Belinda Thomas of Triple Point examines the evolving venture capital landscape and the opportunities for investors.
Venture Capital Trusts (VCT) are a highly attractive investment option, boasting significant tax-efficient returns for investors.
Last year, VCTs raised £728 million, the highest amount for more than 10 years, according to the Association for Investment Companies (AIC). However, changes in last year’s Budget and the Patient Capital Review has focused investments towards early-stage companies, which offer higher potential returns, although also typically carry a greater degree of risk.
In response, the venture capital industry is evolving its approach. A number of different models are emerging, one of which is the challenge-led approach.
The basic premise of the challenge-led approach is to start by identifying the problems facing more established corporates, and then target the organisations with innovative new products and services that can provide a solution.
This approach enhances the potential for success in early-stage investment, through ensuring market validation at the point of investment. It also mitigates some of the risks to investors of investing in this asset class.
Investors will be aware that the VCT landscape has changed significantly in recent years. In the 2015 Finance Bill, the government brought UK VCT investment rules in line with European Union state-aid regulations, by confining the rules overseeing which companies were eligible for VCT investment.
The significant tightening of the rules meant that VCT capital was directed to early-stage companies. These are companies seeking funds for new growth, rather than established organisations looking to use VCT investment to fund management buyouts and acquisitions.
Further reinforcing the emphasis on younger growth companies, the changes ensured that investment eligibility was only for firms in commercial operation for seven years or less, or 10 years for “knowledge-intensive” companies.
Additionally, in response to the Patient Capital Review, the government introduced a new principles-based test, preventing tax-efficient schemes, such as VCTs, from investing in asset-backed companies, instead encouraging greater investment into businesses seeking growth capital.
The 2017 bill also doubled the maximum annual amount that can be invested in knowledge-intensive companies - those that spend a certain proportion of their operating costs on research and development or innovation, and spend at least 15% of operating costs on R&D or innovation in one of the three years. The number was doubled, from £5 million to £10 million.
Adopting new approaches
As a result of the new changes, VCT managers have adjusted their investment criteria towards young, fast-growing businesses. Traditional venture capital investing has been based around researching a broad cohort of early-stage companies and identifying which is most likely to be successful.
For investors willing to take the risks, portfolio returns can be high, but the prospect of failure is also greater. More than 35% of start-ups fail within three years of being established.
This investment model has remained largely unchanged and unchallenged, with little emphasis to mitigate the risks associated with early-stage investments.
However, new thinking is beginning to enter the VCT arena. The industry is pioneering a new “challenge-led approach” – a way to continue to provide impressive returns for investors, while at the same time providing greater support for those start–ups that have a genuine chance of success. This enhances the possibility for start-ups to succeed and for investors to benefit.
A challenge-led approach focuses on larger corporations that may have already identified a business challenge, but which lack the in-house expertise to solve it.
Rather than simply looking to innovative start-ups that may have potential, VCTs deploying the challenge-led approach seek start-ups that can provide the solution for larger corporations’ known business challenges.
This means that a market fit has already been established, as has a clear need for the product or service that the business offers.
What’s more, by solving the problems of larger corporates, the start-up provides a sustainable business model, compatible with investors’ long-term goals.
For start-up businesses, this offers stable funding and a real prospect of future success through working with a significantly larger corporate partner. For investors, this new challenge-led approach to investment helps mitigate much of the risk associated involved with investing in early-stage businesses and start-ups.
A challenge-led approach
At Triple Point, we are already championing the challenge-led VCT philosophy, having recently launched our Venture Fund. Drawing on the specialist skills and experience of all its members, the Triple Point Network has developed a strategy that helps early-stage businesses increase their chances of success.
With close ties to more than 100 large corporates, the fund focuses on the issue facing these large businesses, and then invests in the innovative young company with the solution.
By focusing on early-stage businesses, which have established a market fit for their products and services with large corporates, the fund addresses one of the most significant risks of early-stage venture capital, and can enhance investors’ chances of securing a robust return on their investments.
Belinda Thomas is a partner and head of investor relations at Triple Point.