The Business World: From seed capital mighty profits can grow

The US has the answer, not the EU, and it makes sense to start applying US practice here, as the UK has done successfully in other areas, rather than keep looking for a European solution

WHEN THE stock market turns down, how damaged will companies be, and how should the country seek to protect its business interests?

What happens in financial markets naturally has a profound effect on demand: look at the way in which demand collapsed in East Asia following the financial crises there. But there is nothing much that individual companies can do about that, except to be nimble in responding to external shocks. What they can do something about is preserving the access to capital through the down-turn.

Or rather, large companies can do this, for they are in a sufficiently strong position with their bankers to set up facilities in advance that will see them through any death of market capital. For smaller companies seeking risk capital, this option is not available.

So a financial market crisis, even a financial market hiccup, is disproportionately damaging to the most dynamic sector of the business community: small- and medium-sized, fast-growing firms.

We had a foretaste of the dangers last autumn, when the sharp break in the market took place. Capital dried up, and not just on the market, for there were also a number of instances that came to our notice where banks refused to do deals that they had given oral undertakings that they would do. So there will be some disruption; there is bound to be. What is to be done?

Start with some numbers. I have just been looking at the volume of venture capital raised in Europe, by country and by type, courtesy of Federal Trust, which has just published a new paper on the subject.

The crude numbers show the UK in a rather good light. In 1997 Britain raised 4.4bn ecus (the precursor to the single European currency) in venture capital investment, nearly half the European total of 9.4bn ecus. As a percentage of GDP, UK venture capital is roughly three times bigger than the rest of the EU, and larger even than the US.

But this slightly flatters the UK performance. A large proportion of that UK portion is in management buy-outs: nearly 2.9bn ecus out of an EU buy-out total of 4.9bn ecus. While buy-outs are a form of venture capital in the sense that the managers who are buying the business are taking a risk, and while buy-outs almost certainly result in a better commercial performance, they are not really in the same category as seed capital and business start-ups, or even expansion and replacement capital.

The UK performance on expansion and replacement capital is not bad either by European or US standards, but our performance at the very front end, the seed and start-up capital, is really rather poor. The 1997 total was only 100m ecus, which while higher than France or Italy was half that of Germany and smaller than the Netherlands. It also compares very badly with the US, which raised more than 3bn ecus for new businesses.

What are the implications of this pattern when set against a possible down-turn in financial markets? It would seem to be more or less inevitable that buy-outs will be affected. Not only will managers have to factor in greater market uncertainty, but raising cash for buy-outs is bound to be harder. The trick, surely, will be to try to protect the front-end, the start-ups and seed capital.

And not just protect it: enhance it. As anyone who has helped start a business will know, raising the initial capital for a high-risk operation usually involves either borrowing against one's house (most people's main asset) and/or going to rich friends or family members who are game for a gamble. That is fine for people who have the right contacts. But despite strenuous efforts to make it more organised, for example encouraging "business angels", the seed capital market remains disturbingly small.

This ought to be a fine opportunity. Everyone will be hunting for higher returns over the next few years, as the global tide of deflation cuts nominal returns on conventional investments. Backing start-ups is not just a rational way of trying to achieve higher returns. It also fits in with the more fragmented structure of corporate organisation: more small businesses, more self-employment, more emphasis on human capital rather than financial or physical capital.

This last point is key. It has become a truism to assert that human capital is now the scarcest resource of all: that the world is awash with money but suffers from a dearth of clever people. So the aim of the people with the capital should surely be to use their skills to back these clever people with the relatively small amounts of money to support their ideas. Yet in practice would-be entrepreneurs in Britain, in contrast to the US, do seem to find difficulty in obtaining funds to back their ideas. The anecdotal evidence squares with the figures.

And the solution? I have two suggestions. The first, from the point of view of the entrepreneur, is that anyone seeking start-up capitalshould open up all possible lines of approach now. The only practical way in which small businesses can plan for a down-turn in the financial markets is to build the relations while the good times continue to run. Thanks to the tax breaks on venture capital investment, there does right now seem to be a good flow of funds in to risky investments.

The second suggestion is for the policy-makers. The various investment incentives for enterprise need to be fine-tuned in response to the market demands. We need, for example, to look at US practice in providing start- up capital and we ought to have a target to get that 100m ecus figure up to about six times that amount.

The Federal Trust has some EU-wide suggestions for action, but that seems to me to be to be looking in the wrong direction. The US has the answers, not the EU, and the clever thing to do is to apply US practice here (as the UK has done in other areas) rather than hunt around for some European solution. But the Federal Trust deserves praise for highlighting a problem. Maintaining the flow of funds to new businesses through a period of more difficult markets is a challenge indeed.

`Venture Capital in Europe', Harry Cowie, Federal Trust, 52 Horseferry Road, London SW1