Innovation for Growth i4g

Policy Brief N4
Financing for innovation: addressing Europes early stage venture gap
Reinhilde Veugelers

Findings Innovation and growth performance will require more emphasis to be put on nurturing new firms in new sectors, enabling them to grow to leading-innovator status. European venture markets are too thin, with too low levels of on-going interaction between venture capital (VC) and young, high-potential firms. The critical size for a viable, fluid, thick European VC market can only be reached when VC markets operate at an integrated European scale and are open to the world. Recommendations New initiatives at the EU level are should be undertaken: 1. Grants for yollies to bridge the lab to market gap 2. A fund-of-funds to leverage Europes early-stage VC market

This report does not necessarily reflect the views of the European Commission. These comments are based on a number of previous presentations including expert group reports for the EC.

FINANCING FOR INNOVATION: ADDRESSING EUROPES EARLY STAGE VENTURE GAP

As argued by amongst others OSullivan (2007)), the cause of Europes innovation and growth deficit is rooted in an inappropriate industrial structure in which new firms fail to play a significant role in the dynamics of the economy, especially in the high-tech sectors. Veugelers & Cincera (2011) using the EC-JRC-IPTS Industrial R&D Scoreboard of largest global R&D spending firms confirm that the EU has indeed fewer young firms among its leading innovators and that the EU has less of its young leading innovators in new high technology intensive sectors. They find that missing these yollies in the right sectors is the largest contributing factor to the EUs overall R&D deficit relative to the US. Remedying the European Unions deficient innovation and growth performance will require more emphasis to be put on nurturing new firms in new sectors, enabling them to grow to leading-innovator status. The specific barriers faced by these companies need to be addressed. An important barrier is access to external finance, particularly early-stage venture capital. When innovative projects from young companies enter the commercialisation and growth phase financing requirements quickly become too large to be supplied by friends or business angels. The high risk profile of young highly innovative growth companies is often a barrier to bank financing at this stage. A deficient VC market may thus hamper the development of young highly innovative companies into world-leading yollies. Venture capital financing has some distinctive features. Only a very small percentage of the total company population requires risk equity finance (Shane (2008), VICO (2011)). On the side of VC companies supplying risk equity finance, the returns are highly skewed, made from the realisation of a small minority of exceptional investments within the portfolio. A consequence of this is that venture as an asset class shows extremely large variation in returns. Besides the high project risks, the VC market also suffers from high relatively fixed costs associated with due diligence and deal negotiation (Murray (2008)). Only sufficiently developed (thick) venture capital markets can build the critical scale and expertise needed to overcome these tyrannies and avoid an early stage venture capital gap. A thick venture capital market requires a strong deal flow of attractive, high-potential portfolio companies; VC funds of sufficient scale and managerial competence to make initial and followon investments and to grow portfolio firms until attractive exit opportunities are identified; informed institutional investors (including pension funds, endowments, etc) willing to accept the risks of early-stage equity investment; support from professional services firms, such as specialised lawyers, accountants and consultants; and efficient and liquid exit markets. The problem with early-stage venture capital markets in Europe is a combination of an 'equity gap' (an undersupply of venture capital), and an 'investment readiness gap' (an undersupply of investment-ready projects). European venture markets are too thin, with too low levels of ongoing interaction between venture capital (VC) and young, high-potential firms.

Redressing this thin market, developing a viable VC and venture investing sector will be a long term European policy project. American experience suggests that a venture capital system in its initial build up stage is very fragile and needs decades of experience and public support to function effectively (Lerner, 2009, NESTA 2009). Below we list some of the characteristics, beyond patience and perseverance that policy intervention needs Be embedded within a broader innovation policy to ensure a sufficient supply of profitable projects to fund. Better serve the 'funding escalator', covering the whole cycle from the very early stage of shaping ideas, testing and prototyping, to early commercialisation and larger scale deployment of innovative projects. Policy instruments at each stage of the escalator should include: policies promoting business-angel groups; grants for pre-competitive R&D for highly innovative projects; public procurement based innovation contracts; public and private early-stage investment; government-backed lending. Not fall into the local is beautiful trap. The critical size for a fluid thick VC market can only be reached with an integrated and open EU VC market. Not fall into the 'small and short is beautiful' trap. Small funds are often not viable and have insufficient financial resources to cover their high fixed costs (especially expert management), diversify their portfolios or provide the follow-on funding to the most promising investments in their portfolios. Overall, these characteristics call for a significant reorientation of the all-too-often pursued policies in many European countries, which support subcritical regional funds aimed at supporting a tail of average or below-average potential growth firms. Rather than the quantity of VC funding available, what matters more is how smart the funding is, allocates risk finance to the most promising projects. First and foremost, the fragmentation in the EU venture capital market should be addressed: the critical size for a viable, fluid, thick European VC market can only be reached when VC markets operate at an integrated European scale and are open to the world. Beyond furthering the single market agenda, supporting member state initiatives and re-aligning existing EU instruments into a holistic policy framework (Veugelers (2011)), what follows are suggestions for new initiatives at the EU level. (a) Grants for yollies to bridge the lab to market gap In a Bruegel Policy Brief (2009/01) we proposed a system of grants for high risk taking innovative projects of young companies, during the critical start up and development stages, when financial market barriers are at their highest. It is based to a great extent on the US Small Business Innovation Research Grants programme. Such a programme is currently being developed at DG Research and Innovation. Crucial is a proper implementation such that not only the most promising project will get access to funding, but that also, through certification, the selected ideas get access to private VC investment at later phases of the project. This implies

a critical role for the selection and evaluation process for these grants, which should include beyond technological also commercial expertise in the evaluation panels. (b) A fund-of-funds to leverage Europes early-stage VC market When the European Commission is proposing a fund-of-funds, as part of the Horizon2020, this fund-of-fund should get a clear mandate for targeted stake-taking in private VC firms in Europe, who have the potential to grow to critical scale. To avoid overlap, it should be aligned on the EIF activities

References
Lerner, J. (2009) Boulevard of broken dreams: why public effort to boost entrepreneurship and venture capital have failed and what to do about it, Princeton University Press Murray, G. (2008) Venture capital and government policy, in Landstrm, H. (ed) Handbook of research on venture capital, Edward Elgar Publishing NESTA (2009) From funding gaps to thin markets: UK Government support for early-stage venture capital, available at http://www.nesta.org.uk O'Sullivan, M. (2007) The EU's R&D deficit and innovation policy, Report of the Expert Group on Knowledge for Growth, European Commission DG Research. Shane, S. (2008) The illusions of entrepreneurship: the costly myths that entrepreneurs, investors and policy makers live by, Yale University Press Veugelers, R. (2011), Mind Europes Early Stage Equity Gap, Bruegel Policy Brief 2011/18, Bruegel Veugelers, R. (2009) A lifeline for Europes young radical innovators, Bruegel Policy Brief 2009/01, Bruegel Veugelers, R. and M. Cincera (2010) Europes missing yollies, Bruegel Policy Brief 2010/06, Bruegel VICO (2011) Venture capital: policy lessons from the VICO project, final policy brief, available at http://www.vicoproject.org/doc/policy/VICO_FinalPolicyBrief.pdf