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In at the start10/01/2006. Source: Scottish Equity Partners (SEP). 
A large swathe of the venture capital community in the UK remains inactive in what they perceive to be the risky end of the market, says Scottish Equity Partners. As a result, there are real concerns in some quarters that a lack of developed early stage businesses will create problematic gaps in years to come. Defining the various stages of today’s market is actually more difficult than it was four or five years ago, perhaps reflecting its evolving nature. First round funding still falls into early stage by most definitions, but where second round funding fits in is less clear. “Saying whether the second round is early stage or later stage is becoming more difficult to define,” said Stuart Watson, a partner at Ernst & Young.
“We are faced with a much more considered model than we were before. Investors are more thoughtful about how and when they invest and the whole process is much more tailored,” he said. Yet despite some negative indications around the early stage investment scene, there is still an active core of investors in this segment. Scottish Equity Partners (SEP) continues as one investor committed to the early stage market, which accounts for around half of its business. The other side of its investment strategy focuses on later stage emerging growth businesses.
“We have always been very active in the early stage market,” said Stuart Paterson, a Director in SEP’s Information Technology Group. “We like the balance that these stages of investment give us for our funds.
“You do need a different mindset for investing in early stage though. It’s less about proof and more about potential and investors in early stage have to develop the judgement that will enable them to select those businesses that are going to be very good indeed at a stage where they are very far from realising that potential. There continues to be a great many new businesses starting up in the technology sectors. Not all of them have what it takes to be world class, but when you find those that do, they will reward your faith enormously.”
The pipeline of companies with this kind of potential is healthy if you know where to look, according to Paterson. “We’re very active at generating our own deal flow. We do a lot of research into companies that have secured seed, university and grant funding.”
Although investors like SEP are still active in early stage, there is no doubt that there are fewer investors in this space. After the funding frenzy ahead of the collapse of the dot.com phenomenon, there is a more tempered approach to funding early stage companies than before, with many VCs citing heightened levels of due diligence and co-funding strategies as vital elements of successful deals. However, many VCs are no longer active in early stage investing at all. Ulric Kenny, a director at Dublin-based Ion Equity said: “People call early stage different things and it depends on the development of the company and size of the financing round.”
“For most investors, the starting point for funding early stage companies is later in their development than it was a few years ago. Now, entrepreneurs need either an inspirationally brilliant idea or an experienced management team or you just don’t get the finance,” he added.
This trend is reflected in the European Venture Capital Report published in late September by VentureOne and Ernst & Young which shows that venture capital slowed across Europe in the second quarter of 2005 with €735.6 million invested in 203 financing rounds. The totals represent a 20.1% decrease over the amount invested in the first quarter of 2005 and an 11% decline in deal flow. Year on year, this represented a 34% decrease over the amount invested in the second quarter of 2004.
What the report also shows is that, within this overall picture, investors in Europe were directing a greater percentage of their capital investment into later stage financings, a trend that is also reflected in the €371.6 million that was directed toward later rounds in Europe, accounting for 50% of the total capital invested in the second quarter, compared to 43% of the total investment in the same quarter of 2004.
The amount of first-round deals completed in the second quarter of this year totalled 51, according to the European Venture Capital Report. In the same period in 2004 there were 83 closed deals and in the second quarter of 2003 there were 75.
“The considerable percentage of capital being invested into later stage companies, and the larger sums directed toward second round deals in Europe, is a clear signal that portfolio consolidation is diminishing,” Stuart Watson commented.
“European investors are demonstrating confidence in the prospects of the high quality entrepreneurial companies that remain in their portfolio. The increased attention for later stage investing may also be related to the liquidity environment in Europe, particularly for initial public offerings,” he said.
SEP’s Paterson agrees with Watson and believes that changes in later stage investment activity are skewing the picture of what is really happening with early stage investment.
“One of the reasons that there is an increase in later stage investment is because many companies are delaying IPO exits until the business is much stronger and further on in its development so that they achieve a better valuation. So of course there are more later stage investment rounds, but there is still a very healthy early stage investment market.
“If you aren’t actually active in the market and aware of what is really happening, the statistics can be more than a little misleading,” he added. “Yes, there is less activity in early stage investment, but that represents a natural adjustment from the time when the market was artificially inflated. Technology was seen as an easy place to make money and there was a flood of investment from VCs without much experience in the sector. As a result, many poorer quality companies got funding that wouldn’t have in any other circumstances.
The truth is, good start-ups will always find funding, and the statistical picture conceals a very healthy early stage investment market.”
The key characteristics of this market, according to Paterson, are more experienced investors, who are confident in their judgement of early stage businesses, investing in better quality, more robust start-ups with serious potential to become successful global businesses.
“It is about building serious businesses, not building companies up just to float them,” he said. “It’s not a numbers game anymore. The quality threshold has gone up. The VCs left in this space are not prepared to scatter money across a number of companies in the hope that one will pay off hugely.”
Another commonly-held perception about early stage investment is that companies seeking investments up to £1 million and from the £3 million region upwards are having more luck than those in the so-called middle ground of early stage.
Responding to this issue, the Department of Trade & Industry in the UK announced a venture capital initiative that it thinks will help fill the equity gap faced by early stage companies in an attempt to bring public private partnerships to venture capital.
Up to £200 million will be made available via Enterprise Capital Funds, designed to be commercial funds, to invest in small high-growth businesses that are seeking up to £2 million of equity finance. Investments will be made on like-for-like basis, with a profit sharing approach.
Also, in order to avoid its equity being squeezed out in later-round financings, one of the estimated four or five ECFs would be able to invest more money if the total investment in that company did not exceed 10% of the total fund size. However Stuart Watson of Ernst & Young believes that the soft credits that development agencies offer entrepreneurs are not really that helpful. “I think the way to do it is to provide some kind of incentive but to leave the entrepreneur managing the risk.” He cited the 20% R&D tax credit in the UK as a good example.
Stuart Paterson of SEP also believes that the drop-off in funding rounds under the £3 million mark can be attributed to another, more positive trend of more money going into earlier rounds.
“The fact is that many early stage companies are raising much more money than previously,” he said. “There may be fewer overall companies raising money, but we are seeing much bigger amounts being raised by those that do. It is a sign that early stage investment is being taken more seriously, with more capital put into businesses with the aim of building serious quality global companies which are well resourced.”
Perhaps more relevant in this context is how to bridge what seems to be an enterprise gap, where budding entrepreneurs would benefit from some guidance from the inception of their ideas to help them attract this level of faith from investors.
Wendy Hart, head of the technology group at Grant Thornton in Oxford, believes that more grassroots support is needed. “It’s time for a reality check. The reality is that for every 100 business plans that are put together, probably no more than three or five are suitable for investment.”
“I think if there was more effective support of how those business plans are articulated that would be helpful,” she said. “There needs to be a greater understanding of what a business proposition actually is.”
“There is a skills set shortage and the state of mind is generally lacking among entrepreneurs,” said Hart. “What I see in the US that we just don’t have in the UK is effectively scientists with a commercial head or serial entrepreneurs moving into VC. There’s much more movement between science and commerce in the US.”
Stuart Paterson agrees, pointing out that early stage VCs need to employ their experience not just to select the companies with best potential but also to support those companies as they grow.
“Early stage businesses need investors that understand the dynamics of growing a business, and who have the experience to help them through difficult situations and can offer them the practical support they need, without breathing down their necks,” said Paterson.
He added: “While it is true that investors have become more selective about the companies they invest in, the same can be said for companies considering which investors they want on board. They want more than money. They want investors who will be an asset as the business grows.”
It is this combination of judgement and support that Paterson believes is the secret to successful investment in early stage businesses. “We know from experience that this approach works and means we have a good flow of companies moving from start-up through to exit across our portfolio. It also means we are in a position to feed later stage opportunities to our co-investors as these businesses mature.”
What is very clear, from all views of the early stage market, is that ensuring a sustained and healthy flow of later stage deals over the next four years or so is going to depend on how well active early stage investors and entrepreneurs work together, generating a renewed sense of confidence in the market.
As Stuart Watson concludes: “In the wider venture capital market, the concentration on later stage funding is becoming a permanent feature, at least for the rest of this year and next. Yet, for the brave, there are some very good early stage opportunities to be had.”
Anthony O’Connor
Scottish Equity Partners (SEP) is one of the largest independent private equity groups in the UK, and is currently investing from a venture capital fund in excess of £100 million, which is backed by leading UK and European institutional investors.
With offices in Glasgow and London, SEP is one of the most active venture capital investors in the UK and has a strong investment track record. Typically, we invest between £500,000 and £5 million or more, in financings of up to £30 million, in early stage and growing companies in the information technology, healthcare & life sciences and energy related technology sectors. For more details visit www.sep.co.uk
Anthony O’Connor is a London-based freelance financial journalist and writer, covering topics ranging from private equity to complex structured finance for leading international publishers.
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