Financing of Innovation Part 1 Presentation by Rumen Dobrinsky European Alliance for Innovation Training in the field of Innovation Minsk 26-28 May 2015 1
Structure of the presentation Introduction: Why finance is key to innovation? Module 1. The Nature and Financing of Innovative Enterprises Module 2. Private Early-Stage Financing of Innovative Enterprises. Business Angel Financing Module 3. Private Early-Stage Financing of Innovative Enterprises. Venture Capital Financing Module 4. Public Policy Initiatives to Address the Early-Stage Financing Needs of Innovative Firms Module 5. The Experiences of Different Countries in the Financing of Innovative Enterprises Module 6. Interactive Discussion on the Topic 2
Why finance is key to innovation? The broader picture 3
What is innovation? Introduction to the market of: New products or services New business models that enhance the value of existing products or services Disrupts existing market processes Incremental (small-scale improvements) Radical new ways of doing business 4
Innovation in the modern economy Innovation is a complex phenomenon, requiring a combination of different types of knowledge and skills Involves the interactions of many actors (stakeholders): academic and R&D institutions, firms, public bodies, financiers, users, etc. Innovation is a process with highly uncertain outcomes: therefore there is a need to commit resources to reduce uncertainty 5
Innovation and Finance Innovation is about making money: Whereas R&D focuses on transforming money into knowledge Innovation is about transforming knowledge into money Esko Aho, Former Prime Minister of Finland 6
The innovation-finance cycle 7
How is innovation related to finance? Innovation performance and financial flows are closely interrelated and correlated Finance (relevant and adequate financial support) is a key factor driving innovation at all levels What follows illustrates these links and interrelations at the macro level 8
Measuring innovation performance (EU) The Innovation Union Scoreboard provides a comparative assessment of the innovation performance of the EU28 Member States IUS uses 25 indicators grouped in 3 categories: Enablers capture the main drivers of innovation performance external to the firm Firm activities capture the innovation efforts at firm level Outputs capture the effects of firms innovation activities Average performance is measured by a composite indicator, the Summary Innovation Index (SII) 9
Measuring innovation performance (EU) 10
Performance groups by SII Source: European Commission 11
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Regional innovation performance by SII Source: European Commission 13
Diferent innovation scoreboards Name Innovation Union Scoreboard Innovation Union Competitiveness Report OECD Science, Technology and Industry Scoreboard OECD Science, Technology and Industry Outlook Global Innovation Editing Institution European Commission European Commission INSEAD, Index WIPO Innovationsindikator Telekom Stiftung, BDI Global Competitiveness Report Knowledge Assessment Preparing Institution First Ed. Last Ed. Frequency Standard Target Number thereof structure countries of based on indicators innovation surveys MERIT 2001 2014 Annual Yes EU Member States European Commission 2011 2013 Biennial unknown EU Member States OECD OECD 1991 2013 Biennial No OECD countries OECD OECD 1998 2012 Biennial No OECD countries World Economic Forum World Bank Selection criteria 25 6 Reasoning, Correlation analysis Composite Indicator Yes 51 None No ~180 34 Reasoning No 22 (country fiches) None Not available INSEAD 2007 2014 Annual Yes World 84 None Yes Fraunhofer ISI, ZEW, MERIT Centre for Global Competitiveness and Performance World Bank 2005 2014 Annual Yes Germany and selected countries 1979 2013-2014 2001 2012 Regularly updated 38 None Model, Regression analysis No Yes Annual Yes World 116 None Yes Yes World 148 None Yes 14
Global Innovation Index 2014 (WIPO) Source: WIPO 15
Total R&D expenditure as % of GDP (2013) 16
R&D expenditure and innovation performance Source: European Commission (2013-2014) 17
R&D expenditure and innovation performance, 2013 Source: WIPO; UNESCO; OECD 18
Private equity investment - innovation performance Source: EVCA, European Commission (2013-2014) 19
SME access to finance and innovation performance Source: European Commission (2013-2014) 20
Innovation: the main financing instruments Financing instrument Grant, subsidy Business angel Venture capital Corporate venturing Key features in financing Seed funding for innovative start-ups and SMEs at the seed and early stage Financing source at early riskier stage and provides financing, advice and mentoring on business management. Invests at later, less risky growth stage. Referred to as patient capital owing to the lengthy time span (10-12 years) for investing, maturing and finally exiting. Used by large firms to invest in innovative start-ups with a view to improving corporate competitiveness with either strategic or financial objectives. Remarks Complements market failures, financing at seed and initial stage Financing at start-up and early stage Financing at later expansion stage Strategic motive Crowd funding A collective funding tool via the Internet which makes it easier for small businesses to raise capital at the seed and early stages. Still developing; potential for fraud Bank loans Needs collateral or guarantees in exchange for loans. Obligation to repay as debt Tax incentives A broad range of tax incentives for R&D and entrepreneurial investments in most countries. Indirect, non-discriminatory 21
1. The Nature and Financing of Innovative Enterprises 22
Issues covered in the module The nature and characteristics of innovative enterprises The financing needs of innovative enterprises The financing options for innovative enterprises 23
What are innovative enterprises? Innovation takes central stage in their activity Tend to be new or younger and small (startup, SME) Can grow substantially Account for over half of all innovations and almost all radical innovations Innovation opportunities: Market applications for new inventions or technological discoveries New applications for existing technologies Imitation (replication of business practices/ introducing products new to the local market) 24
Some key factors driving firm innovation Investment in education that is relevant to business. Support to investment in R&D by both government and business. Business investment in innovation strategies. Specific policy measures to create a conducive environment for firms to engage in the commercialization of innovative business opportunities. 25
What determines the prevalence of IE? Overall R&D environment R&D intensity Innovation leaders, followers, catching-up, trailing Attractiveness of entrepreneurship as a career Attitudes and aspirations towards risk and growth Workforce mobility Favorable environment of early stage financing and support (in particular for SME) 26
How innovative enterprises develop? It starts with an individual (group) and an idea Exploration of technical feasibility, market potential, and economic viability Product development Start-up of operations; market introduction Market and organizational expansion Growth 27
Financing needs in different stages Seed stage initial R&D, business concept refinement, feasibility analysis Start-up stage prototype development, market research and outreach, formal organization. Early-growth small-scale commercialization, platform for scalability Expansion substantial growth in scale and market impact. 28
Risks and roles on the journey to market 29
Risks sharing in financing innovation Risk Level Basic Research Discovery Invention Applied R&D Patenting and licensing Prototyping Public Support Public and private initiatives Grants, innovation vouchers, tax incentives Equity (BA, seed finance), convertible loans, guarantee schemes Industrialization Private Intervention VC, IPO 30
Challenges of attracting mainstream finance High uncertainty No track record, no collateral Limited evidence for feasibility and viability Possible high-rates of obsolescence Information asymmetry The entrepreneur s knowledge is tacit Hard to distinguish high- and low-quality opportunities Value is entirely based on the long-term growth potential This is why we need specialized financial institutions for early stage financing! 31
Cash Flow The dynamics of financing needs Public stock markets Debt / Bridge loans Feasibility grants Business angels Venture capital funds Founder, 3Fs Seed Start-up Early growth Expansion Valley of death Development stage 32
Innovation, risk and finance at different stages Turnover Innovation style Funding regime Early stage 0 to 500,000. Likely to pursue radical innovation. Possibly drawing on externally mobilised expertise Equity funding proof of concept / early stage fund Early development 500,000 to 20m 20m to 100m > 100m Likely to develop radical innovation. Possibly drawing on externally mobilised expertise Radical and incremental but at upper end of the turnover range. May suppress radical change if it damages an existing market Radical, incremental and open innovation, but may suppress radical change if it damages an existing market. May seek innovation from other sources such as universities, consultants or small radical innovation based companies. Equity funding angel or venture capital Self funding from revenue or floatation Self funding from mature markets 33
Types of finance in different stages Grants for assessing the commercial potential of the innovative idea/research Proof of concept (pre seed - FFF) Seed (Angel Groups; public funds) Start up (VC; public funds) Expansion (Private VC funds; Bank loans) 34
The financing sources of new firms 35
The financing sources by stages 36
Seed funding (the «valey of death») The stage of greatest uncertainty and risk Innovative enterprises ideally need financing that does not seek guaranteed repayment The 3F (Family, Friends, Fools) Merit-based awards (grants) Funding decisions are based on meeting pre-specified criteria Often provided by public agencies Substantial administrative and decision burden 37
Seed funding (contd.): external equity Match between risk profile and potential payoffs Investors have claims on the residual value of the enterprise (i.e. they share the upside) Investors also share the downside (i.e. they can lose their money entirely) Various mechanisms ensure that they get paid before the entrepreneurs do (e.g. convertible preferred stock) Examples: business angels, seed funds, incubators, venture capital funds 38
Framework conditions Capital Specialized intermediaries Entrepreneurs 39
2. Private Early-Stage Financing of IEs. Business Angel Financing 40
Issues covered in the module What is a "Business Angel What is the role of Business Angels and how do they operate? BAs and BA networks in Europe 41
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The 3F (Family, Friends and Fools) 43
Who are the Business Angels Wealthy individuals, often cashed-out entrepreneurs Make equity investments of $25-50k (up to $1-2m for syndicated deals) in promising ventures Provide substantial portion of the seed and start-up capital of innovative enterprises Provide more than capital (expertise, support) Active & passive; novice & experienced 44
Added Value of Business Angels Business angels bring more than just capital: usually have extensive business and entrepreneurial experience provide strategic, operational, and market advice can offer insights on the specific industry can introduce the entrepreneur to major stakeholders such as customers and suppliers can offer much moral support to an entrepreneur BA s reputations may carry a lot of weight in attracting highquality deals 45
How business angel investment works? Atmosphere of trust between individuals Credible business plan in the eyes of the BA Good management team Fiscal incentives Market knowledge of the entrepreneur Availability of exit route Return on investment (capital gain) 46
How much they matter? (US example) 30 60'000 25 50'000 20 40'000 15 30'000 10 5 0 Business angels Early-stage Venture capital Later-stage 20'000 10'000 0 Business angels Venture capital Amount invested (Billion USD) Number of enterprises financed 47
Key decision criteria for BAs Is proposal unsolicited or through referral? Does the business have solid fundamentals? Potential market impact Sustainable competitive advantage Is the person qualified to run the business? Does the business operate in familiar area? Is it close enough for face to face interaction? 48
Business angel networks (BAN) Pool the financial, knowledge, and information resources of a group of angels Alleviate the inefficient flow of information between (individual) angels and entrepreneurs Attract bigger deal flow Allow individual angels to diversify their portfolios and participate in more deals 49
The operation of BANs Local, regional or national in scope Organized around interests in particular sectors Offer a number of key services Matchmaking Business plan coaching to entrepreneurs Training to both investors and entrepreneurs Syndication support Co-investment funds and opportunities 50
Factors affecting BA investing Potential for promising returns Availability of growth capital Lucrative exit routes Supply of high quality enterprises Tax conditions (tax relief, capital gains tax, dividend tax) Economic conditions (growth, interest rates, inflation) Stock market conditions 51
Number of BA networks in Europe Source: EBAN 52
European BA investment Source: EBAN 53
European BA investment by country, %GDP Source: EBAN 54
European BA investment by country Source: EBAN 55
Average Investment Amount by BANs (mn ) 56
Pros and cons of BAs vs. later stage investors Advantages Disadvantages Major source of funds Possible leverage effect on other investors Less visible on the market More limited investment experience Willing to provide small amounts of funding Less extensive networks Less restricted investment criteria More opportunistic less formal analysis Lower ROI expectations Cheaper in fees to obtain finance Provides know-how, advice and contacts More patient money less pressure to exit Invests in own locality Danger of extensive intrusion in business Less professional experience Less prestigious than VC investment May have hidden motives May become Business Devils 57
3. Private Early-Stage Financing of IEs. Venture Capital Financing 58
Issues covered in the module What is "Venture Capital" How VC investment works? The VC investment cycle VC in Europe and the US Crowdfunding: introducing the issue 59
What is Venture Capital? VC performs an intermediary function, channelling funds from institutional investors to high-potential enterprises VC provides specialized investment expertise Identify potential investments Monitor, provide financing in stages Add value through oversight and guidance Depend on smooth flow of funds from institutional investors and back (with returns) 60
Main functions of VC Provision of professionally managed equity capital to promising enterprises Anticipation of exit (liquidity event) in 5-7 years Patient capital illiquid before exit The bulk (70-80%) goes to early-growth or expansion-stage companies 61
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The levers of VC finance FUNDRAISING INVESTING Institutional investors VC firms Entrepreneurial firms RETURNS EXITING 63
Venture Capital and Private Equity Private equity - provision of equity capital to enterprises not quoted on a stock market. Often associated with buy-outs or buy-ins. Venture capital provision of equity capital for the launch, early development, or expansion of a business (i.e. a subset of private equity) 64
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VC investment process Provide incentives Capital infusion tied to achievement of milestones Entrepreneurs are vested in the residual value Provide expertise Discern opportunities and threats Operational and strategic guidance Professionalization of management Provide network and legitimacy Lend extensive network of relationships Ease the concerns of customers or suppliers 66
How do VC firms add value? Pre-investment Origination, prospecting Screening and due diligence Structuring Post-investment Monitoring and oversight Value adding Exiting 67
Investment decision considerations Detailed evaluation Potential market impact Strength of competitive position Management team quality Initial screening Does it meet the fund s basic investment criteria? Is there a personal referral? Quality of the business plan (executive summary) Due diligence Third-party opinions on underlying technology Corroboration of estimates and assumptions 68
Some important criteria for VC investment Business plan credibility Business plan with patent technology Track record (over previous years) Ability to grow fast and deliver quick ROI Management team quality 69
Sample VC financing process Analysis Process Exclusivity Period (3 months) Deal Generation Pipeline Process Internal Due Diligence Non Binding Offer Due Diligence Process Final Process 2weeks-1month Mini Due Diligence Process NDA: Non Disclosure Agreement Information to the Investment Committee. DD+Legal Contracts If what you say is true, I will be able to pay you... $/. 70
Issues in fundraising Enticing institutional investors Education on VC nature and return profile Qualms about new funds, new managers Natural cycles of ebbs and flows Regulatory issues Existence of dedicated or suitable structure Exemption for cross-border fundraising Capital gain taxation Tax issues Third-party opinions on underlying technology Corroboration of estimates and assumptions 71
Issues in investing Availability of investment opportunities R&D environment Entrepreneurship as a career option; relevant education Availability of seed capital Recognition and selection of opportunities Support network for deal referrals and due diligence Industry specific skills and connections of VC managers Proper risk-return profile Effective contracts Tax treatments of convertible preferred stock Rule of law in enforcing contractual provisions 72
Issues in value adding Incentives to provide value added Stake in the upside Loss guarantees can be counter-productive Leveraging of lower-cost, public funds Ability to provide follow-on financing Small funds can be diluted in later rounds Possession of proper skills by the VC investors Career paths from high-technology settings Mobility of managers across firms and countries 73
Issues in exiting IPOs and trade sales are most lucrative routes Returns are sensitive to 1-2 big hits Successful IPOs require active stock markets, open to new securities IPO windows are sensitive to economic conditions (e.g. 2008-2009) 74
The fate of VC investments Source: Cochrane (2005) 75
Europe VC investment by stage ( mn) Source: EVCA 76
Europe private equity investment by stage ( mn) Source: EVCA 77
Sources of new VC in Europe (% new funds raised) Source: EVCA 78
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EU VC investment by country, %GDP Source: EVCA 80
VC vs. BA investment, %GDP Source: EVCA 81
VC investment in the United States Source: PwC/NVCA MoneyTree Report, Thomson Reuters 82
Crowdfunding: Introducing the issue 83
What is crowdfunding? Crowdfunding is a way of raising money to finance projects and businesses. It enables fundraisers to collect money from a large number of people via online platforms Crowdfunding is a broad concept that may apply to many different types of projects But it is also an approach to fund innovative entrepreneurial projects 84
Three main crowdfunding compnents 1. The project Initiator who proposes the idea and/or project to be funded 2. The Crowd/Community (individuals or groups who support the idea with money) 3. The online Platform that brings the parties together to fund and launch the idea 85
Crowdfunding vs. traditional funding 86
Types of crowdfunding Peer-to-peer lending the money will be repaid with interest. Equity crowdfunding Sale of a stake in a business to a number of investors Rewards-based crowdfunding expectations of receiving in return a non-financial reward Donation-based crowdfunding no financial or material return. Profit-sharing / revenue-sharing sharing future profits with the crowd in return for funding now Debt-securities crowdfunding Individuals invest in a debt security such as a bond. Hybrid models 87
The magnitude of crowdfunding 88
THANK YOU! Thank you! Rumen Dobrinsky E-mail: rumen.dobrinsky@eai.eu rumen.dobrinsky@gmail.com 89