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	Attracting capital to major companies ... when they are still small businesses

As became clear during discussions on the Green Paper on Innovation, it is principally new small and medium-sized enterprises which are best placed to innovate, transforming inventions into new products or processes and thereby creating new jobs. Provided they have the means to do so.
After having first looked at the mechanisms which allow private capital to be invested in innovation, the Commission is now launching a number of initiatives designed to encourage the emergence of a critical mass of technologically innovative companies.

I. Financing Innovative Enterprises

In most cases it is the entrepreneurs themselves who provide the initial funds to launch a new business based on technological innovation. At this initial stage, in which the cultural dimension is paramount (country, training, socio-economic and political environment, etc.), Europe ranks behind the United States, where there is a class of managers who know how to create wealth with research backed up by finance.

" Financing is the obstacle to innovation most often quoted by firms, whatever their size, in all Member States of the European Union and in virtually all sectors " The Green Paper on Innovation

Most innovative European enterprises still have to rely on bank loans as the major source of external finance, but unfortunately only a minority among them are likely to obtain the long-term loans required to develop innovation. Many technological projects are simply unable to satisfy the traditional requirements laid down by the banks (healthy and balanced financial structure, equity capital plus liquid assets, sufficient guarantees). For their part, the banks and other financial institutions generally lack the skills and resources to effectively handle the financing of innovative projects which, moreover, often have specific needs for which existing highly standardised financial instruments are ill-suited.

Nevertheless, attempts have been made in Europe over recent years to take this technological dimension into account when financing companies, for example through methods such as technology rating, guarantee systems based on industrial property rights, and the creation of special units specialising in innovation and technology within the major high street banks. Technology rating is a method of classification and assessment which combines an assessment of the technological potential, the market and the way the company is managed.

Venture Capital: A Crucial Role

Companies which are recording very rapid growth require access to venture capital in order to fund their investments. This venture capital consists of funds raised on the capital market by specialised operators. The investors buy shares or invest convertible bonds in the company, of which they become co-owner.

The above graph eloquently contrasts the performance of a sample of 500 innovative SMEs which received venture capital with the performance of Europe's "Top 500" companies, over a 5-year period (1991-95).

Venture capital operators do not invest with the idea of receiving an immediate dividend, but in order to allow the company to expand and ultimately make a capital gain on their investment. Their job consists of identifying companies with good prospects and injecting them with sufficient funds for them to grow to the point where they can be listed on the stock exchange, thereby allowing them to trade their shares on the open market. Few companies actually achieve this and it is estimated that just 4% of European SMEs are sufficiently attractive to draw in venture capital.

A recent macro-economic survey of the economic impact of venture capital in Europe compared the performances of 500 companies having benefited from this kind of financing with the performances of Europe's Top 500 companies, as established by the Financial Times (FT-Extel Top 500). The survey (see graph) showed that over the past five years SMEs which benefited from venture capital recorded an annual increase in employment of 15%, compared with just 2% for the Top 500. They also showed a 35% annual growth in sales, twice that of the large companies. The vast majority of the business managers interviewed claimed that without the injection of venture capital they would have recorded much less or even zero growth.

Another kind of investment which is crucial for encouraging innovation is the setting up of seed capital for new companies or companies being formed. Once again the need is for venture capital, as banks are not able to back projects without references or solid guarantees. Although the total volume of venture capital invested in the United States (5.74 billion ECU) and the European Union (5.54 billion ECU) is comparable, the share which goes to the initial stages of a business start-up is much higher in the USA (26%) than in the European Union (5.7%).

Finally, new companies can also usefully benefit from the interest of informal investors, or 'business angels' as they are sometimes called. These are individuals, generally from the immediate area, with money to invest. They act at a local level through their personal contacts, so their activities - very numerous but totally independent - are difficult to analyse and quantify. Nevertheless, this type of investment is believed to account for three times the total volume of funds available for venture capital.

Context: Factors for Finance The financing needs of innovative SMEs are determined by three kinds of factors. The project's stage of development: development of a new technology; industrial and marketing feasibility studies; initial industrialisation and marketing; international development. The extent to which the project is innovative: innovation of a radical nature, involving new products or processes; innovation of a progressive nature, such as extending a product range; technological modernisation (new for the company but not for the sector in which it operates). The company's stage of development: newly formed company; established company.

Financing Difficulties

Almost ECU 8 billion was raised for venture capital in Europe in 1996, just a small proportion of which is available for venture capital investment. Technology sectors are receiving a gradually shrinking share of total investments: an average of just 24% of European investments now go to technological development, compared to 70% in the USA.

Information and Communication Technologies (ICT) received 16% of total investments in 1995 compared to 13.5% in 1996. Investment in biotechnologies fell over this same period from 8 to 6.5%. However, in terms of absolute value, the new technologies are attracting more venture capital (ECU 441 million in 1996 compared to ECU 320 million in 1995), even if there has been little change in the number of beneficiaries of start-up investments (939 in 1995 and 941 in 1996).

As these companies are an unknown quantity, investors must study each case in detail. In Europe, the initial project evaluation for a company start-up requires an investment of 1 to 5 man-days per project, plus the costs linked to 'hands on management'.

Injecting venture capital into technological projects is even more costly - venture capital operators specialising in this sector focus their attention on an average of five cases every year, while their general counterparts handle an average of twelve. They also spend more time following up their investment: 220 hours a year, compared to 118 for non-technology sectors. Operators are currently detecting a positive trend towards more venture capital financing for innovative enterprises, but are concerned at the low return on seed capital which remains essential for innovations originating in research.

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