30 Sep 2008   |   News

The credit crunch: start-ups can’t get bank loans, but can VCs and angels help?

Who’s going to rescue the lab that’s come up with a smart, commercially viable invention, or a start-up looking for second stage financing?

It’s not a great time to be looking for finance, whether you are a start-up or a bank. The latter may get baled out by the tax payer but who’s going to rescue the lab that's come up with a smart, commercially viable invention, or an start-up looking for second stage financing?

If you figured that business angels will live up to their name think again. Venture capitalists? If you can find them. Governments? Well, yes, but not in the way that really counts – with cash.

“I woke up that morning, looked at the market and knew the IPO was sunk.”

Science|Business spoke to prominent VCs and business angels to gauge their mood and it’s clear the picture isn't black and white. As far as the public sector is concerned, ministers from around Europe agreed last week at a meeting in Brussels that SMEs need short term help to weather the storm but made no promises.

“While the markets oscillate and the banks are on their knees investors aren’t in a mindset to invest. What's happening out there can’t be good for any entrepreneurs,”’ said Anthony Clarke, chairman of the European Business Angels Network and managing director of GLE Group, an investment vehicle focused on the Greater London region.

His advice to scientists ready to take their ideas to market is as follows, “Look carefully at your cost base, try to cover your short term cash needs and be realistic when it comes to evaluating your business proposition.”

Investors spoilt for choice

According to Clarke valuations are down by around 30 per cent compared with a year ago. If you happen to be an investor who has liquidated your positions in the past few months, you’ll be spoilt for choice, especially as it is much harder for entrepreneurs to get loans from banks.

“The competition among start-ups for the attention of business angels is ferocious now," said Clarke.

George Noel, a director of the European Venture Capital Association (EVCA), agrees valuations are down but said it varies widely from sector to sector. “ICT [information and communication technology] and natural science valuations have been squeezed much more than, say, proposals in the area of cleantech,” he said.

“There is still a very bullish environment in cleantech. Valuations there may be down around 10 per cent, compared with 30 per cent in other areas,” he said.

While the venture capital end of the private equity market isn’t leveraged in the way the large buyout investors are, it is being indirectly harmed by the turmoil on the stock markets, mainly because of pension funds, Noel explained.

As stock valuations tumble these massive funds suddenly find themselves over allocated in private equity, and they could be forced to sell positions in VC funds in order to restore the balance of risk in their portfolios, he said.

“Pension funds are traditionally rather prudent investors, so they don’t want relatively high risk investments such as private equity, and especially VC funds, to take up more than a fixed proportion of their portfolio,” Noel said.

The IPO desert

Another indirect impact on both VCs and business angels from the crisis in the markets is the drying up of the IPO market.

“You are looking at longer lock-in times for your money now,” Clarke said, using a farming analogy to make his point.

“Imagine if you are a pig farmer; you've been feeding your pigs to get them ready to take to market, but then you can't sell them at market, so what do you do – keep feeding them?”

“Early stage investment typically requires a lock-in of four to five years before the investment either attempts an IPO or looks for a trade sale (an acquisition by another company). But now you can’t get shot of them, which means your cash is tied up and can't be used to fund another deal,” said Clarke.

A typical holding period for a VC is six to seven years, Noel said. With exit prospects severely weakened, it's no surprise that VC funds are much more wary of getting involved in the first place.

“VC funds will continue to invest but they will be much more prudent in the current environment,” he said.

A place for optimism?

There is some cause for optimism, however. Recent downturns such as the one that followed the bursting of the dotcom bubble in 2000 saw some spectacular successes that came about thanks to angels and VC funds.

“Skype, the internet telephony company, benefited from angel money in the wake of the dotcom crash. Google too,” said Clarke.

Noel had money tied up in a Belgian investment that was scheduled to go to IPO on Black Monday in 1987, when markets plunged around 17 per cent – far more in percentage terms than the falls seen in the past two weeks.

“I woke up that morning, looked at the market and knew the IPO was sunk,” he said. But the story had a happy ending. The IPO was cancelled and replaced by a private placement from a pension fund.

Another ray of hope for European entrepreneurs is that after being neglected by investors in other parts of the world, they are now arousing more interest.

The EVCA has, over the past couple of years, been effectively doing a selling job for European start-ups and SMEs in countries including Japan, Australia, the US.

“We are seeing clear results. European VC's are again on the agenda for investors further afield, after six or seven years lack of interest,” Noel said. The EVCA isn’t promoting individual companies but the VC industry as a whole, and the EVCA members' 700 VC funds in particular.

“These investors are now coming back to Europe,” Noel said.

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