THE ESTORIL DECLARATION
Principles and Good Practice Policies on the
Financing Innovation Value Chain
The Right Environment
From Ideas to Market
Investment
Readiness
Savings for Growth
CONTENTS
1 THE ESTORIL DECLARATION ........................................................ 5
2 Forum “Financing Innovation – From Ideas to Market” .................... 12
3 Financing of Innovative Young Firms: Summary Discussion ........... 14
2
INTRODUCTION
Financing Innovation requires getting from ideas
to
markets,
making
investment
readiness,
having the right environment and the availability
of savings for growth – i.e a value chain
The European vision of a successful knowledge-based economy, where high
potential enterprises can emerge, growth, create employment and improve
innovative capabilities, has among other priority issues, a major challenge: - to
overcome the imperfect nature of the financial markets.
This huge challenge requires a holist view of the financial system, spanning the
equity-debt spectrum from both formal and informal risk capital markets, to the bank
intermediation process, in order to reinforce the availability of a range of appropriate
financing solutions for Small and Medium-sized Enterprises (SMEs) throughout their
development life-cycle.
The goal requires the active participation of the entire entrepreneurial infrastructure,
including the owners and managers of target businesses, the financial services
industry, government policy makers, academia and the media.
The Estoril Declaration summarises the principles and good practice policies that
should be followed to achieve a more effective integration of the four pillars identified
of the financial innovation value chain: - From Ideas to Market; Investment
Readiness; The Right Environment; and Savings for Growth.
3
The full range of measures that are available to stimulate entrepreneurship and
innovation should be well known and celebrated at all levels of society, and a
stimulus among policymakers to develop suitable policies.
To that end, the Estoril Declaration will be used as the framework for the “Estoril
Observatorium
of
Good
Practice
Policies
on
Financing
Innovation
and
Entrepreneurship” to scan and distinguish, under the Commission’s guidance, the
best cases and experiences in this important field.
4
1 THE ESTORIL DECLARATION
RECOGNISING that the European Union needs to continue to develop a
world-class environment supporting innovative and high growth Small
and Medium-sized Enterprises (SMEs) and in which competitive markets
work efficiently both within and across borders to allocate a range of
appropriate forms of finance and related services, from professional and
well informed providers to similarly competent entrepreneurs and their
businesses at all stages of the enterprise life-cycle,
From Ideas to Market
IT IS RECOMMENDED:
I.
That successful entrepreneurial economies have a ‘can do’ attitude to
transforming interesting and novel ideas and discoveries into new
products and services to both existing and new customers. The full
realisation of Europe’s innovative resources and their delivery to world
markets requires the ‘catalyst’ of a strong entrepreneurial culture to be
supported by efficient financial markets
Therefore, it is necessary:
 To promote an entrepreneurial culture and new business formation
as an attractive and feasible career choice, to be widely fostered
amongst politicians, business persons, academics, students, and
5
those teaching and advising current and future generations of
European citizens;
 To encourage the spin-out activity, commercialising intellectual
property from universities and the research community via
academic-private
funding
arrangements
that
recognise
the
demanding requirements of professionally-run and commercially
attractive fund structures. Effective structures are likely to require
cross-institutional collaboration, co-financing and risk sharing
schemes;
 To assure that Europe’s financial services community supports the
identification and industry adoption of practicable means by which
intangible
assets,
such
as
intellectual
property,
can
be
pragmatically valued in order to attract additional debt finance and
other resources, especially for innovative and technology-based
start-ups;
 To recognize the recognition of the peculiar demands of young
and growing SMEs, by enterprise support infrastructures, as well
as specialist and expert services, and the considerable scale and
scope of benefits stemming from the active concentration of new
enterprise activity into dense and mutually-supportive local and
regional clusters;
 A full spectrum of SME’s life-cycle financial and support services
providers, from ‘seed stage’ incubators through business angels
and debt providers, to corporate venturing and institutional venture
6
capital funds, to be available to attractive growth enterprises;
Investment Readiness
IT IS RECOMMENDED:
II. That new and growing enterprises have access to the right resources
allocated by a free and competitive market. They have to earn
investors’ interest and commitment by the greater attractiveness of
their businesses profile compared to other available investment
opportunities
In order to achieve that, it should be:
 Emphasized the need to improve and reinforce the enterprise’s
internal capabilities
to attract
investors,
namely supplying
sufficient, timely and accurate information to financial providers in
order to get appropriate financial resources and other related
services at competitive conditions. In particular, entrepreneurs,
their commercial partners and their advisers will need to recognise
that Basel II requirements for transparency will impose a greater
effort on all parties to reduce information asymmetries;
 Given high relevance to professional mentoring and other advisory
support services specially designed to meet the needs of attractive
but often inexperienced young businesses seeking external
sources of finance;
7
 Note that, as enterprises assume the responsibility of adopting
appropriately rigorous standards of governance and disclosure,
the financial infrastructure may provide the full spectrum of finance
and support to the specific needs of early growth, development
and the transfer or buy-out of established businesses;
 Given priority to benchmarking tools to enhance the reputation of
the best-performing enterprises, improving their market position
and negotial capabilities among their finance sources, individually
or as a reference group;
 Given priority to recognising and exploiting the critical role of
business angels/informal investors as the largest potential source
of knowledge and of stable, early-stage, informal risk capital to
young enterprises;
8
The Right Environment
IT IS RECOMMENDED:
III.
That Governments ensure that entrepreneurial environments in
which young firms are created, developed and traded are favourable to
entrepreneurs and investors, avoiding inappropriate and costly solutions
related to legislative, fiscal or regulatory systems. Thus, policy makers
should actively strive to remove existing barriers and promote new
business formation and the growth of existing SMEs. Governments have a
key mission in supporting enterprise, but should seek to ensure a
subsidiary role compatible with free market activity
Measures should be taken to support:
 Competitive legal, fiscal and administrative policy frameworks that
directly encourage risk-taking by entrepreneurs and external
investors, such as business angels and venture capitalists, also
encouraging
the
entrance
of
new
market
players
and
professionals;
 Growing levels of cross-border investment with the goal of creating
a single pan-European market in venture capital and private
equity, for which further legal and fiscal harmonisation between
member states is needed;
 Efficient and cost effective transfer of businesses to new
ownership/management in order to ensure the continuation and
growth of existing viable enterprises. Such transfer systems should
also expedite the timely removal of unsuccessful business
9
ventures from the market, thereby assisting the efficient
reallocation of existing resources;
Savings for Growth
IT IS RECOMMENDED:
IV.
To channel savings and to enhance the mobilization of long term
investment in SME assets, through structured finance instruments,
supported by public risk sharing schemes whenever needed, to
encourage private investment into market failure areas where it would be
otherwise particularly difficulty to attract a sufficient stock of funding due
to the well known information asymmetries and the high transaction costs
incurred
It should be acknowledged:
 The valuable role of banks supported by mutual or public loan
guarantee schemes and related initiatives to securitise SME debt,
increasing the liquidity within the financial market and the capacity
for renewed banking exposures on SME finance;
 The importance of risk capital sources for entrepreneurial growth
firms, as direct leverage to access debt financing. Particularly,
special importance should be given to encouraging greater
supplies of early-stage risk capital available to innovative pre-seed
(‘proof of concept’), seed and start-up enterprises in Europe;
10
 The practical relevance of later stage venture capital, by
strengthening the links between business angel groups and the
investors from the formal sector, in order to facilitate the continued
flow of financing for enterprise growth, simultaneously providing
opportunities for early stage investor exits;
 The attractiveness of venture capital and private equity as an
asset class for long-term institutional investors, such as pension
funds and insurance companies;
 The need for public recognition, identification and support for a
single pan-European stock market of sufficient economic scale,
liquidity, technical expertise and specialism in high growth/high
potential, new knowledge-based firms across the member states;
 The importance of active regional stock markets trading in growing
and high-potential companies and acting as an exit channel for
later stage investors;
 The growing need for alternative and novel financing instruments,
including micro-finance, mezzanine and stock options, focused
specifically on the growth needs of young innovative SMEs.
Estoril, 9th of October 2007
11
2 Forum “Financing Innovation – From Ideas to Market”
The Portuguese EU Presidency and the European Commission have underlined
the importance of entrepreneurship in innovative areas by organizing the Forum
“Financing Innovation – From Ideas to Market”, held at Estoril, Portugal, on the
8th and 9th of October 2007. The purpose of the Forum was to promote the
implementation of newly-established policy solutions in the area of European
enterprise and innovation, by direct reference to world-class examples in both
financial practice and complementary government support. Real-life cases were
cited from both within and beyond European borders, with particular reference to
catalysing pragmatic and effective action in alternative forms of innovation
financing in SMEs.
The Forum was organised around a series of plenary sessions and
delegate/expert workshops. The four themes of the Forum, articulated in the
Estoril Declaration, are best seen as a set of related policy frameworks that need
to be put in place in order to realise and sustain a vibrant SME marketplace with
easy access to financial support systems throughout their life-cycles.
I.
From Ideas to Market
II.
Investment Readiness
III.
The Right Environment
IV.
Savings for Growth
The Forum provided an excellent platform to enable Member States, the
European Commission, Financial Institutions and members of the SME and
Innovation/Technology communities, to discuss the realisation of relevant policies
and practices from both a European and global perspective. While issues of SME
finance were central to the discussions, the agenda recognised that effective
innovation activity is a complex mechanism of which access to adequate and
12
appropriate sources of finance from a diversity of providers remains but one
important issue.
Add one page graphic summarising the four themes of the Estoril Declaration
Financing Innovation Value Chain
13
3 Financing of Innovative Young Firms: Summary Discussion
The Estoril Declaration focuses on the need to craft national and pan-European
SME policies that are both comprehensive and work in concert with each other.
Finance and Innovation related policies also must acknowledge and reflect the
changing needs of SME clients as the firms grow and evolve over time. Thus, while
national policy responses are ‘necessary’, they are not ‘sufficient’ in a globalising
world. In order to set the four themes of the Estoril Declaration in this wider context,
the following discussion focuses on a number of financing issues that still need
further policy resolution1.
A Changing and Global Context
The current dynamics of global economic integration, resulting in rapid and highly
significant changes to market structures, has brought strong competitive pressure to
bear on the wider European economy. Member countries of the European Union will
not be able to compete effectively with the emerging behemoths of the BRIC (Brazil
Russia India & China) and other resource or labour-rich nations if they rely solely on
natural factor endowments. Europe has little choice but to exploit its long and
established traditions of innovation and creativity if it is to compete successfully on
world markets and to ensure acceptable living standards for its present and future
citizens.
In 2006, the European Commission launched a revised agenda2 focusing on
knowledge, technology and innovation as key factors for the sustainable growth of
1
In order to keep this document to a manageable length, further detailed reading and references are
added as footnotes.
2
COM(2006) 349 final, 29.6.2006 , Brussels.
14
the European economy, in accordance with the priorities originally established by the
Lisbon Strategy (2000) and subsequently refined in the light of experience. With 23
million SMEs registered in Europe, entrepreneurship was recognised an essential
component of any credible programme to stimulate innovation and to address the
challenges of globalisation. The best SMEs are well versed in the skills of flexibility
and adaptability required to both survive and flourish. The continuous adoption of
new processes, improved organisational methods, the creation of new and attractive
goods and services for existing and new customers are now no longer exceptional
behaviour but the norm if a business is to be successful in the longer term.
The Continued Importance of SMEs
Small and medium sized enterprises (SMEs) play a very important role in the global
economy. Representing the vast majority of all business entities, they are the
dominant form of commerce at local, regional and national levels regardless of
country. In aggregate, it is small businesses not giant global corporations that
represent the majority of wealth and jobs creation worldwide in many sectors of the
economy. Large corporations are not removed from the SME domain. They, in turn,
are dependent both directly and indirectly on a solid foundation of flourishing SMEs
acting as suppliers, manufacturers, distributors and customers. A healthy economy
facilitates this inter-dependence.
This continuing importance of SMEs to the future success of the European Union as
engines of both employment and growth is recognised in a formal set of policies
focusing on improving the environment, and thus the performance, of SMEs in its
member states. The continued centrality of SME policy to the future success of the
15
Europe has been recently reiterated by Günther Verheugen in his role as VicePresident of the European Union. 3
Innovation is similarly recognised as an essential component of the economic growth
process4
5.
As the world’s trading economies become more integrated and
interdependent, the ability of companies to seize upon evolving global business
opportunities - by commercialising new products and processes faster and more
effectively than their competitors - will be critical for their growth and for their long
run survival. This competitive reality informs the inter-related goals of the European
Commission’s Lisbon Strategy for Growth and Jobs6 and the promotion of European
innovation.7 Innovation and SME policies meet in the shape of new knowledgebased enterprises spawned from the region’s infrastructure of universities, research
laboratories and existing high-tech firms.
Increasingly, access to advantage technological skills and processes is not an
insurmountable barrier to SMEs. New technology-based firms (NTBFs) working at
the frontiers of applied sciences, while inevitably a minority of SMEs, are widely
recognised as a key source of entrepreneurial vigour and innovation in a modern,
See Commission Press Release IP/06/893 “Initiative to boost growth of SMEs: EU wants to triple
early-stage capital investments” 30th June 2006, and Vice-president Verheugen speaking at the
Conference on the European Charter for Small Enterprises, Berlin 4-5 June, 2007.
3
“Putting knowledge into practice: A broad-based innovation strategy for the EU. COM (2006) 502,
13.09.2006, Brussels.
4
5
European Commission (2006), Creating an Innovative Europe: Report of the Independent Expert
Group on R&D and Innovation, p.25, Brussels.
“Implementing the Community Lisbon Programme: Financing SME Growth – Adding European
Value”, COM(2006) 349 final, 29.6.2006, Brussels.
6
“Putting knowledge into practice: A broad-based innovation strategy for the EU”- COM(2006) 502
final 13.9.2006, Brussels.
7
16
technocratic economy8. These high-tech young firms, acting as catalysts for
change9, have often played a major role in the introduction of new and disruptive
technological advances10.
Do SMEs Face Financial Constraints?
Small businesses need efficient financial markets that reflect their specific needs
and circumstances. It should not be automatically assumed that a majority of SME
owners believe that there is a problem regarding their access to external sources of
finance. While “the improvement of access to financing is a major factor in the
promotion of the European entrepreneurial spirit“ (European Commission, 2003) is
true as a generalised statement, it should be remembered that capital markets do
generally act efficiently in as far as they are used by a majority of SMEs in major
European economies.
11
The (2005) Flash Euro Barometer
12
notes that three-
quarters of SMEs survey had “sufficient financing to see their projects through”.
Indeed, only around 16% of surveyed SMEs agreed that easier access to financing
8
Siegel, D. S., Wessner, C., Binks, M., Lockett, A. 2003. Policies promoting innovation in small firms:
Evidence from the US and UK, Small Business Economics. 20(2). 121-127
9
Audretsch, D and M. Keilbach. 2003. Entrepreneurship Capital and Economic Performance. CEPR.
London
10
Christensen, C. 2003. The Innovator's Dilemma: The Revolutionary Book that Will Change the Way
You Do Business. Harper Collins. London.
11
COM(2003) 713 final, Bruxels, 01.12.2003, Commission’s Report to the Council and the European
Parliament: Access of Small and Medium Entreprises to Financing.
12
European Commission (2005) Flash EB No 174 SME Access to Finance.
17
would best assure the development of their company. The same study shows that
only around 6% of survey firms had ever received venture capital.
Policy Is Focused on ‘Exceptional’ Growth Firms
The majority of SMEs in most European countries would not place access to finance
for growth as the major barrier to their success13. This is because it is only a minority
of the founders of small businesses would wish to grow their businesses
aggressively. However, significant numbers of the most innovative and ambitious
young companies in an economy still repeatedly cite financial difficulties as a major
constraint to their continuing and rapid development.14 Access to external source of
finance has become worse since the severe correction of the technology
stocks/dot.com ‘bubble’ in Spring 2000.15 The cited Flash Barometer report noted
that some 14% of the European Union’s 23 million SMEs experience difficulties in
raising debt finance. Yet, in SME and innovation policies, it is usually the case that it
is the minority rather than the majority of companies that are of policy interest and
which may need support during critical stages of their development. Thus, an
argument exists for financing mechanisms and programmes that fit more closely the
circumstances and needs of valuable target groups.
13
European Commission Flash Barometer 2005 SME Access to Finance: Executive Summary.
Brussels
14
Maula, M., Murray, G. C. and Jääskeläinen, M 2007. Public Financing of Young Innovative Companies in
Finland. Report to the Finnish Ministry of Trade and Industry. MTI Publications, Helsinki.pp127.
15
Subsequent to this date, the supply of both formal and informal VC funding dropped dramatically as
institutional and personal investors withdrew from the market in the light of severe losses.
18
Therefore, before determining the availability or importance of finance or other
externally sourced resources, the nature of the SMEs seeking finance becomes a
key question. Storey
16
argued on UK evidence that essentially some 4% of new
firms starts will represent over 50% of additional total benefits when measured by
employment, sales, exports or other economic ‘desirables’. His findings can be
generalised to most modern economies. It is this very small cadre of young,
exceptional growth companies that should be the predominant focus for policy
makers’ attention. For Europe, promoting the genesis and growth of a larger number
of these ‘outliers’ will best serve to realise the economic and innovative goals of the
Union as determined in the Lisbon agenda.
Thus, the question when framed as a policy issue becomes: “Do these exceptional
growth firms, often called ‘Gazelles’, suffer from financial rationing in their early
growth stages when applying to the capital markets available to European SMEs?”
Here, the answer is much less clear. There is some evidence that growth-oriented
young firms are likely to experience difficulties in accessing appropriate forms of
finance. The sophistication of the financial services available to small firms also
varies markedly between European countries. Such nascent firms often have little
track record, industrial reputation or tangible assets that can be employed to secure
external sources of debt. Given limited and erratic cash flows at the early period of
the firm’s growth trajectory, the so-called ‘J Curve’ effect
17,
risk capital may be a
much more appropriate form of finance that bank debt with the latter’s requirement
for regular interest payment from retained or trading income. The more technically
complex the activities of the innovative firm, particularly in the case of new
technology-based young firms, the more likely are potential investors to be
intimidated by the complexity and uncertainty of the enterprise.
16
Storey, D. J. 1994. Understanding the Small Business Sector. Routledge, London.
17 Meyer, T and Mathonet, P-Y. 2005. Beyond the J-curve : managing a portfolio of venture capital
and private equity funds. Wiley, Chichester.
19
The Special Case of New-Knowledge and Technology-based SMEs
While a concentration of innovative and successful technology and other new
knowledge-based firms is a uniformly desired goal in economic policies 18, such firms
frequently face constraints and challenges peculiar to working with the often highly
intangible assets of scientific or technological knowledge, competencies and
experience19. Access to appropriate sources of early-stage financing continues to
be one of the most significant constraints to the creation, development and
international success of growth oriented, innovative young enterprises. Often
environments of high complexity, great uncertainty and rapid change exacerbate
funding problems. Such nascent or early growth enterprises are particularly
challenged in seeking to use established sources of finance which are often more
adapted to the needs of larger established businesses. Indeed, the smaller the size
of funds required, the less attractive the applicant is to many investors seeking to
place large sums of finance in secure businesses.20
High potential, young SMEs tend to have a high risk profile for a number of well
researched reasons: the absence of a commercial track record, the existence of
informational asymmetries, limited stocks of fungible assets and recognised
collateral, and insufficient management skills can each serve to reduce access to
18
Porter, Michael. 2000. Clusters and the New Economics of Competition. Harvard Business Review.
Nov-Dec. pp. 77-91.
19
European Commission. 2006. Intellectual Property and Access to Finance for High-growth SMEs.
Summary of the DG Enterprise and Industry workshop, Brussels 14th November
20
One established source of market failure is the problem of providing small tranches of money from
a VC fund in a context where economies of scale and scope are material. (see Murray, G. C. 1999.
‘Early-stage, venture capital funds, scale economies and public support’, Venture Capital, 1, (4) pp
351-384.
20
critical resources for growth21. Additionally, the disproportionately high transaction
costs in relation to the small financing amounts involved, as well as considerable
uncertainties about future performance, frequently make the financing of new
knowledge-based SMEs unattractive to professional, debt or risk capital funding
sources22. There is evidence that these factors serve to create a market failure
whereby young and potentially valuable firms face risk capital rationing, i.e. the
existence of an ‘equity gap’. 23 24
Policy makers, including the European Commission, have recognised the fact that
such high potential but as yet unproven enterprises represent a ‘special case’. A
variety of public support measures at both national and European Union level have
been taken to improve this situation. SME focused initiatives, largely at national
level, have included preferential tax treatment, better regulatory and administrative
environments, reduction in compliance costs (“red tape”), increased public support
for bank loan guarantees and venture capital schemes, measures for business
angels promotion, and initiatives to develop second tier capital markets25.
In this context, issues of formal and informal sources of venture capital, and
initiatives to exploit mezzanine finance, securitisation of debt and the enhanced role
of stock markets for ‘alternative investments’ become major planks of an integrated
21
Dimov, D. and Murray, G. C. 2007 (forthcoming) An examination of the determinants of the
incidence and scale of seed capital investment activity by venture capital firms 1962-2002. Small
Business Economics.
22
European Commission. 2005. Conference Report on the Risk Capital Summit 2005: Investing for
growth and competitiveness in Europe. Small Business Service, Sheffield.
23
Bank of England. 2001. Financing of Technology-Based Small Firms. Bank of England, Domestic
Finance Division: London
24
HM Treasury and Small Business Service. 2003. Bridging the Finance Gap: Next Steps in
Improving Access to Growth Capital for Small Businesses. London
“Implementing the Community Lisbon Programme: Financing SME Growth – Adding European
Value” COM(2006) 349 final, 29.6.2006, Brussels
25
21
SME finance policy response. Such a comprehensive programme needs to
recognise the need for a diversity of instruments appropriate to the circumstances of
enterprises of different sizes, operating in different sectors and at different stages of
their life-cycle. This spectrum of current European policy actions is graphically
summarised in Fig. 1.
Fig. 1 The CIP Policies and Financial Instruments
Source: DG Enterprise, 2007
Market Efficiency – a Demand or Supply-side Problem?
An ‘efficient’ market for debt or equity finance means that the supply of finance
available is sufficient for those enterprises which are prepared to pay the market
clearing price. In SME finance markets, a frequent difficulty is that young firms which
are willing to pay the ‘going rate’ for capital are still not able to attract suppliers of
finance. This is often perceived as a supply side failure. However, an alternative and
often plausible interpretation is that it is the demand side that is failing. In short,
many SME applicants are not sufficiently attractive to the providers of capital
22
given the level of risk pertaining in financing immature and relatively unknown young
businesses. Another means of describing this situation is to argue that the applicant
firms are not yet “investment ready”. This latter explanation would seem to better
accord with the common ‘feast and famine’ conundrum. Namely, many business
founders argue that it is very difficult to find willing sources of finance while
simultaneously many investors bemoan the absence of a regular supply of attractive
businesses for them to back26. Thus, the term “market failure” and its interpretation
as a supply-side problem needs to be used with considerable caution in the absence
of clear evidence of allocative inefficiencies.
None the less, some market inefficiencies in the financing of innovative young firms
are well documented27. For example, firms may suffer capital rationing because
information asymmetries exist with the result that investors are poorly informed as to
the true merits and circumstances of the firm. The inability of investors to secure the
full economic rent of their investment because of the ‘spill-over’ of benefits to other
parties may similar deter their interest. However, it is also true that the returns to
early-stage venture capital financing of young new technology-based firms outside
the world-class clusters of Southern California and Greater Boston has with few
exceptions
26
generally been extremely unattractive for investors28
29.
That such
Queen, M. 2002. Government policy to stimulate equity finance and investor readiness, Venture
Capital: An International Journal of Entrepreneurial Finance, 4(1):1-5.
27
European Commission. 2007. Financing Innovation and SMEs: Sowing the Seed: Main findings of
four workshops, Brussels.
28
Rosa, C. D. M. and Raade, K. 2006. Profitability of venture capital investment in Europe and the
United States. European Economy Economic Papers No 245, DG Enterprise and Industry. European
Commission, Brussels.
29
An informal study undertaken for the UK’s Small Business Service in 2006 indicated that many
institutional investors were deeply antipathetic to investing in early-stage technology VC funds in
23
investors do not allocate funds to young companies that probabilistically cannot
meet the investors’ high cost of capital is not always a market failure. Rather, it may
often be a market working properly and rejecting unattractive proposals. A schema
of common demand and supply-side sources of market inefficiency are detailed
below in Fig. 2.
Fig. 2 Examples of Demand and Supply-side Constraints Associated with
Financing SMEs/Young Entrepreneurial Businesses
Demand-Side Constraints
Supply-Side Constraints
(ex SMEs, Entrepreneurs)
(ex Investors, Intermediaries)
reducing Investors’ interest in SMEs
reducing attractiveness of SMEs to Investors
Relatively poor (risk adjusted) investment returns
to SME investments in Europe
High levels of market concentration (reduced
number of potential financiers)
Lack of perceived quality/accuracy of the
disclosed financial information
Transaction costs high for investments
requiring small amounts of finance
Difficulty in communicating market information,
particularly in new technological projects
Small deals provide little economic incentives
or adequate returns for investors
Poor financial culture, reducing entrepreneurs’
credibility to investors
Need for high level of fund/investor
specialism constrains actions
Difficulty in providing guarantees or security for
investors, particularly in the start-up stages
Conservative and excessively demanding
collateral requirements by lenders
Excessive concentration of ownership in the
enterprise, and entrepreneur’s resistance to
accepting new equity partners or legitimate
external influences
Reduced liquidity in the capital markets with
scarce funds preferentially allocated to larger
companies
Lack of an entrepreneurial growth culture and
wider risk aversion
Entrepreneurs lack of knowledge or cooperation with local agents including business
angels or SME advisers to identify finance
sources
Insufficient investment in business assets including
R&D, professional management etc.
Internationalisation of investment activity
decreases interest in more challenging
‘home’ deals
Tax systems does not provide economic incentives
to entrepreneurial risk takers
Europe with the possible exception of some exposure to specialist funds in the larger centres of
European technological research activity.
24
Government Involvement in Debt and Equity markets
In looking at the role of public policy in promoting appropriate sources of finance for
SMEs, it is necessary to separate debt from equity based instruments. The former
include both bank overdraft and short and long term loans to SME clients. They
represent the vast majority of financial transactions for SMEs.30 Restrictions on
access to loan financing are predominantly felt by small resource-constrained
businesses with insufficient collateral, companies operating in critical (i.e. risky)
stages of their life cycle and/or companies that promote new (and again risky)
innovative processes. While in a number of cases external equity may well be a
more appropriate source of additional finance for growth, the only external financing
source most entrepreneurs and SME founders can realistically expect to find will be
bank credit. For the most risky businesses, they may well be obliged to rely
exclusively on internally generated resources or the support of ‘friends and family’ in
the absence of bank credit or external equity.
Micro Enterprises employing less than ten persons are overwhelming the single
largest category of enterprises within the European Union. Yet, given their small
size, they have received a disproportionately small share of attention or resources
from either public or private agencies. Again, for this target group, financial support
measures may better be implemented in partnership with existing commercial
providers.
30
There are an increasing range of other bank related products including leasing, invoice financing,
mezzanine finance etc that are available to more sophisticated SME users. However, overdraft and
term loans are the two dominant debt products for SMEs.
25
Public Support – A Facilitating and Complementary Role
The role of government is increasingly seen as facilitating the effective, commercial
operation of private, market based providers of SME finance. It is not to provide
alternative sources of ‘cheap’ public funding that undermines or ‘crowds out’ existing
commercial providers31. Examples of complementary, public co-financing include
loan guarantee schemes involving credit institutions, and collaborative arrangements
that recognise the peculiar circumstances facing new businesses. 32
33
Increased
public assistance may be warranted in inner city or peripheral rural areas, or in
entrepreneurial initiatives involving minority communities etc. In some infrequent
circumstances, a strong case can be made for positive discrimination for target
segments including specific categories of SMEs and start-ups.
The debate as to the role of the public support extends to current discussions on the
securitisation of bank debt. The argument is made that to structure and aggregate
debt into instruments that may be traded on a stock market to informed professional
investors should allow a number of benefits to SMEs seeking bank finance. The
securitisation process, it is argued, may provide additional finance to young
businesses by accessing investors’ assets and thereby reducing the asset-based
constraints imposed on banks’ supply of debt finance. Supporters of securitisation
also argue that the use of a market traded securities allows bank lending to be
31
European Commission. 2005. Best practices of public support for early-stage equity finance. (op cit).
European Commission, Brussels, Belgium.
32
See Financing of Young Innovative Companies in Finland by Maula, Murray and Jääskeläinen
(2007), which cites several public/private financing schemes for SMEs.
33
European Commission. 2006. Community Guidelines on State Aid to Promote Risk Capital
Investments in Small and Medium-Sized Enterprises. European Commission, Brussels,
Belgium.
26
removed from the cyclical constraints occasioned by changing economic activity.
Finally, securitisation is believed to increase the range of debt instruments and their
pricing to accommodate a greater variety of borrowers (applicant firms) of differing
risk profiles34. However, as Summer 2007 has shown, stock market sentiments may
on occasions prove highly disruptive to traded assets including securitised bank
debt.
The second major category of external finance available to SMEs is equity or risk
capital. Here, the provider of finance actually becomes a co-owner of the investee
business. As such, this form of co-finance is generally eschewed by all but the most
sophisticated and ambitious entrepreneurs. While considerable policy attention has
been paid to the promotion of formal venture capital 35, the evidence confirms that
early-stage investment in start-up or young businesses has decreased in importance
as a VC product outside the major US centres of new technology and innovation.
Professional VC partnerships in Europe have frequently migrated to later-stage and
less risky deal structures or have metamorphosed completely from new capital/new
business activity to become part of the burgeoning Private Equity/Management Buyout industry. Thus, while the formal venture capital industry receives a great deal of
public and policy attention, its importance as a credible source of financing for new
and innovative young businesses in several European countries is often marginal in
reality. While a number of specialist European early stage VC investors do exist,
their influence on seed and earliest stage activity is relatively modest, and is largely
restricted to a few centres of technological excellence, e.g. Munich, Germany, Paris,
34
European Commission. 2007 Roundtable between Bankers and SMEs: SME Securitisation – final
report, DG Enterprise and Industry, Brussels.
35
“On Implementation of the Risk Capital Action Plan (RCAP)” COM(2003) 654 final, 4.11.2003,
Brussels,
27
France or Cambridge, UK.
36
A large proportion of existing early stage VC funds
have had government support both in defraying operating costs and as a provider of
investment funds (i.e. ‘special’ limited partner).37
Fig. X Graph of Seed and Start-up Finance by value and as a proportion of total
VC/PE funds in Europe over time (10 years) ex EVCA (TO BE ADDED BY EVCA?)
Business Angel Finance – an Under-developed Source of Risk Capital
Of greater potential importance in Europe is the growing activity of informal private
investors38, also termed Business Angels39. USA experience also shows that these
investors are likely to be responsible for a very considerably greater level of both
total investments and aggregate new investment finance into the SME sector than
that coming from professional VC firms40. This reality is being reflected in a growing
attention to the means by which ‘high net worth’ and informed individuals may be
incentivised to invest in early-stage and new businesses as providers of both
additional equity and valuable commercial experience.
36
The UK’s Annual Survey of Small Business showed that 2% of approx. 9,000 surveyed firms had
used equity finance. 4% of firms had considered, and 92% had not considered, equity finance (Small
Business Service, 2005). The UK has the largest venture capital and business angel communities in
the European Union.
37
Almeida Capital. 2005. A Mapping Study of Venture Capital Provision to SMEs in England. Small
Business Service, London
38
Mason, C. M. & Harrison, R. T. 2004. Improving Access to Early Stage Venture Capital in
Regional Economies: A New Approach to Investment Readiness. Local Economy, 19(2):159–173.
39
The term Business Angel or Informal Investor is used solely to describe investors who are prepared
to invest in enterprises outside their family or friendship circles.
40
Sohl, J. E. 2007. The organization of the informal venture capital market. In H. Landström (Ed.),
Handbook of Research on Venture Capital: Edward Elgar Publishing Ltd.
28
Table 1 USA Comparison of business angel and venture capital investments
(Sohl 2006) and VentureXpert/PwC Moneytree (September 2006)
2002
2003
2004
2005
VC investment (US$ billion)
21.8
19.6
22.0
22.7
Angel investment (US$ billion)
15.7
18.1
22.5
23.1
VC investee companies (no.s)
2 608
2 409
2 559
2 626
36 000
42 000
48 000
49 500
Angel investee companies (no.s)
The business angel activity in Europe is still in its infancy with few economies
outside the United Kingdom having a major informal investor presence. Its
encouragement potentially represents a major additional source of finance for
growth-oriented European SMEs. Further, an integration between informal and
formal sources of risk capital could ideally provides a portfolio of financial resources
for SMEs of different sizes and needs at different stages of their lifecycle that
complements existing bank lending.
A second component of this informal investor activity is the promotion of business
angel groups and the general improvement of the quality and experience of informal
investors via network channelled training in deal structuring, due diligence processes
and legal and accounting requirements. Research has shown that there exist a
considerably larger number of individuals who would invest in young enterprises if
they saw attractive opportunities41. Similarly, business angel network (BAN)
managers are aware that a major constraint on such investment is the inexperience
of ‘virgin angels’ with the operational details of the investment process from due
diligence to deal structuring and subsequent governance. Accordingly, informal
41
Mason, C. and Harrison, R. 1993. Strategies for expanding the informal venture capital market,
International Small Business Journal, 11(4): 23-38.
29
investor training sessions are now a major activity of some of the most experienced
BANs in Europe. This upgrading of investors’ skills has made some of the more
established and experienced BANs attractive to professional venture capitalists as
syndicate partners as well as sources of new deals42.
One advantage of business angels is represented by their control over the supply of
funds allocated to equity investments. Essentially, they are investing their own funds
based on whatever allocation criteria they wish to choose. For professional venture
capital partnerships, the major sources of funds are from institutional investors.
Thus, the track record and investment performance of the general partners of the
fund becomes the single most critical variable determining their continued receipt of
investors’ support and funds. Institutional investors will have asset allocations set by
trustees and will often incorporate a global portfolio perspective. For most trustee
groups, venture capital remains a minority interest within a bundle of alternative
assets. If, as is the case in Europe, the economic argument for investing in early
stage ‘classic’ venture capital activity is not yet fully proven, the majority of such VC
funds will not succeed in receiving institutional finance. This skew against European
SMEs as a source of investment opportunity via venture capital is not a foreign bias
exclusively held in New York or Tokyo. It is also reflected in the asset allocation in
the portfolios of major European institutional investors. This mismatch can be
illustrated in part by the scarcity of initial public offerings (IPOs) involving high growth
and new knowledge-based SMEs coming from European bourses43. One outcome
is the abandonment of venture capital financing of young, high growth enterprises by
42
43
See the European Business Angel Network (EBAN) site: http://www.eban.org/
Initial Public Offerings are a major conduit by which VC firms seek to exit their successful
investments and realise their capital gains. The lack of a single European stock market of equivalent
importance to NASDAQ is repeatedly commented on by venture capitalists and their European trade
association, EVCA.
30
many former VC funds in Europe who have now restructured solely as private equity
investors.
A Growing Public Role in Early-stage Finance
Contemporary trends in private equity and venture capital has placed the state as an
increasingly important source of financial support for new and early stage
enterprises. Public finance has often become ‘the investor of last resort’ in an
environment with few alternatives. Even in European countries with highly developed
venture capital industries (e.g. the UK, Germany, France, Sweden) the state
continues to have a large involvement in supporting early stage VC fund activity by
commercial providers. This trend has emphasised the need for informed public
investors operating in concert with private interests rather than as public competitors
for SME /entrepreneur clients. It has also illustrated the need to find new solutions
for the efficient financing of important but invariably risky investment activities where
the social rather than the economic returns alone may justify the legitimate
developmental interest of the member state or the European Union.
The Internationalisation of SMEs and their Sources of Finance
Traditionally, SME activity including its financing has been seen as largely a
domestic activity. However, as the SME sector has grown in importance, particularly
because of new knowledge and technology-based firms, the assumption of primarily
home market activity has been shown to be no longer accurate. NTBFs are known to
internationalise rapidly and extensively. Their ubiquity is a recognition that advanced
technology markets are invariably global in scope. Recent work in Germany and the
UK showed that young high-tech firms started to export to several foreign markets
31
within two years of start-up.
44
Just as firms have internationalised rapidly over time,
so have the sources of professional finance for SMEs. European venture capital, an
infant industry by the start of the 1990s, is now international in scale and scope. In
order to provide multi-national financial services for international companies,
inappropriate legal, regulatory and fiscal barriers to cross-border activities need to
be rapidly dismantled if Europe is to be able to compete effectively on a world scale
in both debt and equity markets.45
If a single pan-European fund structure is not presently feasible, then in the shorter
term the mutual recognition of other European structures as tax transparent vehicles
by member states is urgently required to facilitate further cross-border investment.
Regulatory barriers for cross-border investments, mergers and acquisitions should
be removed to reduce fragmentation of the European markets. The existence of
such barriers represents a major hurdle to increased investment both within and into
Europe, and reduces the growth potential of European businesses.
Efficient, informed and large volume (high liquidity) stock markets are a key driver of
investments.46 Therefore, the development of such channels is of crucial importance.
National stock markets frequently fail to provide sufficient liquidity or the
sophisticated investor base needed by many specialized technology basedcompanies. Therefore, more pan-European exit routes are needed including both
Cowling, M, Fryges, H., Licht, G and Murray, G. C. 2007. The Survival & Growth of ‘Adolescent’
High-Tech Firms in Germany and the UK, 1997-2003. Anglo-German Foundation, London & Berlin.
44
45
European Commission. 2007. Removing Obstacles: Expert group report on removing obstacles to
cross-border investments by venture capital funds. DG Enterprise and Industry, Brussels.
46
Black, B. S. & Gilson, R. J. 1999. Does Venture Capital Require an Active Stock Market? Journal of
Applied Corporate Finance (Winter 1999): 36-48.
32
IPO and trade sales channels.47
48 49
Regardless of its political sensitivity, Europe
must provide unequivocal support for (at least) one European ‘small cap’ market of
international importance when appraised by the volume and value of transactions50.
More Effective and Integrated SME Finance Policies
In conclusion, Europe is not without a considerable understanding of the challenges
facing SMEs. Instruments and infrastructure to effect positive change are in place in
several member states. While considerable improvements have been made in
supporting SMEs and ensuring a conducive environment for their genesis and
growth, effective policy measures are not uniform across the European Union.
Considerable effort is still needed to close the gap between the best performing
member states and the average for the Union as a whole. There remains a critical
need to move from a passive understanding the concept of ‘world class’ policy
actions to their wholesale implementation as the norm of European Enterprise and
Innovation policies. The Estoril Declaration recognises this reality by its focus on the
47
European Commission 2005a. Improving Opportunities for Initial Public Offerings on Growth Stock
Markets in Europe. Report from the workshop held on 24 May 2005 in Brussels. Directorate-General
for Enterprise and Industry.
48
European Commission 2005b. Merits and possibilities of a European fund structure for venture
capital funds. Report from a workshop held on 21 June 2005 in Brussels. Directorate-General for
Enterprise and Industry.
European Commission 2006a. Financing SME Growth – Adding European Value. COM(2006) 349
final. COMMISSION OF THE EUROPEAN COMMUNITIES.
49
The comments in this paragraph were taken from a Finnish government policy document prepared
by Professor Gordon Murray and Professor Markku Maula in 2006.
50
33
need for a common set of coherent and integrated policy themes that span the
evolving finance and related needs of high potential young enterprises across their
life-cycle. In a global and challenging world, this policy coherence must be applied at
a pan European level if the Union is to be able to exploit the full potential of its
enterprises and its citizens.
34