Is money the problem for early-stage investment?

8 December 2008

This isn't going to be a popular sentiment but if the Nesta £1bn early-stage fund comes off, it is almost certainly too much money. The problem doesn't like in cash so much as knowledge. If you create a fund with too much money, it runs the risk of flooding the market with well-funded companies that cannot survive long-term because their ideas are good but cannot sustain a business.

The trouble with early-stage investment is that it is clearly A Good Thing. So, more money for seed investments is clearly A Good Thing. But is it the right thing to do?

Venture capital in the technology sector has, for the past ten years, been a bust. At the beginning of the year, venture capitalist Andy Rappaport told a bunch of TSMC's customers - most of whom had been venture funded - that his industry had not delivered much better returns than the S&P500. Now, this was earlier in the year. The recent stock market crash may have altered the sums, but it's unlikely to have made a huge difference to the attractiveness of venture capital. And the important part is that they weren't making much money even when times were good. They are hardly likely to be piling in when the conditions are bad.

The venture business is high risk. Any student of economics will tell you that high risk demands high potential returns to make the investment worthwhile. If those returns are little better than investing in a stock tracker, why take the chance?

Late-stage investment carries a lower risk, albeit for lower expected returns. But, having tried the taste of high-risk, early-stage funding, many venture-capital funds have pulled back. They haven't all gone. In the UK, we have firms such as Longbow Capital and Pond. They are still around, they are still looking at early-stage funds.

One problem is that the needs of business angels and venture-capital firms turn out to be frequently incompatible. With technology firms in particular, they can be kryptonite for each other. This further reduces the amount of money available to nascent companies.

However, if you dig down into the practices of the early-stage investment business, the problems don't tend to be around the money but confidence in the technology with which investors are presented. It takes specialist knowledge to understand whether an experiment in a lab is going to make it to commercialisation. On top of that, I have seen countless good ideas that deserve a future but are utterly unsustainable in the context of an independent startup. And then you have the pile-on problem.

Someone starts to work around a technology, say UltraWideband (UWB) communications. They get some results and some standards start to form. Then you get the pile-on as a queue of companies turn up at the doors of the venture-capital, often with slightly tangential technologies, saying: "We're in that business." Or, the venture-capital firms warp the business plan to fit that new standard, largely because they know that's how Broadcom and Qualcomm cashed out: being central to certain comms standards.

In the current environment, people go too far down the route of generating a business around a technology before anyone is prepared to look at it. There needs to be more support and advice before this all happens to ensure that the companies that go for early-stage funding are going to be viable even assuming that what they develop works.

That does not mean those who cannot stand alone should never start up. If you look further out from the traditional venture business, you will find firms that are supporting startups that act more like outsourced development labs for larger companies. Gordon Aspin and colleagues from TTPCom set up Camitri Technologies to do this and others are appearing. Larger companies are getting the idea, although there is always the accusation that they are simply cutting back on internal R&D. Frans van Houten, chief of NXP Semiconductors, was in London several weeks ago to describe how work from some UK startups was feeding into his company's development projects.

There are big intellectual property problems in doing a startup as an outsourced lab but, as several people from the university innovation funds said to me: "There is always something you can negotiate."

However, we need to get away from talking about big numbers for venture funding and look harder at how the pipeline works for a plan like Nesta's, or any other's, to succeed.