Creating growth Improving access to finance for UK creative industries

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1 Brief March 2011 Creating growth Improving access to finance for UK creative industries Emma Wild knowledge economy group CBI Access to finance is essential for business growth. For UK creative industries, the structural challenge of accessing finance must be tackled if the sector is to achieve its full economic potential. Creative industries account for more than 7% of UK GDP and have shown consistent, above-average growth for more than a decade. 1 The sector has significant potential to contribute to the UK economy, but only if the business environment is right. It is good news that the UK government is increasingly aware of the economic value of this world-class sector. We have the third largest music market in the world 2 and the UK s video games industry is estimated to be the fifth largest producer of games globally. 3 The global video games market is set to reach $86.8bn by 2014, from $52.5bn in , demonstrating the potential of just one industry in the sector. The UK has the third biggest advertising sector after the US and Japan 5 and the UK film industry has grown steadily in recent years, but remains structurally challenged. But the rise of digital technologies and the growth of the online environment are fundamentally changing the way many creative industries operate. Along with substantial opportunities for growth come threats of increased competition. For the UK economy to benefit the government must unblock barriers to growth: access to finance being one of the most significant. Why does access to finance matter? An appropriate and affordable supply of finance is essential for businesses to operate effectively and grow, helping to create jobs and wealth. Access to finance has been tough for many companies, particularly during the economic downturn, but there is an additional layer of complexity for the creative sector.

2 2 Creating growth: improving access to finance for creative industries Creative businesses vary in size, scale, business model and output. The sector has a disproportionately high number of SMEs and microbusinesses. Many creative businesses are also IP-based, so have an abundance of intangible assets, which some banks may have less experience and confidence in lending against. The combination of these characteristics results in a structural financing challenge for the sector that has only been exacerbated by the financial crisis. The UK government should work with creative industries and the finance community to understand and resolve these challenges as part of an overall strategy for the sector. This brief argues that: Access to finance is a structural challenge for the creative sector. There are simple ways in which the government can help, by ensuring that existing government support and incentives are fit for purpose for the creative sector: Retain and improve the Enterprise Finance Guarantee to ensure it is accessible to creative industries. Review the effectiveness of the Enterprise Investment Scheme and Venture Capital Trusts. Retain and improve the R&D tax credit to increase its applicability to creative industries. Ensure existing funds used to de-risk investments are effectively targeted. Business has an important role in addressing financing challenges. Creative industries and the finance community should also take action to address points of market failure, including raising financial awareness amongst the creative sector. Access to finance is a structural challenge for the creative sector A riskier proposition? Many creative business models are based on original and innovative intellectual property. This is important for building brand and reputation, but at the same time the unpredictability of consumer reactions can make it difficult to gauge the value of a product before it goes to market. It can also make it difficult to build a consistent track record to demonstrate the viability of a potential product to future investors. From an investor or lender perspective, creative industries can therefore be viewed as a riskier proposition, resulting in either a reduced appetite to invest or lend, and/or a higher cost of finance to compensate for the higher level of perceived risk. Providing security for loans The intangible nature of IP can also make it difficult to provide security for debt finance, especially if the business is small or a start-up with limited fixed assets. For the creative sector, where there are a high proportion of SMEs and micro-businesses with few fixed assets, this can be a particular challenge. High development costs Development costs associated with some creative industries can be high, particularly for film, television, video games and animation productions. Given the new and innovative nature of many IP-based products and the upfront nature of a high proportion of development costs, it is often distributors and publishers who are prepared to invest in the development of IP due to their knowledge and experience of working in the sector. But this brings its own challenges, including the risk of dependency on supply chain finance. As with any financing model, an over-reliance on one source of credit can be a problem. For some creative industries, it can also impact on the likelihood of firms retaining their IP as transfer of IP rights is often part of the financing deal. Supply chain finance is an important source of finance for the sector, but it is crucial that an appropriately wide range of financing options exist alongside it for both working and investment finance. Case study music industry Traditionally, the industry has effectively invested in its own supply chain to finance break-through acts. There are many examples of entrepreneurial management companies and record labels that have been self-funded and have reinvested in the industry with their profits because of their knowledge and expertise in the sector. But as with other creative industries, the sector is experiencing large-scale structural change as a result of growth in the online environment. Record sales have fallen in recent years. Where there are areas of revenue growth, such as live performance events and festivals, the trend of investing in new acts occurs less. The traditional internal investment model of supply chain finance is diminishing, which increases the pressure to find other sources of finance.

3 Creating growth: improving access to finance for creative industries 3 Case study independent film industry Financing in the independent film industry can be complex with multi-party structures. Investment is also mainly on a single film basis, rather than in the business. Market conditions are increasingly difficult, with some financing drying up. Combined with the high cost of banking and legal fees, this means that independent producers can find it difficult to establish a sustainable financing model. IP-based business likes creative industries that often lack tangible assets. But the take-up of EFG by creative industries seems low, as noted by the BIS Select Committee inquiry into government assistance for industry. 6 Administration of the guarantee is generally through finance providers who are responsible for identifying potential recipients. This can place the reliance on finance providers to identify creative businesses as potential recipients for the EFG. Statistics on take-up of the EFG that explicitly refer to the creative sector could help government to analyse performance in this area. The creative sector has a high proportion of SMEs and micro-businesses A significant proportion of the creative sector is SMEs and microbusinesses and the financing challenges facing this particular size of business are well-documented. According to IFF Research s Finance survey of SMEs in February 2010, only a third of SMEs use external sources of finance and of this, only two percent make use of equity finance. Many SMEs can be perceived to be higher-risk than their larger counterparts due to limited track record or credit history. This can make it difficult for finance providers to assess the viability of a business. Over time it can also discourage businesses from pitching for finance in the first place. From an equity investor perspective, the cost of performing due diligence on an investment is often the same regardless of the size of the deal and therefore can make SMEs look less attractive than larger investment options. Taking these factors into account, SMEs are often likely to rely on informal sources of funds such as friends or family or re-invest earnings from the business as finance. They are also often reliant on bank finance as the only source of external finance and are now suffering as a result of tighter credit conditions after the financial crisis. Equity finance is often not considered. There are simple ways in which government can help UK creative industries are a significant part of the UK business community and have a key role to play in the economic recovery. The sector is not asking for special treatment from the government, simply a level playing field. There is a number of existing government schemes that could be improved, without additional cost to the tax payer, to increase their effectiveness for the creative sector: Retain and improve the Enterprise Finance Guarantee (EFG) The EFG is a guarantee facility to support viable businesses that cannot provide collateral for loans. The guarantee should be beneficial to Refresh the process of administering the EFG Ensure debt finance providers are aware of the scheme and its applicability to IP businesses like creative industries. Ensure relevant data is available to understand how creative industries are making use of the EFG. Review the effectiveness of the Enterprise Investment Scheme and Venture Capital Trusts The Enterprise Investment Scheme (EIS) supports smaller high-risk companies to raise finance by offering a range of tax reliefs to investors. Venture Capital Trusts (VCTs) encourage individuals to invest indirectly in a portfolio of smaller higher-risk trading companies by offering tax incentives to the investor. Under the existing rules, the benefits of the EIS and VCT are not always accessible to a company that funds the creation of IP, but does not create the IP itself. This can restrict investment in companies set up to commercialise the IP generated by a group IP-based companies. VCTs are also intended as a vehicle for investments in businesses rather than projects. A slate investment approach that enables investors to invest in a portfolio of projects, rather than just businesses, would help to reduce the perceived risk of investing and encourage a greater supply of equity finance. The same is also true of the EIS. The flexibility of such an approach would benefit film for example. CBI recommendation Review the rules relating to VCTs and the EIS to ensure the schemes are sufficiently flexible to cater for the spectrum of creative industries seeking finance.

4 4 Creating growth: improving access to finance for creative industries Retain and improve the R&D tax credit The R&D tax credit is important for encouraging investment in innovation and should be very applicable to creative industries, particularly video game and animation companies. But improvements should be made to increase the effectiveness and applicability of the tax credit further. There are several example restrictions that could exclude some creative industries from benefiting from the R&D tax credit. For example, companies that do not own the IP developed during an R&D project or operate on a work-for-hire basis. This is common in the video games industry, particularly where the project is funded by a publisher or distributor. Businesses also continue to tell us that government understanding of R&D should be greater and the application process for the tax credit remains bureaucratic. There are also challenges on the demand side. Lack of specific tax knowledge in SMEs can add to the challenges of gaining R&D tax relief and can dissuade potential applicants from applying for the credit. Increasing awareness of the scheme among creative industries could also help to ensure that the sector make the most of the tax relief available. Retain the R&D tax credit for small and large companies Review the impact of existing restrictions on creative industry companies that: do not own the IP developed during an R&D project operate on a work-for-hire basis make a loss and have no corporation tax bill at the end of the year Simplify the claimant process Increase the level of administrative support available for claimants Increase awareness of the R&D tax credit among relevant creative industries Make use of sector-specific training offered by companies and trade associations Ensure funds used to de-risk investments are effectively targeted Incentivising the private sector to invest in other businesses is a valuable way of encouraging growth. For creative industries, this is important given the sector s perceived higher-risk profile. Effective methods of de-risking private investment are often based on bringing together appropriate expertise with funds to help optimise business outcomes. This approach can help to address the shortage of equity finance providers for small or new high-risk businesses, including creative industries. There are several examples of capital funds that match public equity funding with private investment, as well as make use of creative sector knowledge with sector-specific finance expertise. Money invested along with expert advice, knowledge of routes to market, contacts and networks can be an effective way not only to finance the industry, but also sustainably transfer sector-specific finance knowledge to the creative business and other investors. Prototype funding is also an example of an innovative use of funding that helps to de-risk private investment. Case study London Creative Capital Fund The Creative Capital Fund is a 6.5m equity fund that provides seed capital investment and business support to creative industries in London. The fund makes equity investments of up to 650,000 in early-stage companies and works as a matching fund. Every 1 invested by the fund must be matched by at least 1 in equity from private investors on the same terms. The fund also works closely with experienced entrepreneurs and professionals to provide business advice and support. Case study North East Creative Content Fund Northern Film & Media has partnered with NorthStar Equity Investors, a venture capital firm, to manage a 2.4m creative co-investment content fund. The fund is open to companies either based in the north east or those who want to base production or build presence in the area. Investment size is in 50, ,000 and the fund targets SME companies from the film, TV, games, interactive media and music industries. The fund makes equity investments but will consider non-equity investments too. The fund is designed to bring together creative and financial expertise to help support high-growth creative industries in the north east of England. Case study prototype funding Given the high development costs and innovative technology associated with video games development, government support to de-risk projects for potential investors is of great value. Prototype funding essentially supports the development of products to the point where it is more likely that other financiers will then invest. Abertay University has a prototype lab and centre of excellence which allows small UK games developers to apply for grants up to 25,000 to support the development of prototypes.

5 Creating growth: improving access to finance for creative industries 5 The role of business Financing challenges are demand and supply-side in nature. This brief refers to several government policies already in place to address areas of market failure from both of these perspectives. But business must play a role too. Finance providers will rightly only fund viable, commercial opportunities. Any business seeking finance needs to demonstrate investmentreadiness or credit-worthiness, depending on the type of finance being sought. Without this, even with a viable opportunity, accessing finance will be difficult. Businesses need to be able to develop a realistic business plan, forecast financial outcomes and understand the range of financing options available. This can be a challenge for start-ups or SMEs that may not have specific in-house financial expertise. Businesses must also understand how to demonstrate finance-readiness. For example, companies are increasingly asked to evidence creditworthiness to existing suppliers before they are able to take advantage of favourable terms. Having a positive credit rating is critical for this. But according to recent research, almost one in three small businesses do not know what their credit rating is, or how to positively influence it despite more than half recognising the importance of their rating in being granted access to credit. The creative sector also has a role to play in helping to de-risk their businesses to encourage investment. For example, steps could be taken to simplify recoupment models and make them more transparent to encourage investment. There is also potential benefit in education around investor or finance readiness, recognising that different types of finance are relevant at different stages of a business s life cycle. For example, equity finance tends to be more important at the early development stage of a business, whereas debt finance is more relevant at the production/selling phase. On the finance side, raising awareness among the banking community of the specific challenges facing the sector would encourage focus and efforts should be made to encourage sector-specific knowledge in the relevant teams. Finance providers should support and mentor SMEs and start-ups in the sector to raise financial awareness and general business skills. Creative sector Enhance financial and business knowledge through existing support networks. Identify and implement the key ways to help build investor confidence in your business including, for example, simplicity and transparency of recoupment models. Finance Enhance financial awareness for small businesses, including mentoring and support networks. Enhance awareness among the finance community of the specific challenges facing the creative sector. Work with trade bodies and other organisations to gain sector-specific knowledge of creative industries. Collaborate to provide good practice guidance on lending against intangible assets. Conclusion Access to finance for the creative industries is a structural challenge resulting from the sector s characteristics. There are a number of government policies in place that should benefit the creative sector but more needs to be done to improve the effectiveness of these policies for the creative industries. Business also has an important role to play in addressing finance challenges and the government should work with the creative sector and finance providers to support this role. The CBI looks forward to working with government and business to overcome the barrier of accessing finance. Further information: Emma Wild Head of group CBI knowledge economy E: emma.wild@cbi.org.uk Footnotes 1 Creating prosperity: the role of higher education in driving the UK s creative economy, Universities UK, p b5ec3a94da42 6 A creative recovery, REFORM, P htm Product code EXE_065