Public cash has to lead the way on start-up funding

Anybody who has tried to get start-up funding will know how much time is wasted and how ‘efficiency’ seems to be an unknown word. Here is an article that, if heard, would make a genuine difference – especially, for example, to fund environmental activities relating to ameliorate climate change.

By Jonathan Kestenbaum

Published: March 25 2008 19:22 | Last updated: March 25 2008 19:22

Tuesday’s story about 3i created shockwaves in the venture capital world and yet it had a familiar ring: private equity firm abandons start-up investment. 3i, like a host of other players before it, is relinquishing its interest in early-stage companies in favour of the promise of higher returns upstream.

The exodus by 3i marks another blow not just to the UK entrepreneur but to the economy. The recent report by Lord Sainsbury, Race to the Top,refers to the need to make UK companies the best in the world, but many will now find it hard to get out of the starting blocks. Evidence suggests a correlation between fast-growing new companies and employment growth. New companies are an important driver of productivity, particularly as they can force established firms to improve. They also find it easier to allow new ideas and ways of working to be tested, some of which can tackle big social issues.

In our experience as an investor, we have helped establish a range of young companies developing solutions to some serious problems, from a possible cure for MRSA (methicillin-resistant Staphylococcus aureus) to a more environmentally friendly fuel cell.

It is easy to build a picture of the impact this latest withdrawal of early-stage funding might have. To a private investor, however, looking at this issue in terms of its negative economic or social impact smacks of an altruism that has no place in the sector. Does 3i, or any other investor, have a responsibility for the funding of innovative firms in the UK? Arguably not.

They should, however, take an interest in innovative firms that will increase their bottom line. And this is what makes 3i’s decision to exit this space disappointing because they do so at a time when the broader value of venture capital-backed deals is starting to show through. Philip Yea, 3i’s chief executive, may be correct that there is more value for investors in later-stage companies in the short term, but is wrong to overlook the returns that riskier, early-stage investments can reap in the long term, and that 3i has benefited from successfully in the past.

What is needed to make private sector investors come back to this space is more proof of the value of early-stage venture investing. The public sector needs to take the lead. The difficulty is that, while many government schemes sound good in theory, they are often surrounded by restrictions, including constraints on co-investment and deal size, that make them risk-averse and inhibit effective investment.

Public funds are also not always well-directed. While the finance minister’s recent addition of £30m ($60m) to the Enterprise Capital Funds is welcome, to date these funds have tended to back companies at later stages of development. Where money is directed at early stages, the migration of other investors upstream means it needs to work much harder and often there is not enough money for follow-on investment. This results in the original investment being diluted and in diminishing returns, both of which do little to prove value.

If early-stage finance is to be successful it will need to look and act differently. Public funds need to take the lead in building new models of investment and rigorously evaluating their effectiveness. If the returns justify the risk, private money will once again follow. The sector needs to make larger investments so that entrepreneurs can spend their time on development, not chasing further funding; and it must forge investment partnerships with the private sector that share risk and reward. The recent budget announcements about expanding the programme for the use of small and medium-sized enterprises in government procurement programmes is particularly helpful in this regard.

Policy has a vital role to play in creating conditions for investment. This will include pioneering tax incentives – venture-backed companies are denied access to a range of schemes available to other business – and helping to ensure entrepreneurs are “investment ready” and able to present a high-quality business plan, management team and clear exit strategy for investors.

Most people in the UK are quick to lament the lack of a UK Google or a Microsoft but overlook the fertile ground from which they are most likely to spring. These are companies that started small in new sectors and grew into world-class companies. Learning what works in early-stage finance will benefit the economy, entrepreneurs and investors alike.

The writer is chief executive of Nesta, the National Endowment for Science, Technology and the Arts

Copyright The Financial Times Limited 2008

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