Research has shown that new business start-ups are one of the key and critical factors in determining and sustaining long term economic real GDP growth of an economy. It is against this background that most governments have invested heavily in industrial parks, new business incubators, and technological support all in an effort to support startups. In fact, aside the above initiatives to foster new business development, little is done to provide the required equity capital and the initial support that new businesses need during their introduction phase.
Venture capital has been considered as one of the important means by which start-up businesses could be supported. According to Investopedia, Venture capital is a form of private equity and a type of financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. This implies that, the venture capitalist buys a stake in an entrepreneur’s idea, nurtures that idea for a short period of time, and eventually exits, mostly with the help of the investment firms. The rationale for this article is to explore the role of venture capitalists in supporting start-up businesses, more importantly, start-ups in emerging economies.
Who is a Venture Capitalist?
Venture capitalists are individuals or firms that help new businesses get started and provide much of their early-stage financing. Usually, individual venture capitalists are called angel investors. Indeed, angel investors are wealthy individuals who invest their own money in emerging businesses at the very early stages in small deals.
Venture capital firms, on the other hand, pool money from various sources to invest it in new businesses. It is refreshing to state that venture capital is mostly not long-term liquidity; instead, they invest in a company’s balance sheet and infrastructure until the company reaches a consideration size and assumes a certain level of credibility that makes it fertile so that the institutional public-equity markets can step in and provide sufficient liquidity.
Why emerging businesses do not get funding from traditional sources?
It has always been very difficult for emerging businesses to secure funding from traditional sources such as the banks, savings and loans institutions, investment firms etc. This may be due to the following reasons:
- The high degree of risk involved: Every start-up business is a risky venture. This is due to the fact that most new businesses fail, and in fact, very difficult to identify and accurately determine its success rate, thereby making it difficult to attract funding from the banks, savings and loans, pension funds etc. These suppliers of capital are indeed averse to undertaking high risk investments, and equally so, such risk-averse behaviours are mandated in regulations that restrict their conduct.
- Types of productive assets: Mostly, before commercial loans are extended to businesses, financial institutions may demand for collateral security in the form of valuable tangible assets such as machinery, equipment, land and building, and physical inventory. This is done with the view to cater for credit risk and other related inherent risks. Normally, most start-up businesses may not have the required productive assets in order to secure financing from the traditional financial institutions.
- Informational asymmetry problems: Information asymmetry arises when one party to a transaction has knowledge that the other party does not. In fact, an entrepreneur knows more about his or her company’s prospects than emerging in new business areas, most investors may not have the expertise to distinguish between competent and incompetent entrepreneur; and as a result, they a reluctant in emerging businesses.
The Cost of Venture Capital Funding
We established that traditional sources of funding are quite difficult for start-up businesses due to the estimated risk associated with it; and that a venture capitalist is more likely to support emerging businesses. It is imperative to state that, supporting emerging businesses comes with cost to the venture capitalist. Indeed, the cost of venture capital funding is high, but the high rates of return earned by venture capitalists are not unreasonable.
- First, venture capitalists are bearing high substantial amount of risk when they fund a new business. This is because, per the literature, on average, for every ten businesses backed by venture capitalists, only one or two will prove successful.
- Second, venture capitalists spend a considerable amount of their time monitoring the progress of businesses they fund and intervening when a business’s management team needs support.
Key participants in the Venture Capital Industry
The venture capital industry emerged in the late 1960s with the formation of the first venture capital limited partnerships; and since then, the annual flow of liquidity into the venture capital firms increased massively. It is worth noting that, today, the venture capital industry consists of thousands of professionals and venture capital firms. Basically, the venture capital industry has four key players:
- Entrepreneurs: The entrepreneurs need funding to develop business ideas, and equally so, expand their operations.
- Investors: The investors in the venture capital industry want high returns on their investment. In fact, investors’ main motivation is high returns on their investment.
- Investment bankers: The main agenda of investment bankers is primarily to sell companies.
- Venture capitalist: The venture capitalists that make money for themselves by making a market for the entrepreneurs, investors and investment bankers.
How Venture Capitalists Reduce Their Risk
Venture capitalists are mindful of the fact that, only a handful of new businesses will survive to become successful firms. In order to reduce their risk, they employ a number of strategies when they invest in ventures, including:
- Staged funding: This tactic of funding involves phases of providing liquidity to the new firm. In fact, the key idea behind staged funding is that each funding stage gives the venture capitalist an opportunity to reassess the management team and the firm’s financial performance. If the performance does not meet expectations, the venture capitalists can bail out and subsequently cut their losses.
- Personal investment: Usually, venture capitalists will require an entrepreneur to make personal substantial financial commitment in the business. The entrepreneurs’ personal investment in the business demonstrates a high sense of confidence in the company and that he is highly motivated to it succeed. This will induce the venture capitalist to provide the needed funding for the expansion of the company.
- Syndicating investments: Syndication is the process whereby the originating venture capitalist sells a percentage of a deal to other venture capitalists. In fact, syndication reduces risk mostly in two ways. First, it increases the diversification of the originating venture capitalist’s investment portfolio, due to the fact that the other venture capitalists now own a percentage of the deal. Second, the willingness of other venture capitalist to share in the investment provides independent corroboration that the investment is a sound and reasonable decision.
- In-depth knowledge: Another key factor that reduces risk is the venture capitalist’s in-depth knowledge of the industry. Normally, a high degree of specialization gives the venture capitalist a comparative advantage over other investors or lenders that are generalists. His specialization helps him to minimize risk associated with the new firm.
Venture Capitalists Exit Strategy
It is interesting to state that, venture capitalists are not long-term investors. Usually, they remain with the new business until it is a successful going concern, which in fact, it takes about three to seven years; then they exit by selling their equity position. Principally, there are three main ways in which venture capitalists or firms exit venture-backed companies.
- Selling to a strategic buyer: One of the ways by which a venture capitalist may exit the venture-backed firm is to sell its equity to a strategic buyer, mostly at a price which earns him a high return. As soon as the deal is finalized, the strategic buyer is expected to create value through synergies between the acquisition and the firm’s existing productive assets.
- Selling to a financial buyer: Selling to a financial buyer is one of the ways by which a venture capitalist can exit venture-backed firms. This type of sales usually occurs when a financial private equity firm buys the new firm with the intention of holding it for a period of time, usually three to five years, and then selling it for a higher price. Mostly, in a financial buyout, the firm operates independently, and the buyer focuses on creating value by improving the firm’s operations.
- Offering stock to the public: A venture capitalist may also exit an investment by taking the company public through an initial public offering (IPO). This gives opportunity to investors to own shares (equity) in the company; and equally so, making sure the capital based of the firm is intact.
Role of Venture Capitalists
Venture capitalist performs two key roles in supporting emerging businesses in an economy. This is done by:
- Providing financing for new firms. Venture capitalists usually provide equity financing to start-ups businesses. By this arrangement, the venture capitalist or firm becomes part owner of the business, and as a result, participate in the management of the business. In most cases, they appoint competent consultants and managers to assist in the running the affairs of the business. They exit when the business or firm becomes a successful going concern by selling off their equity portion in the business.
- Providing advice to entrepreneurs. Due to an in-depth industry knowledge and experience of venture capitalists, mostly, about what it takes for a business to succeed, they are able to provide sound business advice to entrepreneurs in terms of marketing management, strategy, financial management, business planning and strategy.
The writer is a Development Economist and Chartered Financial Analyst. Daniel is the Chief Economist at the Policy Initiative for Economic Development. He also the Director of Research and Analysis, B&FT. He can be reached on email: [email protected]. Tel; 0244 476376/ 0201939350