VCM8158 - Venture Capital Schemes: companies receiving risk finance investments: new product market or new geographic market

The money raised under the 50% test must be used for entering a new product market or new geographic market.

A product market is all those products and / or services which are regarded as interchangeable or substitutable by the customer, by reason of the products’ characteristics, their prices and their intended use. It is not the same as a new product, and relates more to the customer base.

A geographic market is the area in which the company is involved in the supply and demand of products or services, in which the conditions of competition are sufficiently similar and which can be distinguished from neighbouring areas because the conditions of competition are appreciably different in those areas. Entering a new geographic area is not on its own the same as entering a new geographic market.

Whether a company is entering a new product market or geographic market will depend on the precise circumstances of the company: what it has done in the past and what it is intending to do. The company will need to explain in detail what it has been doing (and where), what it will be doing (and where) and why the new activity means it is entering a new product market or geographic market.

The venture capital schemes are intended to address the market failure caused by the difficulties that smaller, unproven companies face in trying to access finance, particularly the lack of financial and performance information available to potential investors. The schemes target the market failure where investors are unwilling to invest owing to the relatively high cost of due diligence.

The key issue for Condition B is when a company is entering a new growth phase, and whether its previous track record can be used to assess the potential of its new activity for investment purposes. Condition B is for use in situations where a company is entering a new product market or a new geographic market, which is analogous to the setting up of a completely new business, with no relevant track record that can be used by investors. It is not intended for instances where the company is growing in small incremental steps.

The scale at which the new market is defined will also vary depending on the specific circumstances of the company. For example, a Manchester-based business which only sells products to passing trade will not meet the ‘new geographic market’ test just by setting up a second branch in Leeds unless it can be demonstrated that the conditions of competition for its products differ between the two cities. Similarly, a company which currently serves a UK market which is seeking to expand into both Germany and France may be considered to be expanding into one new European market or two new separate markets or none, depending on the conditions of competition that relate to its particular activities.

Factors to be taken into consideration include the nature of the competition within the new geographical area or areas compared with the competition within the company’s existing geographical areas.

The investment must be made before the company embarks on the new business activities. The test is the extent to which the company has already started activities for the purposes of entering a new product market or geographic market or not. This is different from the approach taken to determine a company’s initial investing period which relies on the date a company has made its first commercial sale. A first commercial sale may take place after a test sale.

For example, test sales may be for proof of concept only or for seeking feedback rather than generating revenue. They may be at prices that are at or lower than cost, or in very specific areas in order to test the response from a particular type of customer. An equivalent for an app might be a private beta test.

By contrast, if a company has already taken definite steps to enter a new product market or geographical market, for example by setting up processes and delivery chains to allow it to deliver products at scale, the company will have taken sufficient steps for commercial lenders to evaluate whether the activity would be viable, bearing in mind the company’s previous business track record.

Ultimately it will be a matter of fact as to whether a company’s previous activities in a new market are materially significant. Factors to consider may include:

• the amount of activity already carried out by the company in the new market: the more activity carried out, the less likely the company is to be preparing to enter a new market
• the length of time those activities have been carried out for: the longer the company has been investigating the market, the less likely the market is to be new to the company
• the amount of money already expended in the new market as a proportion of the amount of the investment sought: the more money and resource expended before the relevant investment is received, compared with the amount of the proposed investment the less likely the market is to be new.

The factors above are for illustrative purposes only. Other factors may also come into play depending on the exact circumstances of the company, its history and its past and future activities.

Example 33

A company making bespoke shoes for its customers in the UK, selling for more than £5,000 a pair, wants to expand its activities and enter the US market by offering a range of ready-made shoes. The shoes would still be high quality but would retail for less than £500 a pair and, unlike the existing bespoke products which are sold direct to the end user, would be sold wholesale. The company wants to test the appetite of US retailers and commissions another company in Europe with the appropriate machinery to produce a limited run of 500 pairs of a single style of shoes.

The company visits a number of high end shoe retailers in the US with the product. The retailers take the shoes on a sale or return basis and report their findings to the company. On the basis of the sales achieved the company decides to enter the US market. It buys new equipment and takes on staff to make the shoes itself, and advertises its new product line to stockists in the US.

The sales of the 500 pairs of shoes were test sales designed to understand if there would be a viable market for the shoes. The company is entering both a new product market and a new geographic market at the point when it decides to manufacture the shoes and advertises its product.

Example 34

A company that started trading in 1990 to supply unbranded parts for a large car manufacturer wants to start making and marketing bespoke, branded, parts directly to enthusiasts restoring vintage cars.

Is there a new product market?

• if the company’s business has always been to supply the large car manufacturer, the vintage car restoration market may well be a new product market because the vintage car enthusiasts would never have heard of the company let alone consider it could provide parts for their cars.
• however if the company has been operating from premises and supplying bespoke parts for a range of customers, it is likely that the company is already known among the customer base as a source of bespoke parts. In that case there may not be a new product market.
• if the company were to sell the parts through the large car manufacturer for onward sale to the vintage car enthusiasts there would not be a new product market.

Is there a new geographic market?

• what are the company’s current and proposed geographic markets? If the company has been operating in a geographic area, perhaps with its sole customer being a nearby car manufacturer, and if the vintage car enthusiasts are spread across the country, it is possible that the company may now be entering a new geographic market.
• however if the company was supplying several manufacturers across the country (and has always been open to take on new orders) it would be less likely to be entering a new geographic market with its vintage car enthusiasts.
• companies that are already providing goods and services through internet sales are less likely to be entering a new geographic market.

Example 35

A company imports and sells Australian wine to retailers in the UK It also has a website through which it sells its products online. The company’s website specifies that it delivers only to customers in the UK. The company decides to expand its business to France. It amends its website and starts advertising the extended service, including new terms and conditions for delivery as well as hiring staff to deal specifically with this new activity. The conditions of competition for the sale of Australian wine are suitably distinct between the UK and France, and the company is entering a new geographic market.

Example 36

A company has been trading since 2000. It develops and manufactures specialist medical products which it sells to hospitals across the UK and Europe. The company has realised that it can use one of its products for monitoring air pollution but it needs extra investment to fund the development of the product. It will also need money to market the new product.

The company will be entering a new product market. It has been operating exclusively in the specialist medical industry and is proposing to enter a completely different industry. The air pollution industry would never have considered the company as a potential supplier.

Example 37

A company started trading as a teashop in 2005. The company operated from a single site in Devon and sold its own speciality Devonshire cakes and products to its customers. Over time the company’s products started to win a reputation and the company started to sell its products packaged for take away to customers who called into the teashop.

The company now wants to market its products to a wider customer base. To do that it will need to set up a new large scale manufacturing and distribution process, including marketing, packing and customer service staff, on new premises.

The company is not intending to increase its range of products and so the only question is whether it is entering a new geographic market.

The company has been operating solely from its Devon teashop premises. If the company is looking to market its products across a wider area, centred on the teashop, for example by supplying local shops and restaurants, it is unlikely to be entering a new geographic area because it is carrying out a natural expansion of its business. Extending the customer base to neighbouring towns is an incremental development that any developing company would consider especially if it has established products with good customer recognition of its brand.

However if the company is looking to, say, set up an internet site to supply customers across the UK, it may well be entering a new geographic market. The company would need money to pay for website development as well as the marketing, packing and customer services staff.

If the company is entering a new geographic market it must spend all the money raised on the new activities intended to enter the new geographic market. In this example this could include the costs of setting up production facilities specifically to cater for the new geographic market as such facilities would be completely new to the business and not simply an extension of the existing capabilities.

The company cannot, for example, use the money to develop new products for the teashop or engage new staff to promote the teashop or any other part of the existing business. If money is needed to develop the existing business this cannot be provided through the EIS or by VCTs and must instead be provided through the market.

If the company uses the money to develop the new premises and equipment but does not enter the new geographic market or pulls out of it early, the relevant investments will no longer be qualifying investments for the EIS or qualifying holdings for VCTs.