Investing seed capital

Few people invest seed capital and if you leave the definition of seed capital to a man who should know he’s been investing in early stage businesses for 18 years then the constituent of seed investors shrinks further. “MTI’s definition of blue sky research is a concept and nothing beyond the concept. Seed funding might get you from concept to commercial specification or even to a prototype,” says Paul Castle of UK early stage technology investor MTI.

“MTI’s definition of blue sky research is a concept but nothing beyond the concept. Seed funding might get you from concept to commercial specification or even to a prototype.”

MTI does not as a rule invest seed capital. Its potential early stage investments are split into four areas: pre-start-up, start-up, early stage and expansion. Pre-start-up is where the concept and all the commercial aspects have been defined and so the funding gets the company to prototype stage. The other three stages follow on from this as would be expected.

While some investors that see themselves as providers of seed capital would roll Castle’s pre-start-up financing into the seed category, this is not true of all. Whichever definition you take, seed investment is widely said to be increasingly hard to come by in Europe because the constituent of seed investors is asserted to be shrinking. In fact there are a number of active groupings providing seed capital in Europe today, namely business angels, Government initiatives, incubators and accelerators, venture capitalists, corporate venturers and high net worth individuals.

While high net worth individuals and business angels can be one and the same thing, this is not always the case. The year old UK-based networking and seed and early stage investment group, iGabriel, springs to mind as one example of the involvement of high net worth individuals and Elderstreet’s feeder fund as another.

iGabriel’s members currently pegged at around 30 are made up of a group of technology focused individuals from their late twenties to mid fifties so the group has very different types of exposure and consequently the investment opportunities each brings to the group is varied. Each member commits in the region of euro300,000 to euro500,000 as part of their membership deal, which can be invested in opportunities provided the deal introducer also commits personal monies not tied up in the iGabriel pool.

In contrast Elderstreet, the UK focused early stage technology venture capital firm recently acquired by Dresdner Kleinwort Capital (DrKC), operates a high net worth feeder fund alongside it’s institutionally raised funds, which serves more as a deal introducer and technology verifier than an additional source of investment funds. Since going under the DrKC wing, Elderstreet is widening its remit to include continental Europe.

Given the iGabriel and Elderstreet structures it would be wrong to assume that high net worth individuals have little more involvement than parting with their money. Perhaps surprisingly venture capitalists give mixed reviews of the involvement and effectiveness of business angels. Effectiveness in terms of the monetary contribution is not questioned although as Alasdair Warren of early stage technology investor nCoTec points out: “Typically we find that investments by business angels have not been well structured.” This sentiment is echoed by other venture capitalists investing in early stage businesses.

“Typically we find that investments by business angels have not been well structured.”

In practical terms it can cause problems for follow on first round investors when a company has received seed capital from a business angel. This is because the founders are often initially unwilling to agree to the terms and conditions imposed by institutional capital having already received financing on less onerous terms. Business angel investors themselves are reported on occasion to be none too pleased by institutional VC terms too. Recently business angels, like venture capitalists, have been suffering dilution as valuations have fallen and subsequent funding rounds significantly reduce the valuation on the company, and this brings with it another set of negotiating issues.

Although the presence of a business angel in a company seeking follow on funding raises issues, Castle at MTI notes that the presence of a business angel often means that the company’s approach to fund raising is more business like and a more professional image is presented. This can be fairly simple stuff such as presenting a written business plan. Jason Purcell, founder of First Stage Capital, which specialises in providing corporate finance advice to early stage technology companies, is tapped into what he describes as a “tech savvy” group of business angels. It is highly targeted business angels like these that appear to provide the best added value for companies in that there is often a skills knowledge and useful set of contacts that can be tapped into.

Purcell notes that a number of business angels he comes into contact with simply stepped out of the market in Q4 2000 and Q1 2001. It’s only now that pricing has stabilised and entrepreneurs expectations are beginning to get in line with lower valuations that they have begun to re-emerge.

Most countries in Europe have one or more formal networks of business angels and around 18 months ago Eban, the European Business Angels Network, was set up by a number of national business angel networks with the help of EU funding. The strongest networks in Europe Belgium, Germany, Italy, Netherlands and the UK were the most active proponents. Although some national networks release figures of amounts invested this necessarily represents only their membership and as such provides little more than a yard stick against which to measure year on year increases or decreases in investment activity.

For example, the British Venture Capital Association produces an annual report on investment activity by business angels and those registered with the various UK business angel networks made combined total investments of GBP28.3 million in 1999/2000. This represented a 40 per cent increase in value terms on the previous year and a 16 per cent increase in the number of deals, which reached 224.

The average investment size is recorded at GBP55,000 and approximately half the total monies found their way into seed, start up and early stage businesses and just under half ended up supporting technology businesses.

For their part venture capitalists investing seed capital are greatly reduced in numbers across Europe. This is in part explained by the recent surge in venture capital and private equity activity and the attendant interest that is generated.

The swell of money saw to it that many successful early stage and seed capital investors were able to raise subsequent funds far in excess of the first. This meant many moved to investing in later stage deals because they now needed to deploy larger amounts per transaction, and seed capital investing became difficult in terms of the time needed to undertake the transaction and ongoing support versus the total amount of capital that could be deployed.

Many venture capitalists initially cited a desire not to be diluted in their best deals as reason for significantly upping the amount raised for their most recent fund. However, in practice many increased their minimum deal size as well as the amount they would commit to a company across its funding rounds, which translated into a decrease in the available pool of seed and start-up capital.

This shift by the venture capitalist didn’t seem to matter much in terms of the available pool of seed capital since incubators and accelerators were springing up all over Europe at the same time (1999 and 2000.) They appeared in a variety of forms from those that undertook stock market listing in order to raise funds to invest to those receiving support from a handful of institutional investors.

It’s harsh, but fair, to say that a large number of the new breed of European incubators and accelerators are now in a mess. Some have returned funds to their investors, others have dropped out of view taking significant losses with them and others have stopped investing. Although, interestingly, the consolidation predicted when things began to go pear-shaped has yet to appear probably because two wrongs don’t make a right. There have been instances though.

Xworks, a UK business investor and accelerator with some five or six investments to its name and a successful exit – an unfortunately relatively uncommon accolade for the incubator/ accelerator models -, earlier this year reversed into AIM-listed Chrome Technologies. Chrome, which floated on AIM in October 2000 raising GBP1.5 million, had, six months later when the Xworks transaction took place, yet to make a single investment. Late last year another merger took place between two AIM-listed early stage investors each with a portfolio of investments. This time NewMedia SPARK bought Internet Indirect.

Dr Juergen Diegruber, founder and partner of Munich-based seed and early stage investor German Incubator, notes that consolidation among the incubators and accelerators in Germany is gathering pace. German Incubator is set apart from the majority of European incubators and accelerators that took their funds for investment from large corporates and institutions or raised them via stock market listings. In contrast Dr Diegruber felt the right approach was to use a traditional VC framework and so he raised a E15 million fund last year, to which Hypo-Vereinsbank committed E7.5 million.

Dr Diegruber says: “The failure of incubators has led to a reassessment and some of them want to reinvent themselves as venture capitalists with limited partnership structures. I think this is a good idea but not all of them will make it.”

“The failure of incubators has led to a reassessment and some of them want to reinvent themselves as venture capitalists with limited partnership structures…. but not all of them will make it.”

There are a few incubators that have attempted to build pan-European presences, although the operations were very much localised; a necessity for seed investment is a national network in the country in question. Brainspark for one has not invested outside the UK this year, although another,, is still in full swing.

However unclear their longevity and investment rationale the incubators and accelerators were vital in plugging a liquidity gap at the seed capital end of the market. Now that their numbers have been substantially diminished, so has an important source of seed capital across Europe.

One thing that is helping with that liquidity crunch at the early and seed stage investment level is the rise of the corporate venturer. Corporate venturers are organised along many different lines (often related to the push-pull between corporate goals and the need to maximise financial gain) but, unlike the incubators and accelerators, they appear to have a solidity about them for now. The provision of liquidity at the seed capital stage is limited by those that seek opportunities solely from within their parent company’s confines. Reuters Greenhouse fund, Ericsson Venture Partners and DB eVentures are examples where corporate venturers source some deals outside the parent group.

On the other hand BT Brightstar is an example of a corporate venturing unit designed solely to spin out incubated businesses supported by BT intellectual property and patents. BT Brightstar doesn’t actually put any money into the businesses but clearly there is money spent on giving engineers laboratory space and so forth to get them from the blue-sky concept stage to commercial specification or a prototype. Once a business is ready to be spun out this will only be done if venture capitalists are willing to provide start-up funding. Having no money on the table avoids BT and its BT Brightstar corporate venturing unit falling in love with a company that might in fact not have success in the commercial world. BT will retain an equity stake in the businesses that are spun out in return for passing its intellectual property and patents to the company.

Finally, some European Governments have introduced measures to boost investment in seed and early stage businesses. In the UK, for example, the listed Venture Capital Trusts, introduced in 1995, have become an important source of early stage funding. This is because the total amount they can invest in any one company is capped at GBP1 million per tax year and the majority of their investments must be made in UK companies. Seed and start-up capital in the UK received a boost two years ago when the Government set up the University Challenge Funds designed to translate commercially viable University research projects into spin out companies. These too have become an important source of early stage funds in the UK.

In Germany there are a number of soft money schemes that have given early stage venture capital investing in the country a tremendous boost and, as Dr Diegruber notes, they, combined with the Internet bubble, have boosted Germany’s entrepreneurial spirit far beyond expectations. Germany’s soft money, or subsidy, schemes start at State Government level with funds allocated by Bonn-based Deutsche Ausgliechsbank and Frankfurt-based Kreditanstalt fur Wiederaufbau (KfW). Both these institutions are covered by explicit guarantees from the German central Government and in theory (and practice) it has been possible to apply to both banks for the same project and be granted funds by one institution and not the other. Following the merger of Deutsche Ausgliechsbank and KfW, which was announced mid 2000, this anomaly should eventually disappear. At the outset these subsidies covered as much as 85 per cent of the investor’s risk but this has today fallen to around 60 per cent.

Dr Diegruber’s German Incubator is accredited with the KfW and the tbg, which takes about six or seven months to process and then each application takes in the region of three to four months. But the reduction in risk profile for the investors is usually worth the wait.

Some of Europe’s seed and start-up investors have moved in and out of the market to greater and lesser degrees of late causing many to bemoan the lack of available seed capital. However, as amply demonstrated by some incubators, seed investing is a niche skill at which only a few excel. In this light it could be argued that in fact the scarcity of resource will, on average, result in survival of the fittest companies only and as such, scarcity of resource might on balance be a good thing.

“Entrepreneurs often underestimate how long the fund raising process takes. Deal timetables have extended over the last six to 12 months.”

One thing all agree on is that entrepreneurs expectations are gradually coming in line with those of the venture capitalists in this return to normality – as many are describing the era. Purcell of First Stage Capital says: “Entrepreneurs often underestimate how long the fund raising process takes. Deal timetables have extended over the last six to 12 months and it now takes three or four months to raise money and the investors are doing more due diligence.”

Dr Diegruber notes that many managers in Germany still have unrealistic expectations and can be dispirited enough by the start-up process to return to the safety of their previous employer.