EUROPEAN COMMISSION DIRECTORATE-GENERAL FOR ENTERPRISE AND INDUSTRY Financing SMEs, entrepreneurs and innovators Financing technology transfer & Seed finance Discussion document for the workshops Brussels, 08 and 21 November 2006 European Commission
This document served as a basis for discussions during the workshop on Financing technology transfer and Seed finance. 2
BACKGROUND Technology transfer refers to the process of commercialising research results of universities or other research institutes. In recent years technology transfer has received a lot of attention since it is seen as a vehicle to promote economic growth and job creation. According to EVCA seed capital means the finance provided to research, assess and develop an initial concept before a business has reached the start-up phase (EVCA Glossary). There is certainly an untapped economic potential of research results with a large number of dormant ideas in the science sector, failing to contribute to general economic development. Academic institutions wishing to transform research results into commercial success may often do so by granting a licence or by creating a spin-out. A licence is a legal permission for a company to commercialise an innovation and usually involves some compensation in the form of a fee or a royalty. Spin-outs are new companies that are founded in order to commercialise new research findings from research institutes. Creating and financing spin-outs merits attention, as these face many hurdles and in this respect innovative financing solutions can have a significant impact. Individual academics wishing to commercialise their research often face even greater difficulties. Indeed the hurdles faced by academic spin-outs are a good example of the financing problems faced by new firm creations in general. Apart from start-ups and existing SMEs, this can also include spin-offs from large companies. Academic institutions, especially in Europe, are often poor at exploiting research results. Numerous structural, economic and legal barriers hinder their spin-out initiatives. On the one hand, academic institutions often lack management skills linked to business creation; on the other hand, they also need to cope with the complex issues of patents and intellectual property rights 1. Entrepreneurs need to make sure that their intellectual property is well-defined and protected before trying to raise external finance. Compared to the US, European technology transfer infrastructures remain fragmented and suffer from a lack of critical mass. The commercialisation record in the US tends to be much better. According to a recent study conducted by EIF 2, this superior track record can be explained by the significantly larger R&D budgets and the advantages provided by a large homogeneous market for goods and services. In Europe, one important factor in explaining difficulties of academic spin-out initiatives is the lack of proper funding resources. Funding for academic spin-outs is always going to be hard to unlock when inventions have not reached the proof-of-concept stage. Furthermore, entrepreneurs seeking to launch a spin-out often lack the skills to present their invention and opportunity in such a way as to make it as attractive as possible to an investor. They need to understand the process leading to successful investment and the ways of developing the investment readiness of their company. 3 In the early stages of company creation access to finance is crucial, and can be overall the main barrier faced 1 DG ENTR plans to organise a subsequent workshop on Intellectual property and access to finance for high growth SMEs in autumn 2006 2 EIF, Technology Transfer Accelerator Final Report, September 2005 3 DG ENTR plans to organise a subsequent workshop on Investment Readiness in autumn 2006 3
by would-be entrepreneurs at academic institutions. However, there is plenty of evidence pointing to a market failure in the provision of risk capital financing in Europe. According to the EVCA 4, the volume of private equity investments in Europe has shown a sharp increase, whereas the share of early stage investments is still declining. Private equity investments increased by 27% from 36.9 billion in 2004 to 47.0 billion in 2005. However, seed financing did not keep pace with the growth of private equity generally. Seed investments fell by almost 34% from 148m in 2004 to 97m in 2005. This decline is reflected in the sharp decrease of the share of seed investments of the total from 0.4% in 2004 to 0.2% in 2005. Start-up investments increased slightly from 2.2 billion in 2004 to 2.3 billion in 2005. The lack of early stage investors is partly due to low returns on average that make such investments unattractive. The overall profitability of European venture capital market looks low, as shown in a recent study 5 by the European Commission. At the end of 2003, the performance of early stage investments appears particularly disappointing with five and ten year investment horizon IRRs as low as -1.8% and 1.3%. The performance gap between European and US funds is striking with US early stage funds showing IRRs of 54.9% and 37% for five and ten year horizons. These low rates of return clearly cannot generate the levels of private investments that Europe needs. Moreover, the lack of seed and start-up investments prevents new firms from reaching a size where they can attract expansion capital. ONGOING EU INITIATIVES The EU actively promotes the development and funding of research by its framework programmes for research and technological development. Following the end of the Sixth Framework Programme (FP6) in 2006, the Seventh Framework Programme (FP7) will run from 2007 to 2013. Under FP7, the Commission and the EIB have also developed the Risk Sharing Finance Facility (RSFF) dedicated to the financing of innovation. The RSFF will be targeted at large research projects and research infrastructures eligible under FP7, supporting all types of organisations participating in multi-partner consortia, including SMEs. Excellence and attractiveness of the European science base are essential preconditions for the birth of new ideas. But the European Commission pays attention to the full innovation chain, promoting also the commercialisation of research with instruments such as the Competitiveness and Innovation framework Programme (CIP). In line with past programmes 6, the CIP offers support measures to help enterprises and industry to innovate. The financial instruments of the CIP provide equity to venture capital funds for seed and early-stage investments in SMEs and the Seed Capital Action supports the recruitment of specialised staff by seed capital funds. CIP will start in 2007 and run until 2013 with an approximate budget of 3.6 billion. Commission services together with the EIB and the EIF have launched the joint initiative JEREMIE (Joint European Resources for Micro to Medium Enterprises) of the Structural Funds to promote access to finance for micro, small and medium-sized enterprises in the disadvantaged regions of the EU. The programme runs from 2007-2013 and aims to 4 EVCA Yearbook 2006 5 DG ECFIN, Profitability of venture capital investment in Europe and the United States, March 2006 6 For instance, the Multiannual Programme for Enterprise and Entrepreneurship (2000-2005) 4
improve access to finance in the form of loans, equity, venture capital and guarantees as well as to improve the co-ordination and the effective use of public resources. DG Enterprise & Industry is taking a key role in the development and promotion of innovation policy in Europe with initiatives such as Europe INNOVA 7, PRO INNO 8 or TrendChart on Innovation 9. These initiatives provide information about innovation support services for businesses and the developments in European innovation policies thereby also addressing the financing gap of technology companies. For instance, Europe INNOVA developed sectoral Financing Networks to analyse sector-specific financing problems ranging from the drafting of business plans and the preparation of appropriate IP strategies to the formulation of appropriate policy recommendations to overcome sector specific pitfalls in relation to innovation financing. Furthermore, DG Enterprise follows developments in European innovation practises and regularly produces research studies 10 in co-operation with other Commission services, such as DG Research. The European Investment Fund (EIF) has recently launched a Technology Transfer Accelerator (TTA) project. Its aim is to bridge the financing gap between research and early stage investment. The TTA programme seeks to assess the feasibility of a new type of investment vehicle focused on financing the commercialisation of the results of research. The TTA presents an opportunity to find, develop and optimise European ideas from research and academic institutions. University and research institute funding Technology transfer is most often financed internally through university funding or 3F money (friends, family and fools). Business angels and public initiatives play an important role in pre-seed and seed financing. Pre-seed capital is needed during the two to three years of preparation prior to the creation of the new company in order to support the would-be entrepreneurs and to fund minimum market analysis, competitive analysis, secure intellectual property access and freedom of exploitation, and to assemble a team. Seed capital is needed at the time of creation of the spinout company. It should be sufficient to fund the company at least through the period needed to produce the proof of concept of its invention or business idea. The duration of this period may vary between two and five years depending on the type of the underlying funding needs. The required capital can vary according to the business concept and to the technology, from a low of 250.000 to 5 million or more. At any rate, the amounts are generally in excess of the means of the entrepreneurs and mostly too low (and too risky and not cost effective enough) for formal venture capital funds. 7 The initiative Europe INNOVA informs and assists key stakeholders in the field of entrepreneurial innovations (www.europe-innova.org). 8 The initiative PRO INNO Europe (launched in mid 2006) aims to improve policy learning based on sharing experiences, and to increase trans-national innovation policy cooperation (cordis.europa.eu/innovation/en/policy/europe-innova.htm). 9 The Trend Chart on Innovation is a forum analysing, benchmarking and disseminating information on innovation policies in Europe (http://trendchart.cordis.lu). 10 Examples include, but are not limited to: Innovation Policy in Europe (2004), Management of intellectual property in publicly-funded research organisations (2004) or Best practices of public support for earlystage equity finance (2005). 5
In Europe, university funding comes primarily from public sources, although depending on the country and the university this can be complemented by research income, some tuition fees and possibly some private donations. Occasionally, universities have sufficient resources to finance research spin-outs themselves. However, this is often not the case, particularly outside the US. Access to funds for technology transfer is particularly difficult in some Member States where universities are not allowed to take equity stakes in companies. However, even in countries where public research organisations are allowed to take equity stakes (e.g. Belgium, the UK and the USA) this does not seem to be an important source of capital. 11 Some academic institutions try to solve the funding issue by forming an alliance with other academic institutions in an effort to pool resources and attract more interest from outside financiers for investment opportunities (e.g. WestFocus 12 in the UK). In order to increase attention from the industry, academic institutions also try to increase the transparency of research underway or planned for the future. Some academic institutions provide researchers with supporting infrastructures such as technology incubators or technology transfer offices that facilitate commercialisation initiatives by pooling expertise and (financing) resources. Attracting external investors: the equity gap Technology transfer ought to be fertile ground for venture capitalists. Academic institutions have an asset (innovation) that can be translated into desirable and sometimes ground-breaking products. There are some specialist pre-seed investors focusing on very early-stage technologies, such as Pond Ventures 13 in the UK and Heidelberg Innovation 14 in Germany, but they are thin on the ground. The relative lack of venture capital funding for academic spin-outs can be explained by the high risk associated with technology transfers. University technologies require financing at their embryonic stages which venture capitalists are not willing or able to give. The usual reasons identified for this funding shortfall, which is part of a wider funding shortfall called the equity gap, are twofold: The time gap Academic spin-outs are often associated with a high degree of uncertainty because they do not yet have a well-developed business idea and because prospective investment periods are likely to be long. Technology companies first need to develop and commercialise their business idea, and prove the business concept in the market. It usually takes a long time until technology companies earn sufficient revenues that can be redistributed to their investors. The finance gap 11 IWT, Research mandates for technology transfer, December 2002. 12 WestFocus is a consortium of UK universities forming a co-ordinated innovation framework with business and industry pooling a total of 7m in funding (www.westfocus.org.uk). 13 Pond Ventures is a UK venture capital firm investing in early-stage European companies in the communication, infrastructure and processing platforms areas (www.pondventures.com). 14 Heidelberg Innovation invests exclusively in Healthcare companies managing a total of 125million (www.hd-innovation.de). 6
University technologies typically require only small amounts of money to reach proofof-concept and prototype stages of development. However, there is a point below which it is not worthwhile for venture capital firms to invest money. High transaction and management costs reduce the viability of smaller venture capital investments and venture capital funds usually seek less risky projects, based on already tangible ideas and promising quick returns, mostly focusing on later stage investments. Young innovative entrepreneurs often have no collateral or track-record to offset the risk associated with the financing of their company. Furthermore, when venture capitalists do take the risk of early-stage investments, in return for the prospect of higher returns, they run the risk of getting heavily diluted by second-stage investors, if they are not prepared to put up fresh capital. Business Angels The equity gap raises the importance of informal investors, such as business angels. Business angels tend to invest at the stage when 3F money (friends, family and fools) has run out. Business angels may therefore play a key role in addressing the equity gap, being more willing to risk investment in early-stage companies. Business angels possess the necessary industry and management experience, to review and invest in promising technology transfer projects. Furthermore, the amounts invested by business angels tend to be far smaller than investments by venture capitalists and hence more suitable for early stage financing. Business angels can be indeed an important source of capital for pre-seed investments. However, this is less the case in Europe where the business angel community is not as developed as in the US. According to EIF estimates 15, there are around 30 business angels per one million inhabitants in Europe, whereas the number is over 1,400 in the US. Although these numbers should be treated with caution, the difference of two orders of magnitude points to a clear reality: there is untapped potential to increase business angel investment in Europe. Geographical proximity between the company and business angels plays an important role in determining the funding amount, control and degree of post-investment assistance from angels. Close proximity helps to develop contacts with local investors, increases the likelihood of funding and facilitates the monitoring process for the investors. But even if there are not enough European business angels involved in the technology transfer process, developing business angel finance remains important. Business angels have the expertise to help to review technologies and to advice on the commercial potential of technologies, which increases the likelihood of start-up enterprises surviving. This also gives business angels an opportunity to keep themselves updated on university technologies and thus possible investment targets. Some academic institutions in Europe have developed particular relations with certain business angels. 16 Raising awareness about the benefits and services of business angels and angel networks is needed to increase business angel investments. Informing potential angels and entrepreneurs about the advantages of business angels takes time and concentrated efforts of networks and other stakeholders. 15 EIF, Technology Transfer Accelerator Final Report, September 2005. 16 The IP Group has established strong links with UK universities and has invested in Oxford s chemistry department, King s College London and the University of Southampton (www.ip2ipo.com). 7
Obtaining public funding in times of tight budget constraints The role of public money is best seen as leverage for private financial support to spinouts. Financing R&D projects at universities falls without doubt within the remit of public action. In some countries, such public funding has been re-oriented in part to favour research projects showing larger opportunities for commercial exploitation. Such an orientation would play a positive role in setting favourable conditions for the emergence of business opportunities from research activities. Public money usually has an important catalytic effect by assuming up-front risks and thereby making investment more attractive to the private sector. In some circumstances, however, public intervention performs an essentially top-up function, i.e. bridging the gap between the funding already secured and what is needed for a project to successfully proceed. Bank loans are still the main source of finance used by established firms but the risk and uncertainty prevent lending to spin-off companies. Such companies have neither the track-record required to lend against future cash floe nor assets to provide the collateral typically needed by lending institutions. For these and other reasons, even if bank loans are available, they tend to be at prohibitively high interest rates. Access to loans for firm creations is very different across the Member States. Where SME promotional development banks or national risk-sharing schemes are available, access to small loans appears to be easier. Some government-backed loan mechanisms, such as the Finnish LIKSA programme, offer grants combined with convertible loans at preferential rates 17. Researchers often need loans of very small amounts such as microcredits of 25,000 or less. However, there is a market gap due to information asymmetry and due to the fact that lenders often perceive microcredit as an activity with high handling cost. In order to bridge this market gap, varying degrees of public support is available in the majority of Member States and Candidate Countries. In Finland, for instance, Finnvera offers microcredit for entrepreneurs in the start-up phase 18. Grants are a popular way of financing in public programmes aimed at supporting firm creations, such as the PRAXE programme in Greece 19 or Preseed Biotech and Preseed IT & Physical Sciences in Austria 20. Governments may also offer specialised guarantee, risk sharing and tax incentives mechanisms to facilitate technology transfer. A tax environment that encourages risky investments can be encouraged by either a low capital gains tax for business angel investment or by introducing tax breaks for eligible investments that make investments attractive. As for pre-seed capital, the association of money with advice and coaching is seen by many as the best formula to ensure efficiency of the support. Indeed, because those involved in university spin-offs typically possess the required technological know-how but lack the business skills required to set up a successful company, the provision of advisory support is often a key success factor. For 17 LIKSA funding takes form of a convertible loan of 9% p.a. and is supported by a Tekes grant of of up to 20,000. (www.preseed.fi/liksa/default.asp?l=1). 18 Finnvera offers start-up companies microloans of up to 35,000 with a maximum loan period of five years. (http://www.finnvera.fi/uploads/uusi_tuote_esitteet_fi/microloanw0306.pdf). 19 The PRAXE (Programme for the Exploitation of Research Results) funding scheme was introduced to assist spin-off firms with grants co-financed by the private sector and European structural funds (www.gsrt.gr). 20 AWS started the pre-seed programmes to provide future entrepreneurs grants of up to 100,000 for typically two years (http://www.awsg.at/portal/index.php?n=43). 8
this reason, some seed capital funds and grant systems include business advisory support (e.g. mentoring, non-executive board members) as part of an overall package. The impact of public financing initiatives in the area of technology transfer and seed financing is largely dependent on the quality of their structuring and management. Their impact is therefore varied and it is difficult to draw general conclusions. These schemes have, in a number of countries, fostered the emergence and development of new firm creations. A drawback with grant systems, from the public perspective, is that there is no recycling of funds. The process of picking the right investment target when investing in technology transfer projects is crucial in order to ensure an efficient use of public funds, given the high support level. The use of results-based funding such as the FORNY 21 programme in Norway or the Higher Education Innovation Fund 22 (HEIF) in the UK are good examples. Both of these policy measures aim to promote entrepreneurship and to stimulate the commercialisation of innovation. The activities and outcomes of these programmes are monitored and evaluated on an ongoing basis. Funding is provided through government grants and external venture capital. This is important as government programmes should also take the role to stimulate private parties to invest. Public involvement leverages private investments taking its share of the risks. Regardless of the various funding programmes public intervention should aim at improving the administrative, legal and fiscal policy environment of seed financing. In addition, promoting business angel investment by improving the operating environment and the investment readiness of entrepreneurs is important. Workshop outcome Identification of problems that different groups of pre-seed and seed investors face; Presentation of current Member States actions that seek to alleviate these problems; Identification of European level policies and actions that could improve the availability of seed financing and technology transfer financing. 21 The FORNY programme aims to stimulate the commercial exploitation of research within the academic sector (http://www.forskningsradet.no/servlet/satellite?cid=1088789229237&pagename=forny%2fpage%2fhov edsideeng). 22 HEIF is aimed at the promotion of entrepreneurship and the commercialisation of innovation with an overall budget of 219m in the first three years (www.hefce.ac.uk/reachout/heif/). 9
Possible questions to be discussed University funding How can European academic institutions unlock capital for technology transfer? How can restrictions hindering public research organisations to take equity stakes in companies be lifted in order to facilitate technology transfer? Can university alliances aimed at pooling financial resources help in overcoming the funding shortfall of technology transfer initiatives? External Investors What are the key resources and structures that are needed to best develop relationships between Technology transfer offices (TTOs) and VCs/ business angels? How can we best balance the geographical provision of capital and the location of academic institutions? (e.g. extend regional seed funds or existing programmes in place between some academic institutions and investors) Public funding What are good measures for government innovation programmes to facilitate the commercialisation of research results? How to ensure that investors stay focused on seed investments, as opposed to development capital, in co-investment schemes? What is the way to share risks and returns between public and private funding sources? What is the optimal level of public funding? How to make sure that public sector investments contribute to long-term sustainability of private investment and do not crowd out private investment? Structure of financing What are the most effective vehicles to finance academic spin-outs so that all stakeholders get financial incentives? 10