Abstract
The financing of knowledge-based innovative companies that pursue the creation of new products and services is very risky, and requires special skills and the use of sophisticated contracts. Venture capital firms are small partnerships of highly skilled investors with business and entrepreneurial experience. They raise money from institutional investors and use it to fund companies selected through a thorough screening process. Venture investors become actively involved with their companies to help them commercialize their products and services. They also exert tight control on entrepreneurs by using sophisticated contracts. Originating in the US, venture capital is now a global industry.
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Venture capital is a specialized form of financial intermediation that provides funding to innovative companies with high-growth potential, with a goal to exit them within a few years and realize a capital gain. Venture investors use sophisticated contracts and become actively involved with their companies to help them professionalize and commercialize their products and services.
Venture capital is a specialized form of financial intermediation that provides funding to innovative new ventures with high-growth prospects (Da Rin et al. 2013). Venture capital investors (VCs) are typically former entrepreneurs or industry executives with several years of experience in running and creating companies. They operate in small firms with few partners.
Venture finance developed in the postwar years in the US (Ante 2008), and has by now become a way of financing innovative companies that is common in most developed countries. While official statistics are not available, the amount under management in 2011 was likely to be about US$400bn, of which half was in the US and a third in Europe. Investments are usually small, ranging from under $1m for start-ups to several millions for companies that need to scale up and prepare for a stock market listing. Venture capital is a very cyclical industry, receiving large inflows of money at times of high stock market valuations, when investors hope to realize high gains by quickly bringing companies public (Gompers and Lerner 2000). Venture capital has attracted policy support in many countries, since policymakers appreciate its ability to contribute to economic growth and job creation. With some exceptions, the results of these policies have been disappointing, especially when public money has been blindly provided in the form of ill-designed subsidies to investors or companies (Da Rin et al. 2006; Lerner 2009).
Financial Intermediation
It is important to understand that VCs do not invest only their own money but are essentially financial intermediaries, that is, they invest money entrusted to them. More precisely, VCs raise funds from institutional investors and wealthy individuals through structures called ‘funds’ (Metrick and Yasuda 2010). Funds have a set horizon, typically 10 years, and may range from a few dozens to several hundred million dollars. The fixed-term horizon comes from the fact that it takes time to find suitable companies for investment, so that the money committed gets invested over a 4- to 6-year period. It then takes about 5 years to bring portfolio companies to a stage where they can be either sold to an industrial buyer or listed on a stock exchange.
There is an additional reason for having fund structures with a definite lifespan. VCs raise funds to profit from the management fees and performance fees they charge to investors. For investors it is difficult to assess the progress and valuation of a fund’s portfolio companies, since these are private companies that are still in an early development phase. Only when the fund exits a company and realizes a capital gain (or loss) can one assess the profit that the investment has generated. By requiring the fund to have a finite life, institutional investors can therefore verify if their money has been well invested and decide whether to further provide funds to the venture capital firm that managed the fund. Since there are many VCs competing for institutional investors’ money, competition should weed out those which are not able to consistently generate returns adequate to the risk involved in these investments.
A venture fund’s finite lifetime also has an important implication for companies, since it gives a clear horizon to the support VCs provide to their companies. While VCs are relatively patient investors, they also need to exit companies within a few years (typically five) to meet the fund’s end date. This will put pressure on entrepreneurs to put their company up for sale. Additionally, since the fund’s money and the partners’ time are both scarce, VCs may choose to focus their time, money and support towards those portfolio companies that manage to develop faster and appear more likely to provide a profitable exit within the fund’s lifetime. This can penalize those portfolio companies that are weaker but also those that, even with good long-term prospects, are slower to mature.
While ‘independent’ VCs constitute the majority of venture investors, especially in the US, there are also many ‘captive’ venture investors that are owned by banks, companies and governments. Captives do not need to return periodically to the market for funding, since this is provided by their owners. Therefore, their objective may differ from achieving high returns, and include obtaining access to new technologies (Hellmann 2002; Masulis and Nahata 2009), generating new borrowers (Hellmann et al. 2008) and fostering local employment (Lerner 1999).
Active Investing
One key feature of VCs is their active involvement with portfolio companies, which has been shown to improve the likelihood of a profitable exit (Bottazzi et al. 2008). Involvement begins at the time of screening companies, since the expert eye of VCs only admits a very small proportion of the companies that apply for funding (Eckhardt et al. 2006). Investors get involved since their business expertise and their industry-specific knowledge and network of contacts may make a difference in helping the company realize its full potential. They leverage their industry knowledge by remaining focused on one or two industries (Gompers et al. 2009). By getting involved, investors can substantially increase a company’s value, and therefore the value of their equity stake. Involvement can take several forms: monitoring the entrepreneur’s effort, providing strategic and operational support, helping with recruiting, as well as exerting control if the company’s situation deteriorates. Several studies have documented that investor involvement leads to faster professionalization of the company (Hellmann and Puri 2002), more effective product commercialization (Gans et al. 2002; Hsu 2006), faster product innovation (Hellmann and Puri 2000; Kortum and Lerner 2000) and more strategic alliances (Lindsey 2008).
Sophisticated Contracting
Venture capital investing also differs from other sources of finance because of the extensive use of sophisticated contracting (Kaplan and Strömberg 2003). VCs provide funding through convertible securities that give them debt-like protection in case of default but can be converted into common equity if the company succeeds and goes public (Hellmann 2006). Moreover, venture funding is given in stages, so that no more than the necessary capital is contributed at any stage; and only when there is positive information on the company’s progress is more capital provided (Tian 2011). Venture deals are also often syndicated, which allows investors to share knowledge, obtain second opinions and diversify their portfolio over time, with positive effects on both companies’ success and investment returns (Sorenson and Stuart 2001; Hochberg et al. 2010). Several covenants give investors rights to obtain control of the company should it run into trouble, and to transfer control to the entrepreneur as progress towards a successful exit is made (Dessein 2005). Covenants also ensure that entrepreneurs obtain a larger equity stake as time goes by and the company makes progress. Overall, they ensure that both investors and entrepreneurs have incentives to provide high effort in making the venture succeed (Casamatta 2003; Bottazzi et al. 2009).
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Da Rin, M. (2018). Venture Capital. In: Augier, M., Teece, D.J. (eds) The Palgrave Encyclopedia of Strategic Management. Palgrave Macmillan, London. https://doi.org/10.1057/978-1-137-00772-8_680
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