Innovation – why we’re missing a trick for early-stage financing
Innovation – why we’re missing a trick for early-stage financing
There’s a market failure in financing early-stage technology companies. Anyone who watches “Dragons’ Den” will know there’s a fine balance between risk and reward, but for early-stage technology companies, a number of factors combine to make this an extremely tough area. The thoughts and solution outlined below are the result of input from several authors experienced in the creation of innovative technology-based companies, an important component in creating a robust future economy. Thanks are due to the Royal Society which is supporting Pete Hotten as an entrepreneur-in-residence at Swansea University.
We argue that there could be a government intervention-based solution that is easy to implement, could provide positive returns to both Government and the entrepreneurs, ultimately benefiting the UK economy as a whole and ensuring that the UK remains at the forefront of innovation.
The key issue is ‘liquidity’; to be more precise the key problem is absence of liquidity for the high-risk entrepreneurs, management teams and angel investors that create new innovative companies. That is, early-stage investment funds and management teams become locked in to their investments, often having to wait a decade or more to secure any return.
Recycling the entrepreneurs and skilled early-stage management teams is critical for optimising the growth of new innovative companies, as is the ability for investors with specialist early stage capability to realise gains quickly in order to re-invest in further new opportunities.
The proposed solution is a government-backed fund that is structured to provide the opportunity for these key individuals and investors to do exactly that – realise gains and move on to the next opportunity.
Here are some of the elements that combine to create the market failure:
- Investment Managers specialising in genuine early-stage investment are becoming increasingly rare; they find it more profitable to come in when the technology has been proven, markets established and the commercial risk diminished. As a result, there are strong motivating forces at work driving those early-stage investment houses that are successful to move up the food chain to make larger Series A investments, and so on. These economic drivers act to erode the availability of expert early-stage investment in the UK.
- The returns for specialist early-stage investors historically have not been very good.
- Although various mechanisms exist to enable very early investors and management teams to realise value, e.g. requiring existing shareholders and/or incoming new investors being offered the opportunity to buy out the early stage investors and at market value, they are rarely practiced.
- Early-stage investment funds often lack the scale to continue investing in their portfolios and there is uncertainty as to follow-on funding.
- Due diligence costs for early-stage investments are often just as large as later stage ones, and what actually is the due diligence performed on?
- Incoming late-stage investors usually insert ‘cascade’ structures that wipe out earlier funders (mitigated if the new fund provides support to the early stage investors to follow their investments).
- There’s a scarcity of high-quality, industry experts who have the managerial experience to steer start-up companies through early investment rounds and towards revenue generation. This issue is a particular problem outside of the key technology clusters such as London, Oxford and Cambridge.
- Specialist start-up management teams, critical to establishing a robust company, but often not the right fit for later stage companies will need to be replaced by managers with other skills-sets as the business matures. But the incoming management will want a slice of the cake and would probably be unconcerned about the impact of diluting or even eliminating their predecessors’ rights. These situations can result in the acrimonious removal of the early-stage management teams as ‘bad leavers’ who lose their stock options entirely. This will clearly impact on the motivation of such management teams to recycle their skills in other early-stage opportunities that emerge.
A possible solution
A Government-backed fund, operating under specified conditions, to reward both early-stage investors and associated management teams for taking those very high early-stage risks could release these skills and capabilities to be recycled more efficiently. The same mechanism could be used to enable early high-risk investors / management to follow on their investment as an alternative. To some extent tax-favoured Venture Capital Schemes such as SEIS and EIS address this, but they have their limitations.
We propose a more fundamental solution, being a government supported fund mechanism. The fund would not only incentivise more early-stage activity but would also create a return to government over the long term. The fund would acquire an equity position but at a discounted value, i.e. it could buy early investor / management equity at a discount or, in the event the fund enabled an early investor to follow their investment the same discounting mechanism would be obtained by the supported investors / management agreeing to pass on a % of the economic value of any equity they dispose of in the future.
When the fund operates to buy equity, there would need to be clear 3rd party, independent validation of the value of any equity that is acquired, i.e. at the point of a new round of investment where unconnected parties are defining the value of the shares. A Government-backed fund could buy early stage investors out at a clear discount (10%, 20%, 50%) without any State Aid issues and the % discount could be tuned to drive investment to the regions. Investment gain would be subject to corporation tax. The same mechanism could be used to reward management which of course would be subject to income tax or capital gains tax
In conclusion, the market failure in early-stage technology investment is not simply an aversion of technological risk or the traditional low return but rather is compounded by the lack of liquidity for all parties involved and the risk that early investors / managers will be ‘squashed’ by later stage investors and management teams. A mechanism for addressing this market failure has been proposed which is not only State Aid compliant but which can also be tuned to incentivise regional development. The liquidity created in both cash and (now) experienced management teams could be transformational.
It sounds easy; it is easy. If structured carefully it could provide positive returns to both Government and the entrepreneurs, ultimately benefiting the UK economy as a whole and ensuring that the UK remains at the forefront of innovation.