Is State money best way to fund start-ups?

Last week Lightstone Ventures, a US life sciences venture capital fund, became the latest participant in the government's Innovation Fund Ireland initiative, pledging $172 million to invest in early-stage medical device and pharmaceutical companies – some of which will go to Irish based companies.

The fund will also open an Irish office in return for a €30 million investment from the National Pension Reserve Fund (NPRF) and Enterprise Ireland.

But is government support for venture capital funds the most appropriate way of funding start-ups – or does government money, as The Economist last week suggested, spur conservatism, encourage companies to sell early, dampen returns and prevent an influx of US-style private investors? And where does Ireland fit into this?

It's clear that Europe depends ever more on government – or European Investment Fund (EIF) – money to drive start-ups. Back in 2007, just 14 per cent of European VC came from government, with banks and private individuals taking an almost 20 per cent share each. Fast forward to 2013, however, and governments have grown their share to 38 per cent, at the same time as banks' contributions have plummeted.

But Europe is not a homogenous region, with differing tax, labour laws and views on VC right across it.

Indeed, in Ireland the reverse is true. Back in the mid-1990s, government would typically fund up to 50 per cent (the limit) of a VC deal. Now, out of the total under management in Irish seed capital funds of €697 million, about a quarter (€175 million) comes from government.

Interconnections Garret Murray, senior policy and investment adviser with Enterprise Ireland, is keen to stress the commercial element of government-supported VC, pointing out that the investment decisions of the 12 Irish seed capital funds are made "purely under a commercial mandate".

Harvard professor Josh Lerner sees government involvement in stimulating entrepreneurial and venture activity as having two roles: 1) ensuring that the economic environment is conducive to entrepreneurial activity; and 2) directly investing in companies.

However, on the latter point, he does advise the following: letting the market provide direction; encouraging interconnections with entrepreneurs and investors overseas; and minimising the danger of individuals and organisations taking steps that benefit themselves, rather than the broader social good.

So does the Irish approach meet these goals?

Key to the Irish government's approach is to invest on a pari-passu – or on the same footing – basis as private investors, says Murray, so that the State achieves an economic and employment advantages of investment while also equally sharing the risks and rewards of investment with the private sector.

Entrepreneurial Pari-passu mitigates many of the risks of state investment in VC, which may lead to a situation whereby the entrepreneurial environment is being directed, rather than being allowed to act as a free flowing economic phenomenon.

"When you move away from the pari-passu situation, you get into a situation where you're controlling the environment to a greater extent," says Murray.

For Will Prendergast, a partner with Frontline Ventures, "where the State has a very large percentage of the fund it may become an issue".

It received a €9 million investment from Enterprise Ireland last year, but this hasn’t deterred private investors.

“The level of public participation [in its fund] is not at a level that creates an issue for us,” he says, adding that investors tend to look at the substance of strings attached, and whether or not there are stipulations on how to allocate money within the fund.

But is there still an inherent conservatism in investment decisions made by government-invested funds to encourage companies to sell early and potentially miss out on the big payout that might come from taking a bigger risk and staying invested for the long-term?

Interests aligned "Absolutely not," Murray says, noting that an EI client, Mainstay Medical, recently floated on the French and Dublin stock exchanges in a $90 million deal.

Jason Lettman, a partner with Lightstone Ventures, and soon to be head of the fund's Dublin office, agrees that the interests of governments – and those or private investors – can be aligned.

“When we were considering our options to expand outside of the US, we considered a number of different options and many of those had a government component to them.

“Our goal is ultimately to deliver returns to our investors, and I wouldn’t say our goals are any more long-term or short-term than governments,” he says, adding that one of the fund’s reasons for linking up with the NPRF and EI was “because of their long-term goals and strategies. It’s a good match for what we’re trying to do”.

But it's hard to avoid another of The Economist's arguments, that government money comes with strings attached. In the aforementioned Lightstone fund, for example, the VC manager will seek three to four Irish-based investments (out of between 15-17) as part of its deal with Irish government agencies.

“Yes, you have to ensure that a large percentage of money is invested into the Irish economy,” says Murray, adding that “a minimum of double our money” invested in seed capital funds goes back into the Irish economy.

But does this approach have a material effect on return, as government-led funds turn down investments which may end up being more profitable, to support investments that match the government’s criteria?

Murray argues that this doesn’t necessarily result in lower returns and that government VC doesn’t support companies that otherwise should have been allowed to fail.

“The priority is making returns so that the private investors are satisfied. That makes it more complex because private VC won’t invest in a company where they’re not going to make super-normal returns. We make sure we’re private sector- led because they’re the ones that know where the money should go”.

Expectation "As long as people are focused on the commercial returns, everyone works well together," agrees Prendergast.

But government-heavy VC funds have performed poorer than their US counterparts: since 1990 European VC funds have returned just 2.1 per cent a year, according to Thomson Reuters.

In the US, returns have been of the order of about 13 per cent.

There are not yet any comparable Irish figures, but, with both the 2007 and 2012 seed capital funds having 10 years to run, the expectation is that Ireland will outperform its European peers.

“I would be very surprised if when those funds mature they do not far exceed that figure,” says Murray.

Survive But whatever your view on government-led VC investment, it's hard to escape the necessity of government money to stimulate and support start-up activity in the current environment.

“Fund-raising for healthcare has been difficult and early-stage healthcare has been even more difficult,” says Lettman. Lightstone itself had aimed to raise $250 million for its fund, but only reached $172 million.

Indeed, in a tough fundraising environment, government money can help ventures survive.

“Without that [government] money companies couldn’t grow,” says Murray.