Market failure and management letting start-ups down

I had the opportunity last month to go to a day organized by the East of England Development Agency and the St John's Innovation Centre in Cambridge. The day showcased a range of start-ups and the technologies they were working on and also featured a very interesting talk on funding for innovation that I will look at in some detail in this blog post.

Cambridge is known throughout the United Kingdom and much of the rest of the world as a centre for technology innovation, driven largely by the presence of Cambridge University. Without the presence of the university, Cambridge would probably be an unremarkable Fenland market town. Instead there are 1,400 technology based business around the town, employing some 40,000 people featuring world-renowned names such as ARM, that develops the technology behind many of the chips in mobile phones, and Autonomy, which is a world leader in unstructured search and knowledge management.

Technology innovation has been core to the success of all of those companies and as we recover from the global recession, also needs to be a key part of the economy moving forward. Of course the landscape has changed even in the relatively short time since ARM and Autonomy emerged. Globalization has created a global innovation arms race, quipped David Gill, managing director of the high-tech incubator St John's at the event.

Innovation has always been more than just generating ideas. In some ways, that's the easy part. What is just as important is turning these ideas into commercial propositions that can scale well and that people actually want. It's this step that requires funding and support - and the question discussed at the event was where this funding should come from?

Martin Graham, who used to be in charge of markets at the London Stock Exchange, reckoned that he had the answer. "Why don't companies get proper finance for innovation throughout their lifecycle?" he asked. "I believe there are two reasons for this: the first is internal and the second is a problem in the capital markets."

Planning the business

To gain access to finance start-ups need to be well run, and Graham suggests at the very least they will need:

• Strong management team;
• Good accounting and governance practices;
• Ability to execute and scale commercially;
• Clear plan of where the funding will be spent;
• Understanding of the market;
• Superior offering to competitors;
• Preferably in a new market, otherwise the incumbent can make it very difficult.

Without these factors in place start-ups will find it very difficult to raise long-term finance that will allow them to become successful. "Unfortunately most companies looking for finance simply do not meet these criteria," he warns. Identifying the right early-stage businesses to invest in is a risky matter, given that over half of all start-ups with Angel support fail.

Market failure

The second reason there is a funding gap for innovative businesses is more a structural problem of capital markets. There is plenty of short-term finance available through angel funds, grants or incubators such as St John's, but chasing after short-term finance detracts start-ups from the building a long-term business with long-term investors.

Graham says that new mechanisms are needed to match the available long-term finance out there with start-ups. He says that traditional vehicles such as stock brokers and investment banks are not the right approach as their high fees mean that they are less interested in investing in start-ups.

As an alternative, Graham has founded the CMX Capital Markets Exchange, which plans to match small and medium sized enterprises to investment capital from family offices, private equity and venture capital. He plans to vet start-ups on the hygiene factors above, so that the investors can be more comfortable with the risk of investing long-term capital.

St John's Gill also had some ideas on how to improve funding for start-ups. He said that legislation could help create private funds that were of sufficient scale to support businesses throughout their early lifecycle. He added that research from the Harvard Business School suggested that funds need to be over £50 million to provide adequate support, otherwise they'd run out of resources before they can fully support the more successful firms in their portfolio.

One potential source of funding could be the revenue from bankers' bonuses - using as little as 15% of this would match the total funding that the government has invested in early stage funds over the last 12 years. He says that it could be used to create a 3i for the 21st century (which itself was created in the 1930s to plug a funding gap for growth firms). We'll be watching with interest to see if any of these ideas come to fruition.

Also as part of the day a number of the technology firms showcased their innovation and I'll write another blog post this week to highlight my favorites.