The evolution of Scotland’s risk capital market, with angel investors increasingly consolidating their portfolios and more instutional investment going into later-round deals, may be leading to the re-emergence of an equity-gap at the lower end of the investment value scale, according to a new report, The Risk Capital Market in Scotland 2005-07, published today (16 October) by Scottish Enterprise.

The research, which examines the equity investment market in Scotland, suggests that the classic ‘funding pipeline’ model of new venture funding, where angel investors make the first round investments and hand over to venture capitalists for subsequent and larger rounds, is gradually being eroded and replaced by increased segmentation, as more angel investors commit to a ‘cradle-to-exit’ model.

The report finds that while overall investment levels increased from £85m to £114m in 2006 and 2007, investment in new (start-up) companies in Scotland fell from 45 (worth £15 millon) in 2005 to ten (£2 million) in 2007. At the same time, the number of investments over £2 millon increased from eight (worth £32 million) in 2005 to 18 (£75 million) in 2007, suggesting a growing demand for expansion capital from Scottish companies.

According to the report author, Professor Richard Harrison, unless the structure of the early stage risk capital market in Scotland is addressed, the separation of the angel and venture capital markets could limit the opportunities for growth of high-growth Scottish start-ups.

He said: “Our investigation has thrown up evidence that angel investors are increasingly investing in follow-on rounds in their existing portfolio companies, rather than in wholly new deals. This reflects both the desire to maintain control of the investment to secure returns, and the absence, or perceived absence, of venture capital investors willing to provide follow-on finance in deals where they do not already have a seat at the table, and as a consequence of this, the flow of capital into investment-ready new ventures is reduced.

“This is further compounded by the fact that as deal sizes in re-investment rounds increase, the available capital for investment in new companies is reduced, so new start-up companies are facing an uphill-struggle for investment”.

Gerard Kelly, director of investment at Scottish Enterprise, added: “Risk capital plays a vital role in the development of companies and economies and we are working with the private sector to ensure that Scottish companies can access the capital needed to help them become global businesses.

“To do this, we need to be aware of changes in the market and this report is a key tool for gathering intelligence. The findings give us a view on the suitability of our existing funding mechanisms and where, if appropriate, we need to develop new funds as market gaps emerge.

“Scottish Enterprise has seen a substantial increase in demand for investment funds in the first six months of 2008, so the risk capital market seems to be holding up well, in spite of, or possibly because of, the current economic gloom.”

Other key findings from the report include:

• Total early-stage risk capital investment in Scotland was £114 million in 2007

• The east and west of Scotland dominate equity deals, receiving £60 million and £39 million respectively in 2007

• Around one third of investment activity is in university spin-outs, dominated by Edinburgh, Glasgow and Strathclyde Universities. In 2007, this sector represented 32 deals, forming 29 per cent of total risk capital investment, worth £30 million

• Investment in electronic markets continues to dominate other industry sectors

• The majority of investments from outside Scotland come from investors in London and South East England.