the investor's paradigm

You missed our continuous blog posts? Sorry for that, but we have been busy fixing another problem: the lack of Swiss venture capital.

Startup financing has become even more challenging as the private equity sector is still struggling after the financial crisis. According to Swiss private equity organisation SECA, annual investment volumes have decreased from 600 million CHF in 2007 to just about 400 million in 2009.

This decline is even more dramatic for new ventures if one takes into consideration that the lion’s share was used for later stage investments. Only about one third of 2009’s venture capital flowed into companies in seed or early stages – down from two thirds in 2007! As a result, lots of ideas and innovations simply could not be commercialized. “For our long-term competitiveness venture capital is essential”, SECA General Secretary Maurice Pedergnana, concluded in an interview for cash.ch.

Steffen mentioned in one of our previous posts that over a period of ten years (1998 – 2007), only 27% of ETH Zurich startups managed to obtain venture capital funding, whereas close to 60% of the UK university spin-offs were backed by venture capital. This puts the SECA figures in perspective - especially when taking into account that the data was collected before the financial crisis started to affect startup financing. So if the share of venture capital funded companies was already on an insufficient level before the crisis – with more potential capital available and a higher share of seed and early stage investments – we do have a real problem at the moment!

On the other side, Swiss Universities have done a good job fostering innovation. In particular the Ecole Polytechnique Fédérale de Lausanne (EPFL) has done a great job in linking research and business to bring technology transfer forward. Since Patrick Aebischer took over the presidency in 2000, EPFL diversified its portfolio both in technical sciences and the bio-tech/med-tech-sector. Despite the past turbulent years they were able to retain their annual numbers of about 30 spin-offs.

If it takes both innovation and early stage capital to substantiate Switzerland position as an innovation hub, then EPFL gives an wonderful example how the first aspect can be addressed. But with respect to the early stage capital needed, a paradigm shift in the early stage financing market is overdue! We should have a close look not only towards the US, where seed stage funding is comparatively strong, but also on alternative financing concepts coming up. We will be sharing some experience from the first funding rounds on investiere.ch in another blog post.

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Today, we launched investiere.ch - globally the first platform providing small investors access to direct investment opportunities in non-listed companies. Unlike business angel clubs and networks, our offering is not restricted to "accredited" or so-called "qualified" investors.
On the platform, even small amounts can be invested in some of the most promising Swiss startups and it guides investors through a well structured investment process. As a start, three exciting young technology companies have been selected.
With this step, we will continue to support a culture of entrepreneurship in the general public and to realize our vision of a social economy. We help innovative entrepreneurs in early stages to bridge the equity gap and allow small investors to take a stake in the SME economy.

An article in yesterday's NZZ pointed out that the number of Swiss university spinoffs is continuously growing. Even more interesting is the fact that Swiss university spinoffs could be the most solid worldwide, outperforming even MIT in Boston or Oxford. An LSE study analyzing 130 ETH Zurich spinoffs over 10 years suggests that about 90% of these startups survived the first 5 critical years resulting in an average annual IRR of more than 43%. Recent examples are Esbatech, a University Zurich spinoff or Glycart, an ETH Zurich spinoff that both were sold to large corporates for a couple of hundred million dollars. The NZZ author concludes that "these results are positive signals for many investors that by now in Switzerland you can do profitable investments in startups". Also noteworthy is the fact that only 27% of ETH Zurich startups managed to obtain venture capital funding in the past. With UK university spinoffs this ratio is 60%. To close this gap, innovative funding approaches are needed.

An entrepreneur in need for capital might be confused. In the finance industry as well as the media, two buzz words make the round: “equity gap” and “equity overhang”.

Equity gap and overhang are not two sides of a coin. In general, the term “equity overhang” refers to the gap between funds raised and funds invested and thus to a problem institutional investors are facing.  The term “equity gap” is used in reference to the gap between funds required and funds invested and thus relates to a problem entrepreneurs are facing.

Based on these definitions, a first answer to the question raised in the title of this post is: both! Depending on a company’s industry, stage within the company life cycle, and amount of capital required, today’s capital seekers find themselves in one of three clusters of the graph shown on top.

The red cluster of our “private equity cube” indicates which companies typically suffer most under the equity gap. According to the OECD, these are mostly seed and early stage innovative SMEs (“ISMEs”). While figures are difficult to obtain, in the U.S., this gap is said to be around $40 billion. Within this red cluster, first and foremost, entrepreneurs requiring between 200k € and 2 m € are affected, as these amounts are too large for informal players such as business angels but too small for VCs and private equity firms (corresponding to the medium layer of the red cluster). Currently, the only cure for these young and innovative SMEs are business angel syndicates and publicly backed funds, such as CTI Invest in Switzerland or the “Enterprise Capital Funds” in the UK. But the volumes provided by these players are still way too small.

The green cluster, on the other hand, indicates which companies in need for capital are most fought over: expanding or turnaround companies requiring >2m € capital. Only players of the formal private equity industry, such as venture capital firms (“VCs”) and private equity funds, or funds of funds respectively, play in this field. As of April 2009, current figures for the U.S. indicate an aggregated overhang of $400 billion. While the numbers differ, this situation applies globally: VCs are sitting on loads of cash but for two reasons hesitate to invest - due to the economic slowdown and due to a tendency of increasing minimum deal sizes in the formal private equity industry.

But what if an entrepreneur finds himself in the white cluster? First of all: he or she will have to rely on his own funds and capital from informal investors. And three rules of thumb apply: (a) the bigger the required capital, the more difficult it will be to find FFF or angel money; (b) the riskier the business model, the more difficult; (c) the earlier in the business lifecycle, the more difficult. Thus, even white cluster companies are confronted with an equity gap, just less severe than red cluster companies.

In wrapping up posts 1 to 4 on the investor’s paradigm, it seems that market inefficiencies are the overarching problem: from an entrepreneur’s perspective, if your business does not match the preferences of formal VCs and private equity firms, and from an investor’s perspective if you do not happen to qualify as an “accredited” or “qualified” investor. In other words: the majority on both sides relies on the quality of their personal networks.