vol 8, issue 9

Financial woe and the plight of the startup

16 September 2013
By Anne Harris
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A toxic manufacturing landscape graphic

Venture capital is vital for innovative technologies to thrive

Scientists in a laboratory

Support doesn’t always come in the form of financial backing

The success rate for technology start-ups is low, a situation exacerbated by the global financial woes.

Only a fraction of the technology developed around the world makes it onto the commercial market. The barrier is crossing the so-called 'Valley of Death' – the chasm that separates research-proven technologies from reaching the marketplace..

To traverse this 'Valley of Death' entrepreneurs need to understand the true market potential of their product, but more importantly they need to secure funding.

The traditional bank-lending route will not be an option. Banks and other such financial institutions demand assets or a full order book. So the only option available is venture capital. Traditionally venture capital companies will take a minority stake in a company with an expected exit path within three to five years – either when the company is acquired through the M&A process or enters into an IPO (initial public offering).

The CEO at venture capital firm DFJ Esprit, Simon Cook, at his previous company, 3i, invested £2m in a small start-up called Cambridge Silicon Radio. That company went on to list on the stock exchange. For his £2m investment Cook received a return in excess of £50m. That is the profile of gain to be achieved in the high-risk, high-reward world of venture capital funding.

"Not everything is that successful, but the winners pay for the losers, which delivers a return for the investors in the fund," Richard Marsh, partner of DFJ Esprit, explains. "The majority of our investment would come when there is some form of momentum. The technology has been proven or customers are beginning to sign up for the service. However, we will invest across all stages.

"The peculiarity is that there is a lot of money available to fund the seed stage of a company's development, partly to do with government stimulus efforts. If you look at the industry as a whole, the UK is doing a great job at starting companies but there is a lack of funding at the follow-on stage."

Recent figures indicate that, while the seed funding of early-stage European start-ups is healthy, there is a scarcity of follow-on capital for later-stage businesses. The data, compiled from the latest Dow Jones VentureSource figures, also reveals that the UK, which remains the top location for investment, has for the first time lost out to France in terms of the number of larger deals completed in the first half of this year.

"The bulk of the financial returns in venture capital come from the big winners and the major investments that create these companies," says Cook, who compiled the report. "What this data clearly shows us is that Europe is successfully launching fledgling businesses, but there is a scarcity of available capital for the follow-on funding to get them to the next stage. In Silicon Valley the ratio of large investment rounds compared with smaller ones is over 1 to 1, while in this latest data for Europe it is less than half that level.

"From a geographic point of view, the UK is often seen as the US gateway into Europe and many of the leading VC funds in London have strong US links," explains Cook. "But UK's historical position is under threat as governments across Europe use incentives to stimulate innovation and growth. The UK needs to act now to maintain its overall lead within Europe or risk being overtaken."

Seeking out support

Support for companies developing innovative products can come from a variety of resources; national and regional incentives as well as a diverse range of R&D funding. "The support is relatively easy to access, however we think there is room for more cooperation between schemes," Bryn Parry, VP corporate development at Amantys, an innovation driven power electronics company, says. "The biggest challenge is to understand the range of funding options."

He also adds that a simplification of the administration process would be beneficial. "Greater involvement of industry professionals may allow more of a business judgment basis rather than a formulaic approach; also the process is often unwieldy for relatively modest grants," he continues.

VerdErg Renewable Energy was spun out of a successful oil industry subsea engineering company with the objective of transferring competencies into the renewable energy sector. The company are developing an innovative hydro device that will allow conventional small high-speed turbines to generate cost-effective electrical power. "Self-funding is obviously the most reliable source if it is available," says Peter Roberts, managing director of VerdErg.

The general principle in all public sector funding is that the later the stage of the development, the smaller the percentage of the cost that can come from the public purse. For very early stage prototypes, 100 per cent funding may be found from EU sources or the multiple national government, local government and NGO sources that trickle down from it, whereas less than half of the total cost may be available for demonstration projects. "To maintain progress, you wind up self-funding much of your pre-commercial development anyway, which doesn't interest investors," Roberts adds. "There is no shortage of funding options – in fact, there is a baffling universe of acronymic funds, initiatives and competitions."

Funding availability

Whether there is enough funding available for technology start-ups is a contentious point, although many would argue that there can never be an excess of support for innovation. One fact that is readily apparent is that some sectors are better served; a prime example is the area of cleantech.

"We work in the area of energy efficiency for which one often reads that there are considerable public funds available to help commercialise technologies," says Tristan Lewinsohn, director of business development at cleantech innovators, MicroPower Global. "When we set up our company's technical base, locating a region that offered us some form of support was critical. We considered various options, including the UK where a number of our key shareholders are based. Ultimately, we set up in Texas where we received excellent support, albeit indirectly through Texas State University.

"The university has provided us with the ideal facilities and tooling to carry out our prototype development," adds Lewinsohn, "as well as key technical support from 'professors and post-graduates who have worked in tandem with our technical team."

In addition, the university has built a pilot manufacturing facility perfectly suited to the company's needs, and granted exclusive access to a Molecular Beam Epitaxy (MBE) system that will enable them to commence early production of its advanced semiconductor chips. "So, while we haven't received direct funding, the support in Texas has significantly reduced the amount of money we needed to raise, and will allow us to move seamlessly into production with less capital expenditure than is typically associated with the transition to manufacturing," Lewinsohn says.

Roberts feels that although there may be sufficient public sector total funding at the top level, the concern is how much of it actually funds innovation. He also echoes concerns about the high administrative burden of securing this funding. "It seems likely that no one innovative organisation can ever have the time and energy to track and engage with the full pantheon of available funding sources," he says. "It also seems likely that the cost of administering these funds, including the multiplicity of fully-funded peripheral advisors and consultants intended to assist the actual creative innovator through the funding forest, may seriously diminish the money actually funding the innovation.

"Public sector funding bodies appear to be held to a standard of internal accountability that demands that they ensure full justification for every penny of taxpayer funds received by the innovator. This process usually starts with a requirement for a fully justified total cost and time estimate to which the recipient is held without any chance of funded extension."

In the current market

The gloom that surrounds the world economy is no real barrier to securing funding, according to Parry. "We think that the increasing difficulty is linked to the global venture and private equity dynamics," he says. "In Europe in particular, the number of VC funds investing in high-tech has reduced dramatically over the last decade, and for some sectors, the absence of successful exits has deterred new investment; the semiconductor sector in particular has suffered for this. Cleantech is a notable exception to this and has attracted a growing number of new and existing funds."

According to Lewinsohn the financial crisis has meant that there has been less funding available from all sources to develop an innovative technology which in turn has slowed the company's growth. "As we reach the point of commercialisation from a technical point of view, the effect could be more positive than negative – once installed, our technology provides an attractive means of cutting costs by making an industrial plant more energy efficient," he says.

Amantys were one company that enjoyed great success in their search for funding. Their search was boosted by having the right fundamentals in place; defensible technology, strong market opportunity, unique skills and experienced management, as well as the geographic and technology benefits of being in Cambridge and leveraging IP from the university. "A combination of these factors helped raise our chances of success," Parry says. "For the right technology at the right time we've found that there is funding available."

The company successfully launched with private investment and early stage financing and were subsequently able to attract world class backing from private equity and industry investors with Moonray Investors and ARM. "Our profile is now sufficiently exciting that we are attracting interest from potential sector specific partners," Parry concludes.

For MicroPower Global the vast majority of its funding has come from private investors and family who believe in its technology, and appreciate that developing something that could have a significant impact on use of energy cannot be achieved overnight. "If we succeed in our efforts, the potential for our company is enormous, but unfortunately we operate in an area that has been promising great achievements for some time without delivering," Lewinsohn says. "It can be difficult for those without in-depth technical understanding of the key issues to see the wood from the trees.

"The few VC firms who do have that type of knowledge have existing investments in the space which they need to support, while most larger private equity firms or potential strategic partners would prefer to wait until all the risk has been taken out."

He continues: "Of course, the frustration is that once we have distributed prototypes to interested partners, have pilot projects running and are generating revenue – the stage at which most would prefer to invest – we won't require additional funding as our business model does not require huge capital outlay. Generating revenue from one production tool and taking some degree of payment with orders will comfortably enable us to purchase additional tools as we grow in size."

VerdErg have benefitted from three rounds of matched-funding support for its Ultra Low-Head Technology development from the TSB and Carbon Trust in addition to some market survey help from the Carbon Trust. "We also obtained funding from DECC to undertake a major study of our technology deployed in a Severn Estuary crossing," Roberts says. "This gratifyingly showed that when fully developed, our technology would produce 80 per cent of the power for less than half the capital cost of a conventional Ebb-Flow Barrage with minimal environmental damage."

A further success was selection for the UKTI's 'Clean and Cool' Mission to Silicon Valley last year to seek investment for 16 UK Cleantech companies. What has been much less successful has been the outcome of funding intended to promote collaboration with UK universities. "Although we have competitively secured access to such funds, the universities in question have demanded ownership rights to the resulting IP with various license-back concessions," says Roberts. "Compromised IP ownership of this sort is, of course, totally unacceptable to any investor and so we have been unable to accept any such award.

"What is truly worrying isn't that we didn't get the work done because we were in the fortunate position of once again being able to self-fund the same work from commercial laboratory sources, with full IP ownership. The sad fact is that UK universities appear to be cutting themselves off from participation in the very third-party innovation in which they should be involved, by seeking some untenable position half-way between having the industrial knowledge to invent high-potential engineering IP themselves and providing a truly uncompromised commercial research service."

Crowd funding

With the proliferation of social media it is no surprise that there are some offerings that bring innovation, or venture funding, into the realms of the individual investor on a small scale. One such undertaking, Seedrs, has just passed the £1m of investment in start-ups in its first year of operation.

"There are a few different types of crowd funding," Alysia Wanczyk, marketing director for Seedrs explains. "The first is a reward-based concept where people would give money in exchange for a reward on such projects as a film or a creative arts project – maybe an advanced copy or dinner with the artist, any number of rewards. Then there is also peer to peer lending where businesses and individuals seek loans from the crowd and hopefully over a set period of time that loan is repaid with interest.

"Then there is equity crowd funding, and that is what we do; we allow individuals to invest in the equity or shares of start-up companies online and we allow those early stage businesses to raise up to £150,000 from their friends, family and other individual investors."

The minimum investment on the site is only £10. This allows small investors to start developing a small portfolio much as the online brokerages allowed easy stock trading in the 1990s. "Then we have some of the more traditional angel investors who see us as a great way to access increased deal flow and further increase their portfolio with investments of £5,000, £10,000 or £20,000," Wanczyk adds.

It is a fairly simple process. Entrepreneurs approach Seedrs and after answering some basic questions about their business the offer can go live. "They don't necessarily have business plans," Wanczyk explains. "They answer questions about their idea: how much money they require, the amount of equity that they are offering. They also tell us about their team, a bit about the market as well as their monetisation strategy."

Once they have supplied that information an internal team goes through and verifies the information – there needs to be evidence to support the information. If they say they received a first from Cambridge they will need to produce the certificate or if they say they had £20,000 in sales last month they will need to provide some evidence. "Once we are happy with their submission they can load a video and it goes live," Wanczyk says. "Currently we have about 50 start-ups live on the platform for visitors to browse, ask questions of and, if they wish, invest in."

If entrepreneurs are to bridge the 'Valley of Death', traditional and new sources of revenue will both have their part to play over the coming years as the financial situation shows scant signs of easing. But as long as there are investors ready to provide funding, visionaries will continue to push the boundaries of technology with innovative products and services.

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