In all likelihood, the answer from a private equity house will be different from the one given by a business angel actively backing innovative young companies. Once upon a time, there were much clearer divisions between the levels of funding provided by different types of equity providers. Business angels invested lump sums in early-stage companies, venture capitalists (VCs) provided development capital for particularly risky ventures such as technology and were happy to muck in once profits were rolling in.

Mark Wignall, chief executive of Matrix Private Equity Partners, recalls the days when, ‘people were falling over themselves to invest in young, early stage companies.’ It wasn’t that long ago, he says, that 3i dominated the market with, ‘a high-street presence a bit like a bank, so you could pop in during a trip into town and pick up your risk capital!

However, many of those now concede, in private if not in public, that market forces in the last five years have caused a move by VCs and private equity backers away from small, risky investments towards larger, later stage deals. This trend is what James Steward at private equity group ECI Partners calls ‘the flight to quality.’

‘We make a judgement based on the balance between how risky and time-consuming it is to invest in the company in question and what the rewards are likely to be if the gamble pays off. This risk reward ratio is at the heart of any investment,’ he counsels.

‘Private equity providers are therefore leaning towards conducting fewer transactions, but ones of larger value, because this spreads risk more evenly and brings greater returns.’

The impact on small companies

This shift upwards theoretically leaves a gap in funding between the level business angels traditionally provide and what private equity firms now offer. The space between has been coined the ‘equity gap’ and, depending on which statistics you believe, it’s around the £0.5 million to £2 million mark.

Some reports suggest it’s not just early-stage ventures that find it hard to source small equity hits. The Government began a public consultation process on the subject in 2003 with the publication of its paper entitled Bridging the finance gap, which found that ‘while the risks associated with investment in early-stage businesses are often particularly high, established businesses (including those in ‘traditional’ sectors) can also be affected by a shortage of risk capital – for example, when seeking investment to modernise or diversify their activities.’

Government intervention

In July 2005, the Government made up to £200 million available to match private funding from VCs or angels into Enterprise Capital Funds (ECFs). These are designed to be commercial funds to which SMEs can apply for up to £2 million of equity finance.

Throughout England, small amounts of equity are also available from Regional Venture Capital Funds (RVCFs), which aim to provide risk capital finance of up to £500,000 for small firms with good growth prospects in any sectors. The government has endowed nine RVCFs with funding through the DTI and the European Investment Fund, while the rest comes from private sector investors.

Gap, what gap?

A study by research firm Library House entitled Beyond the Chasm found that of the 1,511 current venture capital investments made by private funds, more than half (899) are for £2 million or less. In that band, the vast majority (706) were between £250,000 and £2 million, which is the zone the Government identified as experiencing a market failure that created an equity gap. Library House findings conclude, ‘there is no gap in the range of funding deal sizes available to growing companies in the UK’.

Boyd Mulvey, co-founder and chief executive of Create Partners, which manages the regional venture fund for the East of England, says that where ‘research shows the vast majority of VC deals were between £250,000 and £2 million, those deals could’ve been the first round of a series that ultimately amount to an investment of ten times that. So, small companies seeking an investment total below that level and above angel funding still need help.’

Quality is the key

British Venture Capital Association (BVCA) shows that its members invested in 285 early-stage companies last year, an increase of eight per cent on the year before.

‘The BVCA statistics show that the majority of deals are below £1 million, so it’s just not true to say there is a gap in funding in that area. But venture capital is a world in which one in a hundred deals secures funding so 99 companies will claim there’s an equity gap,’ laments Anne Glover, CEO of venture capital group Amadeus Capital Partners.

‘In some sectors of the economy, there are very few players with the know-how to do deals,’ says Anne Glover. ‘It’s particularly true of early-stage technology, where ventures need seed funding to develop a prototype and then substantial capital in the future. I would describe that as a skills gap.

‘But the market is becoming wiser and changing its perspective on how to evaluate transactions,’ she continues. ‘At Amadeus for instance, we don’t view deals on the size of the investment rounds and never have done. The question we ask is, “What are the total capital needs of the business to take it through to exit or profitability, and what proportion of that should we invest now?”

Glover believes most equity investors are beginning to understand that effectively there isn’t tiering of the market anymore, in terms of early-stage, growth and later stage players. ‘If you want to play, you have to be able to play at all investment stages. The most important thing you must have is the capacity to support a company in its future growth strategy.’

For further information click and visit: British Venture Capital Association. The Library House’s Beyond the Chasm report is available at www.libraryhouse.net