VENTURE CAPITAL AND THE REGIONS 49

Access to appropriate forms of Þnanceis key to ensuring that small- andmedium-sized companies have the

freedom and the scope to grow. Venture cap-ital Ð or long-term committed investments inunquoted companies in return for an equitystake Ð is a potential means of stimulating thisgrowth. For the company receiving the cap-ital it is secure growth Þnancewithout the risks inherent inloans secured on property.For the investor it representsa means of generating rev-enue from the growth of abusiness.

By stimulating this mar-ket the Government wouldtherefore have ample scopefor achieving the highlydesirable policy objectives ofenhancing entrepreneurialactivity and generating eco-nomic growth. Indeed, politicians and com-mentators alike point to examples in the USwhere a buoyant venture capital marketappears indeed to have generated a pro-active, pro-risk entrepreneurial culture, whichleads to large numbers of business start-upsand high growth through small and medium-sized enterprises (SMEs).

Critical differences exist between regionswithin the UK, however, which potentiallyprevent the link between venture capital andgrowth being quite so clear cut. These dif-ferences manifest themselves, Þrst, in termsof macroeconomic indicators such as region-al GDP per head and industrial structureand, second, in terms of cultural factors such

as the acceptability of ven-ture capital to entrepreneursas a tool of business growth.To take account of theseimportant distinctions, anynational level policy has atleast to contain a regionaldimension, if not be explicit-ly regional.

This article looks at the ven-ture capital market as it isdeveloping in the UK, withthe aim of informing govern-ment policy. It is based on

IPPR research, conducted during 1999, whichexamined venture capital across all regions inthe UK. At the time of the research, propos-als for venture capital funds in the Englishregions were out at consultation. Field workresearch sought to identify both the key issuesfacing the Regional Development Agencies(RDAs) and local venture capital providers in

Venture capitaland the regions

Not always the most appropriatefunding mechanism

REBECCA HARDING

University of Sussex

1070-3535/00/01049 + 04 © 2000 IPPR

Òpoliticians andcommentators alikepoint to examples in

the US where abuoyant venturecapital market

appears indeed tohave generated a

pro-active, pro-riskentrepreneurial

cultureÓ

50 NEW ECONOMY

these regions, and any factors critical to estab-lishing regional funds successfully.

This largely practice-based research processled to important conclusions, which mustinform policy if it is to be truly effective. Theprinciple of venture capital investment rests oninvestors perceiving a high return relative torisk. In other words, if the growth prospectsof the company look outstanding, whatever thecompanyÕs core business, it will be appropri-ate as a recipient of venture capital investment.However, two key factors underpin this state-ment and, hence, any policy in this sector:● Return, relative to risk for the investor, is not

always clear. Businesses might fail to deliv-er their full growth potential or fail com-pletely. As a result, many venture capitalfunds will not invest in companies, sincereturns are not guaranteed. This is trueirrespective of the size of the initial invest-ment. Government policy must takeaccount of this commercial imperative fac-ing the industryÕs fund managers by pro-viding risk mitigation through investmentguarantees, for example.

● It is by no means clear that formal venturecapital (provided through funds) is themost appropriate funding mechanism forall the small businesses that policy aims tosupport. Entrepreneurs do not always haveglobal, or even national, pretensions fortheir business, but want simply to providea living for themselves and jobs for a fewemployees. For most of these businesses,alternative, largely debt-based Þnance maybe more appropriate. Others may be able tobeneÞt from informal venture capital, forexample through business angels, as ameans of providing them both with man-agerial and business expertise as well aswith the finance they need. WhicheverÞnance route is taken, however, these busi-nesses are key to the regional regenerationremit of RDAs and their funding needsshould not be forgotten in the rush to estab-lish venture capital funds.

The real policy solution lies in close co-oper-ation between all the different agents in thesystem at a regional and national level. RDAshave the tools at their Þngertips to performthe co-ordinating task and, rather than focus-ing on the funds in their own right, shouldbe concentrating on the issue of harnessingthe latent potential that already exists in eachregion. Many of the problems that currentlymanifest themselves in the market place orig-inate in imperfections in information. In otherwords, entrepreneurs know little about howventure capital works and, critically, policymakers and fund holders alike are unawareof exactly how much demand is in the mar-ket. All can guess, but no one can be precise.Markets will not function without informa-tion and this is abundantly clear for the UKventure capital sector.

The issuesGovernmentÕs role is to address the imbalancebetween the perceived risk of such projectsand their potential return. In the most suc-cessful models of venture capital there is asubstantial degree of government involve-ment, either through direct subsidy, riskreduction or incentivisation to encourageinvestment in higher risk projects. There arealso clear structures for feeding potentialgrowth companies through the system, fromstart-up and early stage through to eventualßotation. These structures only become a sys-tem through direct involvement by govern-ment agencies in ensuring clarity in theoperation of the market.

Perhaps most importantly, given the sizeof the venture capital industry, it remains anunder-utilised means of small- to medium-sized enterprise (SME) Þnance in the UK.British companies have appeared unwillingto use it as a resource, choosing more tradi-tional, debt-based mechanisms (largelythrough banks) to fund their expansion. Fur-ther, British venture capital funds havebemoaned the apparent lack of investment

VENTURE CAPITAL AND THE REGIONS 51

opportunities in potentially high-growthSMEs. They argue that they have funds avail-able for such investment, but see relativelyfew good, investor-ready propositions thatwill provide an adequate return relative to therisk involved. The result is a market that failsto function properly.

The policyThe Government has been quick to spot ven-ture capital potential and launched its supportfor venture capital funds in 1997. It becameexplicit policy in the Competitiveness WhitePaper (DTI, 1998), in which £180 million wascommitted over three years to a nationalEnterprise Fund with the following features:● incorporation of the existing Small Firms

Loan Guarantee Scheme (SFGS)● support for the establishment of regional

venture capital funds● provision of a national venture capital fund

supporting early stage and high-tech busi-nesses

● provision of ßexible support for innovativebusiness proposals currently not catered forby the Þnance industry.

In general terms, the aim was to providefunding for the equity gap Ð in other words,for the smallest companies for start up andearly stage growth.

The subsequent consultation documentfocused speciÞcally on the support for region-al venture capital funds under the provisionof the Enterprise Fund. The consultationaimed to Ôensure that support for regional ven-ture capital funds is designed to meet theneeds of SMEs in all regions and is compati-ble with industry practice.Õ Within the docu-ment, the Government proposed at least nineregionally-based venture capital funds pro-viding Ôequity-based Þnance to Small andMedium Sized Enterprises (SMEs) in amountsbelow £500,000Õ. On the demand side, theobjective is to increase availability of this typeof Þnance to SMEs that would otherwise notbe able to obtain it. On the supply side, the

objectives are to ensure, Þrst, that each regionhas a viable venture capital fund and, second,to encourage investment into these funds.

De facto these funds would be set up bythe RDAs. Accordingly, their establishmentfeatures strongly in most RDA economicstrategies.

The aim is to address the inherent weak-nesses in the UK market through appropri-ate intervention in the marketplace. Suchintervention at a regional level is deemed nec-essary in order to assist the RDAs in further-ing their own objectives of regionalregeneration and competitiveness. Achieve-ment of this aim rests on ensuring that region-al funds are of a viable size and that regionalfund managers have appropriate expertise aswell as local knowledge. It is envisaged ingovernment documentation that the inter-vention will take place in one of three forms:subsidised management costs; co-investmentin funds and guarantees for funds (to spreadperceived risks on high-risk projects).

Venture capital in the regionsDespite the apparent buoyancy of the market,there are some tangible regional issues thatneed to be addressed if all potential high-growth companies are to take advantage ofthis important source of Þnance:● venture capital is under-utilised, particularly at

levels of Þnance of less than £250,000 Ð smallcompanies are reluctant to use equity-basedÞnance for a multitude of reasons, the mostcommon of which are the perceived loss ofcontrol attached to this method of Þnanc-ing and the lack of knowledge about whatventure capital funding actually is

● demand for equity-based finance is variableacross regions in the UK Ð some regions reportrelatively strong formal and informal ven-ture capital activity, notably London, theSouth East, and the East and West Midlands.Further, demand in the East of England iscentred around the Cambridge area andhas a strong high-tech bias. Sophisticated

52 NEW ECONOMY

networks and structures for venture capitalat all levels also exist in Scotland, NorthernIreland and Wales. However, in the north-ern regions of England, there is little or nodemand for venture capital in any formand even the most developed venture cap-ital structures and markets report over-sup-ply of both business angel finance andformal venture capital, relative to demand.Further research is needed to establish theextent of demand for venture capital, sinceÞgures are at best unreliable and at worstonly estimates of activity

● there is not a clear relationship between venturecapital Þnance and growth Ð venture capitalÞnance may well be an important extratool in sectors with high growth potential.However, companies that do not Þt into thisexceptional growth category may not besuitable for venture capital Þnancing but areno less important in creating regionalemployment and growth.

All of these issues give rise to concern aboutthe nature of the industry in general and theoperation of the market in particular. Thereare certainly pockets of venture capital sup-ply around regions in the UK. However, thereis little evidence that a market exists, especiallyin the area of start-ups where informationproblems dominate. A particular issue acrossall regions remains the balance between riskand return.

The variability in venture capital activityacross the regions is marked. This variabili-ty is felt in terms of the presence of existingfunds, the relationship between existing fundsand RDAs and the integration of venturecapital as a growth tool for SMEs into region-al economic strategies. Not all RDAs are con-Þdent that venture capital is the correct toolfor the small businesses that operate in theirregion. Many argue that mentoring and Ôpack-agedÕ Þnance (which may in the mediumterm contain an equity component) would bemore appropriate in the equity gap end of themarket (arguably less than £250,000). All this

leads to substantial differences betweenregions in the time scale envisaged in settingup a regional fund, in the costs of setting upsuch a fund and in the format that it wouldtake.

The cases of Scotland, Northern Irelandand Wales demonstrate that the role of theRDAs in relation to regional venture capitalfunds is perhaps best formulated as a gap Þllerwhose function is twofold: to bridge theinevitable gaps in funds which emanate fromthe imbalance between risk and return inher-ent in these types of investment, and to bridgea knowledge gap between investors andinvestees. This is the product of lack of aware-ness amongst small businesses of the beneÞtsof venture capital as a funding mechanism, oflack of preparation for investment and of lackof information about investment opportunities.

Policy conclusions As it is currently formulated, the EnterpriseFund is largely a supply-side response to anessentially demand-side issue. There are clearimperfections in current market operation,both in terms of demand for venture capitalat sums of less than £750,000 and in theupward spiral of average investments visiblein all funds, even those established with anequity gap remit. These imperfections arisefrom two sources: ● demand: a lack of knowledge about the

potential of venture capital and the processof becoming investor ready

● supply: commercial interests of fund man-agers to supply an attractive return to theirinvestors means that lower risk/higherreturn projects are preferred to higher riskequity type projects at the SME growth endof the industry. This is not a matter of thesize of investment but, critically, concerns thepotential return from any such investment.

The IPPR research suggests that venture cap-ital in itself is not a panacea for providing suit-able funding for SMEs. Policy should also takeinto account:

VENTURE CAPITAL AND THE REGIONS 53

● the clear gap for companies seeking invest-ments of between £250,000 and £750,000in the market. This derives from a fund-ing gap which is the result of a mismatchbetween perceived risk and perceivedreturn, and a knowledge gap which is theresult of imperfect information about thebenefits of venture capital and aboutinvestment opportunities. Both can, andshould, be addressed by government poli-cies to guarantee risks and to improveinformation flows

● the need to enhance the operation of exist-ing structures rather than entrench theimperfections apparent at the equity gapend of the market. Any money directedtowards co-investment in regionally basedfunds will simply exacerbate the upwardspiral of average investments

● the need to incorporate the venture capitalindustry itself. Experienced fund managersand business related professionals (lawyersand accountants, for example) are expensiveand represent an ongoing cost. While allregions anticipate that the management costsof the fund would eventually be borne by theproÞtability of the fund itself, this proÞle andtrack record takes time to develop. Sincefunds from the DETR are for regenerationrather than competitiveness, the RDAs claimthat they cannot afford to subsidise the fundmanagement cost in the short run.

Further, there is an assumption that the region-al funds will be proÞtable. Unless the gov-ernment role can be directed towardsaddressing the issues around investment andreturn, this is by no means clear. The funds willonly be proÞtable if they make investments thatprovide a return. The projects envisaged by theGovernment as being suitable for this invest-ment may not be those which guarantee returnto investors. Policy has to take into account theeconomic imperatives facing the industry.

The market appears clouded by the swatheof initiatives from different government

departments. For example, no intervieweewas clear on the relationship between theSmall Business Service (nominally chargedwith running the Enterprise Funds), RDAs(charged with setting up but not running ormanaging the Enterprise Fund) and the exist-ing Business Links.

Further confusion arises from DETRÕs coal-Þeld fund (the deÞnition and practical usesof which seem unclear to practitioners) andthe DfEEÕs University Challenge funds which,although to be welcomed, do not have a clearlink through to the development of regionalenterprise funds. This confusion adds to mar-ketplace imperfections presenting a chaoticpicture to most of the research participants.A clear, centrally co-ordinated policy state-ment on the links between regional funds andother initiatives is vital if regional funds areto be at all effective.

So where does this research leave gov-ernment policy in these vital areas? There isa role for government involvement in theventure capital industry, but creating mar-ket distortions through that involvementwill not improve the situation. In particularthe Government has to be aware of twothings. First, it must not put money into themarket at a point that exacerbates the prob-lem. The danger with investing in a fundthat expects a commercial return is that itenhances the existing trend towards upwardspiralling average investments. Second,there is little to be gained from providingdirect subsidy to management costs in thelong run, since this again simply puts moneywhere it already exists.

Meanwhile, RDAs have a key role. By cre-ating knowledge gap-Þlling mechanisms theycan be effective in changing culture. By cre-ating Þnance gap-Þlling tools they can engen-der the flexible funds that do encourageinnovation and growth, as they have in theUS and Germany ●