Getting ideas out of the garage

1 Dec 2004

The venture capital industry has had a rough ride these past couple of years but all the signs are that investors are coming out of their shells and looking for good investment opportunities once again. The Irish Venture Capital Association (IVCA) recently estimated that upwards of €200m of VC money was up for grabs and that 90pc of this was likely to be invested in the technology sector.

Yet, despite this bounty, one of the keenest debates currently taking place within the tech industry is whether or not funding actually exists for start-ups and early-stage companies. While VCs vociferously argue that such funding does exist and has done for several years, others, including Cathal Friel, chairman of the Irish Software Association (ISA), argue that the lack of start-up funding has been a serious impediment to the growth of the indigenous technology sector.

At the recent ISA Awards, Friel drew a telling comparison between the Irish technology industry, which employs 20,000, and its counterpart in Israel, which supports 150,000 jobs. Friel argued that the main – though not the only – reason for Israel’s success was that “a wall of money” – US$10bn worth – had been invested in start-ups there in the past few years compared with approximately €1.25bn in Ireland. His theory was that because money had been a lot easier for start-ups to come by, a lot more of them had managed to get off the ground.

The venture capitalists themselves acknowledge that the pipeline of start-ups in Ireland is not nearly full enough. At the IVCA annual dinner in October, chairman Shay Garvey warned that if the indigenous technology sector was to be a real engine for growth in the economy then the number of start-ups needed to increase from the current 200 a year to 500.

Garvey did not offer an explanation for the low start-up rate or relate it directly to the funding environment but he did say that the VC industry needed to improve its support to young tech firms in a number of ways and one of these was by increasing the amount of capital under management.

Overall, however, the VCs would argue that they do funnel a lot of money into seed and early-stage companies. Conor O’Connor, CEO of Enterprise Equity, a Dundalk and Galway-based VC firm that specialises in smaller deals, is adamant that the money is there – but only for the right projects. “Some entrepreneurs feel there are not adequate funds but from the venture side I’d feel there is,” he says, adding: “The good projects get funding. If there was a substantial body of people out there who had successfully progressed without VC funding, then maybe you’d have to ask a question, but I can’t see one.”

There is good evidence to support his claim of availability of funding for start-ups. The Enterprise Ireland Seed and Venture Capital Report 2003 noted that of the €32.7m invested by venture capital funds in 2003, start-ups attracted €12.8m and early-stage companies €12.4 (77pc of the total investment). These are just the investments made by ‘Partnership Funds’ ie, joint ventures between Enterprise Ireland (EI) and private VC funds.

EI also invests an average of €18-€20m per annum directly in companies through grants or equity funding via its High Potential Start-up Company scheme. Denis Murnane, manager of VC and Equity, EI, estimates that between 20 and 25pc of this funding is of the ‘milestone’ type where the venture is at such an early stage that venture capitalists judge it too risky to get involved so EI seeks other investment partners.

Murnane concedes, however, that it is a lot harder to raise money now than a few years ago. This is primarily because VCs were badly stung by the technology downturn and they now think long and hard before investment in technology firms. This is compounded by a second problem. “VCs have not had any decent exits over the past while. There’s roughly €1.25bn tied up in companies that they can’t get out. If you can’t get money out, you can’t recycle it,” he notes.

While money might be tied up, Murnane does not accept there are hundreds of worthy start-ups out there being starved of funds. He reasons that the State could throw many more millions at start-ups but to what end? “A lot of money has gone into early-stage stuff but it hasn’t delivered anything. There’s a balance to be struck.”

O’Connor sees things slightly differently, however. He believes that while the VC industry does fund early stage and seed stages well, there is a funding gap at the pre-seed stage. “Where I’d say we differ from other economies is that it is difficult to get money for ‘garage’ projects, ie, the guys who’re at the very, very early stage, before there’s even a project that institutions could back. That [market] will only develop when there’s a sufficient number of success stories.”

So, without funding, few garage projects will succeed but without substantial numbers of successes around to entice investors, that funding will never materialise. Could this be the vicious Catch 22 that’s choking off the flow of hot technology start-ups?

“I think there has to be a good supply of funding; supply does drive demand and greater supply will encourage more entrepreneurs,” agrees O’Connor.

With VCs unwilling to back these ‘garage’ entrepreneurs, it will fall to that once-plentiful class of punter – the angel investor – to kick-start this segment. These have been as scarce as hens’ teeth since the dot-com crash but with the European Commission recently giving the green light to the Government to restart the Business Expansion Scheme and Seed Capital Scheme, following a period of investigation, the angels could be about to return in numbers.

The ISA certainly hopes so and as an a further incentive, in a pre-Budget plea last month, Friel called on Finance Minister Brian Cowen TD to increase the limits of the BES and SCS to €5m during the lifetime of any applicant company, up from the current €5m, and for the individual limit to be raised to €300k per investor.

Said Friel: “If the Irish software sector is to maintain and develop its role as one of the most successful global players, more needs to be done to encourage individuals to invest directly or indirectly in smaller, higher-risk companies by offering income tax relief to such investors.”

As another proposed measure, Friel also recently called on the Government to give tax breaks to property investors to encourage them to divert some of their property profits into VC trusts, under the management of VC professionals.

The ISA is convinced that, were its recommendations implemented, it will provide the “wall of money” that the domestic technology industry solely needs to crank up a gear or three.

By Brian Skelly

Pictured is Hewlet-Packard’s humble origin: the shed from which the global company originally sprang as, quite literally, a garage industry.