a greater preferred interest in advanced technology investments but it was the
commercial funds which had assumed this role in practice (Table 11). This, as noted,
may be a reflection of the limited supply of such investments in funds constrained by
regional boundaries. Secondly, while both types of fund indicated a preference for
including between a quarter and a fifth of low technology investments, in practice,
these investments represented around 10% of the average portfolio. Managers
observed that technology-based firms were potentially more attractive from either the
perspective of job creation or capital gain.
EXIT ARRANGEMENTS
Central to the logic of venture capital investment is the ability for the investors
eventually to liquidate/realise their investment at a capital gain reflecting risk and
illiquidity premia. (it has been argued that the limited role of small firm stockmarkets
in Europe has been a major disincentive to potential investors in growth SMEs, see
EVCA, 1993; Bannock, 1994).
Table 12 Planned Exit Route for Investee Companies (weighted by rank ordering)
Managers were asked to give their assessment of the most likely exit routes for their
present and future portfolio companies. Table 12 indicates that trade sales remain the
most likely source of a project exit for both types of funds. This is in line with
general venture capital behaviour (Relander & Syrjänen, 1992). The two categories
of funds are similar in their exit expectations. The exception is the relatively greater
importance given to an Initial Public Offering by the commercial funds. However,
such a route is only feasible for the commercially most successful NTBFs. The
limited importance given to a stockmarket exit suggests that only a small minority of
investments are regarded as being of the highest commercial potential or, conversely,
the inappropriateness of existing bourses for NTBFs in several European countries.
The importance of a repurchase of the investors' equity by the original entrepreneur(s)
reflected the peculiarities of investing in small businesses which were faced by
several funds. These managers noted that entrepreneurs would not accept seed capital
investment without the contractual right to subsequently repurchase the investor's
portion of the equity. Such an exit channel is of no interest to commercial investors
as the entrepreneur has a direct incentive in discouraging or delaying the growth in the
value of the enterprise in order to repurchase the equity he/she does not control (an
‘agency cost’ problem, see Amit et. al., 1991). For most funds, this route remained
the ‘exit of last resort’.
Venture capitalists were also seen as a potentially important source of follow-on
finance as co-investors in growing enterprises needing significant increases in
capitalisation. However, Murray, 1994, has noted the limited interest of UK later
stage venture capitalists in providing follow-on finance for seed capitalist derived
projects. It is also noteworthy that there was a negligible incidence of syndicated
financing of the original investments. Mason and Harrison, 1991, have observed that
inter-regional co-investment is one means by which regional equity gaps may be
ameliorated.
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CONTEMPORARY PERFORMANCE OF THE ESCF SCHEME
Subsequent to the original study in 1992, the Commission has provided updated
statistics on both the participating funds and their investee companies on an annual
basis. Two additional funds has been introduced and the non-respondent Greek fund
has been removed from the Scheme.
Importantly, the author’s original classification has been refined by the Commission.
Funds are now segregated into exclusively commercial, high-tech funds, and two
regional categories which are defined by the nature of the predominant sources of
finance. This re-classification serves to increase the differences cited in this paper
between the commercial and the regional funds in 1992.
Commercial Funds:
Private High-Tech Funds (n=4)
investment raised exclusively
from private investors and directed only to high technology projects
irrespective of location
Regional Funds:
i. Private Regional Funds (n=8) >50% of funds raised from
private investors with investments directed to one or more well defined
regions
ii. Public Regional Funds (n=11) <50% of funds raised from
private investors with investments directed to one or more well defined
regions
FUND CAPITALISATION AND INVESTMENT ACTIVITY POST 1992
Table 13 Growth of Total ESCF Scheme Funds Under Management
There has been relatively little additional fund raising in the three year period.
However, nine funds have noted an intent to raise a further ECU 20 million, twothirds of which will be via new shareholders. This imperative is greatest for the hightech funds which are almost fully invested. Their average investment values and the
costs associated with a ‘hands-on’ method of governance remain significantly higher
than for all regional funds. Additional demands on their funds from existing, or new
investees, cannot be sustained from extant resources. This places these funds and
their existing investees in a position of vulnerability in the event of unforeseen
problems.
Table 14 Total Investments Activity by Type of Fund by Jan 1995
The continued structural differences between regional and high technology funds is a
recognition of the diversity of their respective goals (Table 14). Significantly, interim
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figures show the firm failure rate of commercial funds to be nearly one third of that of
all regional funds. This may be a consequence of the ‘better’ stock of available
investee businesses, more discriminating investment policies of commercial funds
and/or their greater investee support activities. However, it is still premature to draw
strong conclusions.
EMPLOYMENT CREATION
Table 15 Number of Jobs Created by Category of Fund and Technology Status
1992-94
Table 15 serves to reinforce the importance of NTBFs as potentially attractive source
of employment creation relative to SMEs embracing less innovative technologies.
The degree of technological sophistication of the investee firms appears directly
related to the firms’ potential to create new jobs. The figures also illustrate a paradox.
The regional funds were created for developmental objectives including additional
employment generation. In contrast, the high technology funds remain primarily an
economic activity. Yet, it is the high technology firms which have recorded the
greatest employment growth per investee firm and per fund. The Commission
(DGXXIII) has drawn the conclusion from the Pilot Scheme results to date that its
future policy focus should concentrate exclusively on commercial funds, which target
high technology enterprises and employ finance from the private sector, regardless of
their location.
Table 16 Cost of Community Support per Job and Enterprise Created
On a Commission assumption of a 30% loan default, the cost to the EC of the Scheme
per job and enterprise created was ECU 1,260 and 13, 979, respectively (Table 17).
These figures appear to be remarkably attractive. Storey’s (1994) analysis of the
Enterprise Allowance Scheme in the UK estimated a public cost of ECU 2,600 per
job and ECU 78,000 per firm. The cost per job of the Urban Development
Corporations in England and Wales has been cited as ECU 28,000 per job (The
Guardian 19/8/95, p.9). Statistics (1980-96) from the Massachusetts Technology
Development Corporation in Boston, an arguably more relevant comparison given its
NTBF focus, show similarly effective public funds leverage with a cost per job of
ECU 1,055 and cost per enterprise of ECU 110,000. MTDC has created relatively
fewer, larger enterprises (60 active) but with a higher average employment growth at
104 new jobs per firm.
The efficacy of the Scheme is in part a result of the leverage effect of public loans on
private investment. While high tech funds created the most jobs in advanced
technologies, the greater total number of jobs and enterprises created by the regional
funds relative to the public subsidies given significantly increased their comparative
performance. However, a more rigorous analysis of the employment impact of the
Scheme will necessarily have to address deadweight arguments regarding the actions
of entrepreneurs in the absence of the Scheme. Further and critically, the longer-term
viability of fledgling NTBFs cannot yet be assumed.
THE THREAT OF INVESTMENT/REALISATION DISCONTINUITIES
13
The interim success of the high technology/commercial funds has produced one area
of considerable threat. In early-stage venturing, the investment cycle is generally seen
as seven to ten years (Bannock, 1991). During this period, successful investees will
frequently require several rounds of finance as the business grows and develops but
remains insufficiently profitable in the short/medium term to fund growth and R&D
investment exclusively from retained earnings (Murray, 1994). The cycle of costs and
returns are not synchronised and the fund needs to be able to have recourse to
substantial finance prior to a profitable realisation of its investments. The ability of
the Scheme’s high-tech funds to meet future cash demands is, at present, highly
constrained in the absence of further sources of finance.
Table 17 Fund Statistics in January 1995
Table 17 takes no consideration that the existing investments of the technology funds
may require additional finance over the remaining six year average life of the funds.
Nor are the substantial costs for an investee firm of a market flotation or a trade sale
included in the above calculations. In short, for the most successful fund category,
there is a present danger that the funds will imminently run out of operating finances
before the majority of their investments can be successfully realised. In these critical
circumstances, any attempt to obtain additional fund finance from investors is likely
to be problematic given the parlous negotiating position of a financially weak fund.
CONCLUSIONS AND DISCUSSION
Problems in the supply of seed and early-stage venture capital remain endemic in
Europe. In the absence of professional investors or the complementary, informal
investor/business angel sector, prescriptions to address ‘equity gap’ issues are heavily
dependent on public initiatives. The ESCF Scheme represents a European response.
It is properly judged according to its objectives. Yet, as a pilot programme, its
findings have their greatest import in influencing subsequent EC regional and
enterprise policies.
By February 1995, at a budgeted public investment of ECU 8.76 million, twenty-three
funds (and a support network) had been created and had attracted ECU 41 million of
institutional finance. The 188 extant, early-stage enterprises had created 2,085 direct
jobs, predominantly in technology-related activities. Failed enterprises currently
represent 17.5% of investments. Under the EC’s revised fund definitions, the
nineteen regional funds representing 60% of the finance raised (ECU 24.8m.) and had
supported 147 enterprises. The explicit objectives of the Scheme had been
successfully realised and the estimated subsidies per job and enterprise created
appeared highly cost effective. EC intervention cannot be challenged on either
‘opportunity cost’ grounds, nor as displacing (‘crowding out’) established private
markets for venture capital (Fisher, 1988).
However, conclusions must remain circumspect until the longer term viability of both
the new enterprises and the funds as economic entities are proven. The urgent need of
the high-tech funds for additional finance raises serious concerns as to future viability.
14
Without exception, the small scale of all funds prejudices viability given the penal
effect of fixed management costs. This future viability may well be conditional on
the development of what Florida and Kenny, 1988, describe as indigenous
‘technology infrastructures’and by which additional finance, information and advice
is efficiently provided to NTBFs and their investors through symbiotic local linkages.
All funds raised institutional finance on the basis of securing an acceptable return for
their investors. This return can only be met by the subsequent, profitable sale of their
portfolio companies. At the end of the 10 year funding period, if the investors do not
receive a risk and time adjusted return on their capital, they have in effect subsidised
the social goals of enterprise creation. This is likely to severely curtail future private
fund raising in addition to increasing significantly the real cost of the Scheme.
There is an evident quantity/quality divide between regional and commercial (hightech) funds. The latter actively discriminated by investing greater finance and
managerial support in a smaller number of attractive (by sales and employment
growth) firms. Unencumbered by developmental goals, the four high tech funds
appeared demonstrably more professional in managerial behaviour. The separateness
of the regional funds from private communities of finance, information and deal flow
is potentially problematic if these agents are to be judged ultimately as commercial
organisations.
The funds had established effective networks as evidenced by the availability of initial
funding and a robust deal flow. There does not appear circumstantial support for
Bennet and Krebs’, 1994, assertion of the more fractionated networks in less
developed regions. However, the regional funds were not sited in the most
economically and socially disadvantaged areas of the Union. The ability of the
regional funds to make technology investments would suggest that a latent demand
exists and is frustrated by supply side constraints of finance. However, that investees
are willing to accept finance allows no observation on the quality of these enterprises.
Indeed, the limited evidence from the study suggests that regional investees are
smaller, grow less quickly, are less technologically intensive and are more liable to
fail than the recipients of commercial fund investments.
That these funds had to be created de novo, lends support to Thompson’s, 1989,
questioning of Neo-classical diffusion arguments regarding the correction of either
regional or early-stage investment shortages. The steeply sloped ‘distance decay
curves’ witnessed by McNaughton and Green, 1988, in Canada remain evident in
Europe. Governance and information demands ensure the continued spatial
concentration of venture capital activity. The materiality of these constraints present a
powerful argument for the logic of public initiatives which address barriers to the
local supply of additional private venture capital finance. However, such schemes are
likely to be necessary but not sufficient catalysts for continued regional enterprise/
employment growth in the absence of complementary, techno-commercial networks
to assist the subsequent development of the new firms.
ooOoo
15
ACKNOWLEDGEMENTS
The author would like to thank the European Commission (DGs XXIII and XVI) for
their financial support of the original 1992 study, and David Francis whose
participation in the fieldwork and subsequent analysis was invaluable. Any errors of
fact, interpretation or omission remain the sole responsibility of the author.
16
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19
Table 1. Allocation of European Venture Capital Investments by Stage 1993-95
Stages of
Venture Capital
Investment:
Seed
Start-Up and
Early Stage
Expansion
Replacement
MBO/MBI
Total Investment
1993
ECU
%
million
Total
1994
ECU
million
%
Total
1995
ECU
%
million
Total
20.8
179.7
0.5
4.4
37.1
273.3
0.7
5.0
34.4
286.5
0.6
5.2
1,888.5
345.9
1,680.2
4,115
45.9
8.4
40.8
100.0
2,294.2
434.1
2401.0
5,440
42.2
8.0
44.1
100.0
2,298.6
354.5
2,572.0
5,546
41.4
6.4
46.4
100.0
Source: BVCA 1995, EVCA 1995
20
100
90
80
70
60
50
40
30
20
10
0
US Technology% Value Total
Investments
1994
1992
1990
1988
1986
EUR Technology% Value Total
Investments
1984
Percentage
Fig. 1. Technology Investments as a Percentage of ‘Adjusted’ Total Investment
(ie. excluding MBOs/MBIs and LBOs/Acquisitions) in Europe and the USA
1984-95
Year
Source: BVCA and EVCA Annual Statistics 1985-96, NVCA
Annual Reports 1990-1996
EVCA statistics aggregate sixteen European countries
including the UK.
NB. The trends in Fig.1 should only be seen as indicative
given broad definition of technology-based investments.
21
Fig. 2. Location of 21 ESCF Scheme Supported Funds Surveyed in 1992
R
R
R
C
CR
C
C
R
R
C
R
C
C
R
C
R R
R
R
R
 = Capital Cities (and Berlin)
C = Commercial Funds
R = Regional Funds
22
Table 2. Typology of Regional and Commercial Seed Capital Funds
Regional Funds
Commercial Funds
Primary Fund Objective
Encouragement of New Firm Attractive Capital Gain to
Formation and Employment
Investors fully reflecting
in location of fund
premia for risk and illiquidity
Secondary Fund
Objective
Positive and Acceptable
Financial Return to Investors
New NTBF Formation
Capitalisation
Public Funds and 'Social'
Investment by Private Sector
Primarily Commercial
Investors but including some
'Social' Investors
Investee Focus
New & Early Stage
Enterprises with some
Technology component
Exclusively, NTBFs with
exploitable Intellectual
Property Rights in attractive
and fast growing markets
Locus of Operation
Development Region
Area determined by
practicability of regular
investor/investee contact
Support Infrastructure
BICs* and other Public
Enterprise Support Agencies,
Public and Commercial
Networks
* Business Innovations Centres
23
Private, Commercial Networks
& Commercial Consultants
Table 3. Statistics of Seed Capital Funds in ESCF Scheme in 1992
Regional Funds
Commercial Funds
ECU 000s
N=13
N=8
Average Fund Size ECU000
Range Funds Raised ECU000
Number of Investee Firms
Average Investment per Firm ECU
Annual Operating Costs ECU
Range Ann. Operating Costs ECU000
Operating Costs as a %
Funds Under Management
1,345.4
500 - 2,575
48
58.922
157,176
21 - 195
2,341.3
750 - 7,000
31
232.777
189,162
87 - 406
11.7%
8.1%
24
Table 4. Types of Institutional Investors in Seed Capital Funds in 1992
Investment
% Total
Investment
% Total
in
Investment
in
Investment
Regional
Commercial
Source:
(ECUs)
Funds
Funds
Private Banks
1,569,000
12.3
3,063,040
16.4
State Banks
2,500,000
13.3
Business Innovation Centres
132,000
1.0
Chambers of Commerce
120,000
0.9
1,000,000
5.3
Churches
556,000
4.4
Private Financial Institutions
2,775,000
21.7
8,751,960
46.7
Nat. Government Agencies
2,886,650
22.6
Reg. Government Agencies
805,600
6.3
750,000
4.0
Private Companies
402,000
3.1
Venture Capitalists
2,748,650
21.5
1,480,000
7.9
Universities
77,250
0.6
Individuals
693,000
5.4
1,185,000
6.3
Total Funds Raised
12,765,150
25
18,730,000
Table 5. Investors' Reasons For & Against Contributing to a Seed Capital Fund
Reasons For:
Ranking
No. Reasons Against:
Ranking No.
Regional
Development /Job
Creation/Social
Responsibilities
SME Development
1
13
Excessive Risk/ Poor
Expected Returns
1
11
2
7
2
3
EC Financial
Support for the
Fund
Growth
Opportunities
New Products/
Technologies
Attractive
Potential Returns
3
6
Alternative Investment
Opportunities
No Seed Capital
Experience/Interest
3=
2
4
4
3=
2
5=
3
3=
2
5=
3
No Track Record
by Seed Fund
Already Investing in
Seed Capital
26
Table 6. Primary Criterion for Fund Performance Evaluation
Regional Funds
Commercial Funds
Fund Performance Criteria:
N=13
N=8
No. of Jobs Created
1
No. Businesses Created
1
Return on Capital
4
5
No Formal Evaluation Criteria
8
2
27
Table 7. Sources of Funds’ Deal Flow 1992
Regional Funds N=13
Commercial Funds N=8
Deal Channels:
% Proposals % Acceptances
% Proposals
% Acceptances
Banks/Fin. Institutions
6.4
0
15.3
27.2
BICs
40.5
50.0
7.6
9.1
Development Agencies
0.7
0
Chambers of Comm.
7.3
9.1
Government
8.1
0
3.1
9.1
Consultants
5.3
4.5
Fund Investors
1.2
0.7
European Commission
0.4
4.5
Universities/SCI. Parks
3.7
3.3
0.1
4.5
Venture Capitalists
3.9
10.0
2.7
9.1
Unspecified Dealflow
24.9
30.0
57.3
22.7
Total Numbers
407
30
Acceptance Rates %
7.4
28
262
22
8.4
Table 8. Fund Managers' Rating of Key Project Selection Criteria
Regional Funds'
Commercial Funds'
Ratings*
Ratings*
Key Acceptance Criteria:
N=13
N=8
Entrepreneur's Character
4.9
4.8
Entrepreneur's Experience
4.1
3.9
Degree of Expected Competition
4.0
4.1
Legal Protection of Technology
3.2
3.0
Nature of Technology
2.8
3.6
*Rating Scale: Not important 1 - Very Important 5
29
Table 9. Fund Managers' Reasons for Refusing New Projects
Regional Funds
Commercial Funds
% Total
% Total
Unprompted Reasons:
N=29
N=22
Entrepreneur's Lack of Experience
20.7}
13.6}
Character of Entrepreneur
13.8} 34.5
22.7} 36.3
Market/Growth Potential of Product
24.1
27.3
Technology Potential
10.3
13.6
Other
30.1
22.8
30
Table 10. Percentage of Investments Made by Stage of Investee Firm Development
Concept Pre- Prodn/
Initial
Early
No. of
Testing
Sales
Sales
Growth
Responses
Regional
Preferred
32
32
36
0
13
Funds:
Actual*
12.5
52.1
33.3
2.1
48
Commercial: Preferred
Funds
Actual*
20
28.1
33
56.3
*Estimated from investments made
31
47
15.6
0
0
8
31
Table 11. Percentage Distribution of Investee Firms by Level of Technological
Innovation
Technology
Low
Medium
High
No. of
Innovation:
Responses
Regional Funds:
Preferred
23.1
53.8
23.1
13
Actual*
11.4
61.3
27.2
48
Commercial Funds: Preferred
Actual*
25
9.5
*Estimated from investments made
32
62.5
46.9
12.5
43.6
8
31
Table 12. Planned Exit Route for Investee Companies (weighted by rank ordering)
Planned Exit Routes:
Regional
Number
Commercial
Number
Funds
of
Funds
of
% Exits
Responses
% Exits
Responses
Trade Sale
34.4
21
34.3
37
Entrepreneur Share Repurchase
33.3
36
31.1
19
Sale to a Venture Capitalist
30.6
33
27.9
17
Initial Public Offering
1.8
2
6.6
4
33
Table 13. Growth of Total ESCF Scheme Funds Under Management
Jan
Jan
Jan
Jan
1992
1993
1994
1995
Number of Funds
21
24
24
23
Total (non-EC) Capital Raised
36.2
37.7
39.9
41.0
Average Capital per Fund
1.72
1.57
1.66
1.78
Average Fund Operating Cost ECU
142,685
155,441
174,254
176,126
34
Table 14. Total Investments Activity by Type of Fund by Jan 1995
Private
Public
Private
Regional
Regional
High Tech
Funds
Funds
Funds
n=8
n = 11
n=4
Average Capitalisation ECU million
1.3
1.3
4.06
Percentage of Fund Invested
45
47
92
Annual Fund Operating Costs ECU
145,997
122,618
259,762
Total No. of Investments
62
85
41
Average Investment Value ECU
59,736
68,836
333,576
Percentage High Tech Investments
31
42
85
Percentage Medium Tech Investments
45
45
15
Percentage Low Tech Investments
24
13
0
No. of Business Failures
21
15
4
Failures as a % of Total Investments
33.9
17.6
9.8
35
Table 15. Number of Jobs Created by Category of Fund and Technology Status
1992-94
Public
Private
Private Total Jobs
No. of
Number of Jobs
Regional
Regional
Highby
Firms
Created
Funds
Funds
Tech
Tech.
by
n = 11
n=8
Funds
Status
Tech.
n=4
Status
High-Tech Companies
261
360
514
1,135
90
Med.-Tech Companies
239
377
119
735
72
Low-Tech Companies
118
97
0
215
26
Total Jobs Created
618
834
633
2,085
188
No. of Jobs/Fund
56.2
104.3
158.3
No. of Jobs/Firm
7.3
13.5
15.4
36
Jobs/Firm
by
Tech.
Status
12.6
10.2
8.3
Table 16. Cost of Community Support per Job and Enterprise Created
Assumption of 30% Repayment
Default
Total Cost of Repayable Operating and
Capital Subsidies ECU million
Estimated Real Total Subsidy Cost
ECU million
Cost per job (2,085 jobs created) ECU
Cost per enterprise (188 enterprises
created) ECU
Overall
Scheme
n = 23
8.76
All
Regional
Funds
n = 19
4.77
Private
High- Tech
Funds
n=4
3.99
2.628
1.43
1.20
1,260
13,979
985
9,731
1,892
29,210
37
Table 17. Fund Statistics in January 1995
Private
Public
Regional
Regional
Funds
Funds
n=8
n = 11
Total Funds Raised ECU million
10.4
14.4
Percentage of Available Finance per
47.4
45.0
Fund Invested
Average Uninvested Finance per
0.68
0.72
Fund ECU million
Annual Operating Costs ECU
122,618
145,997
Time in Years to Exhaustion of
Present Finance (excluding new
5.6
4.9
investment) for an Average Fund
38
Private
High Tech
Funds
n=4
16.2
92.4
0.31
259,762
1.2