Venture capital investment strategies and market dynamics

¶ … Capital

If there is one universal attribute that applies to all investors, it is the undying thirst for higher returns. Venture capital (VC) is founded on this fundamental premise, as it has great potential to provide returns far in excess of conventional methods of investments. What makes VC so important is that it is often the only source of funds to new entrepreneurs, as banks and financial institutions provide finance only against securities or guarantees. VC has grown from a small investment pool in the 60s and 70s to a full-fledged investment tool and a key element in corporate and institutional investment portfolio.

The term 'venture capital' is often used interchangeably with private equity investing, which refers to venture investing and buy out. The astonishing growth and successes of new generation companies such as Apple, Intel, Federal Express, Microsoft, Yahoo and Cisco is a sterling tribute to VC, as these companies had received VC in their early stages of development. The singular difference between VC and other forms of financing is that VC provides money to firms whose success is not guaranteed; in fact, there had been instances when firms had to be funded even for incorporation.

VC investments are characterized by high uncertainty levels in terms of technology risk, product market risk, management risk and liquidity risk. A major distinction is the relationship between investor and investee in a VC transaction. While on a commercial plane, they are bound by the interest in mutual economic benefit, on a legal plane the interests can diverge. For the investor, profits and timely exit from the venture is of paramount importance. The investee would like to retain and ensure her continued role in the company. This requires the investor to respond to the challenges of various exigencies that may arise after the funding process is set in motion. Unlike the conventional lending methods, the only protection for the investor is to ensure that the venture stays on track and succeeds in time, which may prompt the investor to exercise controlling rights when things go wrong. This is perhaps the single biggest challenge that can make or break a venture capital transaction.

A common perception of a venture capitalists are that of a rich financier who is on the look out for start-up ventures to put money with the hope of getting abnormal profits at some point in future. The reality is far different - professional venture capital firms are closely held corporations or private partnerships, funded by public and private pension funds, endowment funds, corporations, wealthy individuals and foreign investors. Not all venture capitalists invest in start-ups; in fact a rational venture capitalist will strive to have a balanced portfolio that will level out risks and ensure a net positive return. VC firms also specialize in other investment alternatives such as initial public offerings, mergers and acquisitions.

Venture capital is a form of equity finance, which took solid roots in the post world war II years, especially in the United States of America. From a relatively small scale in the sixties, the venture capital industry now spans almost all sectors of business and economy. In the last four decades, American venture capitalists have proved time and again that VC can be the prime vehicle for economic growth even in times of recession. Other countries, including the European nations, Canada, Australia and Asian nations seemed to have grasped the significance and potential of VC financing. The philosophy of VC is best described by an old saying, 'the biggest shortage is not the capital, but the people with the right know-how'. As VC markets advance and mature across the world, the challenge facing investors and companies seeking fund is to fully understand the dynamics of VC so that the mutual objectives are realized.

Definition of Venture Capital:

It is the money provided by professional investors, who invest along with management in start-up, young and rapidly growing companies that have the potential to develop into highly profitable ventures. There are many popular perceptions of venture capital and formal definitions are not easy to find. A widely discussed definition is that offered by Dr. Neil Cross, former Chairman of the European Venture Capital Association. According to this definition, venture capital is making facilities for risk bearing capital, which can be by means of a participation in equity, and this would be in relation to companies which have capacities for high growth. The basic characteristic of venture capital is that it is a form of equity finance, participatory in nature with long-term of maturity. Venture capitalists require a high rate of return as a trade-off for the degree of risk and patience for the returns to materialize. The general expected return is approximately 40% per annum compounded. (Bovaird, p.33)

VC financing is provided in several stages based on pre-agreed schedule of achievement of well-defined milestones. A venture capital life cycle has seven stages - seed capital, start-up capital, early stage finance, second round finance, expansion capital, management buy outs and buy ins and mezzanine finance. As the name implies, seed capital is provided for initial product development or the finance provided to the entrepreneur to justify the proposed project feasibility and qualify for start-up capital. The second stage, start-up capital is for the product development, initial marketing and setting up product facilities. Early stage financing is provided to firms that have crossed the product development stage and require funds to commission commercial product and sales.

As the firm expands, it may need more capital, which is provided by second round finance. When the firm reaches breakeven point or has already started making small profits, it will need funding for expansion of the business. This critical requirement in met by expansion capital, which drives the firm to maximize profits. Management buy out is the finance granted to the firm's management and investors to acquire an existing product line or business. As opposed to this is the Management buy-ins where funds are provided to managers outside the firm to buy into the firm with the support of venture capital investors. Finally, mezzanine financing is supplied to the firm to enable it to complete a trade sale or go in for public floatation of the firm's shares. Mezzanine financing is offered either in the form of debt or high ranking equity.

Legal status of VC firms:

VC firms operate in many forms, but most are organized as limited partnerships in which they are general partners. A common type is the private independent firm, which has no affiliation with any financial institution. Apart from limited partnership, which continues to be the major form of VC firms, the government has permitted formation of either Limited Liability Partnerships (LLP) or Limited Liability Companies (LLC). The VC firm can choose the style of organization depending on management responsibility, liability and taxation issues. Typically, the VC firm organizes the partnership as a pooled fund, comprising of the general partner and the investors or limited partners. The funds are fixed life partnerships, with normal life of ten years and each fund is capitalized by investments from the limited partners. Soon after the partnership attains the targeted size, it does not accept further investment, and the fixed capital pool is utilized for investments.

In a different form, VC firms may be affiliates or subsidiaries of commercial banks, investment banks or insurance companies and make investments on behalf of the parent entities, popularly known as 'corporate venture investors' or 'direct investors'. This form of investing was quite popular in the eighties and is now doing back in vogue. In this case, the objective is to identify and invest in opportunities that are synchronous with the parent entities' business strategies. They may also be interested in investing if they can secure access to superior technology they need or achieve cost savings in their business operations. A major feature of corporate venture investing is that the main objective is related to corporate strategy rather than pure financial considerations.

The activities of venture capitalists generally include financing new and growing companies and purchasing equity securities with a long- term perspective. Thus, venture capitalists take higher risks with the expectation of higher rewards, which cannot be provided by other forms of investment. Before investing, venture capitalists make a thorough analysis of the business model of the investee company and estimate future returns. They take active interest and work closely with the management of investee companies, by offering expertise gained from assisting other companies to grow from nascent stage. As part of diversifying risk, venture capital firms invest in a portfolio of young companies under a single fund. It is also common for them to invest as a syndicate with other professional VC firms. Usually, venture partnerships manage multiple funds simultaneously to spread the risk and maximize returns on investments.

Typical venture capitalists would examine many investment opportunities before selecting a clutch of companies to actually put the money. They look for a high rate of return, much higher than most other forms of investment options, within a span of five to seven years. This stimulates venture capitalists to be more than just a financier and involve deeply in management, strategy and operations of the companies they invest in. It is the entrepreneurial spirit in venture capitalists that separate them from the convention financers such as banks and financial institutions. Although they involve in the affairs of the investee companies, most venture capitalists seek to exit from the ventures once they realize the desired rate of return. This enables them to continue investing in other young companies and continue to make higher returns.

Evolution of Venture Capital in the U.S.:

In the United States, venture capital has been in vogue right from the early stages of industrialization, with wealthy individuals, families or closed groups funding companies or projects, which could provide attractive returns. In 1946, Georges Doriot, recognized as the 'father of venture capital', promoted the first venture capital firm in the name and style of American Research and Development. However, the progress in venture capital funding was slow in the early years. J.H. Whitney, hailed as one of the founders of the VC industry, established his own VC firm in 1946 and one of its best known deals was the Minute Maid Juice. The Rockefeller family was known for their interest in VC funding and one of their major investments was in Eastern Airlines.

The sixties saw rich individuals in California investing money in technology companies that were in the early stages and struggling to find capital. The returns on these investments proved to be so good that more and more people started to invest systematically in start-up ventures. These investors were, perhaps aptly, referred to as 'angels', as they seemed to come from nowhere and provide capital to newborn companies with great ideas but little or no money. In 1971, a few successful angels got together and raised the first 'venture capital fund', with support from other rich people and institutions. There was a growing conviction that venture capital funding is the ideal option for super normal profits for the investors and it also provided the much-needed platform for evolution and growth of new companies.

But barely thee years down the line, the stock market crash of 1974 pulled the winds out of venture capital firms. While this slowed down investments, it did not stop altogether. In the mid-seventies, Tandem Computers commenced operations with USD 1 million from a VC firm and proved to be a big success. It grew into a USD 2.6 billion company and Compaq bought it in 1997. The second half of the seventies saw a few VC firms making handsome returns on their investments. The United States government supported the VC industry in many ways and in 1978; it reduced federal taxes on profits made from venture capital financing. The VC firms in America did a whopping USD 750 million business in 1978, which is viewed by many as the first milestone for the so-far fledgling industry.

Venture Capital trends in the U.S.:

Studies conducted by PricewaterhouseCoopers, Thomson Venture Economics and the National Venture Capital Association, venture capital activity in the U.S. showed signs of rebounding in 2003, with total investments pegged at U.S.$18.2 billion in 2,715 companies. While this was lower than the U.S.$21.4 billion investment level in 2002, the rate of decline was lowest in last three years, indicating that the venture capital industry is moving towards realistic and sustainable levels. Investments were fairly consistent on quarter-to-quarter basis in 2003, which could mean greater stability in the years to come. Bio-technology and health sectors are fast emerging as the leaders, ahead of software and information technology companies. For the full year 2003, the Life Sciences Sector comprising of biotechnology and medical devices, were able to attract U.S.$4.89 billion or 27% of the total venture capital. This trend was more evident in the last quarter of 2003, when the biotechnology sector alone garnered U.S.$1.1 billion, relegating software sector, which accounted for U.S.$978 million.

However, the software sector continued to the single largest sector, taking up U.S.$3.6 billion in 2003, representing 20% of the total investments, with biotechnology a close second at U.S.$3.4 billion. Other major segments namely telecommunications and networking cornered U.S.$2 billion (11%) and U.S.$1.7 billion (9%) respectively, a shade lower than the previous year, while the semiconductor industry was stable with investment of U.S.$1.2 billion or 6% of the total investments in 2003. Year 2003 saw a reduction in first-time financings with only 624 companies totaling U.S.$3.4 billion, compared to 792 companies and funding of U.S.$4.3 billion in 2002. The survey pointed out the change in investment strategy of venture capitalists in first time deals, with increasing focus on Life Sciences sector, which represented 20% of all first time financings in 2003.

Software continued to dominate accounting for 20% of the first-time deals. A notable shift is the decline in first-time financings of telecommunications and networking industry, while there seemed to be a surge in electronics and instrumentation sectors. The survey reported a substantial increase in later-stage financings during 2003, indicating that the existing companies who received funding in the past were moving towards maturity stage. The later stage funding in 2003 was U.S.$4.7 billion, equivalent to 26% of all venture capital. This led to reduction in investment for both expansion stage and early stage companies. Expansion stage firms managed U.S.$9.9 billion in 2003, as against U.S.$12.7 billion in 2002.

The trend of increasing later stage financing is expected to be on the rise for the next 1 or 2 years, till a good proportion of the existing companies move out of the venture capitalists' portfolio. (PricewaterhouseCoopers, Thomson Venture Economics and National Venture Capital Association MoneyTree Survey).

According to Tracy Lefteroff, global managing partner of the venture capital practice at PricewaterhouseCoopers, venture capital firms are in for good times due to increased activity in capital markets, initial public offerings and mergers and acquisitions. Venture capital investments, if managed properly, are likely to return impressive profits. Mark Heesen, President of the National Venture Capital Association echoed similar sentiments and claimed that good opportunities are opening up for venture capitalists in many sectors. Commercial information technology sector is back on the growth trajectory and this is providing many options and exit avenues for venture capital firms.

Venture capital in the Europe:

Unlike the U.S., venture capital financing in the Europe has not been very popular and is still considered to be an emerging market. While the U.S. is considered the very epitome of a matured venture capital market, the European market is dubbed as a one which is lagging behind in funding innovative firms. It was only as late as the latter half of the nineties that venture capital took a serious step towards start-up and early-stage financing. The aggregate VC investment level up to the year 1999 was barely one-fourth of the U.S. venture capital market in the same year. In the last four years, Europe has made significant strides in VC funding, but still yet to blossom into a developed market. Research has identified significant gaps in the performance of European venture capital markets in comparison, to say a developed market like the U.S., in terms of rate of return and exit alternatives. (Hege et al., Determinants of Venture Capital Performance: Europe and the United States).

Such gaps can be best understood with comparison to the United States, wherein three major differences are often described. One, the European venture capitalists are not as aggressive or assertive as their American counterparts, especially when it comes to management of poor performance. American investors have shown more willingness to exercise their residual control on defaulting firms or replace entrepreneurs who do not measure up to the expected standards. Two, European VC firms have lagged in employing the real options in stage financing - in other words, American venture capitalists have displayed greater tendency to increase the frequency of stage financing, which increases the probability of higher returns. Three, while European VC firms have shown strong tendency in ensuring investor continuity from one stage to the other, they have failed to fully capitalize on the contractual relationship with the entrepreneur teams, which is an indication of inadequate VC specialization. In essence, while European VC firms are better in concluding financing deals but do not seem to show finesse in controlling and monitoring the performance of the funded companies. In the overall context, this points to the fact that European firms can do a let better in adding value to firms that show promise.

In 2003, about Euro 2.5 billion was raised through venture capital by 599 European companies, steeply lower by 50% to the Euro 4.9 billion coughed up in 2002 over 743 financings. However, the silver lining is that the dipping trend has started reversing from the second quarter 2003 and the trend is expected to continue. Like the U.S., the Life Sciences sector (biotechnology and healthcare) was the flavor of investors, managing deals worth Euro 929 million or 38% of the venture capital. Software deals, at Euro 548 million were the second major funded sector. Number of software financings at 184 was higher than that of life sciences. The telecommunications sector, which accounted for 12.5% in 2002, slipped drastically to only 5.5% in 2003. About Euro 407 million went into 126 technology companies in the form of first-round or seed capital, equivalent to 16.6% of the total venture capital made available. The trend of first-time financing was on the decline - 34.7% in 2000, 24.7% in 2001 and 17.5% in 2002.

United Kingdom

United Kingdom dominates the venture capital market in Europe, closing deals worth Euro 843 million or 34.5% of all technology deals in Europe. Number two is Germany (16.7% in 2003), followed by France (12.1%), Sweden (6.8% in 2003) and Switzerland (5.8% in 2003). The influential venture capital companies in Europe are 3I Group, which closed deals worth Euro 311 million in 2003, covering 97 deals. Other investors include Atlas Venture (Euro 196 million), Apax Partners (Euro 172 million) and Credit Lyonnais Private Equity (Euro 124 million) and Danish Vaekstfonden (Euro 50 million). Auriga Partners, Deutsche Venture Capital, Benchmark Capital, Amadeus Capital Partners, 3I Group are some of the firms showing sustained interest in seed and first round financing. (Tornado Insider Report)

Sweden is rated as one of the key venture capital markets in the world. From the second half of the seventies, when the country saw the venture capital industry taking shape in a small way through government initiatives. The growth in stock markets in the eighties saw the inception of 30 venture capital firms. After a downslide in the late eighties and early nineties, the Swedish VC market started to grow rapidly on the back of a uprising stock market and better economic conditions. Increasing savings and the growing exit options have catalyzed large-scale investments and in 1999, Swedish VC firms invested over 11 billion SEK, with 80% in seed capital for 301 companies. The general climate for venture capital market in Sweden appears encouraging and a notable feature is that foreign funding is more prevalent than from domestic sources. For its part, the Swedish government provides support to the VC industry - for instance, foreign investors need not pay taxes when making an exit. (SVCA)

Canada:

For the country boasting of the seventh largest stock exchange in the world in terms of market capitalization, venture capital offers an attractive option for small and medium sized companies in Canada to invest in American and other world markets. Canada is recognized for its accelerated growth in venture capital funding in the later half of the nineties, even when other countries were struggling to achieve growth in times of recession. However, the size of investments was lower than countries such as the United States.

Venture capital investments, which peaked to U.S. $5.8 billion in 2000, dropped to U.S. $2.5 billion in 2002 and further plunged to a low of U.S. $1.5 billion in 2003, the lowest in seven years, according to figures released by Canada's Venture Capital & Private Equity Association. Internet-based companies continued their dismal performance and were able to attract only U.S.$77 million in 2003, while software companies managed U.S.$258 million. Leading the pack in 2003 were biotechnology and health-related sector raking in U.S.$392 million investments, although this figure was lower compared to the investment of U.S.$479 million in 2002 (Won, Venture Capital sinks to lowest level in seven years).

However, market analysts have expressed confidence that the situation will improve in 2004 and beyond - already there is renewed interest in information technology companies and some initial public offerings are expected to materialize. A point of concern is that Canadian pension funds have not supported VC funding as in certain other countries. For instance, during 1998-2002, pension funds contributed to only 20% of VC investments in Canada, while in the United States it was as high as 50%. In recent years, the government of Canada has implemented significant fiscal measures to spur growth in the venture capital industry.

These include reduction of corporate income tax from 28% in 2000 to 21% in 2004; elimination of federal capital tax for medium sized companies from 2004 and for all companies over a five-year period; reduction of taxes on small and medium scale businesses. The corporate tax incidence in Canada is now already lower than the U.S. levels and by 2008; the tax advantage will be in excess of 6 percentage points. In addition, other measures like reduction of capital gains taxes, deferment of taxation on capital gains on small business shares and encouragement of pension funds diversion to venture capital markets are expected to lead the VC industry to a healthy position in the near future. (Department of Finance: Canada, Strengthening Venture Capital in Canada)

Australia:

Billed as one of the most sophisticated and high growth markets in Asia-Pacific region, Australia's venture capital market represented 24% of the investments in this region during 2004. According to the Australian Bureau of Statistics, the venture capital under management as at the end of June 2003, was USD 5.7 billion and the venture capital invested for the first half of year 2003 was USD 0.46 billion. There are as many as 133 venture capital managers and 850 investee companies. Unlike America and Europe, Australia's bulk of venture capital funding went to the manufacturing and transport industry (U.S.$1,189 million at the end of June 2003). This was followed by retail services and real estate (U.S.$606 million), technology, media, electronics and communication sector (USD 545 million), and biotech, pharmacy and health (U.S.$235 million) and energy sector (U.S.$75 million). However, there is an increasing shift of investment in the sunrise sectors such as information technology and biotechnology. (Axiss Australia, Venture Capital and Private Equity in Australia)

The Australian government, realizing the potential of the venture capital industry announced a slew of fiscal concessions and framed new venture capital laws - as tax exemption for profits on certain investments, flow-through tax treatment for venture capital limited partnerships and alignment of Australian venture capital structures with limited partnership structures in line with international practice. The investor friendly and transparent policies of the government has attracted several major venture capital firms including international agencies such as DB Capital Partners, RMB Ventures, CVC Asia Pacific, Technology Venture Partners, CHAMP Ventures etc.

There are many instances of the venture capital firm enjoying super normal returns on investments. For instance, high speed ferry manufacturer Austal Ships which took VC of U.S.$1.14 million, arranged by a syndicate of investors led by CHAMP Ventures, provided internal rate of return of over 40% to the investors or a cash multiple of 3.9 times the initial investment. ResMed, a global medical technology company received VC funding of USD 0.72 million from the Australian office of JAFCO. Five years down the line, JAFCO had completely exited from the venture, making a very handsome internal rate of return of an unimaginable 98%.

China:

The interest in China's VC trends stems from the economy's size and fast growth rate in recent years. China's VC industry is relatively nascent, making its mark only since the mid-nineties. At present, while there are positive indications of growth, the VC market is still too small and does not seem to have the power to influence the national economy in a big way. However, the Chinese government is focusing on development of VC and implemented several measures to promote a healthy climate for investment. The government established state-controlled venture capital funds at the national, provincial and local levels with the objective of meeting the funding requirements of small and medium enterprises. By the year 2000, China had 100 venture capital companies, with total capital of 8 billion Yuan. Of these, 90% were partly or fully funded by the government (Asian Development Bank Report, Development of Venture Capital in China).

The high level of government control and intervention is perceived as one of the major roadblocks for the development of VC industry in China. For instance, in 2003, the Chinese government accounted for 48% of the total VC investment in the country, an indication that private investors are yet to make major inroads into VC financing. (Sood, China's Venture Capital Regains Confidence) However, with China as one of the most preferred investment destinations for new investments, the VC industry is bound to pick up sooner or later. Much of the current VC investment in China goes into electronics sector, comprising of computer, internet, communications, chip design and other information technology industries.

Impact of venture capital financing on economic performance:

The United States is a classic example of what venture capital can do to trigger growth even in sluggish economies. Over the last ten years or so, when European countries have been lamenting double-digit rates of unemployment, the American economy was able to create new job opportunities and successful in holding inflation to low levels, even in the years of recession. The U.S. has a deficit in balance-of-payments and till recently, reported deficit in her own internal accounts. Many believe that venture capital is one of the major factors which helped the U.S. To consistently achieve high growth rates after the Second World War and also tide over the years of economic crises.

Investors, entrepreneurs, scientists, engineers and other professionals have, in one form or the other, contributed their might to develop, nurture and assist firms in the incubation stage to grow into successful commercial ventures. Venture capitalists must be credited with the conversion of garbage start-up firms into world-class companies that provided the vehicle for America to leapfrog as an economic powerhouse. Both large and small firms have consistently implemented innovative business practices, which has helped the country to overcome the economic stagnation predicted by a section of economists. Innovation has been the driving force of America's success both in terms of micro-economic and macro-economic factors.

An extensive study conducted by the National Venture Capital Association (NVCA) revealed that venture capital financing had a strong influence on the national economic performance. VC investment during 1970-2000, created as many as 7.6 million jobs in the U.S. And generated more than U.S.$1.3 trillion in revenue at the end of year 2000. The VC backed companies were responsible for 5.9% of the total jobs in America in 2000. Companies created by venture capital were estimated to be worth U.S.$273.3 billion and represent 13.1% of the Gross Domestic Product in 2000. VC investments triggered massive creation of new jobs in computer, health care, consumer communications, energy, electronics and biotechnology industries. The research estimated that that one new job was created for every U.S.$36,000 VC investment. (NVCA Press Release)

In the United Kingdom, the 165 VC firms registered with the British Venture Capital Association (BVCA) have provided investment to over 11,000 companies and employed nearly 3 million people in 2003, representing 18% of the private sector workforce. As per a recent BVCA study, employment in the VC backed companies rose by an average of 19% per annum, as against the national private sector employment growth rate of 0.5% in the last few years. In the five years leading to 2003, venture capital and private equity promoted companies registered growth in sales by 21% per annum, more than twice the rate of top 100 companies in the UK. Exports from the VC supported sector grew by 11% per annum, compared to the national growth rate of 5.4%. It has been estimated that VC and private equity driven companies generated sales of British Pounds 177 billion and contributed British Pounds 26.6 billion towards taxes in the five-year period. (BVCA, The economic impact of private equity and venture capital in the UK Economy)

Successful VC backed companies:

It is often pointed out that multi-billion corporations such as Microsoft, Intel, Compaq, Apple, Federal Express, MCI, and Digital owe their success to venture capital funding. At the time of inception, most of these companies had brilliant promoters with great business ideas, but very little capital. This meant they could not commence business operations unless they found investors, who are ready to park funds over a long period and wait for the returns. These companies received venture capital funding in their early stages and then developed at a blistering pace into large and highly profitable corporations, in the process providing very high returns to investors who trusted them.

Over the years, venture capital has been rated as the most powerful driver contributing to the growth of silicon-valley industries. While the successes of the funded firms were due to the innovative ideas and technological excellence of the promoters, the venture capitalists did their bit by providing timely finance, expert advice and supporting implementation of strategic decisions in quick time. They also exercised enough patience, spread over as much as a decade, before they could reap the benefits of their investments. Probably, these companies may never have seen the light of the day if they did not have access to timely venture capital money. The phenomenal success of such companies raises the important question of how VC improves the professional capacity.