Written evidence from SQW Ltd (ATF 17)

Inquiry question: How has the landscape for access to finance evolved since the end of the financial crisis?

1. Most observers agree that it has become more difficult to access finance since the Global Financial Crisis (GFC). There has been a reduction in the supply of bank lending and of venture capital (VC) for early and growth stage finance. Research for the British Business Bank (BBB)[1] suggests signs of recovery, although European Venture Capital Association (EVCA) data indicate that VC investment has not reached pre-GFC levels[2]. Drawing on our own and other research we identify some of the main developments in the landscape since the GFC, focussing on equity finance. This highlights that whilst some finance gaps have become larger, other sources of finance have grown. Therefore, the overall landscape of funding provision, for early stage businesses in particular, is now more complicated.

SQW observation 1: VC firms have moved to later stage investments, creating a gap, particularly in the early stage market, which is particularly acute for some sectors/technologies and regions outside the Greater South East

2. Structural and cyclical characteristics of the UK early stage equity finance market have resulted in what the BBB refers to as[3]: “a sub-optimal provision of funding to smaller businesses with growth potential. Cyclical patterns exacerbate market failures; a slack economy and poor historical returns lead to a tough environment for raising funds and exiting investments through trade sales or IPOs”.
3. The structural failure relates to informational asymmetry between businesses and investors. The traditional “2 and 20” model prevalent in the VC industry - where a VC fund requires a management fee of 2% per year, plus 20% of the profits - incentivises funds to do fewer and larger deals. Added to this, the costs of due diligence and transacting are disproportionately high for smaller investments, which results in larger deal sizes and larger/less risky firms. The transaction costs are not helped by ‘thin markets’ with small numbers of investors and firms having difficulty in finding each other and contracting at reasonable cost[4]. This is exacerbated by the view that there are not sufficient investable firms particularly in some regions (highlighting a demand-side issue to which we return later). Indeed, the regional imbalance continues to be an issue in relation to equity investment. BVCA data indicate that there have been some encouraging positive movements in the amounts of investment outside the Greater South East. However, we know that some activity is dependent on public money, and the data highlight that London and the South East continue to dominate investments[5].
4. As a result of the factors above, VC firms have tended to move to later stage investments, creating a gap in the seed and early stage market. The “equity gap” particularly exists in the £2m-5m bracket, and for amounts below £2m[6]. Our VC research for BIS (2010)[7], and our experience evaluating seed funding schemes[8], has found that sectors such as life sciences and cleantech, where it can take over 10 years to bring products to market, experience particularly acute and larger equity gaps up to £10m.

SQW observation 2: business angel investment is helping to address some of the equity gap, but they are not always the solution

5. Business angel investment is an important source of equity finance, in particular for early stage enterprises. In the past it has been principally associated with investments below £1m, though in recent years investment values have increased to up to £2m, thereby helping to address some of the gap left by venture capitalists. These larger investments have partly resulted from the development of increasingly organised angel groups and formal syndicate structures, and also due to the ability to co-invest alongside public sector schemes.
6. Business angels may also actively support company development, in particular where they have strong interest in the concept or technology. However, this is not always the case, and there is variety in the characteristics of angel investors (see below under the next observation in relation to the links with crowdfunding). Our own work has also found that the added value of angels through mentoring and advice can be low where the angel market is still developing[9], or that other investors, e.g. publicly-backed VC funds may be more active in honing investment plans, refining propositions for subsequent rounds, and establishing appropriate milestones and realistic valuations[10]. Where the local angel market is developing, it can be enhanced over time through links to experienced investors elsewhere and where exits result in funds being recycled and experience being passed on. Supporting cross-referral protocols between funds and fund managers across the UK may help in this regard.

SQW observation 3: Crowdfunding is providing an alternative source of equity finance for early stage businesses, but there are crossovers with angel investment; it is also too soon to assess whether investors will get good returns from these deals

7. Crowdfunding has become an increasingly important source of funding for entrepreneurial ventures, facilitated by technology that has enabled the development of online platforms. British Business Bank (2016), using Beauhurst data, indicated that the number of crowdfunding deals in early stage ventures has grown significantly, from under 10 publicly-known deals in 2011 to over 140 in 2014, representing more (publicly-known) deals than any other source[11] (though not by value given the relatively lower average deal size, which was around £250k in 2015[12]). However, it should still be considered a nascent source of funding, in particular considering that there has been only one exit so far in the UK, E-Car Club, which provided a 3-4x return for its investors[13]. Only time will tell whether average returns are respectable against benchmarks.
8. There is currently a gap in the evidence on the relationship between crowdfunding and business angel investment. Beauhurst (2015) highlighted that crowdfunding may pose a challenge to angel networks, because of the similarities between the two, with both built on the premise that risks are mitigated and scale economies gained by investing alongside others[14]. Beauhurst also suggested that angels may be investing through crowdfunding rather than through angel networks. However, it may be that the characteristics of angels investing through crowdfunding are different from angels that do not. Indeed, current research that we are undertaking suggests that some angels: i) actively avoid investing through crowdfunding, because they want the personal contact with the businesses they invest in; and ii) are reluctant to invest in firms that have secured earlier finance through crowdfunding. This latter point may imply that sourcing early stage finance through crowdfunding may damage prospects of securing subsequent investment from certain angels, perhaps in particular those with the most appetite to mentor and support company development. These issues would benefit from further research in order to understand the drivers, attitudes and implications.

Inquiry question: What are the main improvements or interventions, in terms of finance, that the Government should make to achieve the objective of increasing the number of successful and high-growth businesses in the private sector?

9. The principal response from government has been on the supply side.  Such supply-side interventions are important in addressing what have been identified by the British Business Bank as structural market failures. Here we do not focus on this supply-side response, on which there is already a great deal of attention. Our view is that there needs to be more attention on developing the demand-side. We highlight some of the key issues underpinning this in our observations below.

SQW observation 4: Investment readiness programmes or expert advice can help to stimulate/improve demand for finance that can help companies in start-up and scale-up phases

10. The market will not function effectively and the potential impact of government supply-side policies will be limited if there are not enough quality propositions. Whilst awareness of different sources of finance, such as venture capital and crowdfunding, has increased in recent years, knowledge of specific providers who could be approached, and actual take-up is limited – indeed only 1% of SMEs have sought equity finance in the last three years, and this has not changed since 2012[15]. In terms of improving the number and quality of propositions, specific investment readiness programmes (IRPs) or similar advice may have a key role. Mason and Kwok (2010)[16] identified three aspects in relation to equity finance, and these have broader relevance to other sources of finance:

• “Equity aversion” - owners of growing/growth potential firms not being able to realise full growth potential because they do not want to relinquish control. IRPs can provide information about equity and discuss with businesses issues around control/ownership.
• “Investability” - a high proportion of applications to VC and business angel funds are rejected because the business is not a good “fit” for the investor, or because they do not believe the business would offer strong returns. IRPs can help businesses to understand better the expectations of investors.
• “Presentational failings” - many small businesses lack the knowledge or experience of making an investment proposition, and therefore do not effectively promote themselves. Expert advice can assist through developing business plans, propositions and pitches.

11. Similarly, our own research in Northern Ireland has found that there are insufficient skills and knowledge among those seeking finance on the role and value of equity, with a need to develop the quality of investment propositions to attract more investors, but also on wider business development topics such as management, leadership and marketing[17]. In addition, our research has highlighted that entrepreneurs want a more coherent and less fragmented landscape in the provision of information on where they can access equity[18].
12. The BBB’s Business Finance Guide should help to improve awareness and knowledge of different types of finance, though this needs to be complemented with on-the-ground referrals and advice. The roles of advisors and intermediaries (e.g. coaches, accountants, financial advisors etc.) are important in facilitating this process, and could be supplemented by capacity development for business advisors to raise levels of understanding of the role of equity finance, and support to develop links to specialist finance advisors and investors. As has been shown, specialist advice on accessing finance can help. Those receiving finance advice of the now-closed GrowthAccelerator/Business Growth Service had attracted over £100m of investment, of which over one-third was from venture capital, business angels, government-backed funds and crowdfunding[19]. Whilst the service is closed, specialist advice is available from alternative sources, including private sector providers.
13. There is a link between investment readiness and stimulating demand for finance and wider business growth ambition. Whilst the UK performs well on start rates compared to international comparators, it performs relatively poorly on the proportion of starts reaching 10 employees after three years.  There are a range of business development issues here, as found in our work in Northern Ireland, and accessing finance is one of these, but there are also important links to cultural aspects around ambition and mindset. More research and testing on these issues and their inter-relationships (including the role of demand for finance and investment readiness) is required.

SQW observation 5: there is a need to create the right environment/ecosystem for entrepreneurs wanting to start and grow companies

14. The current landscape encourages innovation in the UK, including through Innovate UK support, Catapults, University Enterprise Zones and accelerators (both public and private). This allows the testing and development of new ideas by start-ups and small firms, which may seek finance and/or require support on the appropriate finance options, in addition to other assistance. If the demand-side is to operate more effectively, with more and higher quality propositions to investors, then the join-up in the landscape, including to private sector sources of advice, is a key area for improvement. This was noted, for instance, in our evaluation of Smart, with aftercare identified as a step in the process where improvement could be made[20].
15. International practice on developing the environment for finance is instructive. Our research for the Department for Enterprise, Trade and Investment in Northern Ireland reviewed six ‘peripheral’ areas, either in global/continental terms (Estonia, Finland, Republic of Ireland, New Zealand) or in terms of their national economy (North East England, Nova Scotia in Canada). From our review seven key themes emerged, because they had or may have relevance for Northern Ireland, and these are presented below. They provide lessons for creating an enabling environment, and all are particularly relevant for regional economies in the UK (especially those weaker markets outside of the Greater South East). Points 2, 3 and 5 also have relevance for UK policy as a whole, given the needs to establish a stronger demand side and to ensure programmes have appropriate spatial footprints.
1. An international mind- and action-set: Whilst early stage investments favour geographical proximity, it is less important for later stage deals. Comparators countries/regions are developing pipelines to investors elsewhere, e.g. New Zealand has adopted an ‘external facing’ approach in developing its early stage and growth finance market, including establishing a joint fund with Taiwan, and importing expertise and knowledge from Israel and the USA to help develop the market in venture capital and angel investment.
2. Focused demand-side stimulation: New initiatives to increase the supply of venture capital must be accompanied by interventions to increase the demand for risk capital. Interventions in Finland have been adopted to improve entrepreneurial capabilities including competence building of start-ups through an investment readiness programme, the introduction of tax incentives for business angels’ investments, and the merger of three universities into Aalto University, as an explicitly innovation-focused institution, and a catalyst centre for an entrepreneurial culture.
3. Funding models at an appropriate spatial level: Scale is a major issue for smaller economies, and some have sought to address this with funds that operate at a scale wider than their own country or region. For example, the Baltic Innovation Fund is a fund of funds initiative across Estonia, Latvia and Lithuania, and Nova Scotia has collaborated with three other provinces in the Atlantic region.
4. Exit-centric approaches to market development: Estonia, Nova Scotia and New Zealand emphasise the impact that ‘blockbuster’ exits can have on the local market. Exits create new investment through re-cycling of funds, and indirectly provide a signalling effect to others both internally and externally (e.g. entrepreneurs and non-local investors).
5. A functioning finance pipeline: Our research identified focus in the £500k-£3m range, where the equity gap was most acute. However, funding is a pipeline, and gaps earlier in the escalator can have knock-on effects. As a result, flexibility is often required to ensure sufficient funding at the seed stage as well in order to generate sufficient flow through. At seed stage this may include other types of funding such as loans and grants.
6. Effective business angel networks: A strong angel community is important as it can facilitate information flows between entrepreneurs and investors, and groups of angels can also make larger investments. Strong networks were identified in New Zealand and Nova Scotia, and weaker ones in the North East of England and Ireland. The value of angels can also be in the mentoring and advice they provide to entrepreneurs, and even where the angel community was identified as being strong (in Nova Scotia), the added value in terms of expertise was considered to be low, and so a barrier.
7. Dedicated institutions and agencies playing policy and advocacy roles: Where the market was identified as being less mature, e.g. in New Zealand, North East England and Nova Scotia, dedicated venture capital and access to finance agencies have been important, playing wider policy and advocacy roles in addition to the management and distribution of finance. In the North East of England, for example, North East Access to Finance has been the ‘policy’ lead and North East Finance the ‘delivery’ lead.

Source: SQW (2015) The Future of Early Stage and Growth Finance in Northern Ireland, Synthesis Report to the Department for Enterprise, Trade and Investment. See https://www.detini.gov.uk/publications/future-early-stage-and-growth-finance-northern-ireland

About SQW

SQW is a leading independent provider of research, analysis and advice in economic and social development. We undertake research and consultancy for the public, private and voluntary sectors in the UK and internationally. Our areas of expertise include innovation, and this broad area covers the processes of business formation and growth, and how enterprise and the application of knowledge can be leveraged by places, businesses, sectors and clusters. More information can be found at www.sqw.co.uk.

9 February 2016