Last updated: February 28, 2010 11:38 pm

IIF to throw entrepreneurs £200m lifeline

British venture capital and the entrepreneurs that it funds are the latest sector to get a state bail-out.

Venture capital

Venture capital

The government last week began the long process of distributing its £200m UK Innovation Investment Fund, which will be focused on life sciences, digital and advanced manufacturing businesses.

It comes at a time when venture firms are struggling to tap their investors – from wealthy individuals to pension funds – for new cash. That in turn is hitting innovation, with the number of venture fundraisings among UK technology companies falling from 210 in 2005 to just 86 in 2010, according to Dow Jones VentureSource.

The UK IIF will be managed by the European Investment Fund, a “fund of funds” which has matched £100m from the government with a further £100m from its own resources. EIF will divide up the £200m between investors with funds for small to medium-sized businesses over four to five years, investing on a commercial basis.

EIF itself is owned by the European Investment Bank and the European Commission. Although it invests aiming for a profitable return, John Holloway, director at EIF, told the FT that the majority of funds for start-ups now originate with the public sector.

“EIF has continued through 10 years to support European venture when most other players have disappeared off the screen,” says Mr Holloway. “There are very few private investors in European venture capital . . . We have found ourselves frequently alone.”

While the most prominent European funds, such as Index Ventures, Balderton Capital and Accel Partners, are still able to raise new funds, many others have closed funding rounds below their initial expectations – or failed altogether.

“Trying to raise any fund at the moment is pretty tough but raising a pure-play VC fund is impossible,” says Mike Reid, partner at Frog Capital, an early-stage investor based in London.

Long-term investment periods, with high risk and limited scope to pull funds out, have deterred investors.

“It is a challenge for the VC industry that it takes ages for investors to get their cash back,” says Tellef Thorleifsson, founder of Northzone Ventures, which raised €90m (£80.4m) for a new fund last month.

One Northzone investment, Spotify, has global ambitions and is run by seasoned entrepreneurs – a combination which investors such as Mr Thorleifsson say has been too rare among European start-ups.

David Carratt, managing director of Kennet Partners, a London-based growth equity investor, predicts a “big shake-out” in the private equity management market, with investors focusing on returns.

That won’t be helped by the recent spate of aborted stock market listings, such as Travelport. “The London IPO market is like a herd of elephants trying to get through a catflap,” Mr Carratt says. “Only the biggest deals will be done.”

Some investors have even been trying to extricate themselves from venture funds for which they can no longer afford the commitments, he says. They are selling their positions at a discount, which in turn is diverting new investors’ money from new funds.

For those funds that do still have cash to invest, the past two years have made them focus even more on later-stage investment, which is less risky and can generate smaller, quicker returns. That presents a real challenge for entrepreneurs looking for first-time funding for a new technology that is yet to generate significant revenues.

One recent victim is Kublax, which developed a recession-friendly personal financial management site. In 2007 it won Seedcamp, a start-up contest which provided it with mentoring and support from some of the best-connected individuals in the London tech community. It raised just less than €1m in 2008 but last month went into administration after failing to raise new funds. It is now in discussions with SimplyFinance, a larger rival, to keep the site alive.

Mr Holloway admits even the government’s latest cash injection won’t solve this “equity gap” problem for early-stage companies entirely, adding that it will take several years for the £200m to filter down to entrepreneurs.

But others question whether government handouts are ever likely to be the solution. “If you look at the US, what has worked well is financial incentives and tax incentives,” says Fred Destin, partner at Atlas Venture. ”What has not worked well is governments putting money directly into innovation. The returns are very poor. The best funds do not need government money, so by self selection it goes towards weaker funds.”

A better way for governments to help would be to increase tax breaks for angel investors, says Matteo Berlucchi, a serial entrepreneur most recently leading Livestation, an online video service for news and sports junkies.

“Investing in a start-up has the same capital gains tax as buying property,” he notes, “but the risk is higher than ever before. The situation is terrible”. Mr Berlucchi reckons a lottery-style system of small hand-outs to lots of start-ups would be a better way of seeding innovation than the current VC model.

VCs argue that demonstrating better returns will revive their industry. “There is still more money going into venture-backed companies than there is coming out,” says Mr Destin.

To that end, the current scarcity of funds may ultimately be beneficial for those VCs that survive. When there was plenty of VC money, entrepreneurs could demand unrealistically high valuations, making it hard for investors to gain a good exit multiple.

“The supply of funds has been so limited that the market can bring about a better balance and better returns,” says Mr Thorleifsson.

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