Venture capital and regional development: Towards a venture capital 'system

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Venture capital and regionaldevelopment: Towards aventure capital 'system'Rebecca HardingPublished online: 26 Nov 2010.

To cite this article: Rebecca Harding (2000) Venture capital and regionaldevelopment: Towards a venture capital 'system', Venture Capital: AnInternational Journal of Entrepreneurial Finance, 2:4, 287-311, DOI:10.1080/13691060050177004

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Venture Capital ISSN 1369-1066 print/ISSN 1464-534 3 online Ó 2000 Taylor & Francis Ltdhttp://www.tandf.co.uk/journals

Venture capital and regional development: towards aventure capital ‘system’

REBECCA HARDING

(Final version accepted 13 January 2000)

This paper provides a critical review of UK government proposals to develop venturecapital funds in the English regions to address the ‘equity gap’. It argues that there iscurrently an adequate supply of equity-type funding under £250,000. The real equity gap isbetween the more informal, packaged finance structures and the formal venture capitalmarket which is dominated by MBOs and MBIs. It is argued that the creation of strongventure capital markets in the regions requires the close co-ordination between all thevarious actors in the system at regional and national levels. Regional Development Agencieshave the tools to enable them to perform this co-ordinating task.

Keywords: venture capital; equity gap; Regional Development Agencies; regional policy;business angels

Introduction

Access to appropriate forms of finance is key to ensuring that small andmedium sized enterprises (SMEs) have the freedom and the scope to grow(Gavron et al. 1998). Venture capital, in other words, long-term committedinvestments in unquoted companies in return for an equity stake, is apotential means of stimulating this growth. For the investee company it issecure growth finance without the risks inherent in loans secured onproperty. For the investor it represents a means of generating revenue fromthe growth of a business. It appears then, that by stimulating this marketthe government would have ample scope for achieving the highly desirabledual policy objectives of enhancing entrepreneurial activity and generatingcompany, and hence, economic, growth. Indeed, politicians and commen-tators alike point to examples in the US where a buoyant venture capitalmarket appears to have generated a pro-active, pro-risk entrepreneurialculture which leads to large numbers of business start-ups and high growththrough SMEs.

However, there are critical differences between regions within the UKwhich potentially influence the efficacy of any national level policy towards

Rebecca Harding, SPRU, University of Sussex, Falmer, Brighton, BN1 9RF, is a Senior Fellow atSPRU University of Sussex and a Research Associate at the Institute for Public Policy Research(IPPR). Tel +44 (0)1273 678169 e-mail: [email protected].

VENTURE CAPITAL, 2000, VOL. 2, NO. 4, 287 ± 311

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venture capital (Mason & Harrison 1999c). These differences manifestthemselves in two ways: first, in terms of macro-economic indicators suchas regional per capita GDP and industrial structure; and, second, in termsof cultural factors such as the acceptability of venture capital toentrepreneurs as a tool of business growth. This means that any nationallevel policy has, as a minimum, to contain a regional dimension, if not beexplicitly regional in order to take account of these important distinctions.

This paper examines the venture capital market as it is currentlydeveloping in the UK with the aim of informing current government policytowards this important sector. The government has addressed the issues ofregional disparity and inadequate provision of funding for SMEs in twoways. First, it has established Regional Development Agencies (RDAs),whose remit includes regional regeneration, competitiveness and GDPgrowth.1 Second, it announced a sum of £180 million over three years toprovide an ‘enterprise fund’. with a regional dimension and with thepurpose of increasing the amount of venture capital funding available toentrepreneurs. However, this study suggests that it is wrong to regardventure capital as a panacea in this area since venture capital is not alwaysthe correct means for funding the very companies that the policy isdesigned to help.

At the time that this study was undertaken, proposals for venturecapital funds in the English regions were out to consultation. The fieldworksought to establish the key issues facing both the RDAs and local providersof venture capital in these English regions and, hence, to establish anycritical success factors in establishing regional funds. These critical successfactors were informed by a bench-marking exercise against Wales, Scotlandand Northern Ireland which are outside of the consultation process: theseregions have existing funds which operate in close co-operation withdevelopment agencies. The research involved over 60 interviews withpractitioners, academics, analysts and policy-makers.2

This, largely practice-based, research process has led to someimportant conclusions which should inform policy if it is to be trulyeffective. The key recommendation is that there is a need for close co-operation between all the different actors in the system at a regional andnational level. RDAs have the tools to perform the co-ordinating task and,rather than focusing on the funds in their own right, should beconcentrating on the issue of harnessing the latent potential that alreadyexists in each region. Many of the problems that currently manifestthemselves in the market place originate in imperfections in information. Inother words, entrepreneurs know little or nothing about just how venturecapital works and, critically, policy makers and fundholders alike arefundamentally unaware of exactly how much demand is in the market. Yetmarkets will not function without information and this is abundantly clearfor the UK venture capital sector.

The next section reviews some of the literature on venture capital anddiscusses the rationale behind policy towards this important sector. It goeson to develop a descriptive model of the developing venture capitalstructures and substructures in England. Section 3 summarizes the progressbeing made towards regional venture capital funds in the light of the model

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developed in the previous section. Section 4 concludes the discussion byexamining some of the key challenges facing policy makers and practitionersin establishing regional venture capital funds. It argues that there iscurrently over-supply of capital relative to demand in some regions, fromboth business angels and venture capital funds. This is a problem of lack ofknowledge on the part of investees about the potential benefits of thisfinancing method. Further, there is evidence that there is adequateprovision for equity-type funding under £250,000 through ‘packaged’financing (for example, business angel syndicates, mezzanine financing andloans) and that in some regions the existing structures provide bothadequate supply to the market and routes through into second roundfinance. Similarly, provision for high growth companies at the higher end ofthe market—projects requiring investments of more than £750,000 (withthis average figure increasing)—is adequate. The real equity gap is in thewidening chasm between the more informal, packaged financing structuresand the formal venture capital market which is currently dominated byMBOs and MBIs. Bridging this gap is as much about changing the attitudesto high risk investments as it is about providing funds.

Why policy towards venture capital?

In principle, venture capital as a means of generating growth can only beviewed as positive. Examples from the US of companies that have usedventure capital to grow are plentiful (Wright et al. 1998). The US SmallBusiness Investment Company (SBIC) Programme, in operation since1958, has spawned such successes as Digital Equipment Corporation,Apple Computers and Sun Microsystems (Bank of England 1996). Thedeveloping system in Germany, which is strongly supported by govern-ment as well as by the increasingly strong technology stock market, NeuerMarkt, is increasingly important in creating small business start-ups,particularly in hi-tech areas (Casper et al. 1999).

In both these countries, the role of government policy is critical inensuring that gaps are filled in the venture capital markets as they emerge.This policy provides both the leverage and the co-ordination through thesystem in both countries. Venture capital fund managers need to bepersuaded to make investments in high growth companies since any growthis, by definition, unrealized at the point of investment and thus uncertain.This makes investments risky, and sometimes too risky, relative to theexpected return. Both in Germany and in the US the role of subsidies inreducing the degree of inherent risk is key. What is important here is therole for government in bridging the gap between risk and return in the waythe market operates.

High growth or hi-tech?

Opinion is divided on the types of projects which are most appropriate toventure capital and at least some of the apparent confusions in the market

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place emanate from this issue. Generally speaking, any company withexceptional growth potential is appropriate for venture capital fundingsince the criteria for a venture capital investment centre around the balancebetween risk and return referred to above. Thus, a chain of restaurants, if ithas the potential for high returns is highly suitable for venture capitalwhere one fish and chip shop is not.

The confusion arises once innovation and hi-tech are introduced. Herethe venture capital industry is itself confused—both about the technologyand its growth potential. Arguably, some forms of technology, for exampleInformation and Communications Technologies, have particularly highgrowth potential because of the meteoric expansion in internet services.Similarly, innovative companies developing or automating existingengineering techniques have vast growth potential. However, these arenot necessarily ‘hi-tech’ businesses as such. They rest on existingtechnologies and platforms and are traditional, ‘marketing’ type venturesin the same way that a chain of restaurants might be.

But hi-tech projects involve radical innovations and radical newinfrastructures to support them. Here the focus is on technologies likebiotechnology which require large capital outlays at the beginning of aproject to research and develop prototypes and to test these prototypes andwhich may subsequently lead to new products and processes with highgrowth potential, but equally may not. The critical issue in funding thesetypes of projects is in ensuring that a critical mass of research is undertakenin order to ensure that any commercial potential is spotted and exploited(Harding and Lissenburgh 2000). These projects may yield exceptionallyhigh returns over a long period of time, but the risks inherent in investmentare high relative to the time period over which returns are expected.

High growth projects are those which are most suitable to venturecapital. These types of business propositions fall into three categories:

1. Simple high growth: businesses and business propositions from anysector that have high growth potential.

2. Technology-based high growth: businesses and business propositionsthat have the potential for high growth through the potential to adapt toexisting technologies.

3. Technology-led high growth: businesses and business propositions thathave potential for high growth because they operate in R&D intensivesectors and therefore are able to produce radical innovations that havethe scope to change the market place.

The policy imperatives and policy response

The issue of appropriate funding for small, high growth businesses is animportant one and warrants the weight given to it in current UKgovernment thinking. Thus far, a substantial emphasis has been placedacross a number of departments (notably the DTI, DETR, Treasury andthe DfEE) on developing support for venture capital. This is seen as beingan engine for promoting innovation, regional development, economic


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growth and employment by enabling the establishment and development ofsmall, high growth potential firms (Mason and Harrison 1999a, 1999b). AsMason and Harrison argue, ‘it is the small minority of fast-growthcompanies that are responsible for generating a significant proportion ofnew jobs and economic growth in an economy’ (Mason and Harrison1999a: 1). This sentiment is echoed elsewhere (Bank of England 1996,Murray and Lott 1995).

It would therefore be tempting to see venture capital as a panacea forcreating growth, innovation and employment. But this is an unwiseperspective on two grounds. First, commentators point to several factorswhich hamper the market in the UK from operating effectively.

1. Inadequacies in the supply of UK investments into venture capitalfunds (US pension funds are currently over-represented as investors inUK funds and currently only 0.75% of UK pension funds make thesetypes of investment) (Cowie 1999).

2. A lack of understanding about technology based projects on the part ofinvestors (Bank of England 1996, Murray and Lott 1995). Thisdifficulty emanates in particular from the lack of a systematic meansof evaluating the risks inherent in technology-based projects.

3. A ‘second equity gap’, preventing small high growth companies fromobtaining second round venture capital funding (Murray 1994, Masonand Harrison 1995).

4. A dominance of Management Buy Out/Buy In investments,3 particu-larly in the portfolios of larger funds (BVCA 1999a) and an increasingupward spiral in the size of average investments by all established funds.

5. A need to improve understanding about the nature of venture capitalboth to potential investors and investees (Aernoudt 1999, Cowie 1999).

6. A lack of an effective equivalent to the US NASDAQ market (Cowie1999).

Second, and of no less importance, the role of government policy is critical.In the most successful models of venture capital there is a substantialdegree of government involvement, either through direct subsidy, riskreduction or incentivization, to encourage investment in higher riskprojects. The role of government has to be in addressing the imbalancebetween the perceived risk of such projects and their potential return.There are also clear structures for feeding potential growth companiesthrough the system, from start-up and early stage through to eventualflotation. These structures only become a system with direct involvementby government agencies in ensuring clarity in the operation of the market.

Perhaps most importantly, however, given the size of the UK venturecapital industry, it remains an under-utilized means of finance by UKSMEs who have instead chosen to use more traditional, debt-basedmechanisms (largely through banks) to fund their expansion. Further,British venture capital funds have bemoaned the apparent lack ofinvestment opportunities in potentially high growth SMEs. They arguethat they have funds available for investment in SME growth, but seerelatively few good, investor-ready propositions that will provide an


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adequate return relative to the risk involved. The result is a market whichfails to function properly.

It is against this background that the government launched its supportfor venture capital funds in late 1997. This became an explicit policystatement in the Competitiveness White Paper published by the Depart-ment of Trade and Industry in 1998. In this statement, the governmentcommitted itself to providing £180 million over three years to a national‘Enterprise Fund’ with the following features (Department of Trade andIndustry 1998):

1. Incorporation of the existing Small Firms Loan Guarantee Scheme(SFLGS).

2. Support for the establishment of Regional Venture Capital Funds.3. Provision of a national venture capital fund supporting early stage and

high tech businesses.4. Provision of flexible support for innovative business proposals currently

not catered for by the finance industry.

In general terms, then, the aim of this fund was to provide funding into the‘equity gap’—in other words, to provide funding to the smallest companiesfor start-ups and early stage growth.

It was further proposed that the total fund would be administered bythe Small Business Service (SBS). The SBS and its likely structures andfunctions were out to consultation at the time of the research (Departmentof Trade and Industry 1999b). However, its broad remit is to act as a co-ordinating mechanism in three principle ways:

1. ensuring representation of small business interests in Government;2. making more cohesive and simple government support for small

business; and3. helping small firms in dealing with regulatory procedures.

In addition, the SBS will, ‘be responsible for managing the Government’sEnterprise Fund which will invest much-needed small scale equity financealongside the existing Small Firms Loan Guarantee Scheme. Through itsregional venture capital funds, the Small Business Service will be looking tostimulate commercial investments in small, fast-growing businesses’(Department of Trade and Industry 1999a).

The Government’s consultation document (Department of Trade andIndustry 1999a) focuses specifically on the support for regional venturecapital funds under the provision of the Enterprise Fund. The consultationis to, ‘ensure that support for regional venture capital funds is designed tomeet the needs of SMEs in all regions and is compatible with industrypractice’ (Department of Trade and Industry 1999a). Within thisdocument, the government proposes at least nine regionally based venturecapital funds providing ‘equity-based finance to small and medium sizedenterprises (SMEs) in amounts below £500,000’. On the demand side, theobjective is therefore to increase availability of this type of finance to SMEsthat would otherwise not be able to obtain it. On the supply side, the


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objectives are to ensure, first, that each region has a viable venture capitalfund, and second, to encourage investment into these funds. De facto thesefunds would be set up by the Regional Development Agencies (RDAs);accordingly the establishment of such funds features strongly in most oftheir Regional Economic Strategies.

The aim is to address the inherent weaknesses in the UK market aslisted above through appropriate intervention in the market place. Thisintervention at a regional level is deemed necessary in order to assist theRDAs in furthering their own objectives of regional regeneration andregional competitiveness. The achievement of this aim rests on ensuringthat regional funds are of a viable size and that regional fund managers haveappropriate expertise as well as local knowledge. It is envisaged inGovernment documentation that the intervention will take place in one ofthree forms:

1. subsidized management costs.2. co-investment in funds.3. guarantees for Funds (to spread perceived risks on high risk projects).

This, then, provides the obvious link through to the remit of RDAs. RDAsare charged with creating GDP growth and regeneration in their regions.However, the role of any venture capital fund in this context needs to bethought through carefully for the following reasons.

The equity gap itself. The size and importance of the equity gap variesbetween regions and between sectors as does the appropriateness of equity-based finance as a means of stimulating SME growth. Indeed, the ‘gap’may not have financial values attached to it at all since venture capital fundswill invest in projects, however small, if they have potentially high returns(i.e. high growth). The ‘gap’ is in the mismatch between perceived risk andexpected return, and this is a function of the nature of the project—somemay be suitable for this type of finance, whereas others patently are not.Thus, it is extremely difficult to cater for the equity gap without anextremely flexible approach.

The nature of demand for equity based finance. This also varies betweenregions, and also between sectors, with some regions presenting a bleakpicture of awareness levels of this type of financing as a growth tool.Although precise data on this are sketchy, what is clear is that informationabout the nature of equity-based finance is not being provided and this isundermining the operation of the market itself.

The nature of supply of equity based finance. This is also variable acrossregions. However, in most of the regions examined in the context of thisresearch interviewees reported an over supply of venture capital relative tothe levels of actual demand. This was most acutely the case at the ‘lower’end of the spectrum (i.e. less than £500,000) where the shortage of ‘investorready’ propositions and an unwillingness of entrepreneurs to enter intoequity-based agreements exacerbated this market imperfection. The issue


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for fund managers was not so much the size of investments needing to bemade as the potential for growth and return. Further, the commercialimperative faced by traditionally ‘equity gap’ funds means that the averagesize of investments has crept upwards. These funds are often reluctant tocater for the ‘equity gap’ through equity based investments because of thegap between risk and return described above. Some have found alternativemeans of providing finance to smaller investments, for example throughfactoring, debt-based finance and corporate venturing. However, the effectof the general upward spiral of investment size combined with a naturaltendency to invest in high return rather than high risk projects has meantthat potential growth companies in the ‘equity gap’ are currently under-provided.

Towards a venture capital ‘system’

The word ‘system’ is used advisedly in the context of the English venturecapital structures that are developing. It implies a degree of co-ordinationand structure, particularly in progressing companies through the differentlevels and types of financing that currently does not uniformly exist. Thechallenge for policy in the English regions is to create growth andemployment generally, not to create growth and employment in the venturecapital industry itself. This means viewing venture capital as an instrumentof growth, not as an object of growth in its own right.

There are several issues to which policy for creating a venture capitalsystem must be directed if it is to deliver on its promises of creating growth.First, policy-makers must be absolutely confident about the appropriate-ness of equity-based finance in engendering growth in all companies. TheBank of England reports a declining dependence of SMEs on externalfinance generally and an increasing tendency to fund growth throughinternal means, for example, through retained profits (Bank of England1999: 3). This is argued by the Bank to be a measure of the increasingappropriateness of SME financing, in particular a reduced dependence ontraditional, and expensive, financing methods like overdrafts. Moreover,there is a relatively low use of venture capital as a percentage of totalexternal funding. Bank of England figures suggest that the average take-upof venture capital has remained unchanged during the 1990s at around 3%of total external funding for SMEs (Bank of England 1999). Thus, theincrease in the amount of venture capital investment (BVCA 1999a) doesnot imply that the actual take up of venture capital has improved. Rather,average investment sizes are increasing—a market weakness highlightedearlier which means that the external financing needs of start-up and earlystage businesses are currently not being met.

This leads to the second critical point which has to be taken intoaccount by policy makers when formulating strategies for creating aventure capital system in England. This research has shown that thecurrent imperfections in the market stem from mutual lack of informationon the side of both investors and investees. This prevents investments inriskier business propositions being made and prevents small, but


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potentially high growth, businesses from taking up venture capital at aturning point in their development. An effective model or system ofventure capital has to provide effective leveraging through the externalfinance system—for example, from loans and hire purchase or leasing dealsthrough to equity-based finance packages. According to the Bank ofEngland (1999), SMEs are increasingly sophisticated in the variety ofexternal finance that they use. ‘Packaging’ of different alternatives may besuitable at start-up or early stage in order that a track record can bedeveloped by the business. This provides a basis on which the venturecapital industry can begin to be involved at a later stage. This type ofstructure is termed a ‘tiered’ system of venture capital and is illustrated infigure 1.

Figure 1 places nominal figures on each tier. These figures were derivedfrom the BVCA directory of members (BVCA 1999c). A database wasconstructed of all BVCA members who claimed to invest in the equity gap.Their investment range and average investments were recorded and thefigures in figure 1 reflect currently espoused industry practice. Thesefigures were corroborated during fieldwork discussions.

The figures at each level are illustrative only, however, and varybetween funds and regions. Since the critical issue for governmentinvolvement is in addressing the gap between risk and return, the key isin understanding the dynamic of the model as depicted in figure 1. Itrepresents leverage between the various stages and, as will be seen in thediscussion of regions outside of England, can, and indeed should, be

Formalization andLeverage:

Figure 1. A tiered system of venture capital co-ordination


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mobilized at a policy level. This is particularly the case in the second tier ofthe structure since it is here that the role for more substantial equity-typefinance emerges, but is also where the perceived gap between risk andreturn is greatest.

The first tier, termed ‘finance packaging’, is currently supplied by arelatively under-co-ordinated (and, by definition, at times informal),largely local and under-utilized collection of business angel networks4

(both public and private sector) and private sector finance provision. Thereare localities within the English regions which provide some form of linksbetween these various actors but the quality of these is variable.Governmental agencies like Business Links and TECs have had someimpact on this tier of small business finance, but the quality of these bodiesvaries across regions and interviewees were not uniformly complementaryabout their services. Where there are developed structures in place, forexample at TechInvest in Cheshire, the Warwick Science Park or the StJohn’s Innovation Centre, these are extremely effective in assemblingdifferent types of financial packages for amounts as high as £350,000 usinga combination of external financing tools. This market is also catered for bythe Midland5 Enterprise Fund which has nine regional outlets, eachestablished to cater for investments of less than £250,000. Here again, thequality of these funds is variable, but there was substantial evidence fromthe research that where these work well they are highly effective in steeringcompanies through the plethora of different financing options. A mosteffective feature of this first tier has to be making potential high growthcompanies ‘investor ready’ through mentoring and business advice.

The second tier of funding implies a formalization of external funding.The amounts involved are too large for individual private investors likebusiness angels and the importance of this tier in generating real businessgrowth cannot be understated. It is currently supplied by existing RegionalInvestment Funds,6 such as Yorkshire Enterprise, West MidlandsEnterprise, the Merseyside Special Investment Fund and Greater LondonEnterprise. All of these funds were established to provide investments forlocal authority pension funds in locally based high growth businesses. Intheir own right these funds have been extremely successful. But a measureof their success is that they are now, like any other commercial venturecapital fund, feeling the pressure to increase their average deal sizes inorder to cater for the financial interests of their investors.

Increasingly then, the English venture capital market is catering forformal equity based deals which exceed £750,000, the ‘formal’ tier asdefined in figure 1. This amount is an average investment figure, and sosome funds may well complete deals which are less than this average, butwill compensate with other deals which are substantially higher. In theinterests of commercial return, fund managers prefer lower risk invest-ments which entrenches the trend of the English venture capital system forMBO/MBI type investments. Yet this tier is essential in allowingcompanies to reach their full growth potential, ultimately through buyouts or flotation.

The arrows in figure 1 are the co-ordination mechanism of the ‘system’and its leverage through different financial stages of development. This is


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the growth between stages of development referred to above. For example,the internal arrows represent company growth and support from policystructures while the right hand arrow represents leverage. In terms ofcreating ‘investor ready’ high growth companies this is achieved bymentoring through the provision of skills and business advice. Currently inthe English regions there is a substantial degree of variability both in theleverage routes through the stages of funding and in the quality and level ofmentoring and support that small businesses receive. Excellent practicedoes exist, particularly in the regional investment funds and business angelnetworks mentioned above. However, these funds and networks do nothave a clearly defined relationship with RDAs and do not have a clearresponsibility with respect to any regional venture capital funds.

There are three features from figure 1 that need to be incorporated inany government policy in order to create an effective venture capitalsystem.

Mentoring and ‘investor readiness’. This involves both financial andadvisory tools at the first tier of the system described above. For example,Yorkshire Enterprise used to run a local authority loan fund. Themanagement costs were funded by the local authority but the managementwas the responsibility of Yorkshire Enterprise. This provided SMEs with ameans of accessing finance and know how since the loan scheme carriedwith it access to business advice as well as a means through into accessingother potential sources of finance. For various reasons which go beyond thescope of this paper this loan scheme is now defunct. However, it didrepresent a useful first step in the process of developing appropriate SMEgrowth funding. There are real concerns amongst fund managers andbusiness angel networks managers that many of the projects that comebefore them are not investor ready. This is a key hindrance on theoperation of the market which could be readily addressed throughappropriate tools.

Risk spreading and guarantee schemes. Tier 2 is currently the gap that isemerging, particularly for non-hi-tech, fast growth, small business finance.As funds start to ratchet up their average investments, the perceived risksof these smaller, but still substantial, investments grow. Specialist funds inspecific sectors (notably biotechnology) do exist for the funding of hi-techprojects which allow companies to grow through the stages of development.This means that the gap is typically less of an issue for good hi-techpropositions. Even so, many ‘conventional’ funds remain wary of anythingthat involves technologies that the fund managers themselves do notunderstand. Since these are also the funds which are increasing theiraverage investment sizes, this is developing into a chasm which needs fillingif the tiered system is to operate. The only way of overcoming this is bysome form of government intervention to share or spread risks on riskierinvestments in this gap.

Information. The under-utilization of venture capital is largely a functionof the lack of information that currently exists. As with every other area


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discussed thus far, there are pockets of good practice around thecountry—for example, investor clubs, networks and opportunities forinvestors and investees to meet. However, local networks and funds areoften unwilling to share information with colleagues in other organizationsfor obvious commercial reasons. Further, there is substantial variation inthe degree to which business angel network managers and fund managerscommunicate in the interests of feeding potential investment opportunitiesthrough the tiered system as described above. This prevents informationabout the supply of and demand for venture capital flowing within regions,let alone between them!

These points will be returned to later when the implications forgovernment policy are considered. But what is important to stress at thispoint is that since venture capital funds, almost by definition, have tooperate on a commercial rather than a subsidized basis, it is evident thatlarger and lower risk investments will be attractive to fund managers as thisincreases the likely potential return. However, this means that any equitygap will widen as the financial imperatives for a commercial return becomemore pressing and as the tendency grows for even ‘equity gap’ type funds toincrease their average investments.

The equity gap is important, however, as it represents commercialpotential to future investors as well as being the engine of economic growthfrom the small business sector. If the equity gap is not financed adequately,then, by implication, there will be large numbers of small businesses withgrowth potential, even if they may be higher risk, which never actuallyachieve their optimum size. This latent growth also represents a significantyet unexploited source of potential earnings for investors.

Evidence from outside England: developing the ‘ideal’

Venture capital systems in Scotland, Wales and Northern Ireland7 caninform the debate for England. Indeed, some commonalities between thethree systems are immediately obvious. In particular, all have beenestablished through the development agencies which have loan and grantfunds available and an ‘equity-gap’ focus before formal venture capital hasbeen introduced as a growth tool. Accordingly, all have in-built linksbetween ‘informal’ venture capital and packaged funding which means thatgood propositions can be guided through the system thus generatinggrowth through effective and appropriate finance. Moreover, as none ofthese models are new there is considerable embodied experience of localSME needs both in the development agencies and in the funds themselves.

Some other features are, however, less immediately obvious but arenevertheless important in informing the discussion of regional venturecapital funds in England. First, all of the venture capital funds operateindependently of the Development Agencies and on a purely commercialbasis. In Wales and Northern Ireland, because of the relatively early stagein their development, there is some involvement of the DevelopmentAgencies as knowledge and finance ‘gap fillers’. But the long establishedScottish fund uses private sector money and terms and conditions despite


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being a ‘public sector instigated’ fund in the first instance. Ultimately, thisindependence is crucial in ensuring both the credibility of the fund and thecredibility of the Development Agencies themselves.

Second, all of the structures outside of the English regions cater for afinite geographical area with specific development problems. All three ofthe structures are catering for economies which have suffered enormouslyfrom structural changes in employment (particularly the decline of specificmanufacturing sectors like ship building and the closure of coal mines andsteel works).

Third, all have identified venture capital as the most appropriatevehicle for driving growth in hi-tech. In addition to the regenerationneeds identified above, all of the models studied have a hi-tech focusand, accordingly, have developed close links with universities andtechnology experts in order that technology proposals can be assessedproperly and that university spin-outs can be stimulated from universityresearch.

Fourth, there are clear routes through the models with packagedfinance at start-up leading to formal venture capital for larger amounts and/or second round finance. Entry and exit routes both for investors anddevelopment agencies are clearly defined and this provides a transparencyto all of the systems which enhances both their credibility and theireffectiveness.

Finally, there is careful co-ordination through the tiers of the models.This is achieved by means of the ‘growth generating’ activities of theDevelopment Agencies and/or fund managers. These activities comprisethe mentoring and guidance activities largely performed through theDevelopment Agencies which ensure that potential clients can accessappropriate finance at the appropriate stage and be fed through to higherfunding levels accordingly.

The importance of the largely uncommercial ‘feed through’, co-ordination and gap-filling roles of the development agencies in Scotland,Wales and Northern Ireland in generating venture capital based growthcannot be under-played. Filling gaps in finance means that the economicimperatives of the venture capital industry (particularly the investmentreturn ratio and the revenue to fund managers) can be met. Thisstimulates the supply of investment capital into otherwise risky areas.Equally, knowledge gap filling, through co-ordination and mentoring,creates cultural change, stimulates demand and ensures that numbers of‘lost’ projects are minimized. This is, perhaps, the single most importantlesson in relation to the development of regional funds in England since itis this that stimulates demand and supply for venture capital andgenuinely turns equity-based finance into an engine for growth in aregion.

What’s happening in the English regions?

With this in mind, then, the discussion now turns to an analysis of progresstowardsestablishingregionalventurecapital fundsacross the English regions.


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Tier 1. Investments below a nominal £250,000: regional informalventure capital and financial packaging

Across all the English regions there is a vast array of different schemesto stimulate the supply of small scale capital through business angels andto prompt entrepreneurial behaviour through tax incentives and loan andinvestment guarantees. For example, business angel networks operatethrough public – private sector partnership organizations (like theNational Business Angel Network (NBAN), Business Links andUniversity Science Parks), private sector organisations and businessangel syndicates. Business angel networks (BANs) operate on aninformal basis principally as introduction agencies for investees andinvestors. In addition, there is governmental level support through theSmall Firms Loan Guarantee Scheme (SLGF) which operates throughthe High Street Banks and various budgetary measures which operatethrough the fiscal regime to provide incentives for high growth firms toaccess equity based finance. These are incorporated under the umbrellaof the Enterprise Investment Scheme (EIS) and include Capital GainsTax relief and deferrals on serial investments, tax relief on allowablelosses and income tax relief at 20%.

Is has already been emphasized that the first tier in the model offinancing of small business is an essential step in steering prospective highgrowth companies. It would be neither necessary nor appropriate to discusseach of the regional structures in any kind of depth. However, a number ofgeneralized points are worth summarizing from wider research and theinterviews conducted.

Informal venture capital. BVCA figures suggest that there is enormousgrowth in the informal venture capital market. It is estimated that there arenow 18,000 business angels across the UK investing upwards of £500million per year in over 3,500 companies (BVCA 1999b). This averages outat approximately £50,000 invested per business angel with larger amountsgoing to individual companies through business angel syndicates andpackaged finance. Mason and Harrison (1997) suggest that 30% of businessangel funding is in hi-tech projects, and some 71% of projects result in dealswhich are favourable to both sides.

Such statistics are only estimates of actual levels of business angelactivity and should therefore be treated with caution. However, thisunderscores the current difficulties in usage of this type of finance.Business angel network managers across all regions bemoaned the fact thatentrepreneurs are unaware of the benefits of informal venture capitalfunding. These benefits are well-documented and it would be inappropri-ate to detail them here. However, of particular relevance to the currentanalysis is the fact that business angel activity tends to be regionally basedand provides the very types of non-commercial support which are sovaluable in providing preparation for ‘investor readiness’.

There is evidence of substantial informal venture capital activity acrossall UK regions. Each region has both EquityLink outlets and businessangel networks linked into NBAN. Indeed, some have several outlets with a


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local rather than a regional focus. There was variability between regions inthe levels of investor interest and investment opportunities, but all areasreported an over-supply of capital relative to the level of demand. Thereasons for the relative over-supply will be discussed in more detail below.For the time being, however, it is important to point out that severalbusiness angel network (BAN) managers reported the ‘local’ bias referredto above as a real hindrance to transfer of investment opportunities betweennetworks. This meant that some opportunities, say in Leeds or Exeter,would be turned down although there may well be an appropriate angel in,say, Sheffield or Swindon.8

A further issue which BAN managers raised arguably contributes to therelative over-supply of capital. The time constraints of travelling to eachinvestment opportunity, combined with relative under-staffing and similarcommercial imperatives for income to those experienced by the largerventure capital funds, means that larger scale investments were preferred tosmaller investments as these guaranteed higher revenue and, hence, thesurvival of the network.

Demand. The level of actual demand for business angel finance is difficultto quantify for two reasons. First, there is a relative lack of informationabout the activities of business angels and the potential they represent toentrepreneurs. Second, all BAN managers reported that clients tend toview equity finance generally as a ‘last resort’ rather than a tool in its ownright. Thus, businesses which might be suitable initially for business angelinvestment often seek loan or grant funding first.

BAN managers identified a number of reasons why demand is lowerthan the level of capital supply in the market. First, referrals mechanismsare difficult and unclear. Respondents reported an unwillingness on thepart of banks and accountants in particular to refer clients to businessangel sources of finance as this was seen as undermining their ownbusiness potential. Many BAN managers argued that while at a nationallevel all the major banks seemed to be positive towards the principle ofsupporting business angel activity, and even invested in NBAN, thissupport was relatively slow in its dissemination to bank branches.Further, considerable variability across localities in the effectiveness ofquasi-governmental organizations like Business Links were seen as ahindrance to referrals. Second, BAN managers pointed to lack of investorreadiness which meant that considerable time and resources were takenup in preparing prospective clients for investment. The time lag andconsumption of resources involved with this were perceived as obstaclesin generating successful deals. Third, entrepreneurs themselves feelintimidated and confused at the language of venture capital. Theyperceive that they will lose control over their projects and are uncertain asto the format of post-investment management and, hence, will only takeventure capital as a last resort. While some areas, notably London, theSouth East, Cambridge and Sheffield reported that there were noticeablechanges in favour of this type of finance, the issues around misconcep-tions about venture capital are important in blocking the establishment ofa more buoyant market.


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Formal venture capital. Activity in the venture capital market for smallerscale investments is not confined exclusively to business angels. Funds suchas the HSBC Enterprise Fund, British Steel Funds and private consortia,such as the Industrial Technology Securities Fund provide equity financeinto the ‘equity gap’. These funds are variable in terms of theirperformance and their regional and sectoral focus.

HSBC Enterprise Funds operate regionally and invest average amountsof around £50,000 in potential high growth projects of any nature although,by their own admission, not all fund managers have the confidence to investin hi-tech. One or two of the funds are well established and extremelyeffective, both in terms of accessing clients and feeding proposals throughto second round and/or higher level funds. The rationale for establishingthe HSBC Enterprise Funds was to provide funding into the equity gapwhich was taken to be amounts under £250,000. However, these funds aremost successful where there are routes through to supporting funds at thesecond tier and/or financial leveraging to give clients access to largeramounts of equity-type finance.

Other formal funds are variable across the English regions, althoughthere is a heavy concentration of them in Cambridge (based onbiotechnology investments) and the South East. They are nominallyattached to Science Parks or universities, but despite their geographicallocation, do not have a local or regional focus, instead concentrating ongood investment propositions nationally.

Financial packaging. The first tier in the venture capital model is not madeup of any single source of finance. Indeed, it is most effective and appropriatefor small businesses when a variety of different financial tools are used. Thisrepresents a form of risk spreading and often has some kind of public sectorinvolvement. Many respondents could point to packages totalling up to£350,000 for individual entrepreneurs. However, they voiced complaints atthe managers of bank branches for being either unaware or unwilling to makeuse of the Small Firms Loan Guarantee Scheme (SFLGS) as a means ofguaranteeing riskier loans. For some business propositions, it was argued, abank loan is the most effective means of financing growth. But, banks areoften reluctant to lend money because entrepreneurs have little or no trackrecord and because they are not aware of the advantages of the SFLGS. As aresult, it was argued, there are potentially large numbers of investableprojects being lost at a very early stage.

Relationship with larger scale funds. All players within this segment of themarket pointed to the upward spiral in average investment size. There wasunanimous agreement that even funds initially established with the equitygap in mind were pushing up their investments in the interests ofcommercial return. This serves to illustrate that the gap at the second tier(between £350,000 – 400,000 and £1 million) is currently under-served inthe market.

Integration into regions—cluster development through science parks. Despitethe absence of systematized co-ordinating mechanisms, there are examples


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of sophisticated networks and clusters developing around science parks.For example, the Warwick Science Park and the St John’s InnovationCentre both manage business angel networks, have an extensive knowledgeof the local conditions for business start-ups and provide access through toother forms of financing. Based on the developing German model ofclusters and science parks in Cologne, the Warwick Science Park is nowintegrating university research (through Warwick’s University ChallengeFund) and corporate venturing9 in the interests of creating hi-tech spinouts.

Summary. Throughout the English regions there is a huge amount ofknow-how and experience in gaining funding for business start-ups, bothin high growth and in high tech projects. However, this activity is largelyuncoordinated, under-utilized and random in its effectiveness. While thereis excellent practice at a local level the results across regions are variable.The effect is an under-exploited sub-structure which in itself represents ahuge potential for growth if effectively funded and structured.

The RDAs represent a core focus for co-ordinating this type of activity.This is not a suggestion that more structures be put in place, however. Thereputed variable quality of Enterprise Agencies, TECs and Business Linkshas over the last 15 years created confusion in the market place which hasstymied potential growth companies. Yet this first tier of the funding modelis critical in ensuring that venture capital is an engine rather than an objectof growth.

Tier 2. Existing regional investment funds

There are Regional Investment Funds which were established with the aimof servicing the equity gap in the North East (Northern VentureManagers),10 the North West (Merseyside Special Investment Fund), theWest Midlands (West Midlands Enterprise) and Yorkshire (YorkshireFund Managers).11 In addition, Greater London Enterprise (GLE) is aregional investment fund, although formally this fell outside of theconsultation process which referred specifically to the English regions. Atfirst glance it would appear that the funds cater for the very gap that iscurrently developing in the second tier of funding since all averageinvestments are at or below £750,000.

This does not, however, provide a full picture of how these fundsoperate or how they envisage their role in relation to the RDAs. Forsuccinctness these are listed in general terms below.

1. All operate on a commercial basis and thus would accept that averageinvestments have been increasing over the past few years. Indeed, it wassuggested that a ‘viable’ investment is close to £1 million.

2. All except Northern Venture Managers have, in the first instance, a localinvestment remit. However, all point out that it makes little differenceto investors where the investment is located providing that a return isforthcoming. As a result, all have started to look at investments outside


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of the region in which they are located, and all are involved with theING-Baring English Growth Fund.

3. West Midlands Enterprise, MSIF and the Yorkshire Enterprise Groupall have funds which overlap with Tier 1 of the model either throughloans, ‘known’ business angels or access to smaller equity funds. Indeed,the local BAN manager for the West Midlands area shares offices withWME executives. GLE increasingly provides this overlap throughfactoring although this is by their own admission not an effectivefinancing tool for all businesses.

4. West Midlands Enterprise, GLE, MSIF and Yorkshire Enterpriseprovide some ‘non-commercial’ support to clients in providing leveragethrough to second round funding and beyond.

5. West Midlands Enterprise and Yorkshire Forward increasingly have atechnology focus—West Midlands through the local universities and theWest Midlands Growth and Innovation Partnership (this has a seedcapital focus) and Yorkshire Forward through its involvement with theRegional Innovation Strategy and its contacts with Cambridge-basedstructures and funds.

6. All expressed concern at the way in which regional funds were being setup. In particular, as investors, all were keen to see the equity gap above,say £350,000 met through risk mitigation (or guarantee) schemes fromgovernment funds.

Progress across the regions towards establishing funds

From the discussion thus far it is clear that there is a substantial amountof activity in the venture capital market, formally and informally, both ata local and regional level. This is significant since any attempt to establishregional venture capital funds would be adding to existing provision inthe market. This makes it doubly important that the structure and remitof these funds are carefully thought through before resources arecommitted.

A number of summary points in relation to the development of regionalfunds from the fieldwork interviews are worth highlighting:

1. There has been a problem with the speed with which RDAs have had tocome to grips both with their Regional Economic Strategies and withthe establishment of a regional venture capital fund. Only three of theRDAs had made substantial progress towards establishing a fund andalthough all but one had made internal appointments to look at issuesaround venture capital, only two of these appointees had any priorspecific knowledge of the venture capital industry.

2. Some regions have a comparative advantage over others in that theyhave established existing funds which would be quickly and costeffectively able to establish themselves as dominant in any tenderingprocess. While this would have obvious costs in terms of competition,the advantages in terms of their existing and specific knowledge of theregion would be substantial. Since many of these have developed funds


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which link formal and informal venture capital, this would have furtherco-ordination benefits.

3. Despite the apparent progress in some regions, however, no region hadestablished a fund by mid-1999. In any event, the sensitivity around thiswas palpable—all wanted to see how the SBS would work and whatother regions and financial institutions would be doing first.

4. The role of government seemed unclear to the majority of interviewees.All wanted explicit statements on the nature of government inter-vention—particularly the link between the DTI’s Enterprise Fund andDETR’s coal field fund and the balance of responsibility betweencompetitiveness and regeneration. Given their regeneration role, allappeared keen to stress their co-ordination role, and all stressed the needfor any fund to be nominally independent of the RDA.

5. Nearly all of the RDAs appeared bemused at their own relationship bothwith existing funds and, critically, with any new regional fund. Allexpressed concern at the need for independence of the fund, at theconfusion between the RDA and the SBS role, and at the likelydifficulties in co-ordinating SBS with existing structures. This was ofparticular concern because of the RDAs’ regeneration role. Anyconfusion was seen as potentially undermining a clear message topotential entrepreneurs and thereby preventing a positive venturecapital climate from developing.

6. All RDAs had embarked on some kind of evaluation survey and all ofthese included an assessment of informal venture capital, loan financeavailability and the need for co-ordination/mentoring type structures.However, none had explicitly taken steps to incorporate business angelnetworks into their proposed fund structures or into their RegionalEconomic Strategies.

7. All RDAs make explicit statements about the need for innovationclusters and integration of universities in their area. Some regions haveuniversities which had been successful in gaining University Challengefunds (Treasury funds managed by local fund managers). However,although the links between innovation and venture capital were seen as a‘good thing’ they were not made clear. Given that this is anothergovernmental department, and given that currently non-RDA fundsmanage these, this is potentially a source of bottlenecks in any co-ordinated system.

8. All saw a role for national players like 3i in any tiered structuring offunds. These larger scale funds could participate as one investor amongseveral in a second layer of a tiered funding structure.

The problem for the English regions

Venture capital should not be seen as a universally good solution forcreating GDP growth, although it clearly does have a role in creating fastergrowth in projects which, inherently have high growth potential. Indeed, itcould perhaps be argued that the panacea is finding an effective and wellunderstood framework for small business growth rather than simply


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throwing money behind the venture capital industry and hoping thateconomic growth will follow.

There are a number of reasons from the research which underpin thisstatement. First, there is a real concern expressed in the industry andamongst practitioners that markets are not currently working. There isover-supply in some areas and, albeit to a lesser extent, excess demand inothers. This is a national problem of the mismatch of demand and supplywhich has a regional solution. In conventional economic terms, if marketsare to be made to work, then there must be a matching of demand andsupply around a ‘market clearing’ price. However, the ‘economic drivers’(i.e. the considerations for commercial return and revenue to the fundmanager) amongst the venture capital suppliers are not the same as thosewhich drive the interests of small business start-ups in the short term. Inthe longer term the interests are the same and centre around continuedprofitability and growth. Thus, to return to the economic analogy, in theshort term, the returns to the investor have to be made the same as returnsto the investee. There is a defensible role for government in amelioratingthis market imperfection.

Second, at the regional (RDA) level there are real concerns in relationto establishing an Enterprise Fund. Unless these are addressed they havethe potential to undermine the credibility of any Regional Fund whichmight be established. Specifically these are:

1. The issue of time. The envisaged timescale in setting up a fund is tooshort for RDA personnel to feel that they can make a good job of thetask in hand. Many of the individuals involved with the fund aresecondees and/or on short term contracts. They have thus been in postfor a relatively short period of time and will be leaving relatively shortly.Frequently, although not exclusively, the individuals concerned are notventure capitalists themselves and a large proportion of their time hasalready been spent on coming to grips with the issues involved. What isclear from the examples of Scotland, Northern Ireland and Wales is thatfunds and structures take time to develop. An effective fund withsubstantial investment requires a track record. Co-ordination mechan-isms require a detailed knowledge of local conditions in order that theyare developed in a manner appropriate to local needs. Neither of thesedevelops over night.

2. The issue of money. These funds cannot be established without using theinvestment expertise of commercial fund managers and the legal skills ofspecialist lawyers. These skills come at a cost—the management costs ofany such fund are estimated variously at between £200,000 and£250,000. While in the long run these costs should arguably be metby the performance of the fund itself, in the short run they have to becovered from alternative sources.

3. The issue of appropriateness. RDAs were not uniformly positive aboutthe use of venture capital funds in stimulating regional GDP growth.Many small businesses do not have high growth potential and are not hi-tech. These projects are unsuitable for venture capital investmentsalthough may in themselves be equally important in generating regional


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GDP growth and employment. For these companies, loans and grantsare as suitable as funding mechanisms and the concern at a regional levelwas that the focus on venture capital funds should not be at the expenseof other, equally important, funding instruments.

4. Evaluation and inherent risk aversion. It has been repeatedly argued, inthis report and by the practitioners themselves, that the fastest growingbusinesses (and hence returns on investment) are in hi-tech. While thisdoes not preclude other high growth projects, it does point to a seriousproblem amongst existing venture capital structures. A significantproportion of the fund managers interviewed did not feel that they couldplace investments in projects which they themselves did not understand(this included low-tech as well as hi-tech). Many of the existingstructures and funds have started to buy in the evaluation skills ofuniversities and technology transfer institutes. However, this is not yetdone on a systematic basis and, as a consequence, there is still anendemic risk aversion within the system.

5. Market failure through structures. RDAs, fund managers and BusinessLink executives all confessed themselves to be confused at theoperational relationship between the SBS, the RDAs, existing BusinessLinks and existing Regional Investment Funds. Markets work best onthe basis of clear and perfect information. At present, one reason for anyfuture market failure will be lack of clarity and task definition betweeneach of the actors (including government departments) operating in themarket.

6. The equity gap itself. The research has clearly identified that the equitygap is not at the level of less than £250,000 currently identified in policycircles.12 In fact, structures providing for this level, although randomand uncoordinated, mean that entrepreneurs can find finance through avariety of different tools which are available through governmentinitiatives and through the private sector. Similarly, the market forquantities of money above £750,000 is also well served providing thelevel of risk can be assessed and deemed commercially attractive toinvestors. The real gap is between these two amounts at the second tierof funding and while current suppliers do have mechanisms for dealingwith this, these are regionally variable and are increasingly secondary tothe understandable commercial interests of fund managers. The BaringEnglish Growth Fund is a step in the right direction for addressing thisgap.

Examining this gap in more detail then, it is necessary to examine theseparate concerns of those supplying the two ends of the existing spectrum.

Less than £250,000: informal venture capital, small scale formal venturecapital. Practitioners operating at this end of the market expressed realconcern about the nature of demand for their services. They argued thatbusinesses were reluctant to use equity based finance as a means offinancing growth. Indeed, the data collected for this research, even if ratherunsystematic, raises serious issues about the very existence of demand forventure capital in some regions. While practitioners could cite vast sums of


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money available for investment, relatively few were able to point tosimilarly vast numbers of clients waiting for this type of investment. Thelanguage of venture capital is frightening and entrepreneurs feel wary of thepotential loss of control. At an operational level, practitioners at this lowerend of the venture capital spectrum also felt that the functional relationshipbetween themselves and any regional fund should be established,particularly if the fund was aiming at the market less than £250,000.

More than £750,000: the formal venture capital funds. The central concernof fund managers at this end of the market was the commercial viability ofthe fund. All were clear that any RDA fund would have to be commerciallyviable and run according to industry best practice in order to ensure itsattractiveness to potential investors and its credibility and ‘safeness’ toinvestees. Again, all confirmed that the gap between £250,000 and£750,000 was the one that really needed to be addressed by any fund.

The key conclusion to emerge from this study is that there is a gapbetween £250,000 and £750,000 which is both a finance gap and aknowledge gap. In terms of the growth model developed earlier (figure 1),it is the second tier of finance and the arrows of co-ordination that aremissing from current provision in the English regions. Thus far, attentionat all levels—government, fund managers and even business angelnetworks—has focused on the supply side—particularly on encouraginginvestments into funds.

However, by addressing the problem from a demand side perspective,the real depth of this problem can be understood. First, there is a gap infinance which makes potential investment opportunities unattractive.Investors will not provide large scale investments into unproven companieswith no track record as the risk is simply too high. This means some formof public sector involvement, albeit on a commercial basis, that providesleverage to larger scale monies once a proposition becomes attractive, or‘investor ready’. Second, the ‘knowledge gap’ is self-evident from thisresearch. This does have a supply dimension as the comments above oninherent risk aversion confirm. However, the main problem is inencouraging entrepreneurs to become investor ready—through mentoringand guidance beyond that which is currently provided.

This boils down to the operational relationship between the tiers offinance in the model described above and characterized as a gap betweenthe informal and formal venture capital structures. This gap can be seenlocally, regionally and nationally and was described variously byinterviewees as ‘tribalism’ and ‘Balkanisation’. But it is this gap which isstopping the venture capital market from being the engine of growth as it isin the US and as it increasingly is in Germany.

Conclusion

The thrust of government policy is to create a high growth knowledge-based economy through the establishment of venture capital funds. But, as


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has been made clear by this research, these funds already exist to a largeextent. What does not exist, however, is a real market for venture capital.While there is supply of funds, there is little in the way of demand for thosefunds. The logical consequence of this is that there has been an upwardspiral of investments and a tendency towards high return MBO/MBIinvestments since there has been a distinct lack of high quality investmentpropositions in which to invest the over-supply. As one high-tech networkco-ordinator be-moaned, ‘With all this money, why aren’t we seeing anyBritish Microsofts?’

The answer to this question lies in the demand issues raisedthroughout the paper. There is no shortage of innovation and noshortage of good business ideas. There is, however, an aversion to usingventure capital as a tool of business growth. From the interviews it isapparent that there are identified difficulties in rewarding talent inEngland and real structural obstacles to creating growth companies fromuniversity spin-outs. A full discussion of these goes beyond the scope ofthis paper, but further research should look at Intellectual Property andcluster development as a means of generating real knowledge-basedgrowth.

A high-growth, knowledge-based economy is necessarily desirable andthere is no shortage of practitioners, academics and politicians who willstand up and espouse the need for policies to achieve this. The UK hasmuch to learn from abroad, particularly the US and, increasingly,Germany in terms of cluster development, regional policies, integratinguniversities and, most importantly for this research, generating growththrough access to venture capital. Repeated studies have shown that thestreamlining of business start-ups and providing incentives to take risks aremajor failings of the UK system (Adams 1999) and that, if anything, thereis excess supply of venture capital relative to demand (Stormont-Darling1999). This does not mean that we need to adopt the US model as the onlyway of generating an entrepreneurial society, however. But the US is acompetitor, and thus has at the very least to be seen as a benchmark.

So where does this research leave government policy towards thesevital areas? There is a role for government involvement in the venturecapital industry, but creating market distortions through that involvementwill not improve the situation. In particular, the Government has to beaware of two things. First, it must not put money into the market at apoint which exacerbates the problem. The danger with putting moneyinto a fund which expects a commercial return is that it merelyexacerbates the existing trend towards upwards spiralling averageinvestments. Second, there is little to be gained from providing directsubsidy to management costs in the long run since this again simply putsmoney where it already exists.

Meanwhile, RDAs do have a key role to play in all this. Rather thanfocusing on creating funds in their own right they should direct theirefforts towards the creation of ‘knowledge gap’ filling mechanisms. Bycreating such ‘finance gap’ filling tools RDAs can engender the flexiblefunds that do encourage innovation and growth, say, in the US orGermany.


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Acknowledgements

This is an abridged version of a report which was published by IPPR(Harding 1999) and funded by 3i plc.

Notes

1. There is a tension between the regeneration and the competitiveness remits of the RDAs which is atleast partly caused by the different sources of governmental funds for these tasks; 98% of RDAfunding is for regeneration and comes from the Department for the Environment, Transport andthe Regions; only 2% of their budget is for competitiveness, but this comes from the Departmentfor Trade and Industry.

2. These included the Chief Executives, or their representatives, of all of the English RegionalDevelopment Agencies, venture capital fund managers and managers of Business Angel Networksin each UK region, high street banks, European Investment Bank, Bank of England andgovernment agencies (HM Treasury, Department of Trade and Industry, Department For theEnvironment, Transport and the Regions).

3. Management Buy-Out: ‘To enable the current operating management to acquire or to purchase asignificant shareholding in the business they manage’ (BVCA 1999a: 17); Management Buy-In(MBI): ‘To enable a manager or group of managers from outside a company to buy into it’ (BVCA1999a: 18).

4. Business angel networks can be publicly or privately managed networks or consortia of individualswho have an interest in making smaller scale investments in potential growth companies. Typically,business angels will invest up to £50,000 in any one project, thus, where larger investments arerequired, loose groupings of angels will co-invest, or alternative forms of financial packaging will besought.

5. Now branded as HSBC. Since the Enterprise funds remain as ‘Midland’ Funds in BVCApublications, this term is used here.

6. Regional Investment Funds were established, often to manage local authority pensions funds, withthe specific purpose of helping local SMEs in the equity gap. These funds, then, are quite differentto some of the formal venture capital funds which have a clear regional bias because of thegeographical location of their investments but which do not have a regional remit.

7. See Harding (1999: 21 – 29) for details.8. The localities listed are for illustrative purposes only and do not refer to actual examples.9. Corporate Venturing is where large companies take an equity stake in smaller, related businesses.

This is particularly appropriate as a tool for stimulating hi-tech and is common practice inbiotechnology.

10. Northern Venture Managers Ltd. is a generalist fund with a UK investment remit rather than alocal focus. It operates on a commercial basis and does not specify the second tier equity gap in itsremit. As it is a UK fund it was not included in the fieldwork for this research but, since it is a VCTfund manager is included for the sake of completeness in this report.

11. Part of the Yorkshire Enterprise Group.12. The summary responses to the consultation process, issued by the DTI in October 1999 further

reinforced the fact that the equity gap was seen as being sums up to £500,000 by respondents(Department of Trade and Industry 1999c).

References

Adams, J., 1999, How much harmonisation does Europe need? Unpublished contribution to session ofGerman-British Forum Fourth Annual Conference, London, 13th October.

Aernoudt, R., 1999, European policy towards venture capital: myth or reality? Venture capital: AnInternational Journal of Entrepreneurial Finance, 1, 47 – 57.

Bank of England, 1996, The Financing of Technology-Based Small Firms (London: Bank of England).Bank of England, 1998, Finance for Small Firms: A fifth report (London: Bank of England).


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Association).BVCA, 1999a, Report on Investment Activity, 1998 (London: British Venture Capital Association).BVCA, 1999b, The Economic Impact of Venture Capital in the UK (London: Bannock Consulting).BVCA, 1999c, Directory 1998/99 (London: British Venture Capital Association).Casper, S., Lehrer, M. and Soskice, D., 1999, Can high technology industries prosper in Germany?

Institutional Frameworks & the Evolution of the German Software and BiotechnologyIndustries. Industry & Innovation Vol 6, No 1, 5 – 24, London, Carfax.

Cowie, H., 1999, Venture Capital in Europe (London, The Federal Trust for Education and Research).Department of Trade and Industry, 1998, Competitiveness White Paper (London: Stationary Office).Department of Trade and Industry, 1999a, Addressing the SME Equity Gap: Support for Regional

Venture capital Funds (Sheffield: Department of Trade and Industry: Small and Medium SizedEnterprise Policy Directorate).

Department of Trade and Industry, 1999b, The Small Business Service: A Public Consultation(Sheffield: Department of Trade and Industry: Small and Medium Sized Enterprise PolicyDirectorate).

Department of Trade and Industry, 1999c, Addressing the SME Equity Gap: A Summary of Responses tothe DTI’s Consultation Document on Support For Regional Venture capital Funds (Sheffield:Department of Trade and Industry: Small and Medium Sized Enterprise Policy Directorate).

Gavron, R., Cowling, M., Holtham, G. and Westall, A., 1998, The Entrepreneurial Society (London:IPPR).

Harding, R., 1999, Venture Capital and Regional Development (London: IPPR).Harding, R. and Lissenburgh, 2000, Knowledge Links: Innovation in university/business partnerships

(London, IDPR)Mason, C. and Harrison, R., 1995, Closing the regional equity capital gap: the role of informal venture

capital. Small Business Economics, 7, 153 – 172 (Amsterdam: Kluwer Academic Publishers).Mason, C. and Harrison, R., 1997, Business angel networks and the development of the informal

venture capital market in the UK: is there still a role for public policy? Small Business Economics,9, 111 – 23.

Mason, C. and Harrison, R., 1999a, Editorial. Venture capital: rationale, aims and scope. VentureCapital, 1, 1 – 46.

Mason, C. and Harrison, R., 1999b, Public Policy and the development of the informal venture capitalmarket: UK experience and lessons for Europe. In K. Cowling (ed) Industrial Policy in Europe(London, Routledge) 199 – 223.

Mason, C. and Harrison, R., 1999c, Financing entrepreneurship: venture capital and regionaldevelopment. In R. L. Martin (ed) Money and the Space Economy (Chichester: Wiley) 157 – 83.

Murray, G., 1994, The second ‘‘equity gap’’: exit problems for seed and early stage venture capitalistsand their investee companies. International Small Business Journal, 12, 59– 76.

Murray, G. and Lott, J., 1995, Have UK venture capitalists a bias against investment in newtechnology-based firms? Research Policy, 24, 283 – 99.

Stormont-Darling, 1999, Enterprise & Venture Capital, unpublished contribution to German-BritishForum, 4th Annual Conference 13th October 1999

Wright, M., Robbie, K., Albrighton, M., Mason, C. and Harrison, R., 1998, Venture Capital in Europe(London, The Stationary Office).


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Documents

Venture capital and regional development: Towards a venture capital 'system