WEDNESDAY 6 MAY 1998

MR MARTIN GAGEN and DR PATRICK SHEEHAN

  180. You called for additional seed capital. Who is going to provide that? Do you reasonably think venture capitalists are? Are you going to provide it? Should the EPSRC be providing it, the way the MRC does?

  (Mr Gagen) We are active players in the seed capital market and after a number of years of attempting to place seed capital investment on an individual basis, the approach we now take is to have a number of relationships, five or six of them now in the UK; one of them is the MRC of which Dr Sheehan is 3i's Board Director on the vehicle there. Also in Scotland we have a partnership between Scottish Enterprise and ourselves. We have a number of them in the Cambridge area which is clearly a good bet. The reason we have done that is that by taking a partnership approach with some others we can both attract better managers and mentors for the seed capital generally and we can frankly approach it on a more cost effective basis. Although we do not approach any investment on a portfolio approach, in seed capital there needs to be realism that probably the majority of the ideas may not make their way to commercial exploitation. There is a degree of managing the total area. What we then do is invest quite substantially through those vehicles but the arrangement 3i has is as they come from that vehicle we will then take them on a solo basis to exploit them further. I think it is fair to say we are fairly unusual in the British venture capital scene in having the depth of those relationships in seed capital, and also the amount of money we put into it. From my position as a backer and admirer of the sector it would be very helpful to us if there were more seed funds.

  181. Where from?

  (Mr Gagen) There is frankly a matter of incentive to come into these areas. If the Government is to do anything here our view is that it should be in partnership with high calibre management which would direct the money in the best area.

  (Dr Sheehan) If I characterise the UK as simply having a lot of good ideas which with work could probably be turned into interesting businesses, seed capital is actually very difficult to provide economically because you are dealing with very small amounts of money and costs are higher. It comes back to the point of whether, if it is not commercially viable, it is going to be very hard to get commercially driven investors to do it. 3i has been doing it because 3i actually has a desire to create a market. There is a good combination of self interest and national interest. For a smaller fund it is really not going to be the case so there is probably a need to look at how to improve that ratio of costs and amount invested. That implies subsidy from some source.

  182. Go on.

  (Dr Sheehan) You probably know better than I the sources.

  183. Speculate. Where do you think you might find them.

  (Dr Sheehan) If I were to speculate I would probably look at government sources, the European Union, whatever. I would probably look abroad to examples of other countries which have done similar things.

  184. What about pension funds and institutions?

  (Mr Gagen) There needs to be principally a ranking of their priorities. At the BVCA clearly this is a market which we talk to a lot because they are providing funds to a lot of our members. The principal objective of those bodies is to make an adequate return on a risk spread basis. Therefore that probably means the amount of money they specifically target on seed investment is always going to be very low and in fact many of the people I spoke to personally would just not see it as an appropriate investment because of the source of their money and the obligations they have. Therefore you either need someone to have created, as we have done, specific arrangements where that is the offering and you find a small number of people willing to do it or you do pursue a pump priming mechanism which really brings you back to what it would take in order to incentivise other people to join the party. There are examples, particularly in other European countries—we have mentioned America too much probably—where it is feasible to incentivise on a relatively neutral basis from the public purse. If a given percentage of these succeed the payback from the successful ones, bluntly, on the tax coffers have come through; if you take a reasonable term view of it, it is probably self balancing. Therefore, asking institutions to volunteer in the sector is always going to be a minority sport and in many cases they would not see it as an appropriate spend at all.

  185. For such a seed fund to be effective, how much? Speculate. You must have a figure in your minds.

  (Dr Sheehan) If I were guessing, it would be a size of £15 million plus per fund. It is not actually so much about the amount of money, it is where it is targeted. One of the attractions to us of being involved with the seed fund set up by the Medical Research Council is the quality of research and that is more important than the size of the fund. What would feel uncomfortable to me would be the broad brush.

  186. From your experience that would help the companies you see who have potential know the people who have ideas and management skills and want to develop them; you think that would be a sea change in this area?

  (Dr Sheehan) If it were allocated to the right institutions which really excelled rather than spread across those which were average, they could do. It would have to be pretty judiciously applied.

  187. With your experience of dealing with venture capital arrangements, what do you think would need to be done to make small companies much more receptive, willing to take on new research and new technology?

  (Mr Gagen) Just to clarify the area of the definition of small companies, the mid market in this country, the "Mittelstand" of Germany, can be quite substantial businesses and be very big private companies. If we are talking about the usual definition of SMEs which might be turnover of a few million, it may be profits in the few hundreds thousands, the real challenge for those is that any degree of speculative investment in R&D which does not have a direct and fairly immediate payoff is actually just not going to appear on their priorities. Therefore our experience is that the majority of those companies have pursued a different route, which is to partner or to seek supply arrangements with people who do have larger resources. There are some very good examples of larger companies which have guaranteed supply arrangements or prices for product which then give them a little bit or margin, latitude, to pursue new applied technology in their products. The payoff for that clearly is that the larger supply partner is benefiting from some outsourced R&D and they also pick up the more entrepreneurial flavour, that is a quicker time to market mentality, in these small companies. The financing cost there, as with many of the things we have said, is probably the least important of that. It is the stability and the protection of what may be an end user. The down side for the SME? There is a loss of independence from that, it is a fairly unequal partnership and one of the roles that venture capitalists do play is to balance that relationship, to provide a little more independence and financial control to the SME which has genuine growth prospects.

  188. Would you see SMEs being a principal customer of some of your ventures which have grown a bit and are getting mature which would then sell them into or merge them with small companies which already exist?

  (Mr Gagen) To focus on the technology development area, some very small companies will in essence be one product companies; they may even be single market companies. Because of that there will come a point in their development when they either need to bet that business again to develop a second string or to partner and in this context sell to or become owned by a bigger business. Some of the buyers will be potentially other larger SMEs which have a related complementary product and if their choice is either to invent one themselves or to pay a price for an existing business, that is open to them.

  (Dr Sheehan) They will approach any one of a number of intermediaries who will search on their behalf and there is quite an active market in mergers and acquisitions in these companies. The issue they are likely to face is really the value they would see in the company that they are trying to acquire, if it is interesting technology, and it may well be less than the value that would be seen by someone who already had a very large market share who could push the SME product through far greater distribution channels. What you tend to see is larger companies growing larger and companies which have high market share being in a better position to buy. An issue for the UK is that in the field of information technology we have few of those companies and therefore relatively frequently the way to create and realise value is to grow companies to a certain size and sell them and go back to the beginning again. You cannot really compete against some of the marketing channels of some of the very large international IT companies.

  (Mr Gagen) May I make one additional comment on how some of these transactions come about. There is a community of these individuals and companies, particularly if they are operating the same area of science and particularly customers. Even away from the advisory market what you will find is that they will track each other quite carefully. I very much agree with what Dr Sheehan said that that community is not bound by the UK geography or even the European geography and so we are seeing a lot of these fledgling British SMEs establishing quite close arrangements with people they have identified in the States or elsewhere who might become their buyer. That community is probably more open with itself than may be apparent from outside. There is a lot of sharing of market strategies for example.

  189. Would they benefit if there were more flow of information between academia and themselves or are they already well provided in that respect?

  (Mr Gagen) It is a varied market. It is better today than it has been, without question. The understanding of good communication and linkage between institutions in our experience has improved dramatically over the last few years. Clearly it can always improve further but there is not an unwillingness on many people's part to try to find new contacts or areas of conversation. What may require some further work is where there are some very early stage developments taking place in certain institutions which have yet to forge those arrangements. We think there is more that could be done; for example at Insead in France, we formed a basis there really trying to sponsor how those links between entrepreneurs and academic work can come about. The minute anyone has been in the sector they are actively hunting out exposure to academic institutions and similarly academics have become very good at understanding what the market potential is and players in the market are.

  190. Obviously governments want to encourage the commercialisation of interesting technologies. We have various schemes in existence such as Business Links, the new University Challenge. I wonder whether you could comment on how successful existing schemes have been and how you feel the new fund will be able to help? Do you think we are ever going to get to a situation where you are going to be spending more than 10 per cent of your capital on these kinds of schemes? I note you said there need to be schemes to aid the career launch of more corporate innovators where so far all you have suggested is that we should have role models. Do you have any other ideas and, widening it, Dr Sheehan was about to tell us about some schemes in other countries and he never got to finish what he was saying?

  (Dr Sheehan) I was on the point of mentioning, though I am not an expert, the sort of pump priming which has been happening in Israel and indeed is now happening in Germany where there has been quite aggressive government support. If you look at the state of technology companies in Israel today, there are probably a couple of hundred which have floated on NASDAQ. It has a very vibrant technology scene, possibly driven on the back of military spending and a spillover but nevertheless from almost nowhere they have come quite rapidly to be a force in the technology market in certain sectors. That would not have happened without quite a lot of pump priming. We are beginning to see that happening now in various states in Germany so I guess two issues come to mind: one is that we can learn from them; two, how we are more directly impacted by them because we live in an increasingly mobile world and some of the things we might like to have seen start here may start there.

  (Mr Gagen) On the historic schemes they have had a couple of advantages. One is that they have usually been organised regionally so that one of the points which has come up in this area is about how you access the idea or the entrepreneur at some point in the country and that has been a plus. Secondly, it has been one of the few fora which has pulled together people of different disciplines. For example, some of those schemes have brought in experienced businessmen, academics and other entrepreneurs. Where have they not been successful? They have been less focused on the very best opportunities and in effect have tried to treat most of the opportunities relatively equally. There could be more focus there. The amount of money which is genuinely available on top of the advice has been quite limited. Although the ideas may have been identified, coming back to Dr Sheehan's point on pump priming, what might be a logical follow through is that with that support system, pushing it through and actually allowing the company to implement some of the advice, which has been quite hard work in the past. The university scheme which has come up is quite an interesting idea in that the amount of money could actually go quite a long way if it is directed correctly. Our view is that the critical point to make is that a successful scheme must focus very much on the managerial and leadership input which will go into it. If we have a fear in that area, it would be that it would try to be too equal in terms of the division between various institutions and then pursue a number of different technologies which may not actually come to fruition. Therefore if we were to advocate two things in the future, one is that we think these vehicles could be used to attract the very best talent who probably have succeeded in the area before. Back to my role model point. This is a good way of incentivising the right people to help. The other attraction of those sorts of people is generally that they have experience outside this country which is, in the area we are talking about, a critical discipline which the very best deal in one part of the UK may actually on a world stage be a very poor opportunity which probably should not be pursued. With that and then a combination of money behind the ideas which are identified, although there are no guarantees, we suspect that would help.

  191. How can we get some of these former GD Searle people back from California?

  (Mr Gagen) I wish I knew. We are trying our best. The globalisation of some of these is built up from understanding whether the company here is going to register on any of those people worldwide. These are people in demand, there is a worldwide shortage and to balance the issue we have in the UK, if you go to Silicon Valley and ask, the one thing they have a problem with is finding enough good leaders to run these companies. They are not short of ideas, as this country is not, so what you are doing is competing in a worldwide market. These are very expensive, very talented people. To incentivise them to come here and pursue an opportunity here the comparison we are making is with the same opportunity in Israel or America and that has some serious challenges on how we could bring them here. It is a combination of fostering good talent here and bringing forward some of what are excellent people in this country, aiding that. Whether we can get enough people to re-plant themselves in Europe as opposed to America is always going to be slightly driven by the much easier opportunity to have a full career with world class companies in quite a small geographical area in the States.

  192. What have been the characteristics of these other pump priming schemes other than putting money into it? It is easy to throw money at something. How do you ensure that you get good value?

  (Dr Sheehan) I have to say I am really not an expert on that so I probably would not give you a good view. I would not mind picking up a couple of points mentioned to try to be helpful on those. It seems to me that it is all about creating the most benign environment that you can and coupling that with a pretty healthy measure of patience. There are several cultural issues which will only change slowly. Setting up a benign environment is in part tax and regulatory and in part it is just changing attitudes and educational. Many of the existing schemes have focused very much on technologies and development of technologies as though to me they were an end in themselves, whereas what actually makes them attractive to investors, to these serial entrepreneurs, is the identification of a market opportunity. If the schemes could go a bit further to make it slightly clearer what the market opportunity was, it would be a lot easier to sell some of the technologies to people who might take the plunge to become serial entrepreneurs or might decide to look at a particular opportunity. We have seen some evidence of people being prepared to come to this country to do that where it is clear enough.

  193. A couple of questions on the financial environment. You mentioned what could be done to improve Capital Gains Tax. Do you think that the changes to CGT which were announced in the most recent budget are having an impact on investment patterns in these technology-driven startup businesses?

  (Mr Gagen) It is too early to tell, is the truthful answer. An observation on it is that it was in the right direction. The subject is exactly the right one because there is this issue we have detected that creating the wealth in these areas is actually hard and it is different to some of the other appropriate targets of Capital Gains Tax. I know the BVCA have submitted on this point, as has 3i. We think that it is not appropriate that the measures which have been introduced, particularly the tapering and the duration of the tapering, do not actually address this market we are talking about today because both the timescale of value realisation is much shorter and the key point is that we are trying to encourage people to do this more than once. This is not building up a company over ten or 15 or 20 years and then retiring. The real value of the people who have done this is to get them from that vehicle into a new business, create another business and move on. The trail they leave behind is actually a series of very good companies rather than one. The current capital gains detail does not really change the current motivation of the entrepreneur in that area at all.

  194. What about the impact of the creation of EASDAQ? What impact has that had on the ability of high growth companies to attract investment?

  (Mr Gagen) Relatively early days for EASDAQ. The rules on EASDAQ are very common with the NASDAQ regulations and the couple of investments which we have had which have floated on EASDAQ actually targeted both markets at the same time. The liquidity on NASDAQ is of an order of magnitude different to EASDAQ, therefore the investor behaviour is different. The other issue in Europe is that other than London, the "Neuer Markt" for example and also the "Nouveau Marche" are all relatively early in this area. The combination of the emergence of capital markets in those countries plus EASDAQ, plus a very good appetite in the UK for this type of company, is beginning to create a much more fluid environment which should help.

  195. If you had to prioritise between creating mechanisms which attract investment and a greater provision of seed capital, where would the priority lie?

  (Mr Gagen) We should both answer that question. We would have two principal priorities on the seed capital areas we have talked about. We have rehearsed some of the difficulties in encouraging other people to go there. One is to find a way of bridging this narrow gap between the end of the incentive programmes which helped some of the seed capital get past initial development and the pickup point of the private sector which is slightly away from that. Anything which could be done to bridge that gap would help. Secondly, any measures, although they may appear to be tangential, which encourage managers to devote their time and attention to this type of company and for it to be seen as a good and socially-acceptable area of work, would probably make the biggest change of all. I would obviously like Dr Sheehan's comment on the same question.

  (Dr Sheehan) I would probably say the same things. There are three ingredients here. There is the raw technology and more seed capital needs to be available just to move that along a bit. We would see great benefit to there being more seed capital around. The second ingredient is "done it before" management. It is very hard to learn other than by doing this. There is a quite visible route map; people who have been the route before and who are willing to do it again. That is the second critical issue. The third, money, would follow the other two.

  196. Should there be more publicity on people who have failed and then succeeded? The evidence is that people who have failed and learned from their failures actually can go on and be successful. Should that not be promoted a bit more to encourage people not to be put off if they do fail?

  (Mr Gagen) Communication and understanding do go a long way in that area, clarifying the difference between failure from incompetence in management, which does happen, and failure from actually everything being right except perhaps the technology was the wrong window or something and it was not actually the fault in any way of the management team or the investors. We actively pursue the latter category because there is nothing better than the guy who has sat in the room and seen his idea not work; he just does not make the same mistakes the second time around and he is a lot quicker off the mark to make changes when the model is not working. That is a thing which we see internationally; the very best of these managers probably have had a failure in their past.

  197. I am sure you would agree that success breeds success, perhaps more so in your business than most. Do you think enough effort is put into sifting ideas in the first instance? Therefore if the ideas were sifted better, the risk could be reduced and if the risk is reduced, then you could attract more seed capital? Is enough effort put in to sifting before seating investment?

  (Mr Gagen) The skill that good venture capitalists have is an ability to do that sifting efficiently and that does make a difference. If you spend too much time on a bad idea, it is not just inefficient but also just clogs the whole regime up. Outside the venture capital community, some clarity about what issues you are looking at to sift out the ideas would be helpful and indeed we publish and try to help clarify that; some of the points we have made today. What were those areas used when we were sifting whether this particular piece of science would fly? Some ideas funnily enough would get past and be pursued and others would not. At the moment we suspect that some education in that area could be good.

  198. You are telling us that the sifting is one of your key skills, one of your core skills?

  (Mr Gagen) It is and the experience base within the business of sifting and explaining to the company why you are not pursuing their idea is very helpful. We have found that if you do that well, that company may come back later, having addressed some of the issues you rejected and then we invest in this at a later date. We find that a very helpful end result which may take some years.

  Chairman: Back to Dr Jones's point; we have been going for over 50 minutes. You have been very fluent witnesses. We thank you very much indeed for the assistance you have given us and for the time you have spent with us. We know from our own experience that it is not just the time you are here; I am sure you have put a lot of time into thinking about the questions and thinking even more about the answers. We are most grateful to you. You have made a significant contribution to our inquiry. Thank you very much indeed.