Science and TechnologyJoint written evidence submitted by Science Policy Research Unit, University of Sussex and Exeter Business School

1. Dr Paul Nightingale is Deputy Director of SPRU, the Science Policy Research Unit at the University of Sussex, where he leads a research group on innovation policy. Prof. Cowling is Professor of Entrepreneurship at Exeter Business School, where he heads a research group on SME financing. Drs Coad and Siepel are researchers at SPRU working on the financing and management of innovative firms. This submission draws heavily on research funded by the ESRC, NESTA, BIS and TSB as part of the IRC distributed projects scheme, as well as research funded by BIS, the BVCA, NESTA, the EPSRC, ESRC and EU through the FINNOV project.1 None of the team have any financial interest in any organisation mentioned.

2. We welcome this opportunity to contribute to this call for evidence on this important topic. Before we address the questions we would like provide a small amount of background and context.

3. Care must be taken when considering the “Valley of Death” as it is partly an artefact of thinking about firm growth without taking into account the extremely high failure rates of new firms. Roughly 50% of new firms will exit the market (fail) within their first three years. Sustained growth is atypical as growth patterns follow a random walk. As a result, we should expect to see “dips” in performance and funding after firms initial start up honeymoon. The resulting market exits allow lower productivity firms to be displaced by higher productivity firms in the economy, creating economic growth in a way that is more important than the growth of new entrants. Government policy that extends the life of poor quality firms can therefore have a damaging impact on the economy and should be avoided. Researchers are often very sceptical that there is a major problem with access to finance outside of a few particular areas. In general, most firms, get most of the funding they seek, most of the time. However, it is an open question whether the small percentage of firms that have trouble raising money overlap with the small percentage of firms that drive economic growth and employment. We believe they do.

4. The contribution of average SMEs and entrepreneurs to commercialisation and the economy more generally is often significantly over estimated in public policy discussions. It is true that entrepreneurs are significantly more happy, and new firms make a significant contribution to job creation in their first year of existence. However, it is not clear that they contribute significantly to innovation, the commercialisation of research, or economic growth. Research by Thomas Astebro suggests that of entrepreneurs seeking to commercialise innovations, only 7% successfully reach the market, and their average financial return is -7%. Nor is it clear that having more entrepreneurs would be beneficial to the UK economy. Market entry rates are extremely high in the UK, and EU, at about 20% a year, and this level of market entry may well be excessive. It may be damaging if poor quality firms drive up factor prices, dilute managerial talent, confuse investors and make it more difficult for higher quality firms to grow. The key public policy issue is encouraging higher quality entrepreneurs and SMEs to grow, not increasing the quantity of new entrants having to cross the Valley of Death.

5. There is already significant support for SMEs and their activities to commercialise research in the UK. David Storey estimates that the UK taxpayer spends some £7 billion a year on SME support. This is more than is spent on the Universities or the Police force. We are unconvinced that all of this spending is valuable and think much of it could be spent more effectively. Using a significant amount of it to give SMEs a National Insurance holiday if they employed new staff until the economy recovers, for example, might be a useful stimulus policy.

6. These levels of spending, which are found internationally, suggest SME financing is an area subject to considerable “rent seeking” where special interest groups lobby governments for anti-competitive support, potentially at considerable social cost.

7. Much thinking about the commercialisation of research adopts an inappropriate and misleading “linear model of innovation” in which university research generates innovations, that are then transferred and commercialised. Only 3% of the economy is in high tech manufacturing that draws on research in this way, so even major improvements are unlikely to have a significant impact.

8. It is more appropriate to think of research as generating talent rather than technology. Universities might be usefully thought of as factories for producing human capital. Research provides training in people who then move from academia into firms where they generate innovations. Sometimes firms generating innovations have technical problems that require them to seek university support, but the main locus of innovation is in firms, not universities. The UK’s problem with the commercialisation of research compared to the US should therefore be seen in the context of lower public investment in research (1.3% v 2.6% GDP), which leads to lower technical skill levels in industry, which makes it harder to generate innovations in firms. Firms with poorer quality innovations then find it harder to raise money, but the difficulties of fund raising are a consequence rather than a cause of poor performance. Providing money without addressing quality may therefore have limited impact.2

9. The UK is extremely rare in having government departments, such as BIS, prepared to subject its (SME) policy to independent criticism. This is highly commendable.

1. What are the difficulties of funding the commercialisation of research, and how can they be overcome?

10. It is well recognised that there are major difficulties in funding the commercialisation of research in the UK and elsewhere and that market failures of many kinds mean investors do not get all the benefits of investment, which can lead to suboptimal levels of investment. This is because of uncertainties, spill overs (where benefits cannot be captured), moral hazards and information asymmetries (where investors do not fully understand their investments and need to depend on trust), and because innovators often lack collateral for loans. We have found evidence this constrains growth.

11. Moreover, it is extremely difficult to make money from early stage investment. Even professional VC funds find it very difficult. Often the problem is not lack of money, but lack of skilled investors and lack of high quality firms worth investing in.

12. Given the difficulties of making commercial returns from innovation, governments have historically played a key role in funding innovation.3 In the US there is significantly more support for innovation than in the UK, which has a more market based approach.

13. The UK has a number of policy tools to address this problem. R&D tax credits which are very expensive and of unsure value. The “Patent Box” which is extremely expensive, badly designed and unlikely to generate additional spending. Equity support schemes (hybrid funds), which were very poor, but are now often effective and cheap. EIS and VCT support, which are expensive and of unclear value. University Technology Transfer policies, which are expensive and of limited value. SBIR schemes could be extended but we are sceptical of their value. SMART type schemes and other grants have value. A key policy tool is to increase competition in the UK (and EU), especially among large firms to drive innovation in the wider economy and encourage corporate venturing.

2. Are there specific science and engineering sectors where it is particularly difficult to commercialise research? Are there common difficulties and common solutions across sectors?

14. Biotechnology seems to have particular problems. Comparative research on the extent of funding problems between sectors is lacking in the UK and more generally. Sectors requiring long term, uncertain investments may have a general problem. Sectors where commercialisation requires the substantial levels of investment generated by Stock Markets may also have a problem in the UK, given the lack of interest of the markets in the UK in technology (in part caused by poor returns compared to sectors such as mining).

3. What, if any, examples are there of UK-based research having to be transferred outside the UK for commercialisation? Why did this occur?

15. It is unclear that this is a major problem. We did not find much evidence of firms migrating in our research. See also Michael Hopkins submission.

16. The UK benefits substantially from the international trade in technology, and protectionist measures might be very costly. Policy in this area should consider the benefits of trade as well as any costs.

17. There is limited peer reviewed research evidence that this is a major problem. Threats by firms to leave the UK unless they achieve some policy aim have become more common in recent years. For example, Hedge funds threatening to move to Switzerland or New York or Private Equity Funds threatening to move to Ireland. We are unaware of any PE funds that have gone to Dublin recently, and note that Hedge funds in New York are threatening to move to London. These threats may be raising public attention about something that is not really a problem. Any problem that does exist could be easily dealt with by effective EU action on tax avoidance.

18. A much more important issue is the transfer of high value added commercialisation activity from larger firms following acquisition, and the problem the UK faces in international UK firms, particularly in the biopharmaceutical industry, moving R&D to the USA. This occurs because US science is better supported.

4. What evidence is there that Government and Technology Strategy Board initiatives to date have improved the commercialisation of research?

19. We are unaware of any evaluations of the TSB. The PACEC report cannot be easily accessed. An evaluation would be valuable. An evaluation of the cost effectiveness of the KTPs would be extremely valuable given their costs and basis in a discredited linear model of innovation.

20. Evaluations of science parks suggest they are ineffective.

21. Evaluations of equity support schemes suggest the earliest schemes were extremely ineffective (ie RVCFs), but that UK policy makers learnt very quickly and more recent funds are very well designed and produce positive impacts.

22. The recent House of Lords S&T Committee report on procurement did not find evidence that procurement was being as effective as it might be.

23. In general, evaluations of this kind are difficult and there are few of them. There are many schemes were an evaluation should be undertaken, such as tax credits, KTPs etc.

5. What impact will the Government’s innovation, research and growth strategies have on bridging the valley of death?

24. It is too early to assess the impact of many recent changes. Some general aims are probably too vague to evaluate. We find evidence that older policies, especially equity support for hybrid VC funds, are having a positive impact.

25. The protection of research funding in the current economic climate is a major and under-appreciated achievement by BIS.

26. Given the economic situation the Government has limited policy options. The resulting Strategy document is thoughtful, well informed and shows a sophisticated understanding of the economic problems it is addressing.

27. Despite our overall positive assessment, we have a number of concerns.

(a)The document still retains an implicit discredited linear model in many places.

(b)There is too much focus on universities and not enough on firms, where the real problem lies.

(c)The value of the SBRI scheme is unclear and the costs do not seem to be fully appreciated. There seems to be considerably more support for this scheme in the UK than the evidence would merit.

28. The policy document seems to be informed by arguments that the UK lacks intermediate institutions to support innovation. We remain unconvinced by this, and suggestions that Fraunhofer type organisations can be transplanted from one nation to another. Nor is it clear that new institutions will always have a positive impact.

29. The final design of the Catapult centres remains unclear, but they seem to be based on a linear model that sees technology transfer as the problem. This reflects a pattern in EU policy whereby, when attempts to improve innovation by increasing technology transfer efforts fail, more money is devoted to technology transfer. Our suggestion is the framing of the policy might be incorrect. The real problem the UK faces is in the lack of innovation (and investment in innovation) in industry. There is also a secondary problem highlighted above related to the lack of spending on research compared to our competitors. There is not a problem of quality in University research in the UK, nor in engagement between industry and universities, which is probably higher than the US, nor in Universities generating firms, which again is probably higher than in the US (although we have major concerns about the quality of the firms that are generated). If UK firms lack the ability to innovate then technology transfer policies are like pushing a piece of string.

30. Outside of a few areas (biotech, etc) universities are poor places to generate technology. Universities lack understanding of markets and customer demands. Academics often lack the skills to run and grow firms. The successful US innovation model involves substantial investment in research in universities, and then very substantial investment in commercialisation in firms. In the EU we spend much less on research in universities, and then attempt to encourage universities to commercialise technology either in firms (that find it hard to raise money because the technology is too early stage), or transfer it to firms that have fewer technical skills and less investment in innovation. Germany has a slightly more effective model that provides large amounts of public support through core funding for technology development institutions embedded within networks of innovative firms. We consider the US model superior.

31. There do seem to be potential problems with a lack of joined up government. For example, taxation policy and innovation policy can sometimes clash. The IR35 legislation, which addresses a real and important tax avoidance problem, can have the unintended consequence of forcing large firms to take on innovative individuals and SMEs as employees. There can be a mismatch between the focus of some departments on long run economic growth and the focus on others on short term returns.

6. Should the UK seek to encourage more private equity investment (including venture capital and angel investment) into science and engineering sectors and if so, how can this be achieved?

32. Policy towards private equity and VC in Europe is often confused because the two very distinct kinds of funding mechanisms are often conflated. Private Equity (PE) investing involves the refinancing and restructuring of existing assets (rather than creating new asset) such as management buy-outs, buy-ins and other later stage development finance. VC is the provision of equity and substantial managerial support to early stage (mainly technology) firms that are developed for subsequent trade sale or IPO. The considerable confusion between VC and PE has allowed PE associations to refer to themselves as VC when lobbying for favourable tax treatment. The effectiveness of this lobbying has made PE investment very profitable, which has attracted VC investors and institutional investors away from early stage investing.

33. Policy making would be improved if VC and PE were considered distinct as is done in the US.

34. It is not clear PE investment is beneficial in the long run to STEM firms. Some PE investments add value by turning around failing firms, while others asset strip. Given PE investments are often targeted at failing firms, evaluating the impact of PE (which may be positive overall), is almost impossible.

35. VC funds struggle to make money from early stage investment. However, a small number of funds do succeed, particularly in the USA where the VC industry and high tech sectors receive considerable government support. These funds have had a huge impact on the US economy. In the UK VC funds are struggling to raise funds. Well designed and well targeted equity support schemes, of the kind developed by BIS, can have a very beneficial impact on the economy at a reasonable price.

36. We believe the value of support for VC funds should be understood in a broad sense, and go beyond the financial returns from the investment (which is likely to be low given the difficulty of making commercial returns from investment in early stage technology firms). It should include the additional taxation that is generated by new firms growing and employing skilled staff.

37. Regional VC funds perform very poorly and should not be supported.

38. Angel investors are playing an important role in funding early stage innovation. Professional angel networks are becoming more sophisticated and are moving into areas of investing that were previously undertaken by VC funds. Making money from early stage investment is not easy, and Gordon Murray has highlighted the moral question of whether the Government should encourage unprofessional investors to invest in areas where professional investors find it very hard to make money. Equity support schemes of the kind used by BIS are effective at supporting business angel networks.

39. In all areas of equity investment policy it is important to recognise that the problems the UK faces are not necessarily on the supply side (ie lack of money). The key problem may well be a lack of good firms worth investing in.

7. What other types of investment or support should the Government develop?

40. As well as expanding the range of options, the Government might also consider ending poorly performing policies (after evaluation) and diverting the funds they consume elsewhere. The patent box scheme and various technology transfer schemes would be obvious options to explore.

41. There are a range of options that the government may wish to consider:

(a)Industry supported (co-funded) grants for academic research.

(b)Grants for early stage technology development outside universities.

(c)Support to improve the capabilities of Angel Networks and the VC industry

(d)Larger, industry-sector focused hybrid funds ie a co-funded VC fund devoted to the specific problems facing the biotech or green tech sectors.

(e)Support for pan European, rather than just national, hybrid funds, which would allow more scale and specialisation.

(f)Loan support schemes targeted at firms seeking funds to invest in commercialisation.

(g)Changes to EU State Aid rules that constrain support for innovative firms. EU level VC funds or EU level funds-of-funds that invest in VC funds or Angel networks help to get around this problem. There is widespread recognition that these rules hinder European innovation and attempts to have the rules either clarified or modified is likely to find considerable support in Brussels.

42. In designing these schemes it is often important to consider how funding and human resource problems interact. This makes managerial skills and the skills of investors in supporting firms extremely important. When firms receive finance to support them through the Valley of Death, they often expand their workforces which makes them more difficult to manage. Similarly firms that expand often require new forms of financing. Funding problems are therefore not only financial problems and should not be considered in isolation.

February 2012

1 In particular the ESRC-TSB-NESTA-BIS grant RES-598-25-0054 and EPSRC grant EP/ E037208/1.

2 Nightingale et al (2009) From Funding Gaps to Thin Markets, BVCA-NESTA.

3 Mazzucato, M (2010) The Entrepreneurial State, DEMOS. FINNOV 3rd Policy Brief (2012) available at www.finnov-fp7.eu/publications

Prepared 12th March 2013