Crunch time for tech start-ups as 3i quits sector

The Government's effort to establish Britain as an "innovation nation" has been dealt a fresh blow after 3i, one of the country's biggest private sector backers of technology start-ups, decided to abandon the sector.

The timing of the move by the former state-owned investment firm was embarrassing for the Government, coming just a week after it published a White Paper singing the praises of the UK's innovative companies and suggesting a wide range of initiatives to foment further start-ups. As the credit crunch tightens the screws on small companies, the exit of the UK's largest listed venture capital investor was pointed to as the latest evidence that the sector has been critically weakened. One venture capitalist said: "Entrepreneurs can't rely on the traditional venture capital marketplace to fund their businesses anymore. The model is not working here."

Since the internet bubble burst in 2000, money available for technology companies in Britain has steadily ebbed away and firms dedicated to the sector have shut. The rise of mega-buy-out funds has exacerbated the situation, attracting capital that would have otherwise gone to smaller venture capital firms.

"As long as private equity firms are raising these giant funds of several billion pounds, in all honesty, it's going to be difficult to get these mega-funds to invest over a longer period at the early stage," said Jonathan Kestenbaum, head of the National Endowment for Science, Technology and the Arts, a £50m fund dedicated to backing the youngest, most risky companies.

3i's decision creates a new £200m hole – nearly a fifth of the £1.2bn it invested last year was in venture capital deals. The Government has sought to fill the void by pledging to pump hundreds of millions of pounds into regional development agencies and programmes to promote university spin-outs. Such schemes are dismissed by critics as simply tinkering at the edges.

Worse, because they often do not apply the same rigour that private investment firms would when making investment decisions, the schemes have been criticised for nurturing a whole crop of commercially unviable companies. Mr Kestenbaum said: "Too many public funds have degenerated into the equivalent of charitable giving, and that does nothing for the commercial culture needed in early stage companies."

3i, which had a string of successes including CSR, developer of the technology underlying the ubiquitous Bluetooth wireless devices, is not the first to make such a move. The buy-out giant Apax Partners ended its early stage investing last summer. The London-based partners of Benchmark Capital, one of the most influential Silicon Valley venture capital firms, last year broke away from the parent company because it wanted to focus on investing in more mature, later-stage companies rather than the youngest groups in which Benchmark specialised.

All were motivated by the same reasons. While America is home to an array of massive successes, from eBay to Yahoo! and Google, the same can't be said for the UK. There are fewer firms willing to invest in the earliest days of a company, and Europe's public markets are much less receptive to striving young companies than they are in America. The upshot is a death of "home-runs", the lifeblood of an industry where nine out of 10 investments will fail. "Groups like 3i, Apax and Benchmark used to participate in all the [financing] rounds, but now they are gone, so there is much less competition between firms, which means [company] valuations don't get that uplift. And because there are so few home runs, the model just falls apart in the end," said the venture capitalist.

The BVCA, the venture capital industry group, is lobbying for tax breaks such as R&D tax credits to get the sector on its feet again. "The BVCA has for some time been calling for a range of measures to help foster a more successful venture capital industry in the UK," said the BVCA chief executive Simon Walker. "These firms are currently denied access to a range of schemes available to other small businesses. This is a legislative anomaly and it would be easy to change."

The Government has been accused of giving mixed messages to the industry. On one hand it pushed through an 80 per cent increase to the capital gains tax rate, which was seen as a key for innovative companies. On the other, the Department of Innovation, Universities and Skills last week laid out its vision to create a formalised channel by which small companies will be able to tap in to the Government's £150bn annual procurement budget.

It wasn't until 2006, as the private equity and stock markets reached their peak, that money invested in the sector reached the levels they did at the apex of the internet mania in 2000. As the economy slows, investors are worried that venture capital funds will again fall off a cliff. This time they have less far to fall.