In November of 2013 the Scottish Government launched its “Scotland Can Do” framework, designed to highlight the importance of innovation and entrepreneurship for the future health of the Scottish economy.
This makes sense. After all, we are at the top of all league tables for the quality of the innovative research at our universities, and the Global Entrepreneurship Monitor (GEM) report, a survey of 70 economies around the world which has been conducted for the last 15 years, has noted that our “Total early-stage Entrepreneurial Activity” (TEA) score has improved in recent years from fourth quartile to the second quartile.
So we have the ideas and increasingly we have the willingness to develop new enterprises, but what about the funding? Do we have sufficient sources of risk finance needed to fund these nascent businesses through their crucial early development phases?
This is the issue that we looked into recently at the Royal Society of Edinburgh (RSE), Scotland’s independent national academy. The RSE published an advice paper in 2012 The Financing of Business Innovation in Scotland which highlighted difficulties in the supply of risk finance. As a result of this report we initiated a working group to examine potential initiatives in this area and we conducted this study in conjunction with two other key organisations: the Institute of Chartered Accountants of Scotland (ICAS), and Scottish Financial Enterprise (SFE), the body which represents Scotland’s financial services industry.
This report is now published. It finds that the climate for funding early stage innovative companies in Scotland is relatively healthy at the start-up stage, but that there is a severe problem with access to larger levels of funding for substantial later growth. In other words, we can create lots of little companies, but we have a real problem with growing them into medium-sized and big companies.
Traditionally, risk finance was provided by venture capitalists (VCs), professional fund managers who specialise in identifying and investing in innovative companies in the hope of a large return later when the companies are eventually sold, or floated on the stock exchange.
The last few years have not been kind to the VC community. The dot.com boom and bust of 2001 blew a massive crater in the performance of most VC funds and just as they were beginning to recover in 2008, the global financial crisis thumped them again. There are far fewer VCs today than there were 20 years ago, and very few outside of London.
Luckily, the UK government came to the rescue by launching tax breaks for individuals (usually called “business angels”) who invest their own money in early stage innovative companies. The Enterprise Investment Scheme (EIS) provides excellent tax breaks for angels who make such investments and this has created a very strong community of business angels in the UK.
Here in Scotland, this community was further encouraged by the creation of a co-investment fund by the Scottish Investment Bank, a division of Scottish Enterprise. Individual syndicates of business angels can apply to become accredited and, if successful, they can then call on the co-investment fund to match their investment in a business. This effectively means that they can “double-up” the funding that they can offer and this often makes all the difference in achieving the required amounts.
When the co-investment fund was introduced in 2003 there were two angel syndicates in Scotland. Today that number is almost 20. This healthy community of angel syndicates means that most Scottish start-ups naturally look to them for their initial investments.
The problem we identify in our report lies in what happens next. If an individual start-up company uncovers an excellent market opportunity and needs follow-up investment in order to grow into a substantial international business, it will find that this kind of money can’t be raised from angels – they don’t have deep enough pockets. They need to look to VCs.
Unfortunately VCs and angels don’t mix. The angels are blocked from getting any of the preferential rights and downside protection demanded by the VCs due to the conditions of their EIS investment status. The result is that angels often prefer to sell their businesses – often too early and too cheap – than bring in further funding from VCs and as a result become “second-class” investors.
Our report looks for Scottish solutions to this Scottish problem. We examine the possibility of creating “angel-friendly” funding sources, and identify some existing funding solutions elsewhere which successfully mix angels with other larger sources of capital.
The goal is to grow more Scottish business to compete internationally – not to sell them off at an early stage.
We believe that Scotland “can do” it, if it wants to.
• Ian Ritchie CBE is an entrepreneur and investor, and vice-president (business) of the Royal Society of Edinburgh