UK: THE VENTURE CAPITAL VACUUM.

UK: THE VENTURE CAPITAL VACUUM. - The ideas are there and the money is certainly around. So why it is that so few venture capitalists are comfortable with backing start-ups?

by Martin Vander Weyer Weyer.
Last Updated: 31 Aug 2010

The ideas are there and the money is certainly around. So why it is that so few venture capitalists are comfortable with backing start-ups?

'Like getting blood out of a rocking horse,' replies one seasoned investor, David Morrison of Abingworth, on the chances of persuading institutional capital to back a start-up business in Britain.

This agrees with the view offered by, among others, the Guardian's economics editor Will Hutton in The State We're In, his best-selling attack on Thatcherite economics. Hutton castigates the City for being short-termist, obsessed with the use of financial wizardry to maximise returns, and disdainful of real, serious, job-creating, export-generating, long-term investment in the manufacturing industry.

Are Hutton and his ilk (many of them of the Blairite, neo-Keynesian persuasion) right or misguided? Are British entrepreneurs disadvantaged by ignorance, greed and excessive caution on the part of institutions who, by observation of the American model of venture capitalism, ought by now to know better? Or is Britain simply failing to produce the right kind of entrepreneurs with ideas and management teams strong enough to merit high-risk investment backing?

Is it simply a problem of misleading terminology? The phrase 'venture capital' suggests start-ups - and actually means it in the US - but has come to be applied in this country to a broad range of what is properly described as development capital and management buy-out financing for relatively mature businesses. British investors cannot be criticised for pursuing these activities, since they have done so with considerable skill over the past 15 years and have enjoyed some spectacular returns.

But a vigorous economy still needs to help entrepreneurs start up businesses. In 1994, members of the British Venture Capital Association (BVCA) collectively devoted £76 million to 'early stage' investments out of a total of £1.67 billion invested in the UK. Brian Larcombe, finance director of 3i, Britain's biggest equity investor in private companies, is the president of the BVCA: 'I am certainly concerned that investment in start-ups has been declining,' he says, noting that the level of start-up financings peaked in 1989. 'But the problem isn't the money, it's finding the management.' Andrew Joy of CINVen (a subsidiary of the coal industry pension fund) has been elected to succeed Larcombe at the BVCA and takes an altogether more bullish line. He observes 'a refreshing number of success stories. Since the early 1980s I've never known a period which has seen as much action in the early stage arena as there is today.' But what does Bob Jones think? Bob who? Jones is a 48-year-old Welsh electronics engineer who used to work for Racal. He describes himself as 'a compulsive business founder' and is in fact one of Britain's most successful high-tech venturers, having built up and sold three separate businesses in the past 13 years. The first, a modem-maker called Steebek, launched with his own modest savings, was sold for £4.5 million after five years. The second, Mayze Systems, had backing from a trade investor, and was sold to Dowty for £6 million. The third, Sonix Communications, began making modems in Cirencester in 1992 with £1.2 million of backing from Schroder Ventures and a specialist technology fund, Greylock Management of Boston. Its turnover this year is expected to be at least £25 million and it has just been sold to 3COM Corporation from the US for £44 million, realising £18 million for the two investment houses within three years.

That kind of result makes venture capitalists dance on the boardroom table, but raising the money was far from easy. 'British institutions make no real secret of the fact that they don't like start-ups,' Jones says. 'The money may well be out there, but the institutions put you through such torture to get to it. The due diligence process is much more severe and soul-destroying in the UK than in the US. It can go on for six months or more, and there are plenty of good people who just can't afford to finance themselves for long enough to wait for a decision.' However, he acknowledges, 'Schroder Ventures was very supportive to us at the end of the day. Greylock is a specialist in our sort of business, and I think the two of them took some comfort from each other's presence in the deal. But there were a number of others who turned us down, and we have a bit of a laugh at them now, because Schroders has really made a lot of money out of this deal.' Persistence is needed to steer a greenfield proposal to a happy ending. Tech-board, as reported in Management Today (November 1994), is Britain's biggest industrial start-up, a £40 million hardboard manufacturing venture in Ebbw Vale. It was backed by 3i and both Rothschild Ventures and the detached London branch of the Rothschild dynasty, RIT Capital Partners. But even with the pulling power of 3i behind it, the project took nearly five years to get off the drawing-board: and the most crucial role in assembling the capital was played not by an institution but by a 'business angel', veteran entrepreneur Peter Learmond, who brought in North American money.

Tech-board's founder, Malcolm Graham, says that most so-called venture capitalists 'were simply not geared up to such a scheme. To them raising £4 million for a start-up would be a major cause for concern.' His associate, Nick Theakston of KPMG, said: 'We spoke to perhaps as many as 40 venture capitalists, many of whom expressed sincere interest. But all we proved at the end of the day was that the market does not like start-ups and in many cases was simply not able to invest in them.' The evidence backs the view that early-stage venture capital in this country is chronically under-developed and over-cautious. Why is that, if the essential problem is not shortage of money? A cross-section of investment experts suggests that the answer is a combination of culture and competing opportunities. Lack of confidence and critical mass give most British investors a negative approach to start-up propositions until the case is proved otherwise; and also they have better things to do with their cash.

Once upon a time, attitudes were more positive - but mostly because every kind of business proposition, 62e however flimsy, could be made to look good in the euphoria of the boom years. As Joy reminds us, 'In the 1980s there was a flush of enthusiasm for early-stage, high-tech companies, but that meant a lot of inexperienced management trying to manage in very fast-moving markets. A lot of projects got funded that did not stack up, and in the end they turned sour. People thought they could simply replicate the US venture capital story.' However, Britain does not have the kind of interconnected business and educational structure that makes California such fertile ground for venture capital in the high-technology field. There are no agglomerations of high-tech companies and intellectual hothouses like Silicon Valley, where new ventures can be examined for original technology. The US has over 250 listed bio-tech companies, compared with less than 10 in the UK.

The UK does not have the personal networks of business school alumni to promote the flow of ideas and money, or a well-developed nexus of relations between universities, research institutions, entrepreneurs and financiers. In the US, venture capitalists do precisely what the name says, often dedicated to very specific areas of technology: they are not to be confused with leveraged buy-out specialists - a completely different kind of beast, in a more dangerous part of the US financial jungle.

Richard Thompson, founding partner of Thompson Clive, notes ruefully that in this country technology investment is still regarded as a highly specialised 'niche', rather than an essential gateway to prosperity. His firm is one of the few in London to declare a genuine passion: 'We're fascinated by the creation of new industries - in life sciences, for instance. It's not a matter of boffins - it's a matter of how you apply technology commercially to markets. We're looking for an explosive fusion of technology and commerce like petrol and air. We're not really interested in recycling mature companies.' This approach raises a fundamental question: with so many more exciting ventures taking off in the US or elsewhere, why invest solely, or predominantly, in Britain? Investors who have seen the light, in Thompson's terms, are bound to start looking for winners abroad. At the end of 1994, Thompson Clive's portfolio had 20 investments in the UK, nine in the US and three in France.

'Our international approach doesn't mean we have a bias against the UK,' he says. 'But it would be difficult to do all our investment in Britain. In the US, start-ups will more easily attract big funds, and it is possible for businesses to get big quite quickly within their home market.' (For example, Silicon Graphics, which grew to a market capitalisation of $1 billion within 10 years of its launch). 'In the UK, you have to start selling internationally very quickly to maintain the growth rate, which means you have to have an international sales strategy from the start, and that makes the whole proposition more difficult. We sometimes find ourselves backing British entrepreneurs in the States, in fact.' Another cultural difference is the managers, or lack of them. Businesses which are going to be big need managers with big-company experience, but British corporate executives have traditionally been reluctant to take that leap into the dark. For those whose prime concern is personal capital formation, the trend towards generous stock option deals makes staying in a successful public company a relatively attractive bet. 'We don't see many proposals where managers are coming out of very good salaried jobs to set up new businesses,' says Abingworth's Morrison. 'But buying into something that already exists in a development capital deal - that's a different matter.' The British capital market conspires to discourage some who may have a go by being intolerant of those who have launched unsuccessful ventures in the past. 'In the US, if you went bust the first time, that's seen as a plus,' says 3i's Larcombe. By contrast, 'in Britain, you take one business failure with you to the grave', says Richard Thompson.

Then there is the stinging accusation that we are a nation of chronic short-termists. Many professionals would agree that the Brits - both as investors and as entrepreneurs - have shorter investment horizons than the Americans, and much shorter than Asian businesses. 'British entrepreneurs reach the threshold for sale earlier - they want to take their profit quickly,' observes David Horner of Strand Partners, a corporate finance boutique which, he says, has found raising start-up money to be a Herculean task.

Jones's Sonix deal excited particular comment because of the relatively short period in which the ventures money was at stake. Joy of CINVen cites a similar example in Firebox, a Birmingham-based maker of local area networking conductivity products. CINVen and its IT partner, Syntech, took an 'early stage' £1.5 million stake in November 1993, and was able to exit with a tenfold profit when the company went public on NASDAQ in May 1995. These are dramatic results when compared with the normal expectation of a six-to seven-year wait before a start-up portfolio begins to show satisfactory returns.

Management buy-out investments, on the other hand, can usually be relied upon to produce good results by the third year, and it is in this sector that most of Britain's 'venture' capital has been devoted. Pickings were particularly rich in early stages of the economic recovery, when assets were cheap, interest rates low and growth prospects good. Interest rates have risen, and prices are rising because trade buyers are likely to be in the market in competition with buy-out teams.

Catherine Wall, a regional director of BZW Private Equity, points out: 'It doesn't follow that if we did less buy-outs, we'd do more start-ups. It's a matter of getting the right return.' Big, well-presented start-up proposals may get more of a hearing - Wall quotes the recent example of the Royal Armouries Museum in Leeds, for which 3i and Schroders have raised £6 million of private equity - but the real gap in the market, she believes, is for smaller start-ups. 'It remains very hard for the engineer in his garage to raise £50,000 to finance a prototype, much harder than raising £10 million for a microchip project. The larger project is more likely to be worth speculative time and trouble on the part of investors, and to be pushed by the right sort of management team.' So, is there hope for British inventors or entrepreneurs? Some may strike lucky with corporate backing of enlightened tycoons such as Richard Branson of Virgin or Sir Colin Southgate of EMI. 'Business angel' capital is available from individuals who have made their fortune by venture capital backing and plough some of it back into the system on a basis that gives them 'more involvement than just picking up the phone to the stockbroker'. In addition, Lord Cobbold (owner of Knebworth House, and a former treasurer of 3i) has made a proposal to the Millennium Commission for a technology fund to offer grants of up to £100,000 for business start-ups, particularly those emerging out of research work at British universities.

'We're still only at the start of what is possible,' Joy says. 'The more it happens, the more it will continue to happen.' Two British companies which have grown out of modest start-up financings are Mercury Communications and Derwent Valley Foods, the Consett-based maker of Phileas Fogg snacks. But there are thousands of bright ideas which never make it over the assault course of the super-demanding British venture capital industry.

Optimism and stamina are distinguishing characteristics of all the best entrepreneurs. There is money for new businesses out there, and everything is possible with a saleable product, a sensible business plan and a balanced management team. With the right formula as Jones of Sonix says, 'There's nothing magic about doing this kind of thing'. Despite the increasingly upbeat tone of some British institutions, it is not that easy either.

Martin Vander Weyer is an associate editor of the Spectator.

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