OPINION OF THE COMMITTEE
2.20 Since our last
report there have been many very welcome changes in both the availability
of finance for small start-up companies and the willingness of
individuals to form these companies. This latter change in attitude
is particularly encouraging. Nonetheless there is evidence of
a market failure in the provision of seed capital to technology-based
start-up firms, due in part to an asymmetry of information (or
understanding) between suppliers and users of finance leading
to different assessments of the risk/reward ratio for such enterprises.
However, while we go on to recommend some specific changes to
help correct this assymetry, our first objective is to ensure
that existing schemes fulfil their original aim. Financial stability
is itself an important objective. All concerned with the formation
of new companies need to feel confident that the decisions they
make are not likely to be rendered nugatory by dramatic changes
in the business environment.
2.21 The role of Business
Angels is widely recognised (for example, DTI, Q 36) and
supported by the tax incentives supplied by the EIS. However,
although there is recent research[4]
which emphasises the importance of their role, there are more
anecdotes than firm information. Some universities and budding
entrepreneurs seem to have little difficulty gaining access to
angel networks, others seem unaware of the opportunities available.
Existing efforts to create a national network of Business Angels
are supported by the charitable donations of a few benefactors.
To increase the number and scope of Business Angel activities
we need to know more about the extent of their present involvement
and any constraints that prevent expansion of their role. EIS
data provides a new and potentially revealing source of information
on the characteristics and interests of these individuals. We
recommend that the role of Business Angels be examined further
by Government, universities and leading financial institutions
to determine the extent of their present involvement and the conditions
that influence their activities, and to identify ways of expanding
their role. We believe particular attention should be paid to
the potential value of Business Angel networks and ways of supporting
a national network.
2.22 The perceived
risk/reward ratio can be reduced if understanding of the technology
and the business can be improved. "Second tier" or
"serial" Angels, who are reinvesting in the area of
their own entrepreneurial success, have this instinctively but
we have received evidence (for example Mr Harvey, Q 271 and
memorandum from Save British Science) of schemes in the US which
help young technology-based companies provide the necessary reassurance
to investors. The effect there of programmes such as the Small
Business Innovative Research Programme (SBIR), which sets aside
a fixed but small percentage of government contracts for small
innovative companies, is to bestow both managerial and technological
accreditation, a "seal of approval", for new start-ups.
Originally started in 1982 with the requirement that federal
agencies set aside 0.2 per cent of their external R&D budget
for small companies, the scheme is regarded by Congress as an
unqualified success-to the extent that the set-aside is now 2.5
per cent. Such schemes, where a technical evaluation is necessary
before Government awards a contract and management and marketing
experience is gained in completing the order, provide the degree
of reassurance which encourages private investors to come forward.
They also address the practical inequality of access faced by
small firms in their dealings with government.
2.23 Existing United
Kingdom schemes do offer some similar "accreditation"
effects. Mr Adrian Piper, Bank of England (Q 125), outlined
the Bank survey which showed 70 per cent of successful start-ups
in the United Kingdom had at some stage been recipients of awards,
in the majority of cases SMART and SPUR. These had "a leveraging
effect that really makes a difference" (Q 127). Some
witnesses expressed opposition to "set-aside" schemes
(Mr Brian Kent, Engineering Council, Q 248) and there will
be instinctive objections to SBIR-like schemes from those whose
budgets would be pre-empted in this way. Nonetheless, although
there was considerable scepticism about the operation of such
schemes in practice we recommend that the Government examines
ways in which its own existing programmes might be used to underpin
the innovation process, following the example of SBIR in the US.
2.24 We identified
two other potential obstacles to the provision of seed capital.
Firstly the reluctance of some entrepreneurs to accept equity
investment with voting rights owing to the perceived loss of control,
and secondly the reluctance of venture capitalists to invest small
seed capital amounts, typically from £100K to £500K,
owing to the relatively high setting up costs (due diligence)
of such small investments. Reducing these obstacles would contribute
to overcoming the innovation-exploitation barrier and would also
deter companies from over-reliance on bank loans with resulting
high gearing. In practice, an initial reluctance to cede equity
can often be overcome by good advice, particularly when successful
examples of those who have followed this route are at hand. But
we recommend that the DTI should examine how the disincentive
of disproportionately high costs of due diligence with respect
to the small investments needed by start-up companies could be
reduced.
2.25 Our concern over
the cost of due diligence and the inhibiting effect this has on
the ability of start-up firms to raise funds is heightened by
the report we have received that the "Big Six" accountancy
firms are acting together to impose standard terms on venture
capital firms to limit their liability on venture capital due
diligence work. This action could result in fundamental changes
in current practice which would restrict the venture capital available
to UK companies. We did not take evidence on this issue and we
are not in a position to comment on the merits of the representations
being made by the venture capital industry but we draw it to the
reader's attention.
2.26 Although we have
received some suggestions that income tax relief on investments
in technology-based companies could be used to stimulate investment
in various chosen sectors (eg ABPI, Q 245), we are not in
favour of any such sector-specific approach. Nonetheless the
treatment of capital gains can have a profound influence on the
investment decisions of the individual investor and here we heard
evidence (Mr Quysner, Q 206) that there is an apparent inequality
of treatment between the individual entrepreneur who has just
founded an organisation and the co-investor institutions. We
recommend that the Government considers equality of CGT treatment
between the individual founding shareholders and the institutional
shareholders.
2.27 We share the views
expressed in the Bank of England's report that the operation of
EIS and Venture Capital Trust (VCT) Schemes should be kept under
close review. These two schemes do not appear to have achieved
in practice their potential for funding technology-based start-ups
and there are signs that the VCTs are drifting towards a risk
averse strategy. The announcement of Venture Capital Trusts in
November 1994 said "the aim, in particular, is to help provide
more funds where they are most needed, among dynamic, innovative
growing businesses" (Treasury statement 29 November 1994).
Speaking to the Association of Investment Trust Companies in
May 1995 the Financial Secretary to the Treasury spoke of the
"general thrust of the legislation to encourage risk".
The initial intent of this innovative scheme, which is explicitly
aimed at the funding gap experienced by start-up companies and
therefore of prime significance to new entrepreneurial technology
based companies, would seem to go a long way towards meeting many
of our concerns in this area. It is perhaps inevitable that any
such novel scheme will undergo change as it develops, but we were
concerned to hear, for example from Sir David Cooksey at the Royal
Society conference on 3 May, that these trusts are now being
used to fund asset backed schemes with significant investments
in property. This completely diverts the intent of VCTs and by
so doing reduces the availability of funds to the intended sector.
We recommend that the Government re-examines the VCT scheme
to see if the present direction is consistent with the original
intent. If there are indications that changes are needed to ensure
these trusts do not become risk averse those changes should be
made promptly. The EIS should also be kept under review to ensure
that the final economic impact of this scheme fulfils the original
aims.
2.28 Other measures
can be taken that, if they do not increase the availability of
start-up capital, can reduce the need for it. We cover in particular
the role of incubators and science parks in Chapter 5. None of
these measures alone can make a dramatic breach in the innovation-exploitation
barrier but each can make a valuable contribution to increasing
the number of entrepreneurs starting up new companies.
4 Business Angels: Tapping the Potential,
Coveney, Moore and Nahapiet, Templeton College. Back
