It’s time for government to get professional about investing in innovation

An Imperial College London study, for the Science|Business Innovation Board, looks at how professional investors pick winners – and draws some lessons for government funders

Professor Bart Clarysse, Imperial College London

Investor Driven Innovation
What can we learn from the way professional investors spot 'winners'? Download the full report.

While it lacks the stellar returns of an Apple or Facebook, the European technology sector has had some notable investment success stories, such as Skype, Spotify and Skype, for instance, received an early venture capital investment of $18.8 million and grew to an $8.5 billion buy-out through the participation of many VCs, private equity and corporate investors. There are now more than 100 million Skype users.

So how do you spot a Skype in the making? That’s the job of a professional investor – and a study we conducted for the Science|Business Innovation Board throws some light on how the professionals work. It also holds some lessons for European policy makers, as they try to make the Skypes and Spotifys of Europe the norm, rather than the exception. In a nutshell: If government wants to spend public money wisely on innovation, it should get more professional about it.

Extraordinary financial returns

We interviewed leading venture capitalists and corporate venture capitalists – the professional investors inside big corporations – to analyse how they pick the winners. There are systematic differences between the way private VCs and corporate VCs operate.

However, in general terms, they use similar practices for identifying high-growth opportunities. In terms of the investment criteria, VCs say their primary goal is – surprise, surprise - to get extraordinary financial returns. Among those investment managers interviewed, they focus their evaluation first on the technology of the opportunity, and then on the market and management of the target company. Unlike VCs, Corporate VCs’ primary goal is to invest in opportunities strategically connected to their main activities; among those interviewed, they look first at the strategic fit with their parent corporation, then they evaluate the technology and finally they assess the management team.

From the interviews, we find:

1.    The management team of the portfolio company is – at least among the investors we interviewed - no longer the dominant investment criterion. Other criteria such as a disruptive technology and a growing market have taken the lead.

2.    They look for disruptive technologies and they use pattern-matching methods to identify them.

3.    Most active and well-performing investors are embedded in an experienced community of professionals, which they use for intelligence and support.

4.    VCs and Corporate VCs rarely invest in seed or pre-seed opportunities but rather in early- and later-stage businesses. Investments in seed and pre-seed stages need intensive mentoring and guidance rather than capital. 

5.    Early-stage investors do not have a global perspective, which makes it difficult for them to syndicate with international well-performing investors.

6.    There is a shortage of capital available for VC investors.

Professionalise public investors

Government can learn from these findings, in particular from the distinctions between the private and public investment processes. Currently, public programmes tend to base their funding decisions on an application form, and on heuristics generated within the bureaucracy. However, private and corporate investors screen the market thoroughly before they make a financing decision. They rely on a broad community of experts and choose the ultimate winners based on a pattern-matching process.

These findings illustrate that the screening and investment process of public investors needs to be professionalised. It seems clear that most promising projects cannot be identified based on an application form and on heuristics rather than on pre-seed performance of the entrepreneurs.

Another noteworthy issue for policy makers is the fact that neither VCs nor Corporate VCs spend much time or money on the earliest, seed and pre-seed stages of a company. What these micro-firms need – even more than money, according to the interviewees – is coaching and management support to help them get to the stage of professional investment.

Organise incubation

In order to fulfil this need, our suggestion is that the European Commission could promote and organise incubation activities that provide active and professional guidance to starting entrepreneurs. In that way, the EC could help many start-ups to take the first steps needed to become ready for early-stage investment provided by VCs and Corporate VCs. This would close the funding gap for many seed and pre-seed companies.

Based on the finding that start-ups tend to be limited in their mobility, the EC could play a role in bringing these start-ups into contact with well-performing investors by stimulating international mobility of entrepreneurs and start-ups. This will help to broaden the start-ups’ communities and accelerate their growth.

Finally, this research suggests that the EC could contribute to making funds available for professional investors by creating a central, early-stage actor, and potentially a professionally managed fund. This central actor should look after the needs of venture capitalists, differentiating them from the private-equity investors. The idea would be to assist venture capitalists during the screening and investment process, and to help them connect to well-performing international investors.

Potentially, and only under a professional and experienced management, this organisation could also include a fund that contributes to the high-tech entrepreneurial ecosystem.

The research described here was commissioned by the Science|Business Innovation Board AISBL, a not-for-profit scientific association formed to improve the climate for innovation in Europe. The views expressed are those of the study’s authors, and do not necessarily reflect the views of the Board or its individual members. The Board wishes to thank EU Commissioner Máire Geoghegan-Quinn for her encouragement and comments on this research.

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Related subjects: Innovation Board, Skype, VC, Imperial, venture capitalists