the investor's paradigm

Most investors understand how venture capital (VC) promotes economic growth. The flow of equity into innovative start-ups can fuel job creation and drive industry development. It lays a foundation for a breeding ground for innovation and inventions. Therefore, the amount of VC money spent in a country is a telling metric to grasp the growth potential and sustainability of this country's economy. Indices exist to compare the VC climate in various countries. We at Verve Capital Partners were curious, what is the VC spent per capita in European countries; and subsequently, does the actual VC spent per capita correlate with attractiveness rankings?

Expecting that the "most attractive" countries would yield the highest VC per capita, some of our findings were surprising.

The analyzed European countries fell within five distinct groupings according to the actual amount of VC spent per capita.

GROUP ONE: $70-$60

Switzerland ($69) and the Netherlands ($62) had the highest VC spent per capita in Europe. As a benchmark, the U.S was calculated at $67. Switzerland's leadership regarding actual VC invested is clearly reflected in its high attractiveness rank (#6) according to the Global IESE Venture Capital Attractiveness index. According to IESE, Switzerland scores well across all "VC attractiveness" dimensions analyzed - among those the quality of deal opportunities (i.e. a flow of technology spin-offs from its world-leading research universities) as well as its attractive taxation. But Switzerland's top position is also made possible due to the help of foreign investors (Switzerland is a net importer of VC) and the expansive wealth of Swiss citizens. The Netherlands' top position has to do with a similarly high VC attractiveness index (#9) and - very much like Switzerland - with a high GDP per capita.

GROUP TWO: $60-$50

Some Scandinavian countries - Sweden, Finland (both $59) and Denmark ($53) - also performed well above the $35 European average. Like group one, these countries' excellent ranks regarding their actual VC spent are well founded by their VC attractiveness indices: #8, #12 and Denmark ranking #11. And again not surprisingly, their attractive VC environments are complemented by above-average GDP per capita.

GROUP THREE: $40-$30

The European average ($35) is exemplified by the U.K. and Ireland (around $39), Belgium ($33) as well as France ($31), whose actual VC spent already positions these countries well behind the second group. This group is the first to deviate from our expectations as most of these countries' actual VC spent per capita is notably lower than their attractiveness rating would suggest. Especially the U.K. is commonly perceived to be one of the leading VC spots in Europe and its VC attractiveness ranking (#3) suggests the same. Much like France (#15 of the globally most attractive), this counter-intuitive finding might have to do with their centralistic economies focused on its large capitals. While especially London remains a leading VC breeding ground, peripheral regions and populations deflate the actual figures of VC spent per capita. There have been attempts to artificially create start-up hubs in the periphery, but more time might be needed for these initiatives to bear fruit.

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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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.

Private equity is for affluent individuals with an attitude, as many people see it. And this notion clearly reflects in the portfolios of small investors. Further is it fortified by some recommendations of business journalists and bankers to their readers or clients respectively, to stay away from this kind of investments. Last but not least: under the banner of investor protection, regulators do their best to maintain the status quo.

An ongoing market study we are conducting sheds a new light on small investors' interests in this regard. Our preliminary findings show that over 40% of investors (defined as someone of minimal wealth) have indicated that they would consider a direct private equity investment in an SME or startup and that they would value improved access to such investment opportunities. This is roughly eight times of what reality is showing today.

Even under more restrictive criteria, requiring not only a clear interest but also preparedness to invest time and accept associated risks, 8.4% of investors or roughly 3.64 million people in Germany, Switzerland and Austria would invest part of their money in new ventures or SMEs. This portion includes individuals already invested in private equity today (currently roughly 3%, read here) and, to a large extent, individuals with an entrepreneurial background or advanced investment track record, in the sense that they have invested in more than one asset class.

Note: 56% stated that they would not invest in this type of investment (including a few participants that gave ambiguous answers).

Interested SME investors are almost exclusively in jobs entailing “independent and qualified” or “highly demanding” tasks (job level categories 1 and 2 out of 4 of the Swiss Federal Statistical Office), with a focus – but not predominantly – on economic, finance and law backgrounds. Men are more likely to invest than women whereas the marital status and family situation do not play a significant role.

While it is not surprising that wealth and income play a role in people’s interest to invest, the study shows that there are many people below the threshold of the so-called accredited investor (according to the SEC, a net worth in excess of $1 million or income of >$200k) that are likely to invest. Figure 2 shows the percentage of investors likely to invest by wealth group, increasing sharply and peaking at 16.5% for individuals with of wealth between $100k and $200k. Declining interest with higher net worth could potentially relate to further alternative investment offerings accessible to these individuals.

The apparent demand clearly raises the question of why no corresponding offering for small investors can be found in today’s markets. We will approach this question from a number of perspectives in subsequent posts, including investor concerns (see Survey findings, part2) as well as regulatory and non-regulatory aspects of the market. (See blog the paradigm, part 3: Legitimate concerns or inefficient markets?). Should a corresponding offering emerge, it will be even more interesting to see how many of the 34.9% already considering SME or startup investments today, will take a more active interest.

At this point however, we simply note that the percentage of investors who are likely to invest in private equity is significantly higher than the percentage invested today. It will be an interesting discussion to lead, how and to what extent this additional source of private funds can contribute to funding a larger portion of startups and SMEs in need for financing - today, more needed than ever. Governments are currently evaluating a myriad of options to support this. However, it will be challenging for them to strike the right balance between their mandates to protect small investors and letting small investors take an active and responsible role.

Along those lines: the financial crisis has taught us that too much trust of investors in the “system” or external advice is not only dangerous for the individual investor, but also eliminating some of the checks and balances for the entire economy - controls that, amongst others, regulations were meant to provide. Maybe some of these checks and balances can be put back in place by letting society vote – by means of investing – not only on large corporates but on smaller and/or upcoming enterprises, as well. This voting mechanism works well if voters are experience and well informed. The study shows that people who are likely to invest bring this to the table.

>> Survey findings, part 2: Investor concerns

Check back soon to read additional findings from the market study such as small investors’ motivations with regard to private equity investments as well as how much they are prepared to invest.

Survey: N=176, including only participants from Germany, Switzerland and Austria in evaluations; in these preliminary findings, no corrective factors have been applied to eliminate potential bias in the sample population

The previous two posts on the investor’s paradigm raise an important question. If we take into consideration our findings (a) that today, only a small fraction of investors in OECD countries engage in the SME segment and (b) that in today’s private equity markets only a few offerings are available for ordinary private investors, we need to ask: why not more?

This question on demand and supply breaks down to the following aspects. Firstly, does the number of current SME investors reflect the number of people with a clear motivation to invest in SMEs? Secondly, if this should not be the case, what are the concerns on part of investors keeping them from doing so? Thirdly, is there a shortage on supply of quality investment opportunities? Lastly, if we allow for the possibility of this being an imperfect or inefficient market, what market distorting factors, regulatory and non-regulatory, can be found?

Let’s start looking at investors’ motivation. We are currently conducting a survey on investment behavior and while it is still ongoing, we already published some interesting preliminary findings. The bottom line is: approximately 40% of survey participants with money to invest would consider investing in ventures and SMEs. And more specifically: in comparison with the few investors already experienced with SME investments (approx. 3% of total investors), more than double (8.4% of investing participants) are clearly motivated to do so. These participants not only indicated an interest in SME investments but also stated that they would accept the associated risks and would be prepared to invest the time it takes to make informed decisions. On top of this, the vast majority of those also has relevant skills and significant experience with investments in other asset classes.

On average, investors participating in our survey indicated a degree of concern over all crucial aspects an SME investment involves - but no concern was seen to be irresolvable. Primary concerns mentioned were: (1.) Comprehensiveness and reliability of information provided on the investment target and (2.) Trust in the capabilities of the management. Fraud risks, concerns related to the liquidation of investments and post-investment monitoring/control were secondary. Surprisingly, the perceived general risk of such investments ranked only second last among all possible concerns. In short: investors’ concerns do play an important role and any approach aimed at promoting SME investments needs to find ways to adequately address them. Survey participants, however, believe all of those could be allayed. Watch out for our detailed survey findings on investor concerns soon to be published.

When it comes to supply, a differentiation of investment opportunities is crucial. While a small percentage of SMEs in need for capital are outnumbered by interested institutional and other accredited investors 10:1, the vast majority of startups and SMEs struggles to find capital. There is general agreement that this “equity gap”, mainly in the space of seed and early stage innovative SMEs (“ISMEs”) which are (in the words of the OECD) “economically significant” and could use this capital “productiv ely”, has largely to do with market inefficiencies in the formal capital markets. The entrepreneur’s perspective thus is important to fully understand the complications of the investor’s paradigm. For that matter, we will focus on the different types of seed, early stage and growth SMEs and discuss related market inefficiencies in part 4 on the investor’s paradigm.

If we wrap up the following interim results: (a) almost double of today’s non-sophisticated investors are qualified and motivated to invest in SMEs, (b) these investors articulate a number of concerns over SME investments, but none of them is seen to be insurmountable, (c) there is no shortage on quality SME investment opportunities, then we are mainly dealing with a problem of market inefficiencies.

Let’s start our analysis on market inefficiencies with a look at potentially distorting regulatory interventions. First and foremost, regulators intend to protect “non-qualified investors” based on the assumption that those are not able to understand and manage risks associated with certain investments. Point taken. A closer look at existing regulations, however, reveals that policy makers settle for damage containment rather than problem-solving. As discussed in the previous post, regulators define a “qualified investor” mainly depending on a person’s salary and wealth. Their logic goes “if rich investors fail, at least they survive”.

The real problem, however, is not one of definition. Instead, the trade-off between investor protection and promotion of SME financing seems out of balance. Many Swiss business angel networks, for instance, grant membership only to “qualified investors” - voluntarily. In other countries, e.g. the UK, business angels are requested by law to sign an official document certifying their capacity as “qualified investors”. For better or worse, our preliminary survey findings underline that many people are qualified and keen to invest long before they make their first million: see our post “A different take on small investor interests”.

Last but not least on non-regulatory market distortions. As mentioned before, the supply side is clearly characterized by market inefficiencies. Formal players (VCs, private equity firms and banks) are not willing to invest in high-cost, high-risk ventures requiring less than €2 million in equity. The OECD therefore acknowledges the need for informal venture capital, especially for innovative companies in their seed and early stages.

In summing up, it’s high noon for governments to not only acknowledge the general importance of informal venture capital, but also the specific importance of private investors not qualifying as business angels, often referred to as friends, family and fools (“FFFs”). Our market study indicates that the last “F” comprises not only fools, but many individuals that are by all means capable to invest. According to our calculations, Swiss business angels made up for only 7-10% of venture capital provided by private individuals in 2008. So with 90-93%, other private individuals (incl. founders) already provided the lions share – despite limited investment possibilities. Let’s make sure they provide even more.

Read part 4 on the investor’s paradigm.