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Growth and jobs: Commission provides more means to finance innovative SMEs

European Commission - MEMO/06/259   30/06/2006

Other available languages: none

MEMO/06/259

Brussels, 30 June 2006

Growth and jobs: Commission provides more means to finance innovative SMEs

Over the last decades, the EU economy saw radical changes and world-wide competition increased. Faced with the fundamental industrial conversion process and the emergence of new science-based industries, traditional bank financing has reached the limits of its capacity. A Eurobarometer poll published in 2005 showed that many SMEs find it more difficult than previously to obtain a bank loan. Improving SMEs’ access to finance is one of the key factors for business expansion, job creation and economic growth. This memo explains what the Commission is doing to promote the financial markets using its financial instruments covering in particular venture capital and guarantee schemes. Examples are underlining that the Commission’s financial instruments have proved to be successful. Both the Commission and the Member States already have programmes partnering with the private sector to invest in SMEs, but more needs to be done.

1. What is risk capital?

Risk capital (or venture capital) is different from a bank loan. It is an equity investment, and as such typically involves higher risk potentially rewarded by higher returns. It is crucial to allow the up-take for potentially high growth companies, and is particularly important for a company during its early growth stages (start-up and development). It covers three sorts of financing: informal investments by private individuals (business angels: see below); venture capital; and stock markets specialised in SMEs and high growth companies. Together these make up the risk capital market.

Why is risk capital important?

Equity financing is essential at the early and expansion stages of innovative SMEs, when the income stream of the company may be low or inexistent. Traditional bank lending could be unsuitable in such conditions where the company is not yet ready to assume interest payments. Moreover, the repayment of principal and interest payments on a bank loan limits cash flow flexibility at crucial times. Innovative growth-oriented firms often require large amounts of financing to invest in R&D, marketing and training.

In addition, the information asymmetries between the entrepreneur and the bank are particularly pronounced in the case of innovative firms. The bank may be missing the skills needed to evaluate the technology of a start-up. A survey carried out by EVCA on SMEs that have received venture capital funding concluded that:

  • Some 95% of companies stated that without venture capital investment, they could not have existed or would have developed more slowly;
  • Almost 60% said, that without VC the company would not exist today;
  • For start-ups with high growth potential, the VC provision is more appropriate than debt financing;
  • During several years, these start-ups would not be able to pay back a traditional bank loan: patient capital is needed, and
  • An average of 46 additional jobs were created by each company following the venture capital investment.

The risk capital markets in Europe: still too small

  • In Europe, SMEs tend to have a low share of own equity in their balance sheets:
  • In 2004, VC investments were € 10.8 bn in the EU versus € 16.5 bn in the US (EVCA; NVCA);
  • The VC markets are picking up in the development stage of a company (ICT, biotech and eco-innovation) but not in the early stages;
  • Early stage deals in technology average € 0.9 m in Europe versus € 6.1 m in the US, and
  • Returns for early stage investments are much lower in the EU than in the US:

5 year return in 2003
10 year return in 2003
Europe
US
Europe
US
2.3%
22.8%
8.3%
25.4%

Source: EVCA report 2004

What are the current obstacles in the European risk capital markets?

The full integration of the European financial markets still needs to be completed. Barriers can be found at the supply and the demand sides.

At the supply side:

  • lack of early-stage private investors: European venture capital funds are on average small and many of them are regionally focused;
  • the fragmentation of the markets in Europe: To achieve an operating scale and liquidity for a sustainable industry requires operating across borders. Current barriers for cross border investments need to be removed. These include permanent establishment of funds in the countries they operate in or double taxation,
  • lack of entrepreneurial spirit and problems of technology transfer.

At the demand side:

  • lack of investment readiness of entrepreneurs (i.e. to be able to evaluate the available funding options and to understand the concerns and the needs of investors).

2. What does the European Commission do for risk capital?

The Commission seeks to enhance the functioning of a single European financial market. The Financial instruments were developed in the framework of the MAP programme for the period 2001-2006 with a budget of € 500 million. Under the Competitiveness and Innovation Programme (CIP), the budget has increased to € 1.1 billion for the period 2007-2013 (see IP/06/716)

The financial instruments cover SMEs’ different needs according to the stage in their life-cycle:

  1. High Growth and Innovative SME Facility (GIF) provides equity to venture capital funds for seed and early-stage investments in SMEs to reduce the gap in early-stage investment by investing in venture capital funds.
  2. Debt and hybrid instruments: SME Guarantee Facility provides co-and counter-guarantees to guarantee schemes. These schemes stimulate the supply of loans to SMEs by credit institutions. It also provides direct guarantees to these institutions under four guarantee windows: loans, microloans, quasi-equity and equity and SME securitisation (more info, see below)
  3. Capacity building: The Seed Capital Action supports the recruitment of specialised staff by seed capital funds and the Partnership Action will support bank lending, notably in new Member States.

COMMISSION

BEFORE
Period: 2000-2006

MAP

Budget: € 400 million

AFTER
Period: 2007-2013

CIP

Budget: € +/-1 billion

ETF-Start-ups
(€ 170 m)
  • VC early-stage investments

High Growth and Innovative SME Facility (€ +/- 500 m)
  • VC funds:
  • Early stages
  • Expansion stages for innovative companies
  • Co-investments in side-funds with business angels

CIP and EIB risk capital mandate for the
period 2007-2013 (est.):
10% of the European
VC market (base: 2005 early-stage investments EVCA Annual Report).

SME Guarantee Facility (€ 340 m)

SME Guarantee Facility (€ +/-500 m)

Capacity Building
(€ 60 m)

Capacity Building
(€ +/- 100 m)

High Growth and Innovative SME Facility (GIF) – How does it work?

The objective of the GIF is to increase the availability of risk capital to innovative SMEs during their creation and their early stage development.

The EIF invests in specialised venture capital (VC) funds established specifically to provide equity or other forms of risk capital to SMEs. The funds considered under this Facility are small or newly established ones, including funds operating at regional level, those focusing on specific industries or technologies and funds that finance the exploitation of R&D results.

Investments are made on equal terms with other equity investors. The GIF Investment Guidelines specify that investments must represent between 10% and 25% of the total capital of a VC fund or business incubator, or 50% in exceptional cases such as new funds which are likely to have a particularly strong catalytic role in the development of VC markets for a specific technology or in a specific region. Investments can be made up to a maximum amount of EUR 10 million. In exceptional, duly substantiated cases the amount committed may be higher, but will not in any case exceed EUR 15 million.

Following the approval of a VC fund proposal by the Commission, the EIF signs contractual agreements. Thereafter EIF disburses the amounts committed to the VC funds in accordance with their investment opportunities and corresponding financing needs.

According to figures of EVCA (European Private Equity and Venture Capital Market Association) European early-stage VC market stands at € 2 bn today. The expected tripling of the European early-stage VC market to € 6bn by 2013 is based on the following assumptions:

  • This is the level that the leading Member States (UK, Sweden, Denmark) have already achieved and even exceeded.
  • This is the level where the US is already in its early-stage investment.

SME Guarantee Facility - How does it work?

The Facility provides

  • support for higher volumes of guarantees for the existing guarantee products of the financial intermediaries (FIs),
  • access to financing for a larger number of small companies for a wider variety of investments and guarantees for riskier loans and
  • supports the creation and development of new guarantee schemes.

The Facility covers part of the losses incurred under the guarantees up to a pre-determined amount (the “cap”). It is managed by the European Investment Fund and other International Financial Institutions on behalf of the EU. The EIF evaluates and selects potential FIs.

The SME Guarantee Facility applies to companies with up to 100 employees. The FIs may have stricter SME eligibility criteria depending on their specific guarantee or loan products. In any case, the origination and risk assessment, with regard to the final SME beneficiaries, is the full responsibility of the selected financial intermediaries.

New sub-windows to the Facility (to expand the range of available guarantee instruments):

Loan guarantees: support enterprises with growth potential and up to 100 employees. Under this window, the EIF issues partial guarantees to cover portfolios of loans or guarantees.

Micro-credit guarantees: support micro-loans for very small enterprises with up to 10 employees. Under this window, the EIF issues partial guarantees to cover portfolios of micro loans.

Equity Guarantees: counter- or co-guarantees to guarantee schemes to cover equity investments in SMEs with fewer than 250 employees (no direct guarantees to VC funds).

SME securitisation: securitisation of SME debt finance portfolios, shall mobilise additional debt financing for SMEs under appropriate risk-sharing arrangements with the targeted institutions. Support for those transactions shall be conditional upon an undertaking by the originating institutions to grant a significant part of the resulting liquidity of the mobilised capital for new SME lending in a reasonable period of time

One Euro invested by the Commission becomes a total of 75 Euro invested: Leverage effect

Guarantee schemes in general have a very high leverage effect. Loan guarantees have high leverage as they are often provided in the form of counter-guarantees to institutions that in turn provide guarantees to other actors such as intermediaries and banks. Due to the risk-sharing between these various actors, the leverage is very high:

SME Guarantee Facility – Leverage (gearing)

Table Leverage effect (gearing) achieved at 31.12.2005 with the Community funds in terms of

estimated volume of loans,


Allocated budget (signed)
Estimated underlying loan volume supported
Maximum EIF Guarantee Amount
Leverage effect

EUR million
EUR million
EUR million

Loan guarantee window
173.8
12,352.5
3,624.1
75
Micro-credit window
32.1
259.1
177.6
8.1
Equity guarantee window
17.3
306.3
89.4
17.7
Total
223.2
12,917.9
3,891.1
60.34



MAP: Leverage effect:
  • SMEG: 340*70= +/- 24 bn
  • VC fund: 170*5= 0.85 bn
  • Total = +/- 25 bn

Nb of SME beneficiaries: 250,000

CIP: Leverage effect:
  • SMEG: 500*60= +/- 30 bn
  • VC fund: 500*5= 2.5 bn
  • Total = +/- 32.5 bn (rounded to € 30 bn)

Nb of SME beneficiaries: 400,000

It is expected that, some 400,000 small and medium-sized enterprises (SMEs) will receive EU support to invest in all forms of innovation and growth between 2007 and 2013.
[Graphic in PDF & Word format]

3. Success stories based on funding of the Commission’s financial instruments

The internet communications company Skype Technologies SA, a peer-to-peer phone services provider using voice-over-Internet Protocol (VoIP), was included in the 100 best-performing and innovative high-tech private companies of Europe and Israel listed by Tornado 100 in January 2005.). Skype was a early beneficiary of the European Commission's ETF Start-up facility investment. The European Investment Fund placed ETF Start-up funds with New Tech Venture Fund of Mangrove Capital Partners (Luxembourg), which in turn became an investor in Skype. Skype was acquired by eBay on October 14, 2005. www.skype.com

WaveLight Laser Technologie AG, a German firm making lasers for treatment of skin and eye complaints, has seen annual revenues grow more than ten times in the past five years, with turnover in 2003-04 reaching €62 million. It found finance from two funds to which the EU had contributed. www.wavelight-laser.com

Fimasys, a French financial-services software provider, also received support from EU funds. With annual revenues growing by more than 50% per year over the past three years, it is listed by the Deloitte Technology Fast 500 ranking of high-growth European SMEs. www.fimasys.com

Created in 1992 and quoted on Euronext Paris, Business & Decision is a European consulting company specialised in business intelligence, Customer Relationship Management and e-business. As of December 2004, it has achieved a turnover of € 64.4 million and a net profit of € 1.8 million. www.businessdecision.com

The Orbita Max - MacGillivray Freeman Films Giant screen co-production "Mystery of the Nile", which won Best Cinematography and Best Soundtrack Awards at the 2005 Giant Screen Theatre Association Achievement Awards in Boston, has achieved box-office takings of more €13 million since its opening in February. This makes it the highest grossing giant screen film released in 2005. The Catalan production company, Orbita Max, founded in 2000 by award-winning Spanish journalist and filmmaker Jordi Llompart, was supported by investment from the Venture Capital Fund Barcelona Emprèn. Barcelona Emprèn was co-financed to the tune of € 226,000 by the Commission through its CREA pilot action.

Peter S. is a young Austrian carpenter. He dreamt of starting his own business and of taking over his employer’s firm. Mr. Alexander W., willing to retire, had no relatives interested in his company. Peter S. had put aside € 40,000. The purchase price was of € 200,000. He therefore addressed AWS. With a 80%-guarantee by AWS, his bank agreed a loan of € 160,000 and made the purchase of the firm possible. Within 5 years, the company grew significantly, increasing the number of employees from 8 to 12. The Commission underpinned this success through its SME Guarantee Facility.

Founded in 2003, Softimus, a Lithuanian furniture design and production company, experienced very fast growth, thanks to their good understanding of the market and their accurate response. Today, the firm is present in Lithuania, Latvia, Poland and the United Kingdom. However, the start-up faced cash flow problems arising from its fast growth. Without INVEGA's 50% guarantee, the company would not been granted working capital finance from a commercial bank. Now, the company continues to expand and has created 12 new jobs. The Commission contributed to this support through its SME Guarantee Facility.

4. Glossary

Business angels

Wealthy private individuals who invest directly in new and growing unquoted businesses. Business angels usually provide finance in return for an equity stake in the business, but may also provide other long-term finance. This capital can complement the venture capital* industry by providing finance at an earlier stage than most venture capital firms want to invest.

Early-stage (capital)

Financing to companies before they initiate commercial manufacturing and sales, before they be generating a profit. Includes seed* and start-up* financing.

Equity

The ordinary share capital of a company.

Expansion capital

Financing provided for the growth of a firm. Capital may be used to finance increased production capacity, market or product development, or to provide working capital.

Microcredit

Small loans, usually smaller than €25 000, granted most often by specialised institutions.

Quasi-equity (or mezzanine finance)

Financing that combines the features of debt and equity. The term covers a variety of instruments tailored to a specific legislative and operating environment. Quasi-equity finance can be unsecured or can have a subordinated claim to security.

Seed capital

Financing provided to study, assess and develop an initial concept. The phase preceding the start-up phase.

UCITS

Acronym used in European legislation, refers to “undertakings for collective investment in transferable securities” (investment funds).


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