Chances and Risks for Venture Capital and Private Equity in Europe

Table of Content

1. Risk Capital and R&D

2. Financing SMEs and Entrepreneurs

3. Challenges facing the European Risk Capital Industry

4. Conclusion

5. References

Appendix: Recent Development of the Venture Capital and Private Equity Industry in Europe

Abstract

The specific aim of this paper is to offer suggestions and guidance on improving the effectiveness between the private and public sector to boost risk capital investment in R&D activities, presenting a series of recommendations in the chapter “Challenges facing the European Risk Capital Industry”, based on the latest report of policy makers in the EU (report of the European Commission) in 2003.

The immediate background of the report was the dramatic change in the economic environment for private providers of risk capital, combined with rising concern for insufficient public risk capital measures in the European Union.

This paper starts with the description of the important link between Risk Capital and R&D, followed by the analysis how private and public risk capital investments affect the business activity of SMEs and Entrepreneurs in Europe.

After reviewing the important use of private risk capital instruments, the author summarizes major findings and explains which lessons have been learnt from the past to tackle the current risk capital funding gaps.

1. Risk Capital and R&D

Risk Capital is an indispensable “public” and “private” financing instrument in order to support activities and investments for innovation and value creation in an economy. Although R&D spending accounts in most European countries for less than 3% of total economic activity^[1], it is an elementary driver of new processes, jobs and products. Innovations from R&D research do improve the economic welfare of a country many times greater than their initial investment. Risk Capital provided to entrepreneurs in the first phase of their business life cycle is associated with “pre-seed” or “early seed” activities, generally supported by incubators. Incubators (“Impulse Zentren”) help improving the management knowledge, techniques and skills of entrepreneurs and SMEs via Competence Centers and represent the first channel of micro-finance initiative for start-ups and growth. Still, the conditions facing potential entrepreneurs in Austria and the European Union are continually being debated, as is the question of whether politicians could and should do more to stimulate firm creation.^[2]

Looking at the current figures presented by the European Commission, the EU is lagging behind both the USA and Japan in terms of expenditure on R&D as a proportion of GDP, primarily due to slow relative growth in business R&D expenditure.

In 2002 the European Council in Barcelona set an overall EU R&D investment target of 3% of GDP by the year 2010, with about two thirds of this figure expected to be contributed by the private sector.^[3] To approach this level, however, dramatic improvements between the public and private sector are needed to stimulate R&D, innovation and further economic value creation.

One way to progress towards this goal is by tackling directly the legal framework in which Incubator, Venture Capital and Private Equity Industry operate, lowering entry and exit barriers, for instance. Secondly, fiscal measures can have, with some time lag, positive effects on the short- and mid term avaibility of risk capital for Seed and Start-up Capital Finance. Thirdly, mechanisms could be found to facilitate loan and equity guarantee instruments from the public sector for Entrepreneurs to stimulate private sector R&D. But hasn’t this been already discussed for quite some time? The simple answer to this question is: yes. But actually the contrary is happening.^[4]

The amount of additional R&D investments that should be stimulated in the European Union by beginning of 2003 was guessed at around €2-5 billion, deriving from a total of new investment of €6-15bn. The contribution to closing the R&D gap of approximately €100 billion per year might therefore take more than a decade.^[5]

2. Financing SMEs and Entrepreneurs

Private Risk Capital is generally given to research intensive SMEs or to Entrepreneurs, both looking to develop their innovation with solid R&D investment levels over a 2-7 years period of time.

1. Pre-/Early- Seed Capital Finance is provided to Entrepreneurs at the very earliest stage in order to give them the possibility to research, assess and develop an initial concept.
2. Start-Up Capital Finance is provided to a company for product development, initial marketing and the commencement of commercial sales

Table 1: The classical ways to finance Entrepreneurs by Incubators

SMEs as a group contribute a relatively small proportion of business R&D spending in the EU as whole, and in the USA (under 20 percent). Overall R&D intensities can be substantially higher among technology based SMEs than among technology-driven large firms. More important, though not well understood, are the leverage and perhaps catalytic effects of SME innovation activity within the whole innovation process. A key function of risk capital, besides relieving specific innovation bottlenecks, may be to enable the establishment of new SMEs that are permanently more R&D intensive in their business culture than the bulk of SMEs, even than the class of

leading technology users. Some of these SMEs will grow to be large enterprises while maintaining high R&D intensity. Small technology-based firms are also important in the competitiveness of large firms that adopt a “buy” rather than a build “strategy”.

3. (Other) Early-Stage Capital Finance is given to an existing company with some revenues but in need of greater investment for e.g. manufacturing and sales development. Expansion Capital Finance for the expansion of an established, usually profitable, company Management Buy-Out (MBO) Finance provided to enable an existing management team to buy a company, or division of a company from its present owners. Usually

profitable, well-established businesses. Management Buy-In (MBI) As with an MBO but with new management brought in, often to turn a company around. Mezzanine Finance used, mainly in larger deals in profitable companies, which combines a small amount of equity with loans secured, where possible, on the company’s assets. Often used as expansion capital. Venture Capital Provision of equity for generally young, unquoted companies with high growth potential and high commercial uncertainty – ranges from seed to late-stage investment with key feature being “hands-on” involvement by the finance provider. Describes the higher risk element of the Private Risk Capital industry, normally excluding MBO/MBIs and Mezzanine. The main purpose of the investment is to generate growth, and it is this growth that eventually allows successful companies to reinvest in future R&D activities. Large national and international corporations are unlikely to need Private Risk Capital for funding R&D, as they have retained earnings and access to public equity markets. Indeed, through direct investment in promising, R&D intensive SMEs and indirect corporate venturing (investing in venture capital funds), many large corporations are supplying funds to the private risk capital market. The main users of Risk Capital for R&D are therefore young, innovation-oriented SMEs with high growth potential subject to internal financing constraints. These represent only a tiny proportion of the general population of SMEs, and only a very small percentage even of technology-oriented SMEs. To meet the requirements of risk capital investors, such SMEs need to demonstrate strong potential for rapid growth and the capacities and capabilities necessary to achieve and sustain that growth. The type of risk capital used by these companies is best

described under the heading “venture capital”.

[...]

^[1] The Barcelona European Council in March 2002 set a target for R&D spending in the European Union of 3% of GDP by 2010, two third of this to come from the private sector.

^[2] Keuschnigg, Ch.; Nielsen, S.B. (2003): “Taxation and Venture Capital Backed Entrepreneurship",

Keynote Lecture at the 59th IIPF Conference in Prague, August 25-28, 2003, p.1 (available online: www.cepr.org/pubs/dps/DP4097.asp)

^[3] European Commission (2003): “Raising EU R&D Intensity - Improving the Effectiveness of Public Support Mechanisms for Private Sector Research and Development”, Report to the European Commission by an Independent Expert Group, European Commission Directorate-General for Research Information and Communication Unit, Brussels, page X.

^[4] i.e. The new Basel Capital Accord, currently being negotiated, proposes risk weightings for banks allocating capital for these investments of 150%, or even 200% for start-up investments, against the current requirement of 100%. Such a change is likely to dramatically reduce the allocations that banks can make to risk capital investment, exacerbating the current problems faced by the industry and endangering its future development.

^[5] European Commission (2003): page xi.