Some private equity and venture capital investors reject the idea that there’s a lack of growth capital available for small companies, but others argue there’s a funding void that Government initiatives are having to plug. Sally Giles investigates the ‘equity gap’ debate
Are small businesses less attractive investments these days? Well, it depends on whom you ask. The answer given by a well-established private equity house is likely to be different to the one from a business angel actively backing innovative young companies.
Once upon a time, there were much clearer divisions between the levels of funding provided by different types of equity providers. Business angels (high net-worth individuals) invested lump sums in early-stage companies, venture capitalists (VCs) provided development capital for particularly risky ventures and private equity firms were happy to muck in once profits were rolling.
Mark Wignall, chief executive of Matrix Private Equity Partners, recalls the days when, ‘people were falling over themselves to invest in young, early-stage companies.’ It wasn’t that long ago, he says, that venture capital group 3i dominated the market with, ‘a high-street presence a bit like a bank, so you could pop in during a trip into town and pick up your risk capital!
‘Then 3i shifted its focus and diversified into other areas and started making much larger investments, leaving a gap for small investments into which a host of other equity providers moved.’
However, many of those now concede, in private if not in public, that market forces in the last five years have inevitably precipitated a move by VCs and private equity backers away from small, risky investments towards larger, later-stage deals. This trend is what James Steward at private equity group ECI Partners calls ‘the flight to quality.’
‘We make a judgement based on the balance between how risky and time-consuming it is to invest in the company in question and what the rewards are likely to be if the gamble pays off. This risk-reward ratio is at the heart of any investment,’ he counsels.
‘Private equity providers are therefore leaning towards conducting fewer transactions, but ones of larger value, because this spreads risk more evenly and brings greater returns.’
Chris Clothier of business angel group MMC Ventures has witnessed the same trend, pointing out that, ‘many equity firms – Advent International is one example – have moved away from providing risk capital and now predominantly back buyouts. Levels of liquidity in the market are still high, so they have large amounts to spend and it’s just not economical to do small deals.’
Laurence Garrett, a partner at 3i’s venture team and director of the group’s Cambridge office, has been conducting venture technology investments for 12 years. He believes, ‘This upward trend has been happening for some time, but it’s a bit of a chicken and egg scenario. Deal sizes are going up because the costs of building substantial businesses are moving up.
‘When I first started in venture capital, you could build successful companies for £5 million. I haven’t seen a business that’s exited for substantial money in the last five years that’s been built on £5 million. Add to that the fact that investors want to work on fewer deals because they don’t want to spread themselves too thinly and you can see that the average deal size is bound to move north.’
Impact on small companies
This shift upwards has apparently left a gap in funding between the level business angels traditionally provide and what private equity firms now offer – the so-called equity gap. Depending on which statistics you believe, it’s around the £0.5 million to £2 million mark, ‘particularly at the small end of that band,’ says Clothier.
Venture Capital Trusts (VCTs) were intended to plug this gap when the Government launched the scheme in 1995. VCTs are pooled funds listed on the Stock Exchange that have become mainstream providers of funding for smaller private companies or those listed on AIM, with around a dozen launched each year since the scheme was initiated. The Government has been keen to promote them in a bid to make Britain more entrepreneurial and subscriptions for new shares in VCTs offer lucrative tax benefits to tempt investors; capital gains tax (CGT) exemption on disposal of shares and no tax to pay on income or gains from the trust.
A total of £718 million was raised by new VCTs in the 2005/06 tax-year. However, since April this year, income tax relief investors receive on money invested in new VCT shares has been reduced from 40 to 30 per cent. Moreover, the law was changed so that VCTs only invest in companies with gross assets of £7 million or less (as opposed to £15 million). The rules also stated that £1 million is the maximum a trust can invest in any one deal to qualify for tax relief. The Government no doubt adjusted the ‘gross asset’ test in a bid to force VCTs to focus on their original remit of backing young, growing companies. But this may have backfired. Simon Rogerson, CEO of Octopus Asset Management, expects the reduction in tax relief to investors will in the future reduce the amount raised by new VCTs, which will result in ‘too little capital chasing too many companies.’
Some reports suggest it’s not just early-stage ventures that find it hard to source small equity hits. The Government began a public consultation process on the subject in 2003 with the publication of its paper entitled Bridging the finance gap, which found that, ‘while the risks associated with investment in early-stage businesses are often particularly high, established businesses (including those in ‘traditional’ sectors) can also be affected by a shortage of risk capital – for example, when seeking investment to modernise or diversify their activities.’
The situation was deemed such a serious threat to the health of the nation’s enterprise sector that the Government intervened again. In July 2005, it made up to £200 million available to match private funding from VCs or angels into Enterprise Capital Funds (ECFs). These are designed to be commercial funds to which SMEs can apply for up to £2 million of equity finance. ECFs are broadly based on the Small Business Investment Company (SBIC) programme that’s operated in the US for the past 45 years, backing the early growth of companies such as FedEx, Intel, Apple and AOL.
London-based Seraphim Capital is the first ECF fund to launch, opening its doors to applicants last September with the aim of providing between £0.5 million and £2 million to businesses UK-wide. It’s a £30 million fund, with £10 million provided by private investors and £20 million from the Government.
David Quysner, chairman of the Capital For Enterprise board, an independent body that helps the Government implement the ECF scheme, clearly feels there’s an equity gap to be filled, saying, ‘ECFs will fulfil a genuine need by addressing a market gap in the availability of equity finance.’
Throughout England, small amounts of equity are available from Regional Venture Capital Funds (RVCFs), which aim to provide risk capital finance of up to £500,000 for small firms with good growth prospects in any sectors. The government has endowed nine RVCFs with funding through the DTI and the European Investment Fund, while the rest comes from private sector investors. The Government has also taken other steps to compensate for the disproportionate costs of making small-scale investments, including tax breaks for Enterprise Investment Scheme investors.
Gap, what gap?
Now that these schemes have been set up to plug a supposed void in funding, many investors and industry experts argue there is no longer an equity gap because businesses with relatively small equi
ty needs can access finance easily. On this subject the debate gets heated.
A study by research firm Library House entitled Beyond the Chasm found that of the 1,511 current venture capital investments made by private funds, more than half (899) are for £2 million or less. In that band, the vast majority (706) were between £250,000 and £2 million, which is the zone the Government identified as experiencing a market failure that created an equity gap. Library House findings conclude, ‘there is no gap in the range of funding deal sizes available to growing companies in the UK’.
On releasing the research, Library House chairman Doug Richard, of Dragons’ Den fame, was quoted as saying, ‘It calls into question a number of very large schemes. The whole venture capital trust industry has no reason to exist if there is no gap.’
David Quysner responded to the Library House findings by pointing out there is good evidence that without Government intervention viable businesses would not get financed. He added, ‘I would be delighted if there was no equity gap, but I have spent most of my working life aware of its existence.’
Boyd Mulvey, co-founder and chief executive of Create Partners, which manages the regional venture fund for the East of England, says, ‘I work with Doug Richard from Library House on a number of projects but I question his conclusions that there is no equity gap.’
Mulvey argues the issue of follow-on funding could be responsible for skewing the statistics. The availability of funding at low levels is often tied to the future investment needs of the business in question. Most private equity backers will, therefore, only back companies with very small initial investments if it constitutes the first tranche of a series of subsequent fundings.
He says, ‘It’s good that Doug has stimulated debate, but where his research shows the vast majority of VC deals were between £250,000 and £2 million, those deals could’ve been the first round of a series that ultimately amount to an investment of ten times that. So, small companies seeking an investment total below that level and above angel funding still need help.’
Create took the prize for ‘Equity Gap Fund of the Year’ at the 2006 Investor AllStars awards, the annual giving of gongs in the investment sphere, so he’s on the frontline of equity gap funding. Mulvey contests that, ‘rare and occasional deals private equity backers conduct in the £250,000 to £2 million space do not constitute equity gap funding.’
Quality is the key
The latest research from the British Venture Capital Association (BVCA) shows that its members – a mixture of UK-based private equity and venture capital firms and their advisers – invested in 285 early-stage companies last year, an increase of eight per cent on the year before. The average deal size was £800,000, so clearly VCs and private equity firms are still as active as ever at the low investment end of the market.
‘The BVCA statistics show that the majority of deals are below £1 million, so it’s just not true to say there is a gap in funding in that area. But venture capital is a world in which one in a hundred deals secures funding so 99 companies will claim there’s an equity gap,’ laments Anne Glover, CEO of venture capital group Amadeus Capital Partners.
Market realities make it inevitable that not all firms applying for investment from angels, funds and trusts can be successful, as there will always be a finite amount of funding available in any economic environment.
Garrett from 3i says, ‘My general feeling is that good entrepreneurs with good ideas get funding. Yes, some entrepreneurs find it hard to raise finance, but is that because there’s an equity gap or because their ideas aren’t good enough?’
Seraphim Capital’s investment director Mark Bogget is less convinced that’s an accurate appraisal, pinpointing that, ‘In my experience we would expect our fund to receive 1,000 to 2,000 business plan applications a year and typically invest in about five of those ventures. Since we launched Seraphim on 11 October, we’ve already received 150 applications from companies and of those between 10 to 20 per cent are high enough quality to warrant investment but won’t get it. ‘That strongly suggests that the argument is less about the quality of business propositions and more that there is not enough funding available in the market for investment-worthy small companies.’
Chris Clothier at MMC Ventures shares that view based on his experience: ‘We see around 500 business plans a year and it’s true to say that there are more companies with exciting opportunities and good management teams than we can invest in.’
One size does not fit all
In the opinion of Mark Wignall from Matrix, there is categorically no longer an equity gap but there is probably what he calls ‘an advisory gap’. ‘Entrepreneurs do need help getting the right funding and perhaps they don’t always get that help.’
‘In some sectors of the economy, there are very few players with the know-how to do deals,’ says Anne Glover. ‘I would describe that as a skills gap. It’s particularly true of early-stage technology, where ventures need seed funding to develop a prototype and then substantial capital in the future.
‘But the market is becoming wiser and changing its perspective on how to evaluate transactions,’ she continues. ‘At Amadeus for instance, we don’t view deals on the size of the investment rounds and never have done. The question we ask is, “What are the total capital needs of the business to take it through to exit or profitability, and what proportion of that should we invest now?”
‘So, deal size becomes an irrelevance in the sense that we will undertake a £250,000 deal that may take £60 million in the long-term in successive funding rounds. We’re active in initial deals at the low-end right up to the high-end, but neither of those deal sizes represent our total capital reserves committed to a company.’
Laurence Garrett echoes this view, adding, ‘At 3i, we’re obviously lucky that we have a wider group and can benefit from deal flow between a range of levels – from early stage ventures through to later stage growth capital deals, large management buyouts and now comprehensive infrastructure deals, such as the AWG deal in the press at the moment.’
Glover believes most equity investors are beginning to understand that effectively there isn’t tiering of the market anymore, in terms of early-stage, growth and later stage players. ‘If you want to play, you have to be able to play at all investment stages. The most important thing you must have is the capacity to support a company in its future growth strategy.’
The future for business angels
Business angels are the one group in the equity finance area that can struggle to bridge the gap between funding levels. Glover, an active business angel herself, says, ‘Angels have gradually learnt that they are extremely vulnerable to being “washed out” [running out of funds] when the capital needs of a business are large. An angel can help if you want a finite investment of sub-£2 million, but if your growth needs will take you beyond that initial investment to more funding rounds then they struggle to come with you, which is an inherent problem.’
The concept of angels clubbing together can make a difference, by providing small equity hits but also the ability to follow on with successive rounds. Hotbed, Cambridge Angels and MMC Ventures are exam
ples of syndicates of business angels that can typically invest between £500,000 and £3 million in the first instance, with the expectation that they may need to follow their money in subsequent rounds.
MMC associate Chris Clothier argues groups like these provide a haven for angels to invest and see greater returns. ‘Because we’re essentially an angel-VC hybrid, offering small sums right through to larger chunks of equity, our structure enhances our ability to de-risk. And, of course, the individuals investing in our fund are often keen to become actively involved in the companies we back, which can either be mentoring and sharing their contacts or taking a seat on the board of that company. All that helps secure future growth for the business.’
Mark Bogget is upbeat about the prospects going forward for early stage and fast-growth ventures seeking investment. ‘All the new investment models in the marketplace, such as RVCFs, ECFs and angel groups, give small companies that have previously been prevented from expanding the means to drive forward and become larger enterprises, which will ultimately bring greater returns for entrepreneurs and investors alike.’
For further information
British Venture Capital Association: www.bvca.co.uk
Library House’s Beyond the Chasm report is available at: www.libraryhouse.net
Small Business Service’s Bridging the finance gap report is available under the research and statistics heading at: www.sbs.gov.uk