INTRODUCTION

  1.  Apax Partners provides private equity funding, corporate finance advice and asset management to entrepreneurial businesses internationally. We are one of the largest private equity organisations operating from 12 offices, across Europe, the US, Israel and Japan, and managing or advising private equity funds with capital totalling about £3\5 billion at current exchange rates. These funds are provided by many of the world's leading institutional investors through 27 funds and they are currently invested in over 150 companies. UK funds under management exceed £2 billion.

SUMMARY

  2.  We believe that several factors mentioned in your terms of reference influence companies in the field of engineering and physical sciences when deciding on developing new products and processes. In particular, we have some suggestions with regard to:

—  Tax incentives for entrepreneurs (reduction in CGT and taxation on stock options).

—  Effective stock markets for growth companies (support for EASDAQ, the European Association of Securities Dealers and Automated Quotations; extension of the AIM relief, including rollover relief, to smaller listed companies with market capitalisations of £50 million or less; support for the EC's "IPO Europe" initiative to facilitate equity offerings across the whole of the EC; and removal of the current anomaly which favours raising debt rather than equity by allowing debt-raising expenses to be deducted against corporation tax but making equity-raising expenses non-deductible).

—  The funding of hi-tec businesses (replicate the US's SBIR programme; introduce grants to equip university labs; set up incubators; provide R&D grants to fund scientists carrying out research with commercial applications; encourage creation of "technology clusters" and easing of planning restrictions for them).

  3.  The Government must recognise the importance of successful entrepreneurship. The result will not only be the creation of successful role models of quality growth companies but also the encouragement of an entrepreneurial "can-do" culture where commercial success is admired, not envied, and where failure is forgiven as part of the entrepreneurial process of trial and error.

EVIDENCE

  4.  In the US, growth companies are the engine of future wealth and employment creation throughout the economy. They should be the same in the UK, but in order to achieve this, and to build on the UK's strong base in science, technology and creativity, they and those who invest and work in them must be given the right environment for risk-taking and reward.

Taxation

  5.  The most effective step that this Government can take towards improving the entrepreneurial environment is a reduction in Capital Gains Tax. For long-term investors in high-risk companies, the current rate of 40 per cent is too high and acts as a disincentive to make adequate funds available on the right terms to entrepreneurs. Entrepreneurship is thus constrained and promising research and development is left unfinanced or exploited outside the UK under more favourable tax regimes.

  6.  There is a strong case in the UK for a lower overall rate of CGT, initially at 20 per cent, for investments held for three years or more. There is also a very strong case to apply such a rate without the complexities of tapering or qualifying periods. In the US, the substantial reductions in CGT at the end of the 1970s helped to ensure a greatly increased inflow of capital into smaller companies precisely because they created a powerful tax incentive for entrepreneurs and investors alike to become involved with illiquid, long-term investment in high-risk growth companies.

  7.  In the US, the CGT tax incentives have engendered a virtuous circle of risk-taking, wealth creation and reinvestment of capital gains in new ventures, which we see today in Silicon Valley and elsewhere. In 1997, to give a further impetus to this process, which helped create 65 million jobs in the period 1980-1995 while 42 million jobs were lost by mature companies, the US has again reduced the general rate of CGT, from28 per cent to 20 per cent, and that for investments held for more than five years in companies with assets of up to $50 million has been reduced to only 14 per cent.

  8.  This contrasts with a US federal income tax rate of 40 per cent. The US has, clearly, found that the benefit to its economy and the gain to its Revenue over the life of the firms created and developed overshadows any possible leakage from tax avoidance.

  9.  A similarly bold reduction of CGT by this Government would have a powerful impact on UK small company creation and growth, including the creation and growth of "tech-stars". We recommend a simple reduction to 20 per cent on investments held for three years or more.

  10.  Another area of taxation which should be addressed by the Government is that governing stock options over shares in smaller companies. For the same reasons, we recommend that all gains on options held for three years or more by employees be treated as capital rather than income, and that the rate of CGT be reduced and the structure simplified by removing the complicated indexation rules. We recommend that for future grants of options, the CGT rate of 20 per cent apply for stock options exercised after three years or more over the shares of companies less than five years old and with assets of £30 million or less.

  11.  The Government should recognise that our tax environment for long-term high-risk capital has to be competitive with the US if we are to develop in the UK the technologies and managerial skills we need to fulfil our economic aspirations.

Effective stock markets for growth companies

  12.  One of the reasons for low levels of investment in early stage growth companies in the UK and more generally in Europe is the failure of the European financial system. Growth companies need to be able to access the public equity markets in order to obtain finance when the venture capitalist leaves off. For the venture capital industry is merely one part of the system. The system involves taking illiquid and "patient" money, in the main from pension funds and insurance companies, and backing new businesses. As these businesses grow, they consume increasing amounts of cash. And the ability of venture capital funds to provide funds to finance their growth is necessarily limited, while the cost of venture capital finance is higher than that of equity raised through the stockmarket. So, once the risk of the venture has fallen sufficiently and its potential can be better measured, the venture capitalist needs to be able to float promising companies on a stockmarket and raise much larger amounts of money from a wider group of investors at a relatively lower cost. One consequence of a successful flotation is that the company's progress will then be reflected in an attractive valuation which will give comfort to the initial shareholders, including the venture capitalist and investors in the venture capital fund. These investors will then be encouraged to recycle any distribution they receive and to increase the allocation they make to venture capital.

  13.  US venture capitalists will confirm that NASDAQ has been and still is absolutely essential to the development of the US venture capital industry, and that its effectiveness as a stockmarket for growth companies has attracted investment into venture capital funds specialising in early stage investment. NASDAQ has developed into a powerful stockmarket for growth companies because it has set out to specialise in them and to be highly regulated against fraud but not against business risk. It has a clear entrepreneurial identity which appeals to managers of entrepreneurial companies, and so attracts new companies as new technologies evolve. And it is managed independently of the NYSE and the American Stock Exchange, which concentrate on larger, more stable companies.

  14.  As a result, NASDAQ has led to the creation or development of new investment banks and market makers such as Robertson Stephens, Hambrecht & Quist, Alex Brown, Montgomery Securities and Cowen & Co., which specialise in growth companies and which realise that the less profitable a company is, the more investors need full and frequent disclosure about its prospects. These investment banks have assembled powerful analysts specialising in growth areas such as telecoms, biotech, information technology and media who continually monitor companies and keep the public and the investment community well informed about them. NASDAQ has also led to the creation of a multitude of specialist investment funds which focus on every type of growth company listed on NASDAQ. All of this creates liquidity for the shares of NASDAQ quoted companies.

  15.  The UK and more generally Europe also need a stockmarket specialising in growth companies in order to encourage early stage investment. We need an effective pan-European market modelled on NASDAQ which channels funds from European and US investors to European growth companies. This is why EASDAQ (European Association of Securities Dealers and Automated Quotations) has been set up.

  16.  EASDAQ has developed, with the help of NASDAQ, as an independent exchange backed by 93 prominent institutional investors, bankers and venture capitalists from the UK, Continental Europe, Israel and the USA. EASDAQ's focus is on European growth companies with international aspirations. EASDAQ has offices in Brussels, London, Frankfurt and Paris. In order to maximise liquidity, it has concentrated on companies with a market capitalisation of $100 million or more. To provide companies with maximum flexibility, it has made it easy to obtain either a single listing on EASDAQ or a dual listing on EASDAQ and NASDAQ, thus enabling growth companies with international aspirations to access both the US and European public equity markets.

  17.  Support should therefore be given to EASDAQ, as a pan-European stock market capable of playing a similar role to that of NASDAQ in the US. After all, it is thanks to this system that sectors such as semi-conductors, personal computers, biotechnology and the Internet have been financed in the USA, including companies like Intel, Apple and Genentech.

  18.  In the UK, further support should be shown by extending the AIM relief, including rollover relief, to smaller listed companies with market capitalisations of £50 millon or less. The Government should also support the EC's "IPO Europe" initiative to facilitate equity offerings across the whole of the EC and the Government should remove the current anomaly which favours raising debt rather than equity by allowing debt-raising expenses to be deducted against corporation tax but making equity-raising expenses non-deductible.

Importance of hi-tec funding

  19.  The third key area of support for the creation of growth companies is the provision of funding forhi-tec companies. Again, we can learn from the US where the Government has initiated the Small Business Innovation Research programme, the purpose of which is to create new technologies that offer solutions to the nation's most pressing scientific and engineering problems. In 1998, the Federal SBIR programme will fund more than $1 billion in early-stage R&D projects at small hi-tech firms—projects with the potential for commercialisation in private and government-sector markets. Small businesses (500 or fewer employees), as well as individual entrepreneurs seeking to start a small business, are eligible to apply.

  20.  We recommend replicating the SBIR in the UK, and allocating 2 per cent of the annual government research institutions' spending to grants for high R&D commercial projects. Other recommendations are to introduce grants to equip university labs, to set up incubators, and to provide R&D grants to fund scientists carrying out research with commercial applications.

  21.  Hi-tec growth companies are best created through "technology clusters". Several examples exist both within the UK and Continental Europe. In the UK, there are specialisations in IT in Cambridge, in semi-conductors in Glenrothes, in man/machine interface in Leicester and in software in the Thames Valley. In Continental Europe, there are specialisations in software in Louvain (Belgium), in IT and Biotech in Sofia Antipolis (France) and in Biotech in Heidelberg (Germany). A technology cluster requires a concentration of a higher centre of learning and/or a Government research establishment, a science park together with a reasonable quality of life environment, effective incubators and the availability of finance through angels, seed finance or venture capital. This concentration leads to a crystallisation of important networks (scientific, sub-contracting, social, technical, managerial and financial), all of which in turn help to create successful role models and a "can-do" culture.

  22.  Support should be given for the establishment of such technology clusters, and we should ease the planning restrictions for them to be located near universities.

23 February 1998