Venture Capital Financing
Prepared for Corporate Financial Strategy (LASKS031), By Brian Wick
UNIVERSITY OF TAMPERE, School of Business Administration, Accounting and Finance
Venture Capital is a form of external financing commonly used in small and medium sized businesses. It can be used to fill the so called “equity gap.” This is usually used in the case when other, more traditional methods of financing are not available or are restrictively expensive to the owners of the company, such as bank loans, bond issues or sale of equity shares. By expensive, I mean that interest rates or arrangement costs and loss-insurance may be restrictively high, or in the case of equity, expanding the number of shares would dilute the share value to existing shareholders. However, venture capital is equity in a company and not a liability.
More Demand than Money Available
VC firms have been established as entities, specifically concerned with accepting investment funds form private investors and institutions, and then finding homes for that money. “A typical venture capital firm receives up to 1000 proposals each year, while it invests in only a dozen or so companies.” (Sahlman 1990) Stringent analysis is conducted on each funding proposal in order to make choices about where the VC funds should be channelled to. Because of the high degree of risk of lose to the investor, it is difficult for VC firms to attract as much money as they might otherwise be able to invest and monitor.
Angels vs. Venture Capital Firms
“It is important to distinguish between angels and venture capital firms. Angels finance new technology-based firms and venture capital firms invest at a later stage in a companies life.” (Berlund, Tom, et al. 1996) Angels actually fund ideas from the ground up, not expecting any investment from the inventor. If it wasn’t for angels, most technological development never would have had the financing need to actually develop prototypes and initial production. Obviously this type of funding is even riskier than normal venture capital funding. At least with VC, the principle in the company have a certain level of personal investment and therefore likely to be more careful about how the investment funds are used and made productive. In the case of Angel financing, the principals (maybe inventors or marketers of the project) may have no personal investments involved. Active Involvement
Risk in VC funding is reduced slightly by the VC firms involvement in not just financing, but also decision making. “In order to control these moral hazard problems the venture capital firm is actively involved in the governance of the firm, usually by having active members on its board. Other commonly applied devices are the use of convertible securities and the staging of capital infusions.” (Gompers 1995) By being involved in the monitoring of daily activities of the firm, it is possible for the VC firm to reduce their risk through staging, or paying in money only when it is needed. This prevent the enterprises’ management from allocating funds to areas that may not meet the VC firms objective of high-return investment. This also give the VC firm the possibility to reallocate funds to other more lucrative projects that come along.
Who are the Angels?
With so many investment opportunities available in the world, just who are the angels and why do they take such risks? “Business angels are usually “well-educated, middle aged person with considerable business experience and a substantial net worth.” (Wetzel & Seymour, 1981) They are willing to take high risks because the investments they make do not put them personally at risk since the investment they make may be only a very small part of their personal investment portfolios. It might even be that the “gamble” of getting involved in a very high risk project is intriguing and exciting to them. When the investment pays off, the rewards can be excellent.
Angels provide an opportunity to entrepreneurs to reach out and try to produce and market ideas (usually high-technology developments) they otherwise may never get a chance. “If an entrepreneur has personal wealth to fall back on, traditional financial intermediaries such as banks can be used, if not then ‘angel’ financing is the only available option.” (Berlund, Tom, et al. 1996) Even with personal wealth, the entrepreneur may not with to take the risk involved in converting their idea to the marketplace. It may need the faith of an outside investor to actually get the project started.
Absolute vs. Relative Risk
When considering investing in a VC project, fund or mutual, it is important to understand just how much risk you are undertaking. “Absolute market risk estimates a potential total loss expressed in currency terms.” (More, Lisa 1995) There is the possibility that every dollar invested into the project will be lost in the sense that upon bankruptcy, foreclosure or liquidation of the target firm, there will be nothing left for the investor, since of course, the investment is considered to be capital and therefore it is not possible to secure it in any way.
“Relative market risk measures the potential for underperformance.” (More, Lisa 1995) In this case, although the target firm did not achieve its target or anticipated potential, the return on the investment may be considered to low, but not a total loss. This scenario may be even more true in the case of an individual’s investment into a mutual fund for VC investments or where a pool of investment money has been used to invest in many target firms. Here it is more probable that underperforming investments will be considered relative market risk with some return on investment.
Compounding risk? How do you pick a VC fund to invest in? Not only are you exposing yourself to the risk of individual target firms, but, if the venture capital fund itself is not well managed, then you are exposing yourself to two level of therefore compounded risk. “Investors in private venture capital funds place their money for long periods of time in the hands of venture capitalists of uncertain ability and who have committed only small amounts of their own funds. The venture capitalist seeks out promising ventures, eventually placing money in risky ventures managed by entrepreneurs whose skills are unknown and whose future efforts are not predictable.” (Barry, C. 1994) It may be prudent therefore to make an analysis of the VC fund you may be interested in getting involved in. Since there are many such funds available on the marketplace, it should be possible to do considerable research to look at historical performance, current investments, type of target funds involved, and information flow or reporting of the venture capital fund firm. All of these may be necessary to really understand where your money will be going and what relative risk you may be getting into in order to achieve the returns indicated in fund prospectuses. If the relative risk return on investment of the target firms is 100% or $2 for every dollar invested (in a given period of time,) but the VC-fund has an historical record of total loss of one half of its investments, the net effect is zero return on investment. That is not a good return relative to the risk taken.
Diversify for Success
Since the nature of venture capital investments is high risk, I makes sense to spread your money as far and wide as possible. This may mean investing in several different VC funds. “Venture capital’s success is highly dependent on finding a few outstanding investments, and diversification is vital.” (Barry, C. 1994) Historical accounts from VC funds may indicate good management by the fund managers, or it may be a stroke of luck on a few excellent performers. What has happened in the past may not necessarily hold true tomorrow or next week though. Funds are subject to changes as they change there investment managers, and investment. What may be hot today, could go sour overnight. By spreading your investment fund around, you may be able to beat the odds by picking a few funds that will excel, and compensate for others that may have been poor choices (in retrospect.)
Not Just Your Cash at Work
VC funds provide added security and reduced risk to the investor by providing management advise to the target firms. “Using other people’s money and having limited liability, entrepreneurs may want to continue to invest even after a project ceases to be viable... In addition, the entrepreneur may overstate its likely outcome.” (Barry, C. 1994) By following the progress of the target firm, their major expenditures and cash flows, the VC fund is able to provide a little insurance again the loss of invested funds. They, in fact, can prevent the total loss of an investment through their monitoring system. This is good for both the investor and the entrepreneur who both want to succeed in the venture.
Convertible Preferred Stock Option
Your investment in the VC fund is further protected from risk since the form of capital is not common stock, the last resort in a liquidation, or in the case of dividends on profits. “The most common form of venture capital investment is convertible preferred stock. The preferred stock gives the venture capitalist a superior claim to cash flow and to distributions in liquidation in the event that the venture is unsuccessful.” (Barry, C. 1994) As far as shares go, preferred shares may even be considered to be a safe investment since they tend to escape the “roller coaster” volatility of common shares. Also, they will always receive dividends before common shareholders.
What Does it Cost?
Funds and fund managers are interested in earning money on the investing work they conduct by they are also willing to take on some of the risk. “Venture capital funds traditionally pay a management fee of 2.5% of assets per year, as well as 20% of any profits.” (Barry, C. 1994) Since the fund manager’s income appear to be largely based on return on investments, they will therefore be very careful to make wise decisions on the target firms they invest in. The better the return they are able to realise on their investments, the more they will be able to profit from their work.
Why Should an Enterprise Accept Venture Capital Funds?
“The main inputs the VC has to offer are: money, operating services, networks, image, moral support, general business knowledge, and discipline.” (Fried and Hisrich, 1995) Usually it is the availability of money that causes the investment relationship to form. As a consultant to the financial services of the enterprise, the VC firm may help to arrange for future alternative financing. As a networker, the VC firm may help to source out and recruit highly skilled managers, lawyers and accountants that may be invaluable to the start-up of a new target firm. The image of the VC firm may be used for developing sources of suppliers and markets. They can provide moral support for managers who need a outlet to discuss sensitive issues about the target firm. VC fund managers tend to be highly experienced in business which can add a lot of value to a group of technologist or engineers trying to produce and market their ideas. As a disciplinarian, the VC firm can guide or even insist that the firm stick to their business plan to ensure the best possible outcome.
Another view of this strategy is as follows: “Investment objective focus is to increase the value of the investment by providing needed expansion capital and strategic advise, identifying and correcting management weaknesses, identifying and securing strategic partners, identifying and accessing new markets and assisting in key contract negotiations. Through direct involvement of the Manager in investee corporations, successful results should be achievable.” (FESA, internet site)
Historical Success Stories
“The stories of America’s technology start-up successes are legendary: Compaq, Cisco Systems, Apple Computer, Oracle, Sun Microsystems--all were created in the last 20 years from nothing. But they strive--growing by 40% per year or more--in part because they were financed by venture capitalists long before any financial market of bank would look at them. More than 70% of computer industry firms were venture-backed.” (Economist, 25.01.97) As an investor, it is important to note that there have also been some really sad stories as well. In fact, most new start-up companies don’t succeed.
Tax Advantage to Canadian Residents
As a tax shelter, venture capital funds have been able to attract a lot of money the incentive is to get a generous tax reduction for moneys invested. This policy has been adopted by the Canadian governments in order to indirectly encourage investors to finance high risk/high technology investments. This saves the government from the risk of using public funds in the form of grants or guaranteed loans. “With combined federal and provincial labour fund tax credits totalling 30%, a $3,500 investment may generate a maximum of $1,050 tax credit.” (FESA, internet site)
In recent year, investment firms have also been promoting the investment into venture capital firms through private retirement savings schemes. “As with other Registered Retirement Savings Plan eligible investments, further tax savings are possible.” (FESA, internet site) High income investors can achieve further reduction in income tax of up to 54% by registering their investments. For someone in the highest tax bracket in Canada, there is an immediate tax savings of 84% of the investment up to a maximum of $2,940 (tax,) thereby reducing whatever the risk of investment to only 16%. This has attracted a lot of small investors into an area that has been traditionally been dominated by only the very wealthy.
How does the venture capital firm choose where to invest, how much and for how long? How does it measure the risk, the potential return on investment and when is it appropriate for the company to go public?
Berlund, Tom & Johansson, Edvard, Why Some Entrepreneurs Must Rely on Angels, December 1996
Berry, Christopher B., New Directions in Research on Venture Capital Finance, Financial Management, Vol. 23, No. 3, Autum 1994
Economist, The, Venture Capitalists: A really big adventure, January 25th 1997
FESA Enterprise Venture Capital Fund of Canada Ltd., internet site
Fried, Vance H. and Hisrich, Robert D., The Venture Capitalist: A Relationship Investor, California Management Review, Vol. 37, No. 2, Winter 1995
More, Lisa and Longerstaey, J., JPMorgan Company, Introduction to RiskMetrics, New York, 1995
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