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Mind the gap

1 Dec 08

If business angels stick with their start-up companies instead of selling on to venture capitalists, where will the next generation of budding entrepreneurs go to ?nd their funding?

The evolution of Scotland’s risk capital market, with angel investors increasingly consolidating their portfolios and more institutional investment going into later-round deals, may be leading to the re-emergence of an “equity gap” at the lower end of the investment value scale, according to a report from Scottish Enterprise.

The Risk Capital Market in Scotland 2005-07 suggests that the classic “funding pipeline” model of new venture funding, where angel investors make the first round investments and hand over to venture capitalists for subsequent and larger rounds, is being eroded and replaced by increased segmentation, as more angel investors commit to a “cradle-to-exit” model.

The report finds that while overall investment levels increased from £85m in 2006 to £114m in 2007, investment in new (start-up) companies in Scotland fell from 45 (worth £15m) in 2005 to 10 (£2m) in 2007. At the same time, the number of investments over £2m increased from eight (worth £32m) in 2005 to 18 (£75m) in 2007, suggesting a growing demand for expansion capital from Scottish companies.

According to the report’s author, Professor Richard Harrison, unless the structure of the early stage risk capital market in Scotland is addressed, the separation of the angel and venture capital markets could limit the opportunities for bringing on high-growth Scottish start-ups.

He says: “Our investigation has thrown up evidence that angel investors are increasingly investing in follow-on rounds in their existing portfolio companies, rather than in wholly new deals. This reflects both the desire to maintain control of the investment to secure returns, and the absence, or perceived absence, of venture capital investors willing to provide follow-on finance in deals where they do not already have a seat at the table, and as a consequence of this, the flow of capital into investment-ready new ventures is reduced.

“This is further compounded by the fact that as deal sizes in re-investment rounds increase, the available capital for investment in new companies is reduced, so new start-up companies are facing an uphill struggle for investment”.

The research looked at investment in the early stage risk capital market, including the number and value of investments made, investment by industry sector, location of companies receiving and investors giving finance and the types of investors getting involved between 2005 and 2007. It used headline figures from 2000-2004 based on a previous study.

Gerard Kelly, director of investment at Scottish Enterprise, says: “Risk capital plays a vital role in the development of companies and economies and we are working with the private sector to ensure that Scottish companies can access the capital needed.

“We need to be aware of changes in the market and this report is a key tool. The findings give us a view on the suitability of our funding mechanisms and where, if appropriate, we need to develop new funds as market gaps emerge.

“Scottish Enterprise saw a substantial increase in demand for investment funds in the first six months of 2008, so the risk capital market seems to be holding up.”

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