«Research commissioned by the Intellectual Property Office, and carried out by: Martin Brassell, Kelvin King This is an independent report ...»
• EFG is more likely than other forms of borrowing to be used to expand a business rather than covering falling sales, increased cost or late payment. The businesses that used EFG for investment purposes rather than working capital grew at a significantly higher rate in terms of sales and job creation, and having EFG available meant that they would invest sooner than would otherwise be the case. Conversely, over 70% of EFG respondents said their business would have shrunk had the scheme not been available
• Despite a higher default rate for the EFG portfolio compared with general commercial lending, the net economic benefit of the scheme is estimated to be £1.1bn, and is likely to be significantly higher since most of the businesses which will default do so at an early stage 31 Economic Evaluation of the Enterprise Finance Guarantee (EFG) Scheme, Allinson, Robson & Stone, Durham Business School, February 2013 32 Ibid 38 The role of intellectual property and intangible assets in facilitating business finance
Feedback from lenders indicates that in practice, security is still considered over all available business and personal assets, excluding any principal domestic residence (which the rules of the scheme prohibit). Before proceeding with any EFG request, lenders will frequently attempt to establish their typical facility process using all security available. EFG will only be available for creditworthy businesses that are viable and that can afford the facility.
Richard Holden, Head of Manufacturing, advised that Lloyds Bank is currently offering EFG loans at secured lending rates, which has led to a recent increase in take-up (although 2% premium is still payable to the Government in respect of the guarantee provided).
Stephen Pegge, Director of SME & Corporate Communications, confirmed that Lloyds has been a very active user of EFG with around 25% of the current book, but that activity fell off for a time owing to concerns about high default rates associated with the scheme, and the bank wishing to ensure that the rules on affordability and viability (intended to be the same as for
regular bank lending) were being correctly applied. He advises:
David Gill, now working in Cambridge and managing equity investments, was previously the instigator of the technology team at HSBC and Head of Technology and Innovation for a number
of years. He commented in more detail on EFG and its predecessor:
There is also some quite complex maths behind the government guarantee. At any one time, it is limited to 75% of any one loan, and this is calculated on 13% of the total loan book under EFG, which boils down to a guarantee of about 9%. It would be very bad luck to go anywhere near that level, as it would have to be more than double the average bad debt ratio, but still… More generally, because the borrower has to pay an extra charge – 2% annually, payable quarterly – there is a bit of an adverse selection issue. If you choose to pay on your credit card not your debit card, what does that say about your credit? By implication, you are a much thinner proposition.
Also, there is always the risk that as you climb the risk gradient, you have to charge more for the increased risk, but that as you also have to charge more per customer individually, you push them closer to the wire.
Stuart Ager now runs the East of England Regional Growth Loan scheme. He is a former head of the Technology Sector Group at NatWest. He had the following observations on EFG from his
The public perception is that the banks only need a 25% guarantee. In practice, there is a quota related to the use of the scheme and the default rate, so the bank doesn’t really know where it stands.
EFG does not change the fundamental issues of assessment – i.e. will the business be able to generate sufficient free cash flow to service the debt level and achieve full repayment over an agreed period of time? If the answer to this question is “yes”, but the quantum being requested goes beyond the level of security available, then the EFG is a valid route to progress.
However, lenders do not like owners/directors who seek to hide their personal assets outside of any security required to support their business. The question is raised “why?” – do the directors not have faith in the business?
Ager does believe that IP and EFG are potentially a good fit:
Whilst SFLG precluded taking any personal security, banks can and do take other forms of security under EFG, and they are only supposed to use it where nothing else can be provided. So banks are turning people down because they could have offered them something else, such as invoice discounting, even if it wasn’t right for them.
Alignment of IP work with EFG makes sense because it could put back some of the ‘skin in the game’, provided that it is crucial to the business. And a valid first step would be to ensure that any problems associated with the IP are sorted out.
40 The role of intellectual property and intangible assets in facilitating business finance
The Scottish Enterprise Co-investment Fund helps to increase the amount of capital that can be invested in promising start-ups. It started in 2003, just after the ‘dotcom bubble’ burst, and was critical in reinvigorating the market. Its principles have now been adopted in England, Canada and Australia. This ongoing presence of assistance and incentives has helped to ensure that the Scottish market has not dipped.
Launched in 2011, the Business Angel Co-investment Fund (‘Angel CoFund’) closely follows the Scottish model. Privately run, it was established with a grant from the Regional Growth Fund, backed by the Government’s Business Bank, which was recently increased from its original £50m to £100m. It is able to make initial equity investments of between £100k and £1m (with an upper limit of 49% of any investment round and with the Angel CoFund not allowed to own more than 30%), working alongside groups of business angels to invest in high growth SMEs across the UK, directly providing funding as well as encouraging the expansion of the business angel market.
The scheme requires there to be a lead angel, to ensure somebody always knows the business inside out – I want the buck to stop with someone! The simplest way to ensure this happens is for three of our advising angels to have a conversation with the lead investor and have a sensible discussion about what the business is doing and the investment terms.
Applications to the Angel CoFund must represent the angels’ first investment in a business. To date the Fund has supported 32 companies (for example Yplan, PlayJam and Micrima) providing over £10m in direct investment alongside £40 million from business angels.
There is also a Scottish Seed Fund (which does not have an English equivalent). Operating on a co-investment basis with either syndicates approved by the Scottish Investment Bank or individual private investors, it primarily uses equity to bring between £25k and £250k to companies who are completing product development or commercialisation and which have growth or export potential. Companies must have secured 50% of the funding being sought prior to application, and the fund is subject to restrictions in terms of sector activities (exclusions include retail, property, banking and insurance and professional services).
Enterprise Capital Funds (ECFs) and the Innovation Investment Fund (IIF)
ECFs are commercial funds designed to bring together private and public money to support businesses with high growth potential. The programme, run by Capital for Enterprise, aims to invest in 2-3 new funds per year by providing gearing on private investments. In effect, these offer enhanced profits to private investors when the funds are successful, to make them more comparable to the returns achievable in later stage funds.
There is now a portfolio of 12 active funds with commitments totaling approximately £400m, of which £240m has been committed by the Government. Latest reported figures show that £166m has been invested in 144 fast-growing businesses with some significant follow-on financings now being achieved. The Government’s commitments are made on a competitive basis to teams who can raise the appropriate level of supporting capital.
IIF operates as two funds of funds – the Hermes Environmental Innovation Fund and the European Investment Fund’s UK Future Technologies Fund. IIF was established in 2009, again with the aim of supporting innovative businesses. It has a focus on strategically important sectors including digital technologies, life sciences, cleantech and advanced manufacturing, all of which are IP-rich.
An assessment of the IIF, conducted in May 201233, confirmed that the £150m invested by Government had been more than matched by private investors, providing £330m at closing. It assesses the experiences of 16 businesses which have received funding from the scheme and concludes that IIF has had a positive influence, though it is too early to assess its full leverage impact.
33 An early assessment of the UK Innovation Investment Fund, CEEDR and Middlesex University Business School, May 2012 42 The role of intellectual property and intangible assets in facilitating business finance
Nesta’s report on angel activity34 found that the typical private investor put 10% of their total net worth into business angel investments (though 44% had only invested 5%). This is consistent
with experience quoted by Bill Morrow, founder of Angels Den:
As well as the capital returns from subsequent successful exits, tax incentives are a further important motivation for angel investing. Subject to some exclusions (including a requirement that there is no previous ‘connection’ with the investee business), angels can use the Enterprise Investment Scheme (EIS) to obtain income tax relief on their investment in the year it is made, or the prior year35. The maximum subscription that can qualify for EIS income tax relief has recently been doubled from £500k to £1m (with effect from the 2012-13 tax year).
The rules concerning these investments have been made more generous in recent years, with tax reliefs provided on EIS being increased from 20% to 30%. In addition, the Seed Enterprise Investment Scheme (SEIS) has been introduced, providing a higher rate of income tax relief (elevated to 50%) to angels who invest up to £100k annually in qualifying seed companies. This was kick-started with a Capital Gains Tax exemption on any gains realised in 2012-13 which were invested via SEIS in the same tax year.
Several participants in the equity financing landscape were asked for their views on the contribution made by EIS (the views of high net worth individuals themselves are shown in Chapter 4). Jenny Tooth, Chief Executive of the UK Business Angels Association, thinks the Seed EIS scheme, with its higher tax relief, “helps angels to get comfortable with the risk that is presented by organisations that are IP-rich but at a very early stage of development.” She also believes that the more generous reliefs now available may be contributing to recent growth in angel activity anecdotal evidence indicates. This has been demonstrated through UKBAA’s recent research with Deloitte which showed that 58% of those interviewed had invested more in 2012-13 compared with the previous year38.
Sandy Finlayson of MBM Commercial is an experienced lawyer working closely with many Scottish syndicates. He contrasts the success of EIS used by individuals with past experience
of EIS funds:
Some of these funds were only interested in the management charges, not in growing businesses, and selling tax shelters is still something of an issue. However, if we could find the right collective investment scheme that would attract EIS reliefs but didn’t need to be regulated, it would be very beneficial.
At the same time, he points out:
None of these serial angels actually need the money; tax breaks are important for the returns (and the portfolio attracts business property relief, which is helpful for older investors in terms of inheritance tax liabilities), but these aren’t the reason for investing.
There’s a lot of desire to put something back.
Bill Morrow voices his opinion on angel motivation:
It’s a kind of altruism I’m still trying to understand, but it’s about passion, wanting to make a difference, and be part of something. In the UK, angels will only invest if they add value (which they nearly always can) and sometimes don’t invest if they can’t, even if a company has good traction. This is a little different from the US where they are often content just to put their money in. If an angel is only interested in tax mitigation – which is perfectly legitimate – they’re probably not going to be best for the company.
Tax reliefs: Entrepreneurs’ Relief
As well as considering the tax incentives for investors to purchase equity in growth companies, the motivations for entrepreneurs to accept funding to grow their businesses and benefit from a subsequent exit need to be considered. If the interests of founders, management teams and investors are not well aligned, this is likely to have an adverse impact on performance and opportunities to realise value from the business.
38 Taking the Pulse of the Angel Market, Deloitte, July 2013 44 The role of intellectual property and intangible assets in facilitating business finance Prior to the introduction of entrepreneurs’ relief, individuals starting, growing and disposing of companies could reduce their capital gains tax liability to an effective rate of 10%, provided qualifying shares had been held for over two years. This was done using a scheme called Business Asset Taper Relief. However, it raised concerns that it was being used for purposes other than those originally intended, and was replaced for the 2008-9 tax year.