VCM0013

Written evidence submitted by Nelson Gray

Nelson Gray – Background.

I have been an Angel investor for more than 25 years, am a member of Angel investment groups in Scotland and the USA, and have personally invested more than 55 companies. Of these 23 are live (two are less than 2 months old) and 12 have managed positive exits, from 1x to 92x.

As a regulated fund manager [No: NXG01075] I have been responsible for investments into a further 50 early-stage companies.

I previously managed, and remain a member of, the Scottish Angel group Archangel, one of the world’s oldest angel groups, founded in 1992, and was a Trustee of the Angel Resource Institute (ARI). The ARI is a USA based charitable organization devoted to providing education and information on best practices in the field of angel investing.

I am presently a Senior Risk Finance Expert with the Word Bank, specialising in the development of early-stage angel and VC finance in emerging markets. Most recently developing a strategy for the development of a VC industry in Georgia. Working with the likes of the UK national and each of the devolved governments, the European Commission, GIZ and numerous other government agencies I have provided advice to government and training and mentoring to entrepreneurs and Angel investors in many counties across Europe and further afield, including the USA, South America, India, Australia, Kazakhstan, Georgia and New Zealand. I have helped to build Angel groups in Scotland, Latvia, Jordan, Russia, Egypt, Georgia, RUK and the Caribbean.

In 2017 I designed the professional BA curriculum on behalf of the €2.5m European Union Directorgeneral for Research & Innovation Early Stage Investing Launchpad (ESIL) project, seeking to increase angel investment capacity across Europe.

I have recently completed a contact on behalf of Enterprise Ireland, Invest Northern Ireland and Intertrade Ireland to assess the operation and future options for HBAN, the all-island umbrella group responsible for the development of business angel networks and syndicates across the island of Ireland.

I am presently on the investment committee of the UK Government’s $130m Angel CoFund.

I was the European Angel of the Year in 2008, am a previous vice president of EBAN, the European Business Angel Trade Association and received the Queens Award for Enterprise Promotion in 2015.

Contributions to published material include:

•       Assessment of opportunities for government backed early-stage VC funds in Georgia, World Bank 2022.

•       The instruction manual “Early Stage Investors Cultivation Manual”, focused on Business Angel Investment Development in an emerging market, World Bank, 2020.

•       “Manufacturing a Start-up: case study of Industry 4.0 development in the Czech Republic”, World Bank 2019.

•       “Angel Investing Diagnostic Toolkit”, analytical tools assess the potential for early stage investing activities in emerging markets. For World Bank, 2019.

•       Report on Co-Investment Funds a framework “tool-kit” for designing and implementing (public/donor funded) co-investment funds. For World Bank 2019.

•       The Angel Group Development Canvas (an adaptation of the Business Canvas), for World Bank 2019.

•       Guidance Document on Developing Angel Investing in Emerging Markets: for World Bank 2019.

•       “Stimulating Business Angels in the Czech Republic”, World Bank Group, 2018.

•       Responsible for development of the curriculum for "The Professional Business Angel", the pan-European standard for training Business Angels under the €2.5m EU ESIL project (2017).   This codified standard formed the foundation of training delivered by the program partners Business Angels Europe (BAE), Go Beyond, European Business and Innovation Centre, European Crowdfunding Network, Bpifrance Financement SA and LINC. It is available here: https://www.dropbox.com/s/n8uq7o98x5pry6n/ESIL%20Training%20Report%20.pdf?dl=0

•       “Angels without Borders, Trends and Policies Shaping Angel Investing Worldwide”, World Scientific, 2015.

•       “Creating Angel Investor Groups: International Edition”, International Bank for Reconstruction and Development / World Bank, April 2014.

•       “Financing New Ventures, An Entrepreneur’s Guide to Business Angel Investment”, Geoffrey Gregson, Babson College Entrepreneurship Research Conference Collection, 2014.

The current state of the venture capital industry in the United Kingdom, including opportunities and threats, such as the availability of domestic capital to allow firms to scale up in the UK.

The UK VC industry has been particularly strong in resent years. International comparisons show the UK to be the clear leader in Europe[1]. UK tech VC investment is third in the world, hitting a record high of $15bn in 2020[2].

The UK has the highest level of venture fund (VC) investing in Europe, by some margin. In 2019, prior to COVID, the UK recorded 1,425 VC deals totalling $14.31 billion, representing 40% of all European VC funding in 2019. The UK total is higher than the combined totals for the next four largest countries, Germany, France, Sweden and Spain[3]. The UKs dominance continued in 2020.  The UK raised 45% of new European VC funds in 2020[4]. It is estimated that there are 327 active VC funds in the UK focused on scale up companies[5].

Globally the VC industry is facing a significant “reset”. This is in part a result of global economic condition, but also reflects a likely return to reality regarding valuations which have seen unrealistic growth as a result of the large amounts of new funding being made available to large VC’s[6].  This however is largely part of the normal economic cycle, and investors and firms are taking appropriate measures to protect themselves[7]. The issues are not structural, and will pass.

There are a number of issues in the UK that, if addressed, would improve market operation:

• Withing policy making, there appears to be confusion regarding the role of VC.
• VC objectives are to provide a financial return to investors. Economic growth may be a by product of this, but it is not its prime objective.
• The reality of VC returns is that the vast majority of firms do not scale. The 51% majority of firms successfully backed by VC “exit” for a value of £30m or less. 22% for less than £10m[8]. This is not some reflection on a lack of ambition among UK entrepreneurs. The numbers are effectively the same in the USA[9]. It reflects that most companies exit via a trade sale to a larger company, and those acquirers set the price based on the perceived added value of the acquisition.
• In truth, you don’t need much funding to grow value to £50m. Inded to get the required returns to offset risk (see below) you can’t put more tan £5m into a company if the exit expectation is the average of £50m. Cash is not the issue – the issue is managerial and engineering talent to enable the companies to develop products that are actually world beating.
• There is a lack of understanding of what VC is[10]: Not all "VC" is the same, and not all is relevant to supporting growth companies. the early stage. The term “private equity” is used as a general catch all description for all forms and stages of funding provided to enterprises not quoted on a stock market (including venture capital, growth capital, replacement capital, rescue/ turnaround and buyouts). The term Private Equity is also, confusingly, used to reference later stage investing (post venture capital). “PE” funds tend to be focused of the acquisition of entire business. These ‘buyout funds” account for by far the largest amount of capital in the industry. Policy makers need to ensure that they are focusing on the level of the market, early stage, that is likely to have greatest impact economically.
• While overall private equity levels have grown substantially in resent years, the critical early-stage funders, Early sage VC, Angels and seed, have declined[11]. More is needed to stimulate these sectors, and policy makers need to have an increased level of advice from experts within those sectors, as opposed to those running large PE funds.
• There are examples from the UK regions of policy that has resulted in significant increased levels of early-stage investing. These should be reviewed for useful lessons to be deployed nationally[12].
• Most High Growth Companies do not get funding from VC’s: Current estimates show that business angels are the most significant source of risk capital for new and young entrepreneurial businesses in most environments[13]. Business angel contribution to the early stages are greater than that of formal venture capital, despite that the majority of scholarly attention has been given to the venture capital industry. Invest Europe (formally known as European Private Equity & Venture Capital Association, EVCA) reported that of the total private equity (PE) investing (€71.7bn) in Europe[14] in 2017, only €600,000 “seed” investments were made by VCs across Europe (spanning 1,081 investments)[15].

This pales in comparison to the €6.6bn of investment estimated to have been provided to 38,230 companies by European business angels[16].

In the United Sates, possibly the most developed venture capital in the world, there were 5,268 VC deals valued at $74.2 billion in 2017, with only $2.5bn of venture funding into 1,524 companies being classified as “seed or early stage”[17]. In the same period however, there were 61,560 angel deals, valued at $23.9bn[18].

This suggests that to support high growth companies, public policy should focus on promoting and developing angel investment. VC investment will follow into those opportunities developed by angel investors. Having angel funding also seems to matter significantly for the ability of a firm to obtain follow-on financing from VC funds[19], [20], in part due to its role in ‘accrediting’ unknown start-ups (start-ups without investment history) and helping start-ups become investor-ready[21].

• The realities of risk/ return are not appreciated.
• A number of studies have shown that even in the USA, the most developed capital market globally, 65% of VC deals return less than the capital that was invested in them[22]. For the VC fund, and the investors in the fund, that’s 65% of investments result in a loss. This means that the other 35% have to repay all the capital lost on the 65%, all the fund fees and costs, and provide the total expected profit to the fund investors.
• In simple terms, the 35% who manage to return a profit, must return an average of 350% (3.5x each) just to give the fund investors their initial investment back (a 1x return). To achieve the typical target rate of return (say 25% IRR) the profitable investment would each need to return 6x the investment over an average 8 years[23]. In the USA, of all investments made, only around 7% manged to achieve that number.
• It may be thought that the poor return rate is due to a few bad funds who invested poorly. The data suggest the opposite. The best performing fund managers actually have a higher number of individual fails[24]. They achieve profits by focusing on the 5% of their investments that provide 90% of the profits. The top quartile firms in the USA have been shown to be capable of achieving returns of up to 30% IRR[25].
• The returns for second quartile firms however drop to 13%, and the other 50% of funds on average struggle even to return capital.
• 66% of UK early stage EIS funds had an IRR below zero[26]. 26% manged 0% to 5%.
• In the lower quartiles, there is a significant churn of Fund Management firms who shut down as their poor performance inhibits their ability to secure new LP’s for new funds.
• Noting that these firms are operating in the most developed capital market in the world, it is appropriate to adjust return expectations in relation to funds operating in emerging markets.
• High performing funds tend to be larger funds, whose size and reputation give them access to the most promising deal flow, and most experienced fund managers.
• Small funds (less than US$100m) are disadvantaged in regards to all aspects of risk mitigation.

The reality of risk return means that investing in VC funds is itself a specialised activity, and such investing is not suitable for the vast majority of consumer investors, or those in need of safe return levels, such as pension funds.

• VC funding is of little interest to, or appropriate for, the majority of business.
• The British Business Bank 2019[27] survey (pre-covid) shows that 58% of SMEs are currently using some form of external finance.
• Of these 62% use some form of loan funding and 3% equity funding.
• Just 4% of companies achieve 20% growth, the minimum level typically needed to attract VC funding, in two consecutive years[28].
• Many companies who may be suitable for VC funding say they don’t want it. While 69% of SMEs stated they were aware of VC as a potential source of funding, 75% of those said they would not use it[29]. This was due to a combination of reasons, including a reluctance to give up any control of the business. In effect, these business owners do not wish to have to dive the exit necessary to provide the VC with a return.

It would be appropriate to look at alternative forms of structured lending, as opposed to traditional VC, as a tool to drive economic growth. In particular many firms would benefit from the availability of Revenue Based finance, a form of quasi loan that does not impact the firms balance sheet, and repaid not from selling the business, but from turnover growth[30].  These structures are increasing popular in the USA. Unfortunately, the UK tax system discourages them in favour of equity structures. This is a substantial lost opportunity to help proved growth finance to many thousands of businesses.

The level of co-operation/integration between start-ups and established industry

No comments.

The operation and effectiveness of the current tax incentives (such as the Enterprise Investment Scheme (EIS), the Seed Enterprise Investment Scheme (SEIS) and Venture Capital Trusts (VCTs)) in the venture capital market, including any options for change.

These schemes generally operate well. A 2017 European study identified 4 of the top 5 tax incentive schemes across 36 countries as being in the UK[31].  Given the realities of risk return, it would not be appropriate to encourage additional early stage investing by consumers through the provision of additional tax incentives[32].

The operation and effectiveness of the regulatory regime(s) concerning venture capital.

The operation of the regulatory regime, in particular the operations of the FCA are overly complex, arduous and slow. Opportunities are being missed in the UK for the operation, for examplele, of Angel group side car funds. These are popular in the USA, enabling more smaller investors to invest alongside experience angel groups, and enable angel groups to make faster decisions, and complete funding round at a speed more conducive to startup needs. The cost and excessive requirements of the present FCA regulations make them impractical in the UK.

The role of other key bodies, such as the British Business Bank and the programmes which it oversees (including the Future Fund and British Patient Capital), and the Advanced Research and Invention Agency, and how they can support the venture capital market.

The British Business Bank is providing direct funding to companies. Research is required to ascertain if this is truly additional funding, or if it is displacing potential private investment.

British Business Investments operate the Regional Angels Programme, to help reduce regional imbalances in access for smaller businesses3 to early-stage equity finance. The Programme aims to increase the availability, supply and awareness of early stage, angel equity investments across the UK[33]. However, applicants must be regulated fund managers, and must demonstrate a track record of investment over past years. These requirements limit the scope of who can benefit from the scheme to existing, established professional fund managers.  Typical angel networks are excluded as few have formal FCA registration. This severely limits the ability of the program to generate and support truly new market entrants. This is contract to Co Investment funds established by Scottish Enterprise[34] and New Zealand Ministry of Business Innovation & Employment[35], both of which resulted in a significant growth of new early-stage investors.

The merits of policy proposals for strengthening the venture capital industry in the United Kingdom, such as:

• Opening new pools of capital for venture capital investment, such as pension funds, retail products (e.g. investment through ISAs)

As noted above, the realities of VC investment returns are largely unappreciated. Such investments are not appropriate for pension funds or the majority of retail investors. Early-stage investments into angel deals (EIS / SEIS) and VCT’s already provide significant tax incentivisation. These would be lost if the investments were to be made through an ISA.

Reported investment returns by VC is generally overstated as it includes unrealised capital gains, resulting from upward revaluations following from additional rounds of funding into existing portfolio companies. The majority of these will eventually be written off. Equity investing is not a place for those with small amounts to invest , and no experience.

One UK equity crowdfunding site promotes itself on the back of 11 companies for which some of their investors have received returns[36]. The majority of these are in the range of 180% to 300%. These numbers look impressive and encouraging to the inexperienced investor. However, a 300% return on an individual investment will not provide an overall return at a portfolio level likely to have a 70% write off rate. Of the 960 companies funded through the site, just 58, 6%, have delivered any financial return (not necessarily a profit, just some cash back). With their typical investor making just 2.4 investments the likelihood of them happening to select a ‘winner’ is small.

In addition to the overall risk level, few investors have a realistic understanding of the level of illiquidity involved in this sector. Once invested, the funds will not be available to meet other needs, foreseen or otherwise, for many years. With virtually no secondary market[37], it typically takes 8 or more years for those few companies that are ultimately successful to achieve a profitable exit[38].

The financial thresholds for high net worth individuals should be increased. The High Net Worth qualifying annual income figure of £100,000 and the wealth threshold of £250,000 have remained unchained since inception in 2005. These numbers are lower than international comparisons for income. They are substantially lower in relation to capital.

The impact on not increasing the thresholds over time is illustrated by the USA experience. The USA figures have largely remained unchanged since introduction in 1982[39]. The thresholds were reviewed in 2020 by the Securities and Exchange Commission (SEC), who decided to make no changes[40]. The primary reason for not increasing the thresholds would appear to be concern over the resulting negative impact upon the amount of funding available to early-stage companies, resulting from the thresholds not being adjusted for close to 40 years.

If the USA financial thresholds were adjusted for inflation since 1983 annual income would need to be $538,000 and net worth $2.7 million. By not adjusting for inflation the SEC estimate that the number of U.S. households that qualify as Accredited Investors has grown from 2% of the population of U.S. households in 1983 to 13% in 2019. As one respondent to the SEC consultation commented “there may indeed now [be] hundreds of thousands of investors who have become qualified as Accredited Investor solely on the virtue of inflation of their asset prices but who otherwise lack necessary financial sophistication to carefully weigh the risks associated in investing in exempt offerings”.

In practice, even the proposed increased welth levels are unlikely to provide sufficient real protection in themselves. “Best practice” suggests that because an investor is likely to lose their entire investment in any single start-up company, they should spread their money across at least ten different companies. It turns out that while the typical angel investor is not apparently following perceived best practice[41], even to do so, and have a portfolio of 10, is not sufficient[42]. Real diversification however takes 15-25 companies[43].

So, presuming you can join a syndicated deal for as little as £5,000 (which is low), £75,000 would give you 15 investments, the minimum for effective diversification. But, one needs to reserve up at least 4x the initial stake for follow on investments, to maintain a valuable holding in those that are successful (some companies will get no follow on, some more than 4 rounds)[44]. So, a capital requirement, over say 7 years, of £300,000. If you follow the advice to not invest more than 10% of your wealth in this asset class, that suggests a wealth of at least £3m.

Generating home-grown talent through the education system

No comment

Attracting international talent through the visa system

No comment

Any other possible Government or public sector intervention

No comment

The effectiveness of any other government or public sector intervention in the venture capital industry.

No Comment

The effectiveness of government policy around venture capital in meeting wider government objectives (for example: around “levelling-up” and tackling regional inequality, the aim for the UK to be a science and technology “superpower”, net zero).

As noted above, in the USA, the most developed capital market globally, 65% of VC deals return less than the capital that was invested in them. The majority of successful VC investment outcomes are relatively small, at around £50m of value based on published outcomes (and a more realistic estimate of half that based on likely non published outcomes).

It is likely that those looking to use VC investment to drive other government objectives, such as “levelling-up” and tackling regional inequality, and net zero will be disappointed. VC is not that good at piking and growing winners.

There are continuing calls for more funding to meet increased demand. There is however no evidence that this demand is “credible” – that those seeking the funding are actually worthy of receiving it. With vast pools of funding available, we already see a 65% fail rate of companies that have been fully assessed, funded and supported. There is no evidence to suggest that tis will be improved by providing more funding to more companies. Indeed, the opposite is likely. More companies will fail as the exiting talent base is more thinly spread.

Annex 1: Venture Capital Definitions

Not all "VC" is the same, and not all is relevant to the early stage. Although the term “private equity” is used as a general catch all description for forms and stages of funding provided to enterprises not quoted on a stock market (including venture capital, growth capital, replacement capital, rescue/ turnaround and buyouts), the term is also, confusingly, used to reference later stage investing (post venture capital).

Source: Invest Europe.

June 2022

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