Why is it that some companies find it easier to raise £500,000 when they barely have a business plan and one employee and yet can struggle to raise £5m three years from launch, having built strong revenue streams, won loyal customers and broken into new markets?
It’s a problem that has blighted the British startup world for years but it is finally getting attention, with both the prime minister and the chancellor recognising that companies find it hard to make the leap from startup to scaleup. But they have taken some action, appointing Sir Damon Buffini, governor of the Wellcome Trust and a former head of private equity group Permira, to chair a Patient Capital Review for the Treasury.
Patient capital is another name for long term capital. With patient capital, the investor is willing to make a financial investment in a business with no expectation of turning a quick profit. Instead, the investor is willing to forgo an immediate return in anticipation of more substantial returns down the road.
Adopting a patient capital approach in the UK could really change the nature of venture capital here and, more importantly, flexibility in how investment funds are sourced and that has to be a good thing.
To understand the issue, it’s necessary to consider the current model of venture capital. Funds raise money to invest in early stage companies over a pre-defined period, usually three to four years, with an exit window in the following three years, giving a normal fund “lifetime” of around 7 years. The aim is to generate enough success with the first fund to go through the whole process again and raise a second fund, which will often be larger than the first.
The problem with this business model is that every 3-4 years the rush to raise another fund can be a massive distraction away from the day job of helping to turn businesses with potential into something that can produce returns. VCs can be so busy demonstrating a few steep increases in company valuations that other investments suffer.
If you can’t raise another fund you are toast. Seven years down the line from fundraising, questions from investors about how they will get their investment returns will become increasingly loud. Exits need to be found. Things can get uncomfortable.
This model ignores the fact that it takes time to build global companies. If a fund is driven purely by shorter term return needs, then the desire to supply an investor with liquidity may trigger unintended consequences such as a sale to a private equity house, or selling to a multinational strategic buyer.
This is probably the backdrop to Edinburgh company Skyscanner’s sale to Chinese travel giant Ctrip.com last month.
To make sure companies and investors have other options, we need more patient capital throughout the different stages of growth.
In the US the attitude to larger fundraising at a later stage in a company’s growth cycle is hugely different from here in the UK. It is often quite common for companies worth over $1bn to use their position to raise significant further funds. This gives them a significant advantage when investing in innovation and in research and development, the expenditure that drives growth in productivity and market share.
At the same time, founders and seed investors may take a partial exit. This isn’t just so that they can buy the house on the beach: but ,more often than not, realising some reward after years of hard work and basic salaries, helps to renew their enthusiasm for the company they are leading.
We need to help achieve longer term funding options for companies in the UK, so that there isn’t a chasm between the money available to startups and the financing routes for established companies that are ready for the next stage in their growth. If we get this right, the reward will be creating even more globally successful companies to support our economy and create the next wave of entrepreneurs.
So how does patient capital differ?
Firstly, there’s no frantic fundraising in the first place.
Secondly, patient capital gives you flexibility to invest in a measured way. If an investment takes more than ten years to realise, then so be it. Given the recent shocks in the market, frankly, the greater flexibility that founders and investors can get, the better.
What traditional Venture capital needs to generate a return as opposed to patient capital is no different. However, if after seven years, the value of the company is still rising, it makes sense for both the company and the investor to stick together. With the patient capital model this can happen easily, for a more traditional VC fund it is much harder.
The Government has already created many incentive schemes such as EIS to encourage private investors to put money into early stage companies, but it would be great if more investors were encouraged to take a “patient” longer-term view.
2016 has been a year of shocks and surprises and in this new era of economic uncertainty, there is no better time to advocate the virtues of long-term investing.
It is good to see funds now emerging with patient structures, such as BGF Ventures, Draper Esprit and Woodford Patient Capital and we think rewards will come to those funds in good time. Lets hope the Treasury sees this trend and helps to support the Funds willing to adopt the Patient approach.
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