Innovative Companies: spreading the risk

The European Commission and the European Investment Bank Risk Sharing Finance Facility (RSFF), set up in 2007, aims to improve access to debt financing for investments in the field of research, development and innovation. At present, the facility has a capital cushion of €2 billion, with half coming from the EIB and half from the Commission’s 7th Research Framework Programme (2007-2013), enabling the EIB to lend more than €10 billion.

(This is the second report on a recent Science|Business roundtable meeting. The first article appeared on 25 November.)

The progress to date with this new approach to financing R&D was discussed at a recent roundtable meeting on November 17, when Science|Business brought together policy makers, government officials, financiers, researchers and industry players, to discuss how to help small, innovative companies find the financing they need to get moving towards the market. Erika Mann, chair of a group of independent experts which this summer produced a mid-term assessment of how the RSFF is performing, highlighted the group’s recommendation that the Commission’s funding be increased from €1 billion to no less than €5 billion after 2013 and suggested the capital released when current RSFF loans are repaid should be added to that amount.

Mann also suggested that up to 10 percent of structural funds be freed up so they are not restricted to being spent on research carried out in countries that have the greatest structural economic and social problems, but can be redirected towards promising and innovative research in any part of the EU.

Overall, Mann said, the expert group had an extremely positive view of the RSFF’s first years. It has allowed debt financing to be used for research that was previously dependent on grant funding and, significantly, has encouraged private investors to remain involved in backing riskier activities, even during times of financial crisis.

Increase risk funding for SMEs

One area where the expert group did call for improvements is in increasing the number and range of SMEs that can access finance under RSFF. “We would like a stronger, more specific emphasis in the second phase of RSFF on financing research, development and innnovation-intensive SMEs through a range of appropriately specialised intermediaries, whether banking or non-banking institutions,” its report says.

Marc D’hooge, RSFF programme manager at the European Investment Bank, acknowledged that to date RSFF has not catered as much for small and medium-sized companies as it has for larger projects.

He said the main reasons for this are the limited number of staff working on RSFF projects; the difficulty in finding SMEs with research, development and innovation plans that are big enough to be eligible for direct financing under RSFF; the fact that most SMEs can’t cope with complex loan negotiations, and the fact that equity and other forms of finance may be more appropriate.

However, D’hooge said the facility has provided financing for a couple of SMEs, including the Liege-based digital cinema company XDC, and has supported small companies via open innovation platforms, such as one in the life sciences and another headed by Philips in Eindhoven.

The EIB Group (consisting of the EIB and the EIF, its venture capital arm) also has a wide range of other products to support SMEs, and which complement the RSFF, for example, EIB loans for SMEs that are channelled through commercial banks, allowing simpler and more flexible loans to reach a greater number of SMEs. More than €10 billion was handed out to SMEs under this scheme in 2009 and 2010.

Loans may not be the answer

Debt financing isn’t always the solution. Sometimes a different type of loan is required, sometimes a grant, and in yet other cases the focus needs to be on equity funding.

David McMeekin, chairman of the London Technology Fund, which helps provide funding for new, high-growth technology companies based in Greater London, told the meeting it is not the role of banks to provide loans to finance start-ups that actually need equity. “Loans should not replace equity,” he said. Any bank making a loan to an SME would need to ensure there is tangible security and the company can service the debt. The problem is that the main asset of most start-ups is intellectual property, which cannot be sold for a sufficient sum to repay loans if a young company fails.

London Technology Fund, which is funded by the London Development Agency and the European Regional Development Fund, invests from £50,000 to more than £1 million, aiming to bridge the funding gap for technology SMEs in the earliest stages of development, by leading and building a syndicate of investors, or by completing the gap in an existing syndicate.

Typically, first rounds total between £1 million and £10 million. McMeekin believes the key to this model is that it enables a public sector fund, managed by the private sector, to act as a catalyst to attract different private sector co-investors to invest on an equal footing, and on a case-by-case basis. The proof of the model is that co-investors, such as specialist venture capital funds and corporates, have invested over £3 for every £1 of public money put in by the London Technology Fund.

Designing new financing instruments

EU policy makers can also play a role designing financing instruments that will help SMEs gain access to finance. However, to come up with the right tools, there needs to be an objective way of assessing companies, said Peter Dröll, Head of industrial innovation policy development at DG Enterprise. Data such as hourly productivity - to indicate potential growth, knowing which products are going to which export markets, and what share of a particular sector is made up of innovative companies, would all be useful, Dröll said. “I’m a believer in measurements. We need them to make comparisons.” Countering the argument put forward by others that numbers are of little use, he highlighted the EU’s Innovation Scoreboard, noting it has led to specific actions by member states. “It has a proven track record on the precision of policymaking,” he said.

What to look for in a start-up

Of course, it’s not the case that every start-up will be worthy of investment, and Andrew Herbert, Chairman of Microsoft Research EMEA told the meeting what he looks for in identifying an innovative SME that has the potential to grow and be successful.

The most important factor is the people, Herbert said. He wants to see a strong management team with people who have some experience of having been there before, have a “hunger” to succeed, are aware of the risks involved, the endurance required and the challenges ahead. A combination of technological and business knowledge is crucial, he added.

With this foundation in place, he then looks for a key idea, or what he termed a “secret sauce”, which could be a technological idea, a patent or a trade secret, and how the company plans to protect this secret. The idea also needs to be one that can be “scaled up and out,” or in other words, not only having the potential for initial sales, but also one that can be developed into Version Two of the idea.

On the financing front, there has to be some proof that this is a company to be trusted, Herbert said. That could be in the form of backing from business angels or endorsement by a large company. If bank financing has been secured, this indicates some hurdles have had to be passed. The amount of personal financial risk being taken by the founders is also an indicator of the level of commitment.

And it is important to have an exit strategy, be that initial public offering or acquisition, Herbert said, because this helps define the execution model.

In summary, the key is to “pick races, not winners,” says Herbert. The initial idea is often not the one that ends up being the winner, but if you have the right people, who understand their key idea really well, you increase the chances of a winner emerging.

Links

RSFF mid-term report (PDF).

London Technology Fund.