Going to seed

The well-charted migration by many in early stage UK venture to the more predictable returns of later stage investments has certainly placed pressure on seed and early stage investors in recent years. But for those who remain, bringing to market the next big success stories, the outlook may be challenging but it is not without its growing stable of entrepreneur wannabes.

Entrepreneurial spirit is seemingly alive and well in the UK. “I genuinely believe the critical mass of entrepreneurs in the UK is much more significant than it was. As well as angel investors becoming used to repeat transactions, we’re slowly losing the taint of failure. Historically, it was viewed as the kiss of death to make a mistake,” says Ernie Richardson, managing partner at MTI in London.

But as much as the British may be learning to deal with failure as a cultural phenomenon, it is not just mediocre, profit-making, yet innovative companies that seed and early stage investors are looking for. They want to discover the next Baidu, Google, Skype or Yahoo. Or at least their materials sciences, cleantech or medtec equivalents.

The UK’s National Endowment for Science, Technology and the Arts or NESTA for short, is the largest source of seed capital for technological advances in the UK, according to its London-based managing director Jonathan Kestenbaum. NESTA launched a £50m early stage start-up fund in March 2007.

In 2007 and until the end of Q1 2008, NESTA examined 400 investment opportunities, took 40 of them to the next stage, out of which just six new investments were made. Judging by this breakdown, entrepreneurs in the UK have to be in the top 1.5% to be successful in securing seed capital.

“The one fundamental criterion we are applying is the criterion of exceptional growth prospects. There’s a huge difference in the opportunities that provide profits and those that provide exceptional growth prospects,” says Kestenbaum.

NESTA is able to hold on to companies for five to seven years. “But many of the funds are just not able to work across time spans like that,” says Kestenbaum.

“What we are anticipating over the coming years is that there will be much more cooperation and a collaborative approach between public and private funds at the seed stage. Public funds can take a much more patient view; they have much longer time horizons. We make no investments at all until we can assure ourselves that private money is there and until revenue is being generated,” he says.

However, the days of public funds trying to cover all bases and provide top-down service are over. Kestenbaum describes them as previously “suffering from the tyranny of multiple objectives”. “Every time another objective was added it became tougher,” he says.

Government involvement

Anthony Clarke is managing director of GLE Growth Capital, operating a £30m early stage venture capital fund specialising in providing early stage equity finance for high growth businesses. Called Seraphim Capital, £10m comes from private investment and £20m from government funding. Seraphim is one of the first of five new Pathfinder funds established under the Enterprise Capital Funds (ECF) initiative. The unregulated angel-led fund enables investment from £750,000 to £2m.

GLE Growth Capital also includes the London Business Angels Network and its fully invested sister angel co-investment fund London Seed Capital, which invested in 22 companies.

While the UK Government has worked hard to stimulate the sub-£2m investment area for start-ups, and has secured state aid exemption from the European Commission to do so, the main players in this space are primarily business angels and public/quasi-publicly funded funds, explains Clarke. These investment sources account for about £1bn each year in the UK, he adds.

Clarke says the key to this market is the business angels themselves because there is no need for public funding, they have the business skills and contacts, and they generally have hands-on small-to-medium (SME) business backgrounds.

Not surprisingly, Clarke says: “One of the biggest challenges is getting more business angels to invest.” While they are inclined towards longer investment holds – five years is normal – the problem prevails over the exit market.

London Business Angels, for example, is just one example of several pockets of the 21 associations dotted around the country that are made up of either high net worth individuals or those defined as “sophisticated investors”. An estimated 5,000 business angels operate in the whole of the UK.

Clarke says that about US$5bn (equivalent) in angel funding is completed each year in Europe, which is about 20% of the annual volume recorded in the US.

“One of the great things that has been happening over the last five years is that people have been re-investing,” says Graham O’Keeffe, a partner at Atlas Venture in London.

Saul Klein, Doug Richard and Niklas Zennström are just a few of the high-profile names active in the UK and across Europe.

Recessionary threat

But whether a sluggish economy will takes its toll on seed finance is a point of debate, and one which will only become clearer should the UK economy slouch into recession.

“Business angels pack up their bags when the economy is going through a tough time,” says Andrew Carruthers, CEO of SPARK Ventures in London.

“I suspect the UK economic climate’s impact will become more apparent on exits rather than on new investments. This will result in people holding investments for longer, I think,” says Richardson.

Referring specifically to the credit crunch, Kestenbaum says: “We find this is having no impact on investing. The main reason is that deals are completely un-leveraged.” But optimists who think the buyout funds will look down the capital ladder will probably be disappointed.

“In terms of supply matching demand, there is a good balance of seed capital and an over-supply of later stage capital but for venture we could do with more money in the industry. I call it the balanced engine but it is rarely perfectly correct as you sometimes have too much money in some areas and too little in others,” says Nigel Grierson, co-managing director and founder at Doughty Hanson Technology Ventures in London.

A few examples show that some early stage investors are also active at seed capital stage with the view of taking companies through the investment cycle.

Just one year after its seed capital round, Bristol-based XMOS Semiconductor, a creator of Software Defined Silicon (SDS) chips, secured US$16m in round A funding in September 2007, provided by Foundation Capital and existing investors Amadeus Capital Partners and DFJ Esprit. Amadeus and DFJ Esprit had seed funded the company.

Atlas Venture and Advent Venture Partners each provided £500,000 to Ubiquisys, pioneer of intelligent 3G femtocell access points for the residential market, and then completed the US$12m A round with Accel Partners in September 2006. Then in July 2007, a US$25m B round featured the A round investors plus Google. And in March 2008, T-Mobile Venture took a strategic stake in the company.

Cambridge-headquartered Light Blue Optics (LBO), a developer of holographic laser projection technology, raised US$26m in a round A funding round in October last year, led by Early Bird Venture Capital and Capital-E. Existing investors 3i plc, who led LBO’s US$3.5m seed-funding round, and NESTA also participated.

LBO was the largest Series A funding round, made to accelerate its product development programme, in the European electronics sector for the past five years.

Mind the gap

But the draw of taking companies from seed stage to commercial success is limited and also underscores an obvious gap in UK venture.

“Early stage is where the gap is,” says Carruthers. “I don’t think the credit squeeze has endeared people to look at early stage.”

“If there is a gap in the market it is potentially at round A. The other thing I’m struck by is we see a lot of interest in co-investments because investors don’t want to make investments in funds and they generally don’t want to lead, but they prefer to follow,” says Richardson.

“It saddens and disappoints me that people have moved up the market in search of better returns. Deals with 10 times or 20 times returns are going to get done at round A – they are not achievable at the DevCap stage,” he says.

Tech venture in Europe is estimated at around US$5bn a year, of which the UK accounts for about half. In comparison, over the last five years, it is estimated that venture has increased from US$22bn a year in the US to around US$30bn a year. It may be a quantum leap, but many think the UK could evolve into a larger tech venture market.

“Many of the best engineers and scientists in the UK work in the safe confines of organisations,” says DFJ Esprit CEO Simon Cook. It’s all about educating 18 and 19-year-olds to think they can become serial entrepreneurs, he says.

“In Europe, people start businesses and bootstrap their companies with either credit cards or customer money. There is still a need for a lot of education as a lot of people are still nervous about having eternal funding in place,” according to Cook.

Why bootstrap when companies can think bigger! “When a company comes to see us we tend to ask them what they would do with their business with more money,” says Cook

“We live in a single global community and if you have developed a great mousetrap you have to be willing to sell it globally from day one. You really can’t build a customer base in your home country, wait for a few years and then look to other markets. We also need a number of larger venture funds that can invest in seed deals and fund them properly,” he says.

It is not just the responsibility of budding entrepreneurs and VCs. Corporate UK has to be more open to ideas instead of closing its doors to innovation, many believe.

“Getting technology adopted in the US is much easier than it is in the UK. If you persist, a US CTO or COO will give you five minutes of their time to present your product, but this is not always the case in the UK where it is still difficult to find the right person to speak to and to get them to listen to you,” says MTI’s Richardson.

A senior tech manager at BT in London tells EVCJ that listening to outside ideas is “challenging”. He says that much of the organisation is still getting used to being privatised (British Telecom was privatised in 1984, spookily so) and senior management get bogged down in administration rather than innovation.

What everyone agrees about is the UK is a hotbed of scientific, medtech and technical innovation. And while venture firms like MTI have recently partnered with academic institutions like the University of Manchester in the UMIP Premier Fund, and Imperial Innovations has demonstrated science can be successfully commercialised, venture investors want that IP to be exported to markets all over the globe.