High-tech startups desperately in need of growth and seed capital

By The Chilli staff

The DTI (Department of Trade & Industry, Small Business Service-SBS) recently issued a consultation document on improving access to growth capital for small businesses. It fails to distinguish the specialist needs of a high-tech startup from a traditional small- to medium-sized enterprise or lifestyle company. This is the claim of a report due to be published by Parmar House, an independent think tank dealing with entrepreneurial issues. In this article, The Chilli provides an outline of the main issues raised by the think tank report.

The SBS consultation document from the DTI, entitled "Bridging the finance gap - improving access to growth capital for small businesses", raises many complex issues related to the market failure of seed and growth capital access by entrepreneurs. Parmar House has identified how some of these points need to be re-considered by the government in order to better serve the funding and growth requirements of high-tech start-ups (HTSUs). Some of the areas it looks at include:

• market failure mechanisms and government intervention
• lessons from the USA, small business admin service and how the UK can take advantage of a similar programme called SBICs (small business investment companies), where private investment is matched one-to-one by government backed bank loans
• failure to take inputs from the entrepreneur community before key policy decisions are made
• how the government has a false sense of progress with regard to business angels, university spinouts, cluster and network formations
• poor government communications and perception about its enterprise initiatives
• the setting up of sector specific SBICs, their remit, competition, regulation and compliance, liquidity of funds and deal flows
• the proposal for SBICs to provide a combination of equity, loan notes and debt finance and their relationship with regional VC funds.

The Parmar House report highlights the need for better definitions of the different types of companies, namely traditional SMEs, high tech start-ups (HTSUs) and life style companies (LSCs), all requiring seed and growth capital, but with different needs and capital requirements. It also highlights the efficiency of targeting enterprise initiatives at specific domain sectors (the report highlights over 20 such sectors) which are the main drivers for growth in capital formations, productivity, use of highly skilled labour and the general economy. Each domain sector has different scale in terms of seed S1, S2, S3 and R1 funding (see the startup definitions), and a single threshold of £250K will not meet the need of most HTSU companies. This is the biggest opportunity for the government to fix a glaring market failure and the rush to create yet another quick fix government policy, may mean the UK will continue to trundle along as a low productivity "sweat economy" compared to its existing and new competitor nations.

For example paragraph 1.7 of the DTI reports states:

"Market failures: the UK lacks the number of high growth startups that rapidly create jobs, improve productivity and exports."

The response to this is that the SME (small to medium sized enterprise) grouping needs to be further sub-divided into HTSUs, LSCs, and other traditional non-tech SMEs. High productivity, export and higher numbers of well-paid jobs are predominantly created by the HTSU sectors. In contrast, small LSCs employ less than 20 people and sell mostly small-scale services to larger firms in localised markets. Both require access to growth capital but have different and distinct requirements, which the Parmar House report expands on in detail..

Lifestyle companies sell mostly professional services and niche products to local or large sector companies. A web design company or local IT service company would fall into this category. Local LSCs have little, if any need, of protecting their IP (intellectual property), other than the skills of the founders. LSCs are content to limit their total number of employees to less than 20 people in order to remain focused, financially viable and manageable. LSCs would rather use debt repayment, interest on loans and dividends to potential investors and are loath to lose any management control of their companies. Exit routes are normally mergers with other LSCs companies and/or repurchase of minority investor equities.

In contrast HTSUs positively seek and understand the need for external equity investors and it's relevance to their formation, growth and survival. They expect and plan to expand aggressively to reach a critical mass of professional employees, in order to serve their chosen market niche. They expect to sell their product or service all over the globe, although they may initially start in their domestic market. The founders and management expect and plan to lose a degree of management control, as the company reaches different milestones and growth stages. Most of the new (the 3rd wave) entrepreneurs are already experienced in their domain sector. Their products and services have a high degree of self-generated IP and need for IP protection. Their preferable exits routes are trade sale, mergers, acquisition and/or IPO, when the market sentiments are right.

In terms of encouraging an enterprise culture, Parmar House acknowledges the government has made tremendous progress in recognising some of the issues and devising appropriate policies. However it is concerned that there is still a need for more balanced, objective, independent reports and studies which fully take the entrepreneur's views into account. Some of the research council funding needs to be channelled towards more independent studies and industry groups, as well as continue to fund the academic institution studies in this area. Industry-experienced entrepreneurs have difficulty relating to academic and government bodies, so efforts must be made to bring these parties together.

Government departments, the Bank of England, CBI and other institutions have generated various reports, highlighting some of the issues and barriers facing SMEs and HTSUs. But Parmar House feels the vast majority have failed to take into account inputs from entrepreneurs, and thus failed to generate the appropriate responses and remedies. Some of these reports use loosely defined concepts or definitions, which cloud the picture further, for example, the use of the term 'Angel' investors. Hearsay feeds hearsay and becomes part of well-accepted criteria, but in reality, this is creating a false sense of progress where none has been made.

For example it is stated that there are more than 18,000 Angel investors in the UK, for which there is no independent verification. Another example is that of the Cambridge cluster being perceived as a phenomenal success, when real data fails to back up this accepted wisdom. The government has a duty to invite well-researched, documented reports to form the basis for appropriate policies and ensure that entrepreneur's views are taken into account in any future area of study.

Recent examples of false premises that have not served the small business HTSU well are:

• a recent Bank of England report relies on the financial vendor community to verify that there are no problems in business organisations attempting to raise debt finance
• a CBI report on SMEs rarely mentions credit/finance as a problem area
• a forum found that, of 39% of businesses which applied for a loan, 94% received the full amount, but forgets to mention what happened to the other 61% unable to raise any finance
• many reports use flawed statistics, such as the number of business angels (18,000) who have between them invested £0.5 billion to £1.0 billion in start-ups. If this is the case, then the UK would have generated more start-ups than the USA - which clearly is not the case.

There has been a complete market failure in generating the number of HTSU companies in the UK, compared to the US, due to several factors, some of which are:

• lack of risk capital in the £50k to £2.5m range for early seed (S1, S2, S3, R1) stage companies
• lack of awareness amongst the high-tech entrepreneur community of various Government initiatives
• lack of trust by entrepreneurs on the advisor community, who have created a whole industry around a plethora of services for startups, but failed to deliver value, i.e. adequate funding, management support or legal protection for the founders.

The Government could miss out on one of the biggest opportunities to address not only the funding/equity gap problem but also kick start a programme of rejuvenation of SMEs, LSCs and HTSU companies, which will lead to higher capital stock formation, productivity growth, high value exports and subsequent tax receipts. This can only be done by building in adequate flexibility that balances between the needs of the LSCs, HTSUs, their founders, management and the need to provide adequate investment return for HNWIs (high net worth individuals), angels, limited partners, including the government. Government cannot abdicate its responsibility of ensuring compliance, competition, and effectiveness of the SBICs programme to an informal group of private equity investors and angel networks.

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© Chilli Publishing Ltd 2003

10OCT2003