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111219 Pc Rv Mind Europe s Early-stage Equity Gap

111219 Pc Rv Mind Europe s Early-stage Equity Gap

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Published by: Bruegel on Dec 19, 2011
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ISSUE 2011/18DECEMBER 2011
MIND EUROPE’SEARLY-STAGEEQUITY GAP
REINHILDE VEUGELERS
Highlights
Remedying the European Union’s deficient overall business research anddevelopment performance requires the nurturing of more new companies in newsectors, enabling them to grow to leading-innovator status. This means addressingyoung leading innovators’ access to external finance, particularly early-stageventure capital.
The funding system for aspiring young leading innovators (
‘yollies’ 
) needs to beunderstood as an interconnected system comprising different types of fundingat different stages of company lifecycles. Venture capital funds are critical atthe early commercialisation stage.Venture capital investors rely on a good deal flow of high-potential investment-ready firms, on skilled investment managers, and on developed exit markets.Poor returns from early-stage investments in Europe on a smaller deal flow havesignificantly reduced the appetite for early-stage venture capital. This exodushas left a funding gap in Europe for aspiring yollies.The evidence suggests that there are a number of ineffective public schemessupporting mediocre deals at mediocre funds. Shutting those down would freeup enough funding to allow a significant shift towards a more effective ventureinvesting system focused on high quality venture capital and innovative projectsfrom aspiring yollies.Reinhilde Veugelers (reinhilde.veugelers@bruegel.org) is a Senior Fellow at Bruegeland Professor at the Katholieke Universiteit Leuven.
Telephone
+32 2 227 4210info@bruegel.org
www.bruegel.org
BRUEGEL
POLICY
CONTRIBUTION
 
MIND EUROPE’S EARLY-STAGE EQUITY GAP
REINHILDE VEUGELERS, DECEMBER 2011
02
BRUEGEL
POLICY
CONTRIBUTION
1. See eg Bruegel PolicyBrief 2009/01, ‘A lifelinefor Europe’s youngradical innovators’.
1WHY WE CARE ABOUT FINANCE FORINNOVATION-BASED GROWTH
Europe’s innovation and growth deficit is rooted inthe structure and dynamics of its industries andenterprises. In a Bruegel Policy Brief, Veugelersand Cincera (2010) show that the EU’s persistentbusiness R&D deficit relative to the United Statescan be almost entirely accounted for by the EUhaving fewer yollies in new, high-growthinnovative sectors, particularly health andinformation and communication technologyservices.Why is the EU on average and in contrast to the US,not able to redirect its specialisation pattern tonew high-tech, high growth sectors? What holdsback new European firms in new markets fromgrowing into global leading innovators?An extensive body of theoretical and empiricalevidence demonstrates the importance of financial constraints as a major barrier toinnovation (see eg Hall, 2002, for a review). Therisks associated with innovative projects hinderthe ability of financial markets to swiftly allocatefunds to innovative projects. These capital-marketimperfections are likely to hold particularly foryoung innovators (eg Hall, 2002). Although younginnovative companies are rich in intangible assetssuch as technology and specialist knowledge,they lack the sort of collateral assets that helpthem access external finance. Young innovators,combining the disadvantages of small scale, shorthistory, less or no retained earnings and morerisky innovative projects, can therefore beexpected to be more affected by financial barriers.Although access to finance is a significant issue,the importance of other barriers to aspiring yolliescannot be ignored. These relate to the difficulty inaccessing lead customers, regulatory burdens,access to skills, difficulties with intellectualproperty and obstacles to partnering
1
. Thesebarriers are reminiscent of the often-citedfragmentation of product, services and labourmarkets in the EU compared to the US, as well asthe failure of the EU’s innovation ‘system’ toeffectively link its participants. All this is a strongreminder that access to finance cannot be tackledin isolation but should be embedded in aninnovation policy that also addresses the otherbarriers to innovation. As these other barriersreduce the expected rates of return on innovativeprojects, they will affect the deal flow and theappetite of financiers to provide funds forinnovative projects.
2WHY WE CARE ABOUT VENTURE CAPITAL INEUROPE2.1 Venture capital on the funding escalator
There are a range of individuals and organisationsthat play a role in financing start-up or early-stageinnovative projects. These include family andfriends, business angels, private venture capitalfunds, corporate venture funds and public funds.All of these should be seen as playingcomplementary parts along the ‘funding escalator’for innovative projects. While initial ideas can stillbe funded by own funds and those from ‘friends,families and fools’, business angels come in whenthe ideas move to feasibility testing andprototyping. Venture capital typically enters theframe when commercialisation is considered.Start-up venture capital financing includesfinancing for companies for use in productdevelopment and initial marketing. Early-stageventure capital provides funds to initiatecommercial manufacturing and sales. Theseactivities may not yet be generating profits. Oncesales are realised, internal funds and loans can bepart of the funding escalator.The ability to secure financing during the initial
MIND EUROPE’S EARLY-STAGE EQUITY GAP
Reinhilde Veugelers
 
stages of the escalator often improves later-stagefinancing. This holds when the quality of the early-stage funding selection provides ‘certification’,reducing the typical asymmetric informationproblems that plague the financing of innovationprojects. For instance, selection in highlycompetitive public grant schemes may make iteasier to access further venture capital funding.Firms that have been backed by famous businessangels may find it easier to access venture capital.And firms that have been backed by qualityventure capital may find it easier to find financingpartners at later stages.Nevertheless, the escalator seldom runssmoothly, with entrepreneurs incurringsuccessive costs to find and negotiate with newand multiple parties, imperfect transformation of information between parties, existing financiersexpressing concerns about dilution and otherconflicting interests between old and newfinancing partners.
2.2The supply of venture capital to aspiringyollies
When innovative projects from young companiesenter the commercialisation and growth phases,venture capital becomes a critical financingsource (eg Lerner, 2009). At this stage, financingrequirements quickly become too large to besupplied by friends or business angels. The highrisk profile of young highly innovative growthcompanies is often a barrier to bank financing atthis stage. A deficient VC market may thus hamperthe development of young highly innovativecompanies into world-leading yollies.Venture capital is guided by the VC cycle (Gompersand Lerner, 2004)
2
. After the fundraising,screening and negotiating, the investmentprocess starts. At this stage, non-capital value isadded to the firms in VC portfolios through themonitoring, advice and guidance of the fundmanagers. The entire length of the investmentprocess for early-stage ventures is estimated to
2. Venture capital is definedas dedicated pools of capital provided by thirdparty investors that focuson equity, or equity-linkedinvestments in privatelyheld, high-growthcompanies (Lerner, 2009).The limited liabilitypartnership arrangement,LLP, is the dominant fundmodel in the venture-capitalindustry. The fund is ownedby third-party investors,known as the limitedpartners, and managed bythe venture capital fundmanagers.
03
BRUEGEL
POLICY
CONTRIBUTION
‘When innovative projects from young companies enter the commercialisation and growth phases, venture capital becomes a critical financing source. A deficient VC market may thushamper the development of young highly innovative companies into world-leaders. ’ 
be on average about 6-7 years. Exit is the finalstage of the VC cycle. This occurs through an initialpublic offering (IPO), trade sale, secondary sale toanother financial institution or fund, buy back bythe entrepreneur or write off. The first of these, theIPO, is perhaps the most celebrated and prominentin the literature, yet the second method, the tradesale is the most common successful exit methodfor VC funds (Soderblom, 2006).Venture capital financing has some distinctivefeatures. Because venture capital funding isequity funding, it transfers part of the ownershiprisk from the entrepreneur to the investor. Unlikedebt funding, it encourages venture capitalists toprovide managerial support to entrepreneurs. Asfund managers are typically rewarded with apercentage of returns above a certain threshold,fund managers are incentivised to focus on the‘big wins’ from a portfolio of investments. Inaddition, because VC is a very costly and riskytype of financing, high financial returns arerequired from their successful investments inorder to be economically viable. The returns toinvestment are highly skewed. Where attractivenet returns are made by the fund, it is likely toresult from the realisation of a small minority of exceptional investments within the portfolio. Aconsequence of this is that venture as an assetclass shows extremely large variation in returns,and only a small number of exceptional start-upsare likely to attract VC attention.In summary, for venture capital to be a viablebusiness model, it needs to be ‘smart’, ie able toselect potential ‘hits’ and carry them through tothe exit stage by providing both financial and non-financial support.
2.3The demand from aspiring yollies for venturecapital
The number of companies requiring equity financeis a relatively small percentage of the totalcompany population. For example, Shane (2008)notes that since 1970, VC firms have funded
Reinhilde Veugelers
MIND EUROPE’S EARLY-STAGE EQUITY GAP

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