Part 1 Presentation by Rumen Dobrinsky European Alliance for - - PowerPoint PPT Presentation

Financing of Innovation Part 1

Presentation by Rumen Dobrinsky European Alliance for Innovation

Training in the field of Innovation Minsk 26-28 May 2015

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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

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Structure of the presentation

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Why finance is key to innovation? The broader picture

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What is innovation?

• Introduction to the market of:

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

• f existing products or services
• Disrupts existing market processes

– Incremental (small-scale improvements) – Radical – new ways of doing business

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• 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
• utcomes: therefore there is a need to commit

resources to reduce uncertainty

Innovation in the modern economy

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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

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The innovation-finance cycle

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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

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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)

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Measuring innovation performance (EU)

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Source: European Commission

Performance groups by SII

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Source: European Commission

Regional innovation performance by SII

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Name Editing Institution Preparing Institution First Ed. Last Ed. Frequency Standard structure Target countries Number

• f

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

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Global Innovation Index 2014 (WIPO)

Source: WIPO

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

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R&D expenditure and innovation performance

Source: European Commission (2013-2014)

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R&D expenditure and innovation performance, 2013

Source: WIPO; UNESCO; OECD

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Private equity investment - innovation performance

Source: EVCA, European Commission (2013-2014)

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SME access to finance and innovation performance

Source: European Commission (2013-2014)

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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

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• The nature and characteristics of

innovative enterprises

• The financing needs of innovative

enterprises

• The financing options for innovative

enterprises

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Issues covered in the module

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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)

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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

• pportunities.

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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

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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.

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Financing needs in different stages

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Risks and roles on the journey to market

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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

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Challenges of attracting mainstream finance

This is why we need specialized financial institutions for early stage financing!

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The dynamics of financing needs

Development stage Cash Flow

Seed Start-up Early growth Expansion

“Valley of death” Founder, 3Fs Business angels Venture capital funds Public stock markets Debt / Bridge loans Feasibility grants

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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)

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Types of finance in different stages

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The financing sources of new firms

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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

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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

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Seed funding (contd.): external equity

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Framework conditions

Capital Specialized intermediaries Entrepreneurs

• 2. Private Early-Stage

Financing of IEs. Business Angel Financing

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• What is a "Business Angel“
• What is the role of Business Angels and

how do they operate?

• BAs and BA networks in Europe

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Issues covered in the module

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The 3F (Family, Friends and Fools)

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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

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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

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• 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?

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How much they matter? (US example)

5 10 15 20 25 30

Business angels Venture capital

Early-stage Later-stage 10'000 20'000 30'000 40'000 50'000 60'000

Business angels Venture capital

Amount invested (Billion USD) Number of enterprises financed

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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?

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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

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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

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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

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Number of BA networks in Europe

Source: EBAN

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European BA investment

Source: EBAN

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European BA investment by country, %GDP

Source: EBAN

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European BA investment by country

Source: EBAN

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Average Investment Amount by BANs (mn €)

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Advantages Disadvantages

Major source of funds Less visible on the market Possible “leverage effect”

• n
• ther

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

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• What is "Venture Capital"
• How VC investment works?
• The VC investment cycle
• VC in Europe and the US
• Crowdfunding: introducing the issue

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Issues covered in the module

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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)

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• 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

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The levers of VC finance

Institutional investors VC firms Entrepreneurial firms

FUNDRAISING INVESTING EXITING RETURNS

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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)

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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

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• Pre-investment

– Origination, prospecting – Screening and due diligence – Structuring

• Post-investment

– Monitoring and oversight – Value adding – Exiting

How do VC firms add value?

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• 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

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• 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

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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

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• 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

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• 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

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• 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

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• 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

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The fate of VC investments

Source: Cochrane (2005)

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Europe VC investment by stage (€ mn)

Source: EVCA

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Europe private equity investment by stage (€ mn)

Source: EVCA

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

Source: EVCA

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EU VC investment by country, %GDP

Source: EVCA

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Source: EVCA

VC vs. BA investment, %GDP

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VC investment in the United States

Source: PwC/NVCA MoneyTree Report, Thomson Reuters

Crowdfunding: Introducing the issue

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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

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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

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Crowdfunding vs. traditional funding

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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

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The magnitude of crowdfunding

Thank you! Rumen Dobrinsky E-mail: rumen.dobrinsky@eai.eu rumen.dobrinsky@gmail.com

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THANK YOU!