i4g policy brief 4 - financing innovation

7/28/2019 i4g Policy Brief 4 - Financing Innovation

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Innovation for Growth i4g

Policy Brief N4

Financing for innovation: addressing Europes early stage

venture gap

Reinhilde Veugelers

Findings

Innovation and growth performance will require more emphasis to be put on nurturing

new firms in new sectors, enabling them to grow to leading-innovator status.

European venture markets are too thin, with too low levels of on-going interaction

between venture capital (VC) and young, high-potential firms.

The critical size for a viable, fluid, thick European VC market can only be reached when

VC markets operate at an integrated European scale and are open to the world.

Recommendations

New initiatives at the EU level are should be undertaken:

1. Grants for yollies to bridge the lab to market gap

2. A fund-of-funds to leverage Europes early-stage VC market

This report does not necessarily reflect the views of the European Commission. These comments are based on a

number of previous presentations including expert group reports for the EC.


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FINANCING FOR INNOVATION: ADDRESSING EUROPES EARLY STAGE VENTURE GAP

As argued by amongst others OSullivan (2007)), the cause of Europes innovation and growth

deficit is rooted in an inappropriate industrial structure in which new firms fail to play asignificant role in the dynamics of the economy, especially in the high-tech sectors. Veugelers &

Cincera (2011) using the EC-JRC-IPTS Industrial R&D Scoreboard of largest global R&Dspending firms confirm that the EU has indeed fewer young firms among its leading innovators

and that the EU has less of its young leading innovators in new high technology intensive

sectors. They find that missing these yollies in the right sectors is the largest contributingfactor to the EUs overall R&D deficit relative to the US.

Remedying the European Unions deficient innovation and growth performance will requiremore emphasis to be put on nurturing new firms in new sectors, enabling them to grow to

leading-innovator status. The specific barriers faced by these companies need to be addressed.

An important barrier is access to external finance, particularly early-stage venture capital. Wheninnovative projects from young companies enter the commercialisation and growth phase

financing requirements quickly become too large to be supplied by friends or business angels.

The high risk profile of young highly innovative growth companies is often a barrier to bank

financing at this stage. A deficient VC market may thus hamper the development of younghighly innovative companies into world-leading yollies.

Venture capital financing has some distinctive features. Only a very small percentage of the total

company population requires risk equity finance (Shane (2008), VICO (2011)). On the side ofVC companies supplying risk equity finance, the returns are highly skewed, made from the

realisation of a small minority of exceptional investments within the portfolio. A consequence ofthis is that venture as an asset class shows extremely large variation in returns. Besides the high

project risks, the VC market also suffers from high relatively fixed costs associated with due

diligence and deal negotiation (Murray (2008)). Only sufficiently developed (thick) venturecapital markets can build the critical scale and expertise needed to overcome these tyrannies and

avoid an early stage venture capital gap.

A thick venture capital market requires a strong deal flow of attractive, high-potential portfoliocompanies; VC funds of sufficient scale and managerial competence to make initial and follow-

on investments and to grow portfolio firms until attractive exit opportunities are identified;

informed institutional investors (including pension funds, endowments, etc) willing to accept therisks of early-stage equity investment; support from professional services firms, such as

specialised lawyers, accountants and consultants; and efficient and liquid exit markets.

The problem with early-stage venture capital markets in Europe is a combination of an 'equity

gap' (an undersupply of venture capital), and an 'investment readiness gap' (an undersupply of

investment-ready projects). European venture markets are too thin, with too low levels ofongoing interaction between venture capital (VC) and young, high-potential firms.


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Redressing this thin market, developing a viable VC and venture investing sector will be a

long term European policy project. American experience suggests that a venture capital systemin its initial build up stage is very fragile and needs decades of experience and public support to

function effectively (Lerner, 2009, NESTA 2009).

Below we list some of the characteristics, beyond patience and perseverance that policyintervention needs

Be embedded within a broader innovation policy to ensure a sufficient supply ofprofitable projects to fund.

Better serve the 'funding escalator', covering the whole cycle from the very early stage ofshaping ideas, testing and prototyping, to early commercialisation and larger scale

deployment of innovative projects. Policy instruments at each stage of the escalator

should include: policies promoting business-angel groups; grants for pre-competitiveR&D for highly innovative projects; public procurement based innovation contracts;

public and private early-stage investment; government-backed lending. Not fall into the local is beautiful trap. The critical size for a fluid thick VC market can

only be reached with an integrated and open EU VC market. Not fall into the 'small and short is beautiful' trap. Small funds are often not viable and

have insufficient financial resources to cover their high fixed costs (especially expertmanagement), diversify their portfolios or provide the follow-on funding to the most

promising investments in their portfolios.

Overall, these characteristics call for a significant reorientation of the all-too-often pursued

policies in many European countries, which support subcritical regional funds aimed at

supporting a tail of average or below-average potential growth firms. Rather than the quantity of

VC funding available, what matters more is how smart the funding is,allocates risk finance tothe most promising projects.

First and foremost, the fragmentation in the EU venture capital market should be addressed: thecritical size for a viable, fluid, thick European VC market can only be reached when VC markets

operate at an integrated European scale and are open to the world.

Beyond furthering the single market agenda, supporting member state initiatives and re-aligning

existing EU instruments into a holistic policy framework (Veugelers (2011)), what follows are

suggestions for new initiatives at the EU level.

(a) Grants foryollies to bridge the lab to market gap

In a Bruegel Policy Brief (2009/01) we proposed a system of grants for high risk takinginnovative projects of young companies, during the critical start up and development stages,

when financial market barriers are at their highest. It is based to a great extent on the US Small

Business Innovation Research Grants programme. Such a programme is currently beingdeveloped at DG Research and Innovation. Crucial is a proper implementation such that not

only the most promising project will get access to funding, but that also, through certification,

the selected ideas get access to private VC investment at later phases of the project. This implies


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a critical role for the selection and evaluation process for these grants, which should include

beyond technological also commercial expertise in the evaluation panels.

(b) A fund-of-funds to leverage Europes early-stage VC market

When the European Commission is proposing a fund-of-funds, as part of the Horizon2020, thisfund-of-fund should get a clear mandate for targeted stake-taking in private VC firms in Europe,

who have the potential to grow to critical scale. To avoid overlap, it should be aligned on the

EIF activities

References

Lerner, J. (2009)Boulevard of broken dreams: why public effort to boost entrepreneurship and venture capital havefailedand what to do about it, Princeton University Press

Murray, G. (2008) Venture capital and government policy, in Landstrm, H. (ed)Handbook of research on venture

capital, Edward Elgar Publishing

NESTA (2009)From funding gaps to thin markets: UK Government support for early-stage venture capital,available athttp://www.nesta.org.uk

O'Sullivan, M. (2007) The EU's R&D deficit and innovation policy, Report of the Expert Group on Knowledge

for Growth, European Commission DG Research.Shane, S. (2008) The illusions of entrepreneurship: the costly myths that entrepreneurs, investors and policy makers

live by, Yale University Press

Veugelers, R. (2011), Mind Europes Early Stage Equity Gap, Bruegel Policy Brief2011/18, Bruegel

Veugelers, R. (2009) A lifeline for Europes young radical innovators,Bruegel Policy Brief2009/01, Bruegel

Veugelers, R. and M. Cincera (2010) Europes missing yollies,Bruegel Policy Brief2010/06, BruegelVICO (2011) Venture capital: policy lessons from the VICO project, final policy brief, available at

http://www.vicoproject.org/doc/policy/VICO_FinalPolicyBrief.pdf
http://www.nesta.org.uk/http://www.nesta.org.uk/http://www.nesta.org.uk/http://www.nesta.org.uk/

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