Financing of Innovation Part 1

Presentation by Rumen Dobrinsky

European Alliance for Innovation

Training in the field of Innovation

Minsk 26-28 May 2015

1

Introduction: Why finance is key to innovation?

Module 1. The Nature and Financing of Innovative Enterprises

Module 2. Private Early-Stage Financing of Innovative

Enterprises. Business Angel Financing

Module 3. Private Early-Stage Financing of Innovative

Enterprises. Venture Capital Financing

Module 4. Public Policy Initiatives to Address the Early-Stage

Financing Needs of Innovative Firms

Module 5. The Experiences of Different Countries in the

Financing of Innovative Enterprises

Module 6. Interactive Discussion on the Topic

2

Structure of the presentation

3

Why finance is key to

innovation?

The broader picture

4

What is innovation?

• Introduction to the market of:

– New products or services

– New business models that enhance the value of existing products or services

• Disrupts existing market processes

– Incremental (small-scale improvements)

– Radical – new ways of doing business

5

• Innovation is a complex phenomenon, requiring a combination of different types of knowledge and skills

• Involves the interactions of many “actors” (stakeholders): academic and R&D institutions, firms, public bodies, financiers, users, etc.

• Innovation is a process with highly uncertain outcomes: therefore there is a need to commit resources to reduce uncertainty

Innovation in the modern economy

6

Innovation and Finance

• Innovation is about making money:

• “Whereas R&D focuses on transforming money into knowledge

Innovation is about transforming

knowledge into money“

Esko Aho, Former Prime Minister of Finland

7

The innovation-finance cycle

8

How is innovation related to finance?

• Innovation performance and financial flows are closely interrelated and correlated

• Finance (relevant and adequate financial support) is a key factor driving innovation at all levels

• What follows illustrates these links and interrelations at the macro level

9

Measuring innovation performance (EU)

• The Innovation Union Scoreboard provides a comparative assessment of the innovation performance of the EU28 Member States

• IUS uses 25 indicators grouped in 3 categories: • Enablers capture the main drivers of innovation

performance external to the firm • Firm activities capture the innovation efforts at firm level • Outputs capture the effects of firms’ innovation activities

• Average performance is measured by a composite indicator, the Summary Innovation Index (SII)

10

Measuring innovation performance (EU)

11 Source: European Commission

Performance groups by SII

12

13 Source: European Commission

Regional innovation performance by SII

14

Name Editing Institution

Preparing Institution

First Ed.

Last Ed.

Frequency Standard structure

Target countries

Number of indicators

thereof based on innovation surveys

Selection criteria

Composite Indicator

Innovation Union Scoreboard

European Commission

MERIT 2001 2014 Annual Yes EU Member States

25 6 Reasoning, Correlation analysis

Yes

Innovation Union Competitiveness Report

European Commission

European Commission

2011 2013 Biennial unknown EU Member States

51 None No

OECD Science, Technology and Industry Scoreboard

OECD OECD 1991 2013 Biennial No OECD countries

~180 34 Reasoning No

OECD Science, Technology and Industry Outlook

OECD OECD 1998 2012 Biennial No OECD countries

22

(country fiches)

None Not available

No

Global Innovation Index

INSEAD, WIPO

INSEAD 2007 2014 Annual Yes World 84 None Yes

Innovationsindikator Telekom Stiftung, BDI

Fraunhofer ISI, ZEW, MERIT

2005 2014 Annual Yes Germany and selected countries

38 None Model, Regression analysis

Yes

Global Competitiveness Report

World Economic Forum

Centre for Global Competiti-veness and Performance

1979 2013-2014

Annual Yes World 116 None Yes

Knowledge Assessment

World Bank

World Bank 2001 2012 Regularly updated

Yes World 148 None Yes

Diferent innovation scoreboards

15

Global Innovation Index 2014 (WIPO)

Source: WIPO

16

Total R&D expenditure as % of GDP (2013)

17

R&D expenditure and innovation performance

Source: European Commission (2013-2014)

18

R&D expenditure and innovation performance, 2013

Source: WIPO; UNESCO; OECD

19

Private equity investment - innovation performance

Source: EVCA, European Commission (2013-2014)

20

SME access to finance and innovation performance

Source: European Commission (2013-2014)

21

Financing instrument

Key features in financing Remarks

Grant, subsidy Seed funding for innovative start-ups and SMEs at the seed and early stage

Complements market failures, financing at seed and initial stage

Business angel Financing source at early riskier stage and provides financing, advice and mentoring on business management.

Financing at start-up and early stage

Venture capital Invests at later, less risky growth stage. Referred to as patient capital owing to the lengthy time span (10-12 years) for investing, maturing and finally exiting.

Financing at later expansion stage

Corporate venturing

Used by large firms to invest in innovative start-ups with a view to improving corporate competitiveness with either strategic or financial objectives.

Strategic motive

Crowd funding A collective funding tool via the Internet which makes it easier for small businesses to raise capital at the seed and early stages.

Still developing; potential for fraud

Bank loans Needs collateral or guarantees in exchange for loans. Obligation to repay as debt

Tax incentives A broad range of tax incentives for R&D and entrepreneurial investments in most countries.

Indirect, non-discriminatory

Innovation: the main financing instruments

1. The Nature and

Financing of Innovative

Enterprises

22

• The nature and characteristics of

innovative enterprises

• The financing needs of innovative

enterprises

• The financing options for innovative

enterprises

23

Issues covered in the module

24

What are innovative enterprises?

• Innovation takes central stage in their activity

– Tend to be new or younger and small (startup, SME)

– Can grow substantially

– Account for over half of all innovations and almost all radical innovations

• Innovation opportunities:

– Market applications for new inventions or technological discoveries

– New applications for existing technologies

– Imitation (replication of business practices/ introducing products new to the local market)

25

Some key factors driving firm innovation

• Investment in education that is relevant to business.

• Support to investment in R&D by both government and business.

• Business investment in innovation strategies.

• Specific policy measures to create a conducive environment for firms to engage in the commercialization of innovative business opportunities.

26

What determines the prevalence of IE?

• Overall R&D environment – R&D intensity

– Innovation leaders, followers, catching-up, trailing

• Attractiveness of entrepreneurship as a career – Attitudes and aspirations towards risk and growth

– Workforce mobility

• Favorable environment of early stage financing and support (in particular for SME)

• It starts with an individual (group) and an idea

• Exploration of technical feasibility, market potential, and economic viability

• Product development

• Start-up of operations; market introduction

• Market and organizational expansion

• Growth

27

How innovative enterprises develop?

• Seed stage – initial R&D, business concept refinement, feasibility analysis

• Start-up stage – prototype development, market research and outreach, formal organization.

• Early-growth – small-scale commercialization, platform for scalability

• Expansion – substantial growth in scale and market impact.

28

Financing needs in different stages

29

Risks and roles on the journey to market

30

Risks sharing in financing innovation

Basic Research

Public Support

Grants,

innovation

vouchers,

tax incentives

Discovery

Invention

Applied R&D

Public and private

initiatives

Equity (BA,

seed finance),

convertible

loans,

guarantee

schemes

Patenting and

licensing

Prototyping

Industrialization

Private Intervention

VC, IPO

Risk

Level

• High uncertainty – No track record, no collateral – Limited evidence for feasibility and viability – Possible high-rates of obsolescence

• Information asymmetry – The entrepreneur’s knowledge is tacit – Hard to distinguish high- and low-quality opportunities

• Value is entirely based on the long-term growth potential

31

Challenges of attracting mainstream finance

This is why we need specialized financial

institutions for early stage financing!

32

The dynamics of financing needs

Development stage

Cas

h F

low

Seed Start-up Early growth Expansion

“Valley of death”

Founder, 3Fs

Business angels

Venture capital funds

Public stock markets

Debt / Bridge loans

Feasibility grants

33

Innovation, risk and finance at different stages

Turnover Innovation style Funding regime

Early stage €0 to €500,000.

Likely to pursue radical innovation. Possibly drawing on externally mobilised expertise

Equity funding –proof of concept / early stage fund

Early development €500,000 to

€20m

Likely to develop radical innovation. Possibly drawing on externally mobilised expertise

Equity funding – angel or venture

capital

€20m to €100m

Radical and incremental but at upper end of the turnover range. May suppress radical change if it

damages an existing market

Self funding from revenue or floatation

> €100m

Radical, incremental and open innovation, but may suppress radical change if it damages an existing market. May seek innovation from other sources such as universities, consultants or small radical

innovation based companies.

Self funding from mature markets

• “Grants” for assessing the commercial potential of the innovative idea/research

• Proof of concept (pre seed - FFF)

• Seed (Angel Groups; public funds)

• Start up (VC; public funds)

• Expansion (Private VC funds; Bank loans)

34

Types of finance in different stages

35

The financing sources of new firms

36

The financing sources by stages

• The stage of greatest uncertainty and risk

• Innovative enterprises ideally need financing that does not seek guaranteed repayment

• The 3F (Family, Friends, Fools)

• Merit-based awards (grants)

– Funding decisions are based on meeting pre-specified criteria

– Often provided by public agencies

– Substantial administrative and decision burden

37

Seed funding (the «valey of death»)

• Match between risk profile and potential payoffs

• Investors have claims on the residual value of the enterprise (i.e. they share the upside)

• Investors also share the downside (i.e. they can lose their money entirely)

• Various mechanisms ensure that they get paid before the entrepreneurs do (e.g. convertible preferred stock)

• Examples: business angels, seed funds, incubators, venture capital funds

38

Seed funding (contd.): external equity

39

Framework conditions

Capital

Specialized intermediaries

Entrepreneurs

2. Private Early-Stage

Financing of IEs.

Business Angel Financing

40

• What is a "Business Angel“

• What is the role of Business Angels and

how do they operate?

• BAs and BA networks in Europe

41

Issues covered in the module

42

43

The 3F (Family, Friends and Fools)

44

Who are the Business Angels

• Wealthy individuals, often cashed-out entrepreneurs

• Make equity investments of $25-50k (up to $1-2m for syndicated deals) in promising ventures

• Provide substantial portion of the seed and start-up capital of innovative enterprises

• Provide more than capital (expertise, support)

• Active & passive; novice & experienced

45

Added Value of Business Angels

• Business angels bring more than just capital:

– usually have extensive business and entrepreneurial experience

– provide strategic, operational, and market advice

– can offer insights on the specific industry

– can introduce the entrepreneur to major stakeholders such as customers and suppliers

– can offer much moral support to an entrepreneur

– BA’s reputations may carry a lot of weight in attracting high-quality deals

46

• Atmosphere of trust between individuals

• Credible business plan in the eyes of the BA

• Good management team

• Fiscal incentives

• Market knowledge of the entrepreneur

• Availability of exit route

• Return on investment (capital gain)

How business angel investment works?

47

How much they matter? (US example)

0

5

10

15

20

25

30

Businessangels

Venturecapital

Early-stage Later-stage

0

10'000

20'000

30'000

40'000

50'000

60'000

Businessangels

Venturecapital

Amount invested (Billion USD) Number of enterprises financed

48

Key decision criteria for BAs

• Is proposal unsolicited or through referral?

• Does the business have solid fundamentals?

– Potential market impact

– Sustainable competitive advantage

• Is the person qualified to run the business?

• Does the business operate in familiar area?

• Is it close enough for face to face interaction?

49

Business angel networks (BAN)

• Pool the financial, knowledge, and information resources of a group of angels

• Alleviate the inefficient flow of information between (individual) angels and entrepreneurs

• Attract bigger deal flow

• Allow individual angels to diversify their portfolios and participate in more deals

50

The operation of BANs

• Local, regional or national in scope

• Organized around interests in particular sectors

• Offer a number of key services

– Matchmaking

– Business plan coaching to entrepreneurs

– Training to both investors and entrepreneurs

– Syndication support

– Co-investment funds and opportunities

51

Factors affecting BA investing

• Potential for promising returns

– Availability of growth capital

– Lucrative exit routes

• Supply of high quality enterprises

• Tax conditions (tax relief, capital gains tax, dividend tax)

• Economic conditions (growth, interest rates, inflation)

• Stock market conditions

52

Number of BA networks in Europe

Source: EBAN

53

European BA investment

Source: EBAN

54

European BA investment by country, %GDP

Source: EBAN

55

European BA investment by country

Source: EBAN

56

Average Investment Amount by BANs (mn €)

57

Advantages Disadvantages

Major source of funds Less visible on the market

Possible “leverage effect” on other investors

More limited investment experience

Willing to provide small amounts of funding Less extensive networks

Less restricted investment criteria Danger of extensive intrusion in business

More opportunistic – less formal analysis Less professional experience

Lower ROI expectations Less prestigious than VC investment

Cheaper in fees to obtain finance May have hidden motives

Provides know-how, advice and contacts May become “Business Devils”

More “patient money” – less pressure to exit

Invests in own locality

Pros and cons of BAs vs. later stage investors

3. Private Early-Stage

Financing of IEs.

Venture Capital Financing

58

• What is "Venture Capital"

• How VC investment works?

• The VC investment cycle

• VC in Europe and the US

• Crowdfunding: introducing the issue

59

Issues covered in the module

60

What is Venture Capital?

• VC performs an intermediary function, channelling funds from institutional investors to high-potential enterprises

• VC provides specialized investment expertise

– Identify potential investments

– Monitor, provide financing in stages

– Add value through oversight and guidance

• Depend on smooth flow of funds from institutional investors and back (with returns)

61

• Provision of professionally managed equity

capital to promising enterprises

• Anticipation of exit (liquidity event) in 5-7

years

• “Patient” capital – illiquid before exit

• The bulk (70-80%) goes to early-growth or

expansion-stage companies

Main functions of VC

62

63

The levers of VC finance

Institutional

investors VC firms

Entrepreneurial

firms

FUNDRAISING INVESTING

EXITING RETURNS

64

Venture Capital and Private Equity

• Private equity - provision of equity capital to enterprises not quoted on a stock market. Often associated with buy-outs or buy-ins.

• Venture capital – provision of equity capital for the launch, early development, or expansion of a business (i.e. a subset of private equity)

65

66

VC investment process

• Provide incentives – Capital infusion tied to achievement of milestones

– Entrepreneurs are vested in the residual value

• Provide expertise – Discern opportunities and threats

– Operational and strategic guidance

– Professionalization of management

• Provide network and legitimacy – Lend extensive network of relationships

– Ease the concerns of customers or suppliers

67

• Pre-investment

– Origination, prospecting

– Screening and due diligence

– Structuring

• Post-investment

– Monitoring and oversight

– Value adding

– Exiting

How do VC firms add value?

68

• Detailed evaluation – Potential market impact

– Strength of competitive position

– Management team quality

• Initial screening – Does it meet the fund’s basic investment criteria?

– Is there a personal referral?

– Quality of the business plan (executive summary)

• Due diligence – Third-party opinions on underlying technology

– Corroboration of estimates and assumptions

Investment decision considerations

69

• Business plan credibility

• Business plan with patent technology

• Track record (over previous years)

• Ability to grow fast and deliver quick ROI

• Management team quality

Some important criteria for VC investment

70

Deal Generation

Pipeline Process

• 2weeks-1month

• “Mini Due Diligence Process”

• NDA: Non Disclosure Agreement

Internal Due

Diligence

Non Binding

Offer

Due Diligence

Process

•Information to the Investment Committee.

•If what you say is true, I will be able to pay you... $/.

Final Process

• Analysis Process

•Exclusivity Period (3 months)

• DD+Legal Contracts

Sample VC financing process

71

• Enticing institutional investors Education on VC nature and return profile

Qualms about new funds, new managers

Natural cycles of ebbs and flows

• Regulatory issues Existence of dedicated or suitable structure

Exemption for cross-border fundraising

Capital gain taxation

• Tax issues Third-party opinions on underlying technology

Corroboration of estimates and assumptions

Issues in fundraising

72

Availability of investment opportunities R&D environment

Entrepreneurship as a career option; relevant

education

Availability of seed capital

Recognition and selection of opportunities Support network for deal referrals and due diligence

Industry specific skills and connections of VC

managers

Proper risk-return profile

Effective contracts Tax treatments of convertible preferred stock

Rule of law in enforcing contractual provisions

Issues in investing

73

Incentives to provide value added

Stake in the upside

Loss guarantees can be counter-productive

Leveraging of lower-cost, public funds

Ability to provide follow-on financing

Small funds can be diluted in later rounds

Possession of proper skills by the VC

investors

Career paths from high-technology settings

Mobility of managers across firms and countries

Issues in value adding

74

IPOs and trade sales are most lucrative

routes

Returns are sensitive to 1-2 big hits

Successful IPOs require active stock

markets, open to new securities

IPO windows are sensitive to economic

conditions (e.g. 2008-2009)

Issues in exiting

75

The fate of VC investments

Source: Cochrane (2005)

76

Europe VC investment by stage (€ mn)

Source: EVCA

77

Europe private equity investment by stage (€ mn)

Source: EVCA

78

Sources of new VC in Europe (% new funds raised)

Source: EVCA

79

80

EU VC investment by country, %GDP

Source: EVCA

81 Source: EVCA

VC vs. BA investment, %GDP

82

VC investment in the United States

Source: PwC/NVCA MoneyTree Report, Thomson Reuters

Crowdfunding:

Introducing the issue

83

84

What is crowdfunding?

• Crowdfunding is a way of raising money to finance projects and businesses.

• It enables fundraisers to collect money from a large number of people via online platforms

• Crowdfunding is a broad concept that may apply to many different types of projects

• But it is also an approach to fund innovative entrepreneurial projects

85

Three main crowdfunding compnents

1. The project Initiator who proposes the idea and/or project to be funded

2. The Crowd/Community (individuals or groups who support the idea with money)

3. The online Platform that brings the parties together to fund and launch the idea

86

Crowdfunding vs. traditional funding

87

Types of crowdfunding

• Peer-to-peer lending – the money will be repaid with interest.

• Equity crowdfunding – Sale of a stake in a business to a number of investors

• Rewards-based crowdfunding – expectations of receiving in return a non-financial reward

• Donation-based crowdfunding – no financial or material return.

• Profit-sharing / revenue-sharing – sharing future profits with the crowd in return for funding now

• Debt-securities crowdfunding – Individuals invest in a debt security such as a bond.

• Hybrid models

88

The magnitude of crowdfunding

Thank you!

Rumen Dobrinsky

E-mail: rumen.dobrinsky@eai.eu

rumen.dobrinsky@gmail.com

89

THANK YOU!