In times of general financial crisis, it’s easy for the problems facing pre-revenue companies to go unnoticed. After all, there are whole industries to be saved or lost.

One organisation doing its best to keep these ventures on the agenda is the National Endowment for Science, Technology and the Arts (NESTA). Its research shows that only £179 million of venture capital (VC) was raised in 2008 – a fall of 70 per cent on the year before. The average size of an early-stage fund has dropped from a peak of £38 million in 2004 to £26 million, and only 13 out of 39 active funds have more than £5 million left to invest.

‘Risk capital is eroding,’ says NESTA’s chief executive Jonathan Kestenbaum. ‘There is no longer the patience to accept a five- to seven-year pre-profit time horizon.’

According to Kestenbaum, venture has been damaged both by the credit boom and the subsequent crunch. In the boom, it was easy to make money through buying large businesses via leverage, with the result that ‘many pioneers of the [VC] industry have essentially become buy-out houses’. In the crunch, all-round risk aversion has reduced the pool of funding available for early-stage enterprises as depleted funds are forced to pump more money into their existing investments to keep them going. All this at a time when ‘we have never had a richer crop of interesting opportunities, particularly in the [university] spin-out world’.

Global outlook

Born to American parents in Japan but educated in Cambridge and London, Kestenbaum is a persuasive speaker who would surely have enjoyed a successful career in politics. But his aspirations took him in a different direction. After selling a commodity trading business which he helped set up with his family, he was able to ‘go off and do other things’, which included taking the position of chief executive in the office of the Chief Rabbi, Jonathan Sacks.

‘My identification with the Jewish community in Britain is an important part of my life,’ says Kestenbaum. ‘It’s an interesting case study of a community, many of whom like me were immigrants within the last 100 years, who have made this country their home and I think benefited the UK in terms of their entrepreneurship and their determination to make a wider national contribution.’

The vision

After a spell as chief executive of Jewish youth charity UJIA in the late 1990s, another dramatic change of direction saw Kestenbaum join private equity firm Apa Partners, working as chief of staff in the office of co-founder Ronald Cohen.

‘He remains the single most significant influence on my career,’ he says. ‘Working with him really taught me how you can blend focused rigour and tremendous attention to detail on the one hand, with a soaring vision on the other.’

Backing innovation

NESTA has endowment funds of £300 million, the interest from which funds all its investments. The core of the organisation is financing high-tech enterprises in the UK, either directly or through third parties such as AIM-listed investor IP Group and software-focused Pentech Ventures. This is accomplished through an ‘evergreen fund’ of £50 million, returns from which are reinvested.

Kestenbaum accepts that some are sceptical about the notion of public sector venture capital. ‘Public capital in the early-stage space has had a mixed record at best,’ he concedes. ‘The reason for that is because it has been insufficiently preoccupied with making a commercial case for pre-revenue venture finance. It has been overly preoccupied with a lot of other things, mostly political, such as job creation, regional development and sectoral interests.

‘One thing we’ve learnt is that it’s hard to make money investing in pre-revenue companies – each new objective you add diminishes your opportunities of making a commercial return.’

This is why the venture side of NESTA is run separately from its social enterprise arm. ‘We have decided that as yet our investments [in social enterprise] can’t be commercial, so we have split off that side of the business,’ Kestenbaum states.

The trend towards social enterprises as an entrepreneurial alternative to charities is well established, but Kestenbaum feels the concept is still in its infancy. ‘The fanatics of the social investment field are overstating the potential economic return to the investment community, and that does the field a disservice,’ he argues. ‘It can certainly be more than charity, but venture returns you are never going to get.’

Playing the long game

As for NESTA’s commercial operations, Kestenbaum argues that ‘patient capital’ from the public sector has an important role to play in UK innovation, given that VCs are increasingly unwilling to invest in pure blue-sky technology start-ups.

‘There is this notion that “if it’s an investable proposition, they’ll get investment”, but that’s complete nonsense,’ he claims. ‘Let’s say they meet all the classic requirements [of VCs], so a strong management team, a scaleable proposition, and consumer demand are all in decent alignment. Even then, if they are six years pre-profit, VCs won’t be able to absorb those costs. That’s where the government comes in.’

That said, NESTA rarely invests without ‘a pretty keen sense of where the co-investment is going to come from’. It tends to back companies with an initial investment of £100,000 to £250,000 and can invest up to £750,000 in any one enterprise, while total follow-on funding requirements can be as much as £10 million.

‘Follow-on finance is the key to success,’ says Kestenbaum, adding that helping a fledgling company assemble a strong management team and instilling sound corporate governance are crucial parts of NESTA’s contribution.

It isn’t always easy. ‘We back a lot of science entrepreneurs who invariably are geniuses,’ says Kestenbaum. ‘But in most cases, they are utterly uncommercial. They have a limited grasp of the financial engineering involved [in a deal], and not a huge grasp of where their product meets the market.’

In the worst cases, entrepreneurs fall in love with their product. ‘That is the kiss of death,’ Kestenbaum remarks. ‘They feel that no one appreciates the pure genius in their product, and they are probably right. But what you really want to be doing is building great businesses.’

Making the cut

NESTA’s portfolio companies include medical imaging company Dexela, “alternate reality game” producer Six to Start, and clean refrigeration specialist Camfridge. Kestenbaum says the organisation typically gets 300 proposals a year, of which around 50 are taken to due diligence, and ten to 12 ultimately receive investment. A similar number of follow-on investments are made in existing portfolio companies. Kestenbaum claims that NESTA is ‘probably the largest source of seed capital for pre-revenue high tech [companies] in the country’.

As for exits, there were only three last year and prospects are not much better for this one. ‘Our projections for this year were for at least four exits through public markets, and at the moment they are [virtually] closed. We will probably be holding onto investments for longer,’ says Kestenbaum.

NESTA has been making a lot of noise in recent months. In December, the organisation called for a new £1 billion fund, half of which would come from the taxpayer and half from private sources, to stimulate venture capital in the UK. This was followed in March by a proposal for a five-year £12 billion package aimed at cleantech, healthcare and the creative industries.

Prime minister Gordon Brown spoke of his belief in innovation at a NESTA summit in May last year, and it’s to be hoped that the organisation’s proposals, backed by its research, find a sympathetic ear in government. Not that Kestenbaum pulls his punches in his criticism of current policy.

‘The cost of this type of package is substantially less than the £120 billion recently ploughed into the financial sector.

It also compares favourably with the £2.3 billion that has been used to support the car industry,’ he argues.

‘Government has to make the switch from bailing out industries to investing in growth sectors where future market demand is strong. If we fail to do so, we will be paying the price for many years to come.’