The Entrepreneur and the Taxpayer

Nesta’s Jonathan Kestenbaum: “The worst thing for early-stage entrepreneurs is for public finance to be a source of philanthropy, rather than of development capital.”

While the retreat of venture capitalists was first sounded in the dotcom and genomics busts of 2001–2002, the new data show they were not attracted back in rosier times. Indeed, the position seems to be getting worse in that the size of individual venture capital investments fell from a peak of £1.9 million per deal in 2006, to £ 865,000 per deal in 2007.

All of which points to an extremely volatile seed and early stage investment market, in which entrepreneurs are increasingly reliant on public sources of capital to get their ideas to market, according to a report to be published next week by Nesta, the UK National Endowment for Science, Technology and the Arts.

Faced with a dearth of deep-pocketed VCs, the majority of deals are being stitched together as co-investments between public funds, private funds and angel investors, says the report, “Shifting sands: the changing nature of the Early Stage Venture Capital Market in the UK.”

Angels to the fore

While private equity’s share of the early stage market has fallen overall, angel syndicates and individual private investors have become more prominent, increasing their share of private sector investments from 16 per cent in 2000, to 41 per cent in 2007.

A shortage of money is one – significant – problem. But the retreat of private capital has other repercussions believes Jonathan Kestenbaum, Chief Executive of Nesta, who says VCs are needed to bring “rigour, expertise and experience” to public sources of capital.

He also points out that the shift from private to public funding increases the onus on public funds to demonstrate the economic return of their investments. In addition to convincing government and taxpayers the money has been well spent, public funds now encumbered with the additional duty of trying to convince private capital to invest.

Or, as Kestenbaum puts it, “The worst thing for early-stage entrepreneurs is for public finance to be a source of philanthropy, rather than of development capital.”

Based on the conclusions of the report, which was written by Yannis Pierrakis, Nesta’s Investment Research Manager, and Colin Mason, Professor of Entrepreneurship at Strathclyde University, Scotland, Nesta is planning further research with the British Business Angels Association to understand to understand the changing role of the UK’s angel investment community, and with the British Venture Capital Association on which government initiatives have been most successful in stimulating early stage investment.

No doubt, there are lessons here for other countries in Europe, and for the European Union, as it strives to increase investment in early stage companies and deliver on the Lisbon objective of building a knowledge economy.

Where are the VCs?

In common with counterparts elsewhere, the UK government has instituted various measures to address the shortage of seed and early-stage funding. It seems the result is not as hoped – that VCs have been drawn in – but rather that swathes of spin-out and commercialisation activity are now dependent on the public purse.

Last year, public funds were the sole investors in 21 per cent of early stage deals, though this accounted for only 9 per cent of the total amount invested.

One bright spot is the increasing significance of business angels, who are prominent co-investment partners, involved in approximately half of all public–private co-investment deals. Indeed, deals involving public–private co-investors increased from 11 per cent of all deals in 2001, to 35 per cent in 2007. In terms of the amount invested, co-investment deals accounted for 37 per cent of the total in 2007, compared with 10 per cent in 2001.

In summary then, the study uncovers three trends that have changed the nature of the UK’s early stage venture capital market since 2000. First, although they remain prominent, private sector investors are now proportionately less significant, leaving the public sector to shoulder more and more of the weight.

Second, the type of early stage private investor has changed, with funds becoming less significant and private individuals becoming more significant. This includes ‘mega angels’ investing alone, angel syndicates, and other forms of organised angel investing.

Third, public sector investments increasingly take the form of co-investments with private investors, rather than free-standing investments.