THE EQUITY RISK CAPITAL MARKET FOR YOUNG COMPANIES IN SCOTLAND GAVIN DON Equitas. and

Transcription

1 THE EQUITY RISK CAPITAL MARKET FOR YOUNG COMPANIES IN SCOTLAND GAVIN DON Equitas and PROFESSOR RICHARD T HARRISON School of Management and Economics Queen s University Belfast In association with SCOTTISH ENTERPRISE JANUARY 2006

2 TABLE OF CONTENTS Page Preface 3 1. Summary of Main Findings 5 2. Introduction: Risk Capital and Economic Development The Venture Capital and Private Equity Industry The Venture Capital and Private Equity Market in Scotland BVCA Data The Scottish Risk Equity Capital Market 2004: A Comprehensive Analysis Conclusions and Implications 71 Appendix 1 Methodology 76 Appendix 2 Latent demand for capital 81 2

3 Preface A vibrant risk capital market is vital for the development of an entrepreneurial economy. It is also clear that an entrepreneurial environment fosters dramatic jobs growth and economic prosperity. For example, a recently published report by the European Venture Capital Association estimated that one million new jobs were created by European private equity and venture capital financed companies between 2000 and Yet these figures only paint a partial picture of the influence of the private equity and venture capital industry on economic development, since they do not capture the activities of private investors, angel syndicates, corporate investors and hybrids. This is the second of Scottish Enterprise s annual analysis of the risk capital market in Scotland, tracking all risk capital investments in Scottish young companies since This report is unique in Europe, in that we can now describe accurately what the industry is, its scale, and where the gaps in the supply of risk capital are. Our report s findings will therefore influence the way both the private and public sectors engage in the arena of equity investment in the future. In particular, it demonstrates the on-going need for Scottish Enterprise intervention to work with the private sector to improve the supply of finance for growing companies. The risk capital market in Scotland continues to grow, with a 40% increase in investment activity from 2003 to m was invested in 490 young Scottish companies between 2000 and Scottish Enterprise influence on this segment of the risk capital market is substantial. The Business Growth Fund and the Scottish Co-investment Fund accounted for 7% of total monies invested in Scottish young companies during 2004, yet we were represented in 55% of all deals recorded, an increase from 4% of the capital in 44% of all deals recorded in A significant part of the renewed buoyancy in the Scottish risk capital market can, therefore, be attributed to the intervention of Scottish Enterprise. 3

4 For a public sector investment of 18.3m, 53.7m of new risk capital was subscribed by private sector investors. I believe this level of shared risk is remarkable. However, this report also highlights an emerging second equity gap for companies seeking to raise risk capital in the range 2m to 10m. Left unchecked this market gap will increase in size and become a serious threat to the ability of the economy to create, nurture and develop greater numbers of growth-oriented businesses with the potential to become internationally competitive companies of scale. In order to address this problem Scottish Enterprise will introduce a new product from April 2006, the Scottish Investment Fund (SIF), which will help develop the 2m to 10m investment market in Scotland by increasing the level of risk capital and the number of providers of that capital available to Scottish companies. It is anticipated that once established SIF will further improve the availability of risk capital within the Scottish market. This report brings transparency to the Scottish risk capital market giving investors and companies greater understanding of its workings and helping influence policy development whilst confirming the validity of continued Scottish Enterprise intervention. I commend the report to you. Jack Perry Chief Executive Scottish Enterprise 4

5 1. Summary of Main Findings This report presents the findings of the annual Scottish Risk Capital Survey for the calendar year The Risk Capital Survey and this report are based on a unique data set which tracks investments made in Scottish young private companies each year. This data set now includes transaction information on all risk capital investments in young Scottish companies since The Risk Capital Survey tracks investments by reference to records of deals filed at Companies House the UK company register supported where appropriate by other market intelligence. As such this is the only systematic annual survey of its kind carried out in Europe. Key Findings Key findings of the 2004 Risk Capital Survey are as follows: Over the past five years ( ) a total of 843m of risk capital has been invested in 732 deals done by 490 young Scottish companies. In 2004 the Risk Capital Survey identified 170m of investment in Scottish young companies. Risk capital investment activity in Scotland was 40% higher in 2004 than in 2003, suggesting that the risk capital market is beginning to bounce back after the disruption of the collapse of the venture capital and technology markets at the start of the decade. Institutions (both conventional venture capital partnerships and other financial and non-financial corporations) invested 121m in Scottish young companies in 2004 accounting for 71% of the market. Institutional activity in 2004 increased by 40% over Three large deals ( Blockbuster investments) accounted for 35% ( 60m) of the total investment recorded in This is entirely in line 5

6 with the patterns of previous years, in which the three largest deals have accounted for between 23% and 41% of the total each year. When the three largest Blockbuster transactions are removed from the total, Institutions account for 64% of the balance of activity. This again is in line with previous years, where Institutions account for half to three quarters of investment in the rest of the market. The most dramatic shift in investment patterns in 2004 was in the angel market. Angel investment rose by 70% to 34m. In the past five years only one year has seen higher Angel investment 2001, during the heat of the VC technology boom. Just over half of this remarkable advance, though, was provided by non-scottish Angels investing in a single large deal Microsulis. The Scottish element of Angel activity nevertheless rose by 30%, from 20m to 26m, confirming the importance of this market segment to the financing of young companies in Scotland. For 2004 the British Venture Capital Association (BVCA) reported that its members invested a total of 14m in Scottish startup and early stage companies, and a further 69m in expansion stage funding equivalent to approximately 8% of total identified activity in the Scottish market. It continues to be the case that the largest part of the Scottish young company investment market is accounted for by non-bvca members. 1 Among Angel investors we have seen no seven figure single investments by individual Angels. Seven figure single investments appeared briefly in 2001, and since ceased. 1 Note that our data set does not exactly overlap the BVCA s definition of Startup and Early Stage, as a small number of companies in our survey are still young in that they are still short of breakeven, but might be counted by BVCA members as development. Likewise, not all BVCA s expansion capital will be in companies defined here as young companies. We do not have access to the BVCA raw data in order to reconcile these potential differences. It is the case, nevertheless, that the BVCA data significantly underestimates the scale of the risk capital market in Scotland. 6

7 The average size of Angel investments has stopped declining: the average Angel investment package in 2004 was 338k, compared with 199k in 2003 and 213k in Angel deal sizes varied substantially according to whether or not the Angels were co-investing with Institutions and/or with Hybrids. Where Angels invested without Institutions or Hybrids the average transaction size was 179k. The average investment package rose to 475k when Angel investors coinvested with a Hybrid - suggesting that Hybrids, notably the Scottish Co-Investment Fund, help increase the leverage of Angel investment - and to 901k when coinvested with an Institution. 70% of deals involving a combination of Angel and Institutional money were follow-on deals. Angels invested in new deals with Institutions only five times in Four of these deals were with Institutions which were not conventional VCs. We conclude that conventional VCs have lost any appetite for investing in new deals alongside Angels. In % of Institutional deals were follow-on investments. The follow-on proportion fell to 70% in 2003, and was only 50% in However, this return to the new deal market did not mark a return of VCs to the market but rather a return of non-vc Institutions. VCs appear to have lost interest in the new deal market in Scotland. Outwith the Blockbuster category, traditional VCs made only three new investments in Scotland in Non VCs (such as the Bank of Scotland) and specialists accounted for most of the Institutional new deal activity. The Royal Bank of Scotland, Lloyds TSB and the Clydesdale Bank all appeared to be inactive in the young company risk capital market in saw Hybrids 90% or so of whose activity is accounted for by Business Growth Fund and Scottish Co-Investment Fund - accounting for a substantial proportion 11% by value - of the non-blockbuster 7

8 market. Overall, Hybrids committed 12m investment to 87 transactions, and were involved in 55% of all transactions in A significant part of the renewed buoyancy in the Scottish risk capital market, therefore, can be attributed to the growth of the Hybrid sector. Approximately 90% of the Blockbuster deal market was taken by investors not based and controlled in Scotland. This emphasises the inability of the local players currently active in the market to service these very large transactions, and reinforces the need to both increase the supply of capital in this range and attract further non-scottish investors into the Scottish market. 8

9 The division of the Scottish Risk Capital Market between different types of investor, and between new, follow-on and Blockbuster deals may be illustrated as follows: Institutions 65m Institutions Angels Capital invested m Hybrids Institutions 51m Founders Institutions 4m Angels 10m Angels 16m Hybrids 8m Hybrids 5m Angels 10m Founders 2m New deals 1m Follow-ons Blockbusters Note: numbers rounded 9

10 Implications Based on this analysis there are a number of implications for the risk capital market in Scotland: With the development of Hybrid investors and the related resurgence of the Angel investment market, the supply of capital in the under 2m category for start-up and young companies is more buoyant than in previous years. As a result, we are likely to see more companies entering the pipeline with external start-up risk capital. However, as VCs withdraw from making new investments we see an emerging structural gap for start-ups requiring initial investments of 2m or more and for more established young companies requiring investment in the 2m to 10m range. This gap will progressively constrain the development of those young companies now receiving investment, and will reduce their potential contribution to the development of the Scottish economy. The centre of gravity of VC investment is firmly in follow-on finance rounds, and there has been only 2.5m of VC investment in new deals in Scotland in 2004 (out of a total new deal market of 24m). This suggests that the new deal market is now serviced almost entirely by Angels, Hybrids and non-vc Institutional investors (corporates such as banks investing their own funds). This is a potential problem for the availability of risk capital in Scotland. While the Angel market has grown strongly, capacity is still constrained by the need to provide follow-on finance to past investments, among other factors discussed below. As VCs move away from the new deal market the supply of investment capital into this space will fall well below the level of latent demand (if levels of entrepreneurial activity are to be raised to those in comparator economies), which we estimate at around 1bn annually. Given that there is now very little evidence of meaningful complementarity (co-investing) between Angel and VC investors, it is likely that this emerging gap will be widened. 10

11 2. Risk Capital and Economic Development The Scottish Economy For several decades, the Scottish economy has been dominated by a small number of large, internationally competitive, corporations, today concentrated in the financial services, oil and gas, transport and utilities sectors 2. While these companies are important for the development and competitiveness of Scotland s economy, they represent only one segment of the necessary corporate base of a dynamic economy. Also required are: a strong mid-corporate sector (defined as those companies with a value-added of between 100m and 250m), which is weak in Scotland, and a dynamic entrepreneurial economy characterised by the establishment and growth of new business ventures, some of which will become the mid-corporates and international corporations of the future. For over a decade, in the Scottish context, the role of new companies, and in particular those based on the development and exploitation of new technology, has been a key focus of policy interest. This interest has shifted in focus over time, from a general policy of increasing the number of new business start-ups (through the business birth rate initiative) to a more focused emphasis on the development of high growth potential businesses which would be competitive internationally, and would provide an effective and sustainable source of new employment and industrial growth opportunities. 2 Royal Bank of Scotland (2004) Wealth Creation in Scotland: A Study of Scotland s Top 100 Companies 11

12 Such firms are dependent, to a greater extent than the general population of small and young firms, on an effectively and efficiently functioning capital market to provide the resources necessary for their formation and growth. These firms may access capital from a number of sources, including personal and family resources, customers and suppliers and the banking system. They may also source capital, and managerial and business development competence and expertise, from suppliers of risk equity capital (venture capital firms, private or Angel investors and other providers of equity capital). The absence of a supply of such risk capital is recognised as a constraint on the development of innovation-based high growth potential business ventures 3. There is, in other words, a growing recognition in Europe, as well as in the US where the role of venture capital and private equity has been much better understood, that risk equity capital is an important driver of the entrepreneurial process in providing support for young rapidly growing companies 4. Risk Capital and the Equity Gap The existence of a gap between the supply of risk capital and the level needed to underpin an entrepreneurial economy is long-standing in the UK, for example, concern can be traced back to the 1931 Macmillan report on 3 Paul A Gompers and Josh A Lerner (2001) The Money of Invention: How Venture Capital Creates New Wealth, Harvard Business School Press 4 Rudy Aernoudt (1999) European policy towards venture capital: myth or reality? Venture Capital: An International Journal of Entrepreneurial Finance 1, 47-58; Commission of the European Communities (1998) Risk Capital: A Key to Job Creation in the European Vision. Luxembourg, Office for Official Publications of the European Communities; Günseli Baygan and Michael Freudenberg (2000) The Internationalisation of Venture Capital Activity in OECD Countries: Implications for Measurement and Policy. OECD STI Working Paper, OECD, Paris 12

13 finance. Recent analyses, such as the Cruickshank Report on UK banking 5, conclude that in the UK there is still a clear market failure: there is clearly a mismatch between the needs of firms requesting small scale equity investments and the supply of these investments. Venture capital deals tend to be too large and Angel finance is underdeveloped (page 172). This market failure has its roots in economic realities: The fixed transaction and administration costs of operating a VC fund; The higher returns required from smaller investments to service these costs. More recently, a joint US-EU report has confirmed that there is a fundamental market failure in the venture capital market: 6 The VC market is turning to more mature companies and declining to invest in early stage and start-up companies This is in pursuit of higher returns and lower risks in later-stage investments (in both the US and Europe) This trend may become self-reinforcing, and the flight from early stage become a structural feature of the market The remaining seed and early stage funds and Angel investors cannot by themselves cover the demand for equity investments. 5 Don Cruickshank (2000) Competition in UK banking: a report to the Chancellor of the Exchequer, HM Treasury, chapter 6 6 Working Group on Venture Capital Final Report (October 2005), United States Department of Commerce International Trade Administration and European Commission Directorate- General for Enterprise and Industry this group included industry representatives, venture capitalists, academics and policy makers 13

14 The Report concludes that: The failure of the venture capital market to meet the need for early stage risk capital on both sides of the Atlantic is so significant that public intervention is desirable Public money should now be allocated to larger funds that can command economies of scale, provide suitable advice to portfolio companies and recruit suitable managers, rather than to a proliferation of smaller new funds Public sector action to stimulate early-stage investment should work with markets and not crowd out private investment Politicians need to be educated as to the importance of venture capital and private equity to wealth generation and economic activity. Regional Perspectives on the Risk Capital Market As the risk capital industry has developed, the extreme regional concentration of both the investments made by the venture capital industry in particular and the management of funds for investment in general has come under increased scrutiny 7. In consequence, it has been suggested that this regional concentration places new and growing firms located in outlying regions at a disadvantage relative to their equivalents in the core economic regions with high levels of venture capital 8, and there have been a number of efforts made to stimulate the risk capital market in the regions using public policy measures 9. 7 Milford Green (1991) Venture Capital: International Comparisons, Routledge, London; Ron Martin (1999) The new economic geography of money, in R Martin (ed.) Money and the Space Economy, Wiley, pp. 3-27; Colin M Mason and Richard T Harrison (2002) The geography of venture capital investments in the UK, Transactions, Institute of British Geographers 27, Richard L Florida and Martin Kenney (1988) Venture capital, high technology and regional development, Regional Studies 22, Gordon Murray (1998) 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 14

15 In the Scottish context, and with the exception of 3i as the largest and longest established UK-based venture capital investor, and despite the relative sophistication of the financial services sector in other respects, Scotland was historically slow in developing Institutions specialised in the provision of venture capital to growing companies 10. However, with the establishment of Scottish Development Finance (now Scottish Equity Partners) by the then Scottish Development Agency in 1982, the risk capital market in Scotland began to grow, and through the 1990s an increasing number of risk capital investors developed a presence in Scotland, others participated as investors in a number of investment deals, and a visible Angel market began to emerge, to the extent that it made sense to refer to the Scottish risk capital market. However, this expansion of the risk capital market in the 1990s does not necessarily indicate that the growth constraint, experienced by start-up and growth potential firms, of an underdeveloped risk capital market has been overcome: the market may still be immature and incomplete, and not yet fully developed to the point where it offers full support to emerging companies, industries and technologies. Furthermore, the risk capital market is highly fragmented. It includes venture capital Institutions, a number of which are members of the British Venture Capital Association, are listed in the BVCA directory of members and contribute to the regular statistical report on investment activity in the UK produced by BVCA 11. It also includes Institutional venture capital investors that are not BVCA members, private or Angel investors, and other categories of investor (including trusts and public sector bodies). There is no comprehensive directory of these investors 12. As a result until recently we have not known with any degree of accuracy what the industry is, its scale (in Scheme, Regional Studies 32, ; Richard T Harrison and Colin M Mason (2000) Special issue: public sector venture capital and regional development, Venture Capital: An International Journal of Entrepreneurial Finance 2, Neil Hood (2000) Public venture capital and economic development: the Scottish experience, Venture Capital: An International Journal of Entrepreneurial Finance 2, BVCA (2004) Report on Investment Activity, London 12 Some directory information is published in VCR Directory 2004: Private Equity and Venture Capital Firms in the UK, Europe, Israel and South Africa 15

16 terms of the annual flow of new investment activity) and where (if at all) the gaps in the supply of risk capital are. Consequently, it is only now possible to: determine the extent to which the risk capital market is complete and efficient in how it functions in channelling finance to early stage and growing companies; determine with accuracy the extent to which there is a deficit in the supply of finance to growing companies in Scotland; establish the extent to which there is an on-going need for policy intervention to improve the supply of finance and the flow of finance into these companies. A final consequence of the fragmentation and opacity of the risk capital market is the creation and perpetuation of an aura of difficulty around the market, which itself discourages potential participants (capital holders, capital users and the intermediaries which connect them) from entering and deepening the marketplace. 16

17 The Market Report In this report we provide a detailed profile and analysis of the risk capital market in Scotland, using a database which covers risk capital investment in young companies in the five year period 2000 to This allows us to identify the investment activity of all actors in the market and estimate the total flow of risk capital investment into early stage Scottish companies over the past five years. Three features of the data used in this report are important: the data used refer to actual investments made in Scottish companies, based on Companies House records (see Appendix for more details) these are actual investment flows, not commitments which may or may not actually be followed through as investments the data refer specifically to early stage investment, and the focus of this report is on the flow of risk capital into start-up, early stage and growing Scottish companies this report excludes later stage financial engineering transactions (such as management buy-outs and management buy-ins) used to support ownership changes in established businesses the data refer to investments made in the five years 2000 to 2004 inclusive this covers the period of the bursting of the dot.com bubble, the collapse in the technology markets and the crisis of investment in the venture capital industry in the early 2000s, and the subsequent slow recovery in the risk capital market. The data provide an opportunity to examine how the risk capital market in Scotland has fared over this unique period. 17

18 The remainder of the report is structured as follows: Section 3 summarises the nature and role of the equity risk capital industry as part of the necessary infrastructure for the development of a dynamic entrepreneurial economy Section 4 provides an analysis of the visible segment of the Scottish risk capital market, primarily based on the data published by BVCA from its survey of member firms Section 5 provides a comprehensive and detailed analysis of the actual risk capital market in Scotland, based on the analysis of all identifiable investment transactions recorded between 2000 and 2004 Section 6 summarises the conclusions and implications of this analysis of the Scottish risk capital market, and presents some recommendations for further action. 18

19 3. The Venture Capital And Private Equity Industry Introduction It is now widely recognised that access to a strong supply of risk equity capital is important for national and regional economies because of the catalytic role that it plays in the entrepreneurial process 13. Although the risk capital market is made up of a number of different types of investor, much of the discussion has referred to the visible segment of the market represented by Institutional venture capital funds, for which data on investment activity is most readily available. By providing finance to companies seeking to exploit significant growth opportunities, usually as a result of technological and/or market innovation, and which are unable to fund this growth from internally generated sources of finance and debt finance or are too small or too risky to access public equity markets, the risk capital market is an integral part of the overall entrepreneurial system. Moreover, many of the assets of such firms are likely to be intangible (e.g. patents, trademarks, human capital) which are difficult to value and have uncertain secondary markets and hence are unacceptable as security. 14 Banks will therefore not finance such firms, or will only do so as part of a wider funding structure that includes equity risk capital investment. Usually, any acceptable forms of personal collateral are likely to have been exhausted. However, providers of risk capital do have distinctive competence and expertise in understanding the risks involved in financing such firms, and possess the know-how to overcome these risks and achieve commercial success. Moreover, they seek to add value to their investments by investing 13 See Colin M Mason and Richard T Harrison (2002) The geography of venture capital investments in the UK, Transactions, Institute of British Geographers 27, for a more detailed discussion of the issues raised in this section. 14 Paul A Gompers and Josh A Lerner (2001) The Money of Invention: How Venture Capital Creates New Wealth, Harvard Business School Press 19

20 expertise (their business development competence 15 ) as well as capital, by coaching the entrepreneur, providing strategic advice and assistance, attracting additional finance, managers and directors to the business and making the appropriate contacts with suppliers, customers and advisers 16. Without access to risk capital and the related expertise, such firms have a high probability of being aborted or failing in infancy 17. Evidence for the economic significance of venture capital is available at two levels. From a technology perspective, according to leading commentators on the venture capital industry in the US, venture capital has played a unique role in the formation and commercialisation of entirely new industries: personal computers, cellular communication, microcomputer software, biotechnology, and overnight delivery to name a few 18. Based on an analysis of US patent activity it is clear that venture capital drives innovation 19. From an economic perspective, there is conclusive evidence that firms backed by venture capitalists grow more quickly and reach the public market sooner than similar non-venture firms, and continue to outperform nonventure companies long after they go public 20. Studies undertaken on behalf of the US, UK and European venture capital associations also highlight the importance of venture capital in financing growing businesses, in terms of job creation, increased sales, exports, innovation, investment and growth 21. The importance of risk capital is not simply as a source of finance. Venture capital firms, active and informed Angels and syndicates and other risk capital investors are an integral part of a well-developed local technology 15 Dilek Çetindamar Karaömerlioglu and Staffan Jacobsson (2000) The Swedish venture capital industry: an infant, adolescent or grown-up? Venture Capital: An International Journal of Entrepreneurial Finance vol 2, pp On the post-investment value added contribution of risk capital investors, see the research studies collected in Mike Wright, Harry J Sapienza and Lowell W Busenitz (editors) (2003) Venture Capital. Volume III. (pages 3-271). An Elgar Reference Collection. Edward Elgar Publishing, Cheltenham. 17 William D Bygrave and Jeffry A Timmons (1992) Venture Capital at the Crossroads (Harvard Business School Press) 18 William D Bygrave and Jeffry A Timmons (1992) Venture Capital at the Crossroads (Harvard Business School Press), page Samuel Kortum and Josh Lerner (2000) Assessing the contribution of venture capital to innovation, RAND Journal of Economics 31, Paul A Gompers and Josh A Lerner (2001) The Money of Invention: How Venture Capital Creates New Wealth, Harvard Business School Press, pages See, for example, BVCA (2004) Report on the Economic Impact of Private Equity in the UK 20

21 infrastructure. They enhance such environments by acting as both catalyst and capitalist, providing the resources and the contacts to facilitate new business start-ups, spin-offs and expansions. Because they sit at the centre of extended networks linking financiers, entrepreneurs, corporate executives, head-hunters and consultants, venture capitalists have a propulsive effect on business formation" 22. This is important from an economic development perspective. In order to be successful, technological pioneers at both the individual firm level and the economic system level - have to bundle together a number of inter-related competencies into a 'competence bloc'. This has been defined as the total infrastructure needed to create (innovation), recognise (risk capital provision), diffuse (spillovers) and successfully exploit (receiver competence) new ideas in clusters of firms 23. An extensive, efficient and effective risk capital market is crucial for sustained regional economic development through the exploitation of new technology and market opportunities. Specifically, a risk capital market that comprises competent capital, in the sense of comprising investors with specific industry/technology and business development experience and expertise, is critical. However, while this may be necessary for the development of an entrepreneurial economy, it is not sufficient. There is a parallel requirement for a flow of entrepreneurial capital individuals and teams able to see and willing to exploit entrepreneurial opportunities and a pool of managerial talent (human capital) with the experience and expertise to successfully manage the business growth and market development process. To these must be added deep pools of intellectual capital the ideas and creativity on which business is based and market capital deep knowledge of and experience in relevant markets (see Figure 1). Evidence from the 22 Richard L Florida and Martin Kenney (1988) Venture capital, high technology and regional development, Regional Studies 22, pages Gunnar Eliasson (1996) The Pharmaceutical and Biotechnological Competence Bloc. Occasional Paper of the Royal Institute of Technology, Department of Industrial Economics and Management, Stockholm; Gunnar Eliasson (1996) Spillover, integrated production and the theory of the firm, Journal of Evolutionary Economics, 6,

22 international Global Entrepreneurship Monitoring project 24 and from those involved in risk capital investment and business development suggests that Scotland remains deficient in many of these areas. Figure 1 Sources of Capital for Effective Regional Development 25 INTELLECTUA L CAPITAL MARKET CAPITAL ENTREPRTEN URIAL CAPITAL RISK CAPITAL HUMAN CAPITAL Conclusion A vibrant risk capital market, characterised by so-called classic risk capital, is a vital requirement for the development of an entrepreneurial economy. It is an essential component of the regional competence bloc that creates (innovation), recognises (risk capital provision), diffuses (spillovers) and successfully exploits (receiver competence) new ideas in clusters of firms. However, it is not the only component, and while the adequate supply of risk capital, whether provided from investors within Scotland or by investors based outwith Scotland identifying and exploiting opportunities in the country, is necessary for sustained economic development, it is not sufficient. In the remainder of this report we do not address directly the wider issues of developing a dynamic entrepreneurial economy in Scotland. Rather, our Adapted from Richard T Harrison (2005) The rise of co-entrepreneurs: from capital investors to knowledge investors, Keynote Address to the ebrc/sky Venture to Capital Conference, Tampere, Finland, November

23 emphasis is on providing the most detailed and comprehensive analysis to date of the equity risk capital market in Scotland. This account will improve our understanding of the scale and scope of this market, identify the contribution made by risk capital investment to business ventures in Scotland, provide a robust evidence base for the development and evaluation of policies to stimulate the market, and dispel misunderstandings about the availability (or non-availability) of risk capital which act as a constraint on the willingness of individuals to identify and act on entrepreneurial business development opportunities. 23

24 24

25 4. The Venture Capital and Private Equity Market in Scotland BVCA Data Introduction Until our last report on this market in November 2004 the primary published information on the scale of the venture capital and private equity industry in the United Kingdom has come from the annual survey of its members undertaken by the British Venture Capital Association 26. The 2004 BVCA Report is based on returns from all 168 member firms. The BVCA Report on Investment Activity suggests that Scotland has performed well in reporting a higher proportion of venture capital and private equity activity than would be expected on the basis of the size of the industrial base in the region. This is particularly the case when only classic venture capital 27 that part of the industry focused on start-up and early stage investments with company growth as the primary aim - is considered. Investment Activity Overall, the BVCA figures identify 1.26 billion invested in 531 transactions 28 in Scotland in the five years : There has been an increase in the number of deals in 2004 (Figure 2) 26 BVCA (2004) Report on Investment Activity, London 27 American researchers have distinguished between classic venture capital, focused on start-up and early stage investments and merchant capital focused on later stage development investment, financial engineering and ownership changes through management buy-outs and management buy-ins. While both have a role to play, it is classic venture capital that underlies the development of an entrepreneurial economy. See William D Bygrave and Jeffry A Timmons (1992) Venture Capital at the Crossroads (Harvard Business School Press) 28 Throughout this report, the data cited refer to deals or transactions reported the number of separate companies receiving funding will be rather lower than this figure as a number of companies will report more that one deal/transaction. 25

26 Figure 2 Number of VC and Private Equity Deals in Scotland (BVCA) No Number of transactions There has been a slight recovery in reported venture capital and private equity investment in 2004, though this is still only 40% of the 2001 peak (Figure 3) Figure 3 Venture Capital and Private Equity Investment in Scotland (BVCA) m VC/PE investment In terms of both the number of transactions reported and the value of these deals, the proportion of total UK venture capital and private 26

27 equity activity accounted for by Scotland transactions has fallen: from 11% to 8% for transactions and from 9% to 3% for investment value (Figure 4). Figure 4 Venture Capital and Private Equity: Scotland as % of UK (BVCA) % of UK Investment Transactions When measured relative to the stock of VAT-registered businesses (to provide a measure of the size of regional economies) it is clear that Scotland has generally accounted for slightly more than its expected share of transactions in recent years (Figure 5). 27

28 Figure 5 Venture Capital and Private Equity Transactions per 1000 VAT Registered Businesses Scotland UK Investment Activity by Financing Stage Using BVCA data, it is also possible to analyse the composition of the visible venture capital and private equity market in Scotland in terms of the three main financing stages defined by the BVCA: Early stage this includes start-up and other early stage investments in new and growing companies Expansion this includes expansion/development funding for established companies, secondary purchase and refinancing bank debt transactions MBO/MBI this includes both management buy-outs and management buy-ins 28

29 In terms of both the number of transactions and investment value (in terms of funds committed), expansion transactions dominate in Scotland. Over the four years there were: 304 expansion financings reported by members of the BVCA, for a total transaction value of 614m (average 2.02m) 51 MBO/MBI financings for a total value of 511m (average 10.02m) 176 early stage financings for a total transaction value of 133m (average 0.76m) The number of expansion financings in Scotland has remained stable, both in terms of numbers and as a proportion of the UK total (9%), and there have been falls of around 50% from peak numbers in the number of both early stage and MBO/MBI deals (Figure 6). There has been an uplift in the number and value of reported early stage transactions in Figure 6 Transactions by Financing Stage (BVCA) No Early stage Expansion MBO/MBI 29

30 In terms of investment amounts, there has been a recovery in investment in each category in 2004 (Figure 7). As a result, the average transaction consideration, with the exception of MBO/MBI investments, has risen in 2004: expansion average transaction value in m MBO/MBI - average transaction value in m Early stage - average transaction value in m Figure 7 Investment by Financing Stage (BVCA) m Early stage Expansion MBO/MBI In 2004 BVCA members reported 14m of new commitments to 34 early stage transactions in Scotland, an increase over the 2002 and 2003 positions. The Scotland proportion of UK total early stage transactions has fallen (from a peak of 40% to 32%), and the proportion of investment has fallen from 21% to only 8% in 2004 (Figure 8). 30

31 Figure 8 Early Stage Investment in Scotland as % of UK Total (BVCA) % Transactions Investment Conclusion Based on the BVCA Report on Investment Activity for 2004 it is clear that: There has been a considerable volume of venture capital and private equity investment in Scotland over the past five years (over 1.2bn in over 500 deals) However, most of this investment (by value) has been in MBO/MBI transactions (39%) and in expansion/development capital provision (50%); only 11% of reported investment has been in early stage companies. There has been a recovery in the level of venture capital and private equity investment in Scotland in 2004, but levels are still well below the 2001 peak This fall has been more pronounced than that in the UK as a whole, and Scotland now accounts for only 3% of total recorded venture capital and private equity investment in the UK 31

32 There has been a very sharp reduction over the past three years in the level of investment in early stage companies (from around 50m to around 10m annually). This has major implications for the development of the next generation of start-up and early stage companies in Scotland. However, instructive and revealing as these figures are, as the only consistent published information on the activity of the venture capital and private equity industry in the UK, there are limitations to the data. Specifically, the data reported is provided by members of the BVCA. Although this is now a complete survey of BVCA members, it remains a partial summary of activity in the risk capital market in the UK. In particular, the BVCA data does not include: Investment activity by Institutional risk capital providers which are not members of the BVCA many of these are smaller (in terms of funds under management and number of investment executives) and tend to be regionally based and focussed. Investment activity by the Angel community (both individual Angel investors and Angel syndicates) previous research suggests that this is a significant source of equity risk capital across a wide range of national and regional economies which makes a major contribution to the start-up and growth of entrepreneurial companies. Investment activity in the UK by non-uk based venture capital and private equity Institutions which do not have BVCA membership in the case of Scotland, partly as a result of initiatives such as the Connect investment conferences and the efforts of Scottish Development International, there have been a number of, sometimes significant, investments which fall into this category (for more details see next section). 32

33 Investment activity stimulated and supported through initiatives such as the Co-Investment Fund and Business Growth Fund in Scotland and the regional venture capital funds in England, except to the limited extent to which they, or their partner investing Institutions, are BVCA members. Taken together, these other sources of equity risk capital are significant in the financing of entrepreneurial ventures. Research in Sweden, for example, has demonstrated that there are a significant number of Institutional venture capital funds whose investment activity is not included in the published industry statistics 29. Furthermore, this research has suggested that these other, non-included, venture capital providers tend to be smaller, more regionally based and more strongly oriented to start-up and early stage investment than are the members of the industry association. Overall, therefore, the analysis of the BVCA data tells an interesting story and raises a number of issues. However, it tells only part of the story. We need a more comprehensive analysis of the overall equity risk capital market, and the activity in that of all actors who play a role in the financing of entrepreneurial ventures, in order to: assess the scale of the equity risk capital market understand the options facing entrepreneurs seeking capital identify weaknesses/gaps in the market in terms of the size and diversity of the sources of risk capital and the experience and expertise of the pool of investors identify the extent to which there is an unmet need for interventions to improve the efficiency of the market in any of these dimensions. In the following section of this Report we provide a comprehensive analysis of the early stage equity risk capital market in Scotland which addresses these issues. 29 Dilek Çetindamar Karaömerlioglu and Staffan Jacobsson (2000) The Swedish venture capital industry: an infant, adolescent or grown-up? Venture Capital: An International Journal of Entrepreneurial Finance vol 2, pp

34 34

35 5. The Scottish Risk Capital Market 2004: A Comprehensive Analysis Definitions of the Market Unlike other reported data on the risk capital market such as those published by the BVCA and summarised above - the data in this Report refer to the actual flow of investment funds into early stage Scottish companies. In other words, whereas data such as the BVCA data refer to the supply of investment capital, derived from a survey of the providers of that investment, the data reported here refers to the receipt of investment capital as reported by the companies receiving the investment. This leads to an important distinction. In the analysis of the venture capital and private equity market using published data, the figures reported generally relate to the headline amount of investment agreed subject to phased drawdown. Thus a 10m transaction might only see 4m drawn down at the first close, but be publicised as a 10m deal. Second and subsequent drawdowns are often publicised again, sometimes using the full committed sum as the headline, further muddying the waters. A significant number of tranched deals see no later drawdown as the investee has missed milestones, ceased trading, or the investors have lost interest, and others see drawdowns of unexpected and often undisclosed amounts in interim rounds. The data reported in this Section relate specifically to the injection of funds into an investee business at the time those funds are invested. As such, the data refer to the actual, rather than headline, investment activity in the market. The database developed by Equitas over the past five years includes all young companies (mostly less than twelve years old at the time of investment) that have received detectable risk equity from an unconnected third party in each calendar year. We survey only investments aimed primarily at business growth. The survey therefore excludes investments of risk capital the prime purpose of which is to effect an ownership transfer between parties (typically MBOs and MBIs), and also excludes investments the prime aim of which is to replace one part-owner with another (replacement capital deals). We exclude 35

36 any deals transacted through an investment exchange (Ofex, AIM, London Stock Exchange), though we include deals which precede such listed transactions, and also include private placings transacted by broking firms. This analysis presents a picture of the Scottish early stage equity risk capital market. Under the term Scottish we include investments in companies registered in England, but operating primarily or largely in Scotland, and we exclude investments in companies registered in Scotland but headquartered and operating largely in England. While the Risk Capital Survey includes only investments in Scottish-based companies, we include investments in such companies whatever the location of the source of investment. A substantial amount of Institutional investment in Scotland flows from elsewhere in the UK (over the past five years we have identified over 40 Institutional investors who have been involved in risk capital financings in Scotland) and from foreign Institutions, and a proportion of Angel investment comes from investors located in England, with a further proportion of Angel investment flowing from outside the UK. We exclude deals in which the investors are connected by ties of blood or marriage. This means that we exclude the whole self-funded sector in which entrepreneurs provide 100% of the risk equity personally. We also therefore exclude investments made through companies under the control of the founding entrepreneur. As the recent reports from the international GEM (Global Entrepreneurship Monitor) project make clear, investment from family and friends ( blood money ) is an important source of finance for start-up and early stage business ventures, and one in which Scotland is relatively deficient 30. However, as this investment capital is channelled into ventures on the basis of familial relationships rather than being available to all prospective start-up and expanding ventures we do not consider it to constitute part of the market as we define it for the purposes of this report. 30 William D Bygrave, Michael Hay, Emily Ng and Paul Reynolds (2003) Executive forum: a study of informal investing in 29 nations composing the Global Entrepreneurship Monitor, Venture Capital: An International Journal of Entrepreneurial Finance vol 5, pp

37 We include deals in which risk equity has been provided in the form of loans, loan stock, loan equipment, guarantees and other risk bearing debt instruments. These are naturally harder to identify and classify than pure equity investments. Loan investments also require some judgement on where the border between debt risk and equity risk should be drawn. We have taken the approach that debt in such deals will be counted as equity unless it is debt which might reasonably have been secured on non-equity terms at arms length from a commercial lender. Based on these definitional issues and considerations, it is clear that the creation of accurate size of market data is not the simple and objective task that we would like. It will always remain possible to interpret numbers around the edges of the survey, and to argue for the inclusion or exclusion of any particular deal. However, we believe that the application of these definitional standards (as set out in the description of the methodology in the Appendix) has been consistent and robust, and that we can present the most comprehensive analysis of the early stage risk capital market in Scotland. The Players in the Market For the purposes of the Scottish Equity Risk Capital Survey we divide providers of risk equity into four groups: Angels Under this heading we include private individuals investing their own capital on their own account as principals. We include among Angels those who invest through syndicates, as each individual Angel remains responsible for the decision to invest, and holds the stock bought as a principal. We also include individuals who invest from family trusts (typically on behalf of children), from offshore trusts, from personal pension funds, and from family controlled operating or investment companies. 37

38 For the purposes of the survey, the underlying definition of Angel turns on the question whether the beneficial owner of the cash is making the investment decision personally. As noted above, this Survey excludes investment by family members in their own or relatives business ventures. Institutions Under this heading we include investment vehicles in which an individual or individuals who is/are not the beneficial owners of the invested cash make/s the investment decision. This classification therefore includes conventional venture capital companies, both members of BVCA and non-members, but also includes limited partnerships, corporate investors (other than those under the control of a single family), offshore investment funds, collective investment companies, banks and investment trusts. While the great majority of members of the BVCA investing in Scotland will be included in Institutions, it is equally true that many of the investing Institutions we observe are not members of the BVCA. Even without allowing for the investment activity of Angels and other investor categories (see below), we have identified that the BVCA-reported statistics do not represent full coverage of Institutional investment in the early stage risk capital market in Scotland. For the purposes of this Survey, in other words, the underlying definition turns on the question of beneficial ownership, with Other People s Money being the key identifying characteristic of the Institutional investor. Hybrids Under this heading we include any investor which (or sometimes who) has an agenda that combines financial returns with policy objectives or returns. Scotland contains many such investors, including those to be found in the Scottish Enterprise network (notably the Scottish Co-Investment Fund and Business Growth Fund), investment funds under the control of local and city 38

39 authorities, those in the charitable sector (eg Princes Trust), in the academic sector (Edinburgh Technology Fund, the University Challenge Funds), and even in the private sector (the Baxi Partnership). Indeed Scotland now contains perhaps fifty Hybrids with a wide variety of agendas, relationships and private/public sector participation. Most of these are small and episodic investors, or occupy small and very specific investment niches. Perhaps as much as 90% of the investment activity of the Hybrid investors is represented by the most recent policy initiatives by Scottish Enterprise. The underlying definition of Hybrid turns on the dilution of narrow financial aims by policy, charitable or social aims. In some cases this is within the context of a remit to operate on fully commercial terms (as with the Scottish Co-Investment Funds, where investment decisions lie with the commercial partner in the Fund and not with SCF); in others (eg University Challenge Funds), the commitment to fully commercial operating practices is less clearcut. We introduced this classification in 2003, but have back-analysed older data for the purposes of consistent presentation where possible (a task made difficult by the fact that a leading Institution of 2003 was effectively a Hybrid in 2000). Founders Although we exclude family investments in family-owned companies, we do include investments made by the founding principals of the investee company. In practice this group is the hardest to define, partly because the public record does not obviously disclose who among a group of shareholders are the insiders and who are the outsiders, and partly because the Scottish market is becoming more complex, to the point where the philosophical distinction between insider and outsider can become meaningless. We have sought to identify founder-ness in so far as this is possible, not because most founders invest much cash, but because in a handful of large start-ups each year we see successful entrepreneurs investing six and seven 39

40 figure sums in a new business along with a few outsiders, and inclusion of such deals in the Angels category would misrepresent the Angel data 31. Definition of Investment First, the surveys rigorously include only cash actually invested or drawn down in a calendar year. In contrast with this narrow definition deals are typically announced and publicised with the whole possible future amount in the headline, while in fact the amount is subject to tranching, with tranches released on achievement of milestones. Second, at the smaller end investments are frequently made via the provision of services. We include these at their monetary value only where that monetary value is recorded and disclosed in company filings. Third, in the academic sector investments are frequently made in the form of a transfer of Intellectual Property. As these are not financially quantifiable we exclude them from the totals in the Survey. Last, investors frequently provide bridging loans to investee companies. As these are clearly risk equity we include them at the date drawn down, and exclude them from subsequent capitalisation share issues when the loans are subsequently swapped for equity (or more rarely) repaid. Size of Market Including identifiable investment from all categories of investor as defined above, around 150 young companies in Scotland have received risk capital investment in 2004 (Figure 9). With the exception of the peak year of 2001, 31 There is a parallel here with the phenomenon of entrepreneurial recycling the reinvestment of some or all of the proceeds of a successful exit from an entrepreneurial company into a new venture by the principal entrepreneur. See Colin M Mason and Richard T Harrison (2004) After the exit: acquisitions, entrepreneurial recycling and regional economic development, Working Paper, Centre for Entrepreneurship Research, University of Edinburgh Management School and Hunter Centre for Entrepreneurship, University of Strathclyde. We discuss this phenomenon in more detail later in the Report. 40

41 this is the highest number of funded companies recorded in the past five years, and suggests that demand for risk capital continues to recover. Overall, during this five year period, we record a total of 843m of identifiable risk capital invested in 732 deals done by 490 young Scottish companies (Figure 10). There are clear signs that the hint of recovery reported in last year s report in 2003 has continued. Figure 9 Number of Risk Capital Investments in Scotland No Number of companies Figure 10 Total Risk Capital Investment in Scotland m Total investment 41

42 Blockbuster Investments Behind this overall picture, however, lies a blend of two quite different early stage risk capital markets. First, at the top end of the market, Scotland continues to produce three large Blockbuster deals each year (Figure 11). As such, these three deals represent a very significant segment of the overall risk capital market in Scotland, accounting for over one third of the total market in 2004 (Figure 12). In 2004 two of these three blockbuster deals were life sciences companies Prostrakan and Microsulis, and the third was a software company Picsel. Almost two thirds of the 60m of capital invested in these three deals was sourced from outside Scotland, and even outside the UK. 3i was the largest UK investor in Prostrakan and Microsulis, accounting for approximately one third of the total ( 20m). If 3i is considered to be a non-scottish investor then 90% of Scotland s Blockbuster capital came from outside Scotland. Small amounts of the balance came from Scottish based investors. Picsel s investment was sourced in Malaysia. It would not, therefore, be unfair to conclude that the top end of Scotland s Risk Capital market depends fundamentally on continued investment from outside Scotland. The ability of an economy to generate investment opportunities attractive to outside investors is important for its success, but the absence of a local supply of this investment capital is a potential weakness of the economy as it represents an attenuation of the regional capital market which as a result is unable to meet all the demand for risk capital throughout the business development cycle from start up to harvest. 42

43 Figure 11 Role of Blockbuster Deals in Scotland m Blockbuster deals Rest of risk capital market Figure 12 The Share of Blockbuster Investments in the Scottish Risk Capital Market % Share of institutional investment Share of total market Shape of the Market Second, excluding the three largest, or Blockbuster, deals, it is possible to divide the total risk capital market between Institutions, Angels, Hybrids and Founders. Overall, between 2003 and 2004 the rest of the market grew by over 30%, from 85m to 110m (Figure 13). The balance within the market has shifted slightly in the past year: Angel and Hybrid investment has increased significantly in volume terms, while Institutional investment is only 43

44 slightly increased on 2003 levels. In other words, once the impact of the three blockbuster deals is taken into account, the recovery in the Scottish risk capital market in 2004 reflects the increased appetite for investment of the Angel and Hybrid investment community. Figure 13 Sources of Investment in the Scottish Risk Capital Market m Blockbuster deals Other institutional Business angels Hybrids Founders Angel investment has been a growing segment of the risk capital market in Scotland over the past five years, accounting for around 27% of all investment, excluding Blockbuster deals (Figures 14 to 18). By 2004, Angel investment represented 31% of the non-blockbuster segment of the market (Figure 18). In 2004, Angels by themselves invested more than twice as much in Scotland as BVCA members reported as commitments to early stage companies, reinforcing other analyses of the Angel market in the UK Colin M Mason and Richard T Harrison (2000) The size of the informal venture capital market in the UK, Small Business Economics 15,

45 Figure 14 Risk Capital Investors (excluding 3 largest transactions) by Value, % 2% 26% 70% Institutions Business angels Hybrids Founders Figure 15 Risk Capital Investors (excluding 3 largest transactions) by Value, % 4% 25% 67% Institutions Businiess angels Hybrids Founders 45

46 Figure 16 Risk Capital Investors (excluding 3 largest transactions) by Value, % 4% 29% 65% Institutions Business angels Hybrids Founders Figure 17 Risk Capital Investors (excluding 3 largest transactions) by Value, % 5% 24% 64% Institutions Business angels Hybrids Founders 46

47 Figure 18 Risk Capital Investors (excluding 3 largest transactions) by Value, % 3% 31% 55% Institutions Business angels Hybrids Founders Summary of the Market This evidence allows us to draw up an overall summary of the structure of the early stage risk capital market in Scotland (Figure 19). This indicates that Hybrid investors operate largely in the sub- 1m investment space, but fund companies across the age range in the young company sector. Angel investors (who are significant coinvestors with Hybrid funds see below) also invest across all ages of companies and operate in the space up to around 2.5m in transaction size. As the Angel syndicates develop and become more sophisticated, Angel investors and Hybrids are extending into larger deals than hitherto, a development which has potential implications for the availability of small tranches of finance at the bottom end of the market. Institutions (the VC segment) are rarely represented in the start up (less than two years old) company segment of the market, and are concentrated in the 1m to 7m investment space. However, the evidence from the 2004 Survey suggests that almost all VC investment is now follow-on investment in existing 47

48 portfolio companies rather than investment in new companies, and that Institutions are moving away from the lower end of their investment space. Blockbuster investment is largely confined to established young companies (typically over five years old) involved in transactions of 10m or more. These are all follow-on investments, involving mainly foreign investors. Over the five years for which we have data it appears that there are around three such deals in Scotland annually. Figure 19 The Risk Capital Market in Scotland The emerging gap The Anvil 10 7 Approx age of company (years) 5 VCs, 95% follow-on Blockbusters Mostly foreign All follow-ons 3-4 per year 3 2 No pattern of deals Deal value Hybrids Angels VCs Blockbusters m General trend Mapping the market in this way suggests that there is a structural gap emerging. With the development of the Angel and Hybrid markets, there is good availability of capital for start up and young companies in the sub- 3m space (though volumes are still not as large as we would like). There is also good availability of Institutional capital from VCs in the 2-7m space, but only for existing portfolio companies there is no evidence that VCs are committing to investing in young companies for the first time in Scotland. However there is an emerging gap which, if not addressed, will constrain the development and expansion of growing companies in Scotland. 48