Venture Capitalists on the Seed Stage Arena A Fit or Misfit Johan Adolfsson Avdelning, Institution Division, Department Datum Date 2003-06-03 Ekonomiska Institutionen 581 83 LINKOPING Language Svenska/Swedish X Engelska/English Report category Licentiatavhandling Examensarbete C-uppsats X D-uppsats Ovrig rapport ____ ISBN ISRN Ekonomprogrammet 2003/30 Serietitel och serienummer Title of series, numbering ISSN URL for elektronisk version http://www. ep. liu. se/exjobb/eki/2003/ep/030/ Title Author Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Johan Adolfsson
Abstract Background: Growth oriented entrepreneurial businesses need funding for the development of their idea, technology, product etc. However, for the businesses in the very earliest stages of development, access to funding is very limited. Growing young ventures are important job creators and positively affect growth in an economy. Bridging the gap of funding to these companies is therefore on the agenda of governments around the world. Purpose: To describe the situation facing seed stage investing venture capitalists. I will emphasize difficulties and evaluate venture capitalists ability in addressing them.
Effects of the difficulties in form of access to financing for entrepreneurs and a possible need for government intervention will be examined. Method: Empirical information from seed stage investing venture capital organizations have been collected in the form of face-to-face interviews, email- questionnaires and a telephone interview. Organizations from Sweden, Denmark and Germany are included in the study. Result: Several factors make seed stage investing unattractive compared to later stages. Important difficulties are higher risks, high costs for fund anagement, goal incongruence in the investor – venture capitalist relation and lack of bargaining power for seed venture capitalists. Environmental factors that have an impact on seed investing are the deal flow, the investment climate and access to soft funding. Seed stage investing is a very challenging business and the difficulties are to a large extent hard to overcome. The investors more likely have to accept them and I conclude that long term profitability of seed funds is unlikely, at least in absence of government support in form of soft funding towards the entrepreneurial businesses.
Keywords Seed capital, Venture capital, Financing, Equity gap, Soft funding, Entrepreneurial activity, Oystein Fredriksen Avdelning, Institution Division, Department Datum Date 2003-06-03 Ekonomiska Institutionen 581 83 LINKOPING Sprak Svenska/Swedish X Engelska/English Rapporttyp Licentiatavhandling Examensarbete C-uppsats X D-uppsats Ovrig rapport ____ ISBN ISRN Ekonomprogrammet 2003/30 Serietitel och serienummer Title of series, numbering ISSN URL for elektronisk version http://www. ep. liu. se/exjobb/eki/2003/ep/030/ Titel Forfattare Riskkapitalister och Investeringar i Sadd Stadiet Johan Adolfsson
Sammanfattning Bakgrund: Sma tillvaxtorienterade foretag behover kapital for att utveckla sin ide, teknologi, produkt etc. Tyvarr ar dock tillgangen till kapital for dessa foretag for narvarande mycket sparsam. Detta ses som ett problem ur ett nationalekonomiskt perspektiv eftersom tillvaxtforetagen ar mycket viktiga skapare av arbetstillfallen samt ekonomisk tillvaxt. Syfte: Att beskriva den situation riskkapitalister star infor vid investeringar i sadd stadiet. Jag poangterar svarigheter och varderar riskkapitalisternas kapacitet att hantera dessa.
Betydelsen av statligt stod i olika former diskuteras. Metod: Empirisk information samlas in fran riskkapitalister som investerar i sadd stadiet i form av personliga intervjuer, telefonintervjuer samt e-mail formular. Organisationer fran Sverige, Danmark och Tyskland ingar i studien. Resultat: Manga faktorer gor sadd investeringar oattraktiva jamfort med investeringar i senare stadier. Viktiga svarigheter ar hogre risk, hogre forvaltningskostnader, malinkongruens mellan investerare och riskkapitalist samt brist pa forhandlingsstyrka hos sadd aktorer.
Dessa svarigheter ar svara att hantera och det ar troligt att sadd investerare snarare maste acceptera dem. Att pa lang sikt lyckas astadkomma vinstgivande investeringar i sadd stadiet ar inte troligt, atminstone inte utan statligt stod i form a mjuk finansiering. Nyckelord Seed capital, Venture capital, Financing, Equity gap, Soft funding, Entrepreneurial activity, Oystein Fredriksen
This problem is discussed in terms of an equity gap and economists fear that it can restrain future economic growth. In the UK, widespread concern at the “shortterminism” of the financial markets is particularly referenced to the situation facing start-up and young companies. Decreasing willingness to invest in early stage, technology-based firms have been referred to as the evaporation of “classic venture capital” in the US. (Murray, 1994) The situation in Europe can thus be seen as even more alarming, since venture capitalists in Europe overall are more restrictive to early stage investments then their American colleges. De Clercq & Sapienza, 2000) A factor explaining this situation could be that investors are risk-averse while early stage investments are highly risky. (Ruhnka & Young, 1991) Based on this it is rational for governments to try and stimulate early stage investing. Different policy models have been used in trying to bridge the equity gap. In the US an indirect model has been used. The idea is to provide incentives for investments to be made, for example lower tax on early stage investments. A more direct model of stimulating small entrepreneurial activity has been used in Ireland.
The Irish government is through the formation of venture capital funds directly investing in promising young firms. (Papadimitriou & Mourdoukoutas, 2002) 1. 1. 2. Sources of Finance According to Hamilton (2001) there are three potential sources available for startups to finance their activity. They are self funding, seed capital from venture capitalists and large corporations venture funds. Each of these has a set of risk and reward tradeoffs for the entrepreneur. 1 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 1 Self funding includes money from friends, family and angel investors.
Generally the self funded firms are formed from the entrepreneur’s vision, filling a need were the entrepreneur has specific skills or resources. The self funded ventures are constantly under environmental pressure since funds are limited and growing sales is the only way to grow the business. The angel investors are sometimes considered to be under the category of venture funding, however angels are often more on the same wavelength as the entrepreneur and less focused on valuation. Self funding has been the dominant source of funding in the earliest stages of the business lifecycle.
However reacting to the successful investments in the beginning of the hightech boom, venture capitalists began to invest earlier and earlier. Seed capital funding from venture capitalists provide the entrepreneur with protection from the limitation of funds that shapes the life of the self funded firm. However, now the threat to the entrepreneur lays in whether it will be capable of performing up to the demands of the venture capitalist. Venture capitalists demand high growth in their invested money in a relatively short timeframe. The third source, corporate funding, constitutes of investments made by corporations.
Investments are often made in spinouts from their own activity, but this connection does not always exist. Generally investments are made for strategic reasons and financed entrepreneurs are working in areas related to the corporation’s activity. From these three sources of funding for entrepreneurs I have chosen to study the venture capitalists investing patterns, this for two reasons. Firstly, because venture capitalists moved towards investing in earlier stages during the hightech boom, while in more normal markets the challenges of investing are stronger. The suitability of venture capital investing is put up to test.
Secondly, because of the history of growing venture capital activity presented next. 1. 1. 3. Venture Capital Funding Venture capital dates back to the formation of American Research and Development in 1946. The following decades a number of other venture capital funds were started, but venture capital activity did not increase on a large scale until a policy change in the US 1979. Pension funds had been avoiding venture capital since they had limited freedom to do high-risk investments. After 1979 pension funds where free to do highly risky investments, providing that their portfolio where diversified.
Venture capital funding thereafter started to grow dramatically. (Kortum & Lerner, 2000) In Europe the funds raised have been increasing rapidly over the last decade. 2 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 1 50000 40000 30000 20000 10000 0 1990 1992 1994 1996 1998 2000 2002 Funds Raised in EUR m illion Figure 1: Funds Raised by VCs in Europe. 1 (EVCA, 2002. p. 46, and evca. com, 2003-03-13) Venture capital activity is dependent upon the current market conditions, which can be seen in Figure 1 and Figure 2. In recent years the amount of seed capital raised has changed dramatically.
During the high-tech boom seed capital funds, as a subcategory to venture capital, increased dramatically, until it reached its peak year 2000. Thereafter a steady decline has been observed. Funds raised in 2002 were lower than what was observed in 1998. During 2001 7% of venture capital investments were made in seed capital (EVCA, 2002 p. 59). 1000000 800000 600000 400000 200000 0 1997 1998 1999 2000 2001 2002 Seed Funds raised in EUR thousand Figure 2: Seed Funds Raised by VCs in Europe. 2 (EVCA, 2002, p. 78, and evca. com, 2003-03-13) 1 2 2002 amount of funds raised includes estimation for the fourth quarter. bid 3 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 1 1. 1. 4. An Area of Great Importance It is imperative to future economic growth that young companies are allowed to grow. To facilitate this, one important feature is securing appropriate funding mechanisms. The current lack of financing available for seed stage ventures implies that investing at this stage is financially unattractive. There are apparently real difficulties, which I aim at identifying. I believe doing so to be very valuable when trying to stimulate investing in the seed stage, and thereby bridge the equity gap.
The long term growth of venture capital activity (Figure 1) makes the financing role of venture capitalists increasingly important, which justifies focusing on venture capitalist as the source of finance. 1. 2. Problem Area and Research Questions I find it interesting to study why a pattern of few early stage investments has occurred. What are the differences between investing in the seed stage and investing in later stages? One feature of importance already mentioned is the high risky nature of early stages. However there are probably other features as well to consider for the investor. What are the important differences that make investing in the seed stage unattractive compared to later stages? The environment surrounding the venture capitalist is likely to affect the possibilities for successful seed investing. For example the impact the hightech boom made, and still makes, shows the great influence the environment can have on venture capital activity. Not only market conditions but also other factors such as research activity and government intervention will be considered, when studying the investment environment of venture capitalists. Government intervention refers to so called soft financing programs. • In what ways do different environmental factors influence the venture capital activity in seed investing? I will hereafter study how these seed stage differences in combination with environmental factors effect the suitability for investments by venture capitalists. How venture capitalists work is studied and this framework is used 3 Government funded loans to young entrepreneurial ventures, see 4. 4. 4 and 5. 2. 3. 4 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 1 to investigate whether their methods solve for difficulties in investing in the seed stage. Are venture capitalists suitable for seed stage investing? 1. 3. Purpose Statement To describe the situation facing seed stage investing venture capitalists. I will emphasize difficulties and evaluate venture capitalists ability in addressing them. Effects of the difficulties in form of access to financing for entrepreneurs and a possible need for government intervention will be examined. 1. 4. Delimitation I choose not to include self funding and corporate funding of seed stage companies. I believe focusing on one party will facilitate possibilities for a more in dept study.
Venture capitalists from Sweden, Denmark and Germany will be included in the study. The results are therefore primarily applicable to these three markets. 1. 5. Terminology The term venture capitalist (VC), in my study, refers to the organization operative in venture capital investing, particularly when describing actions and views of venture capitalists. When I refer to individuals in venture capital organizations I use terms such as employee, partner, or investment manager. I frequently use investment manager and refer to all the employees of the venture capital organization active in management of portfolio ompanies, not only the employees actually titled investment managers. The term venture capital funds are often used in venture capital literature. A definition of a venture capital fund is; a pool of capital risen periodically by a venture capital organization. Usually in the form of limited partnerships, venture capital funds typically have a ten-year life, even though extensions of several years are often possible. (Gompers & Lerner, 1999, p. 344) In this study far from all venture capitalists are organized using a fund the way it is explained above. This is explained further in 4. 1. , however for the purposes of this thesis, venture capital fund discussions can be broadly applied. Both to venture capitalists structured and not structured in this manner. 5 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 1 1. 6. Disposition The remainder of the thesis will be organized in the following way: Chapter 2: Methodology outlines how the study has been conducted and the reasons for doing so. Criticism to chosen methods is presented continually through the chapter. Chapter 3: Venture Capital Framework constitutes a review of current theory in the venture capital area.
It is specially directed towards theories relevant for early stage investing. Chapter 4: Venture Capitalists and Seed Stage Investing presents the views of venture capitalists investing in the seed stage. Descriptions of the venture capital organizations, their views of seed investing difficulties and environmental factors as well as strategies in investing, are included. Chapter 5: Analysis constitutes of my investigation of the research questions asked, using relevant theories and empirical findings. Chapter 6: Conclusions outlines the key findings of the study.
I provide my view of seed investigating venture capitalists and suggest an area of interest for future research. Chapter 7: Bibliography informs of the primary as well as secondary sources of information used in the study. Chapter 8: Appendix consists of the questionnaire used in interviews. 6 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 2 2. METHODOLOGY 2. 1. Thesis Focus Evolves The area of study largely effects appropriate method to use. Studying venture capitalists investing in the seed stage have been as interesting as it has been challenging.
I have worked in the area appointed by PVA-MV AG in Rostock, Germany. My supervisor at the company, Sascha Hocherl, defined a broad area of interest. Decided from PVA-MV was for me to work in the area of venture capital fund management. The specific focus of the thesis was left open for me to decide. A couple of factors effected the decision. Firstly, of course, I would not choose to study an area that does not interest me. Secondly I did not want to study an area in which too much is already known. With the aim of finding a topic matching these criteria I extensively studied current venture capital literature.
Lundahl & Skarvad (1999) regard studying prior knowledge in the area to be an effective way of practicing research. Doing so the researchers avoid squandering time and energy investigating what others have already concluded. Reading about venture capital I soon found interesting results and patterns that I wanted to investigate further. Many findings conclude that entrepreneurial activity is a very important source of job creation and economic growth. Further, financing in the earliest stages of company development was decreasing.
These two conclusions put together provided reason for distress signals about the future economy. Governments have reacted and intervened to support entrepreneurial activity. What I found is not as well explored as the reasons for lack of financing to the earliest stages, and specifically the stage often referred to as the seed stage. This is how the focus of my study evolved. Extensive insight into the venture capital research also provided great help for the work to be done ahead. 2. 2. Type of Survey Gilje & Grimen (1992) describe two different ways of conducting a study.
They are the inductive and the deductive approach. In the inductive approach the researcher should enter the investigation with an open mind to study a number of cases. Information from these cases is concluded and used to come up with new theories. The deductive approach starts from current theories. The researchers set up hypothesis and thereafter try and falsify those using empirical studies. My starting point is empirical findings from the venture 7 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 2 capitalists situation, which I use to try and provide broader conclusions.
In the study venture capitalists are the sources of primary information i. e. information that have not previously been documented. (Ericsson & Weiedersheim-Paul, 1999) My study can not be seen as a pure inductive approach since my previous studies and literature readings to a large extent will effect my conclusions. Ericsson & Weiedersheim-Paul (1999) separates a qualitative study from a quantitative study based upon whether the information desired is of quantifiable nature or not. In my study both types of data are important. The quantifiable data can be used when evaluating the information gathered.
For example, in my study, the answer to what value VCs can provide to ventures is evaluated by; (1) asking how many investment managers per portfolio companies they apply and (2) asking what background the managers have. However, by itself, the qualitative information is the most important for my purposes. Therefore a methodology of information gathering which can provide this kind of information was essential. 2. 3. Survey Approach 2. 3. 1. Form of Correspondence To use face-to-face interviews, to the extent possible, was at no point questionable for me.
Ericsson & Weiedersheim-Paul (1999) say face-to-face interviews provide benefits since the interviewees’ ways of expressing themselves, with body language as well as speech can be studied. This adds to the value and credibility of information. For time and financial reasons I could not commit face-to-face interviews with all studied VCs. The Danish and German interviewees were instead offered the choice of either a telephone interview or an email questionnaire. The questionnaire is available in 8. 1 and is largely same for face-to-face interviews as it is for telephone interviews and email correspondence.
The questionnaire was discussed with my supervisor Sascha Hocherl before the first interview. Sascha is experienced in the venture capital field and could provide valuable input to my suggested interview guide and questionnaire. Lundahl & Skarvad (1999) mean that using different methods of collecting data can damage the reliability of the investigation, since the surrounding of the interviewee do influence the answers from respondents. Standardizing the 8 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 2 investigation is therefore preferred.
I think it was helpful to have started with face-to-face interviews. I learned which questions were hard to understand and could enhance the accessibility of these questions. However, it was important for me not to change the meaning of the questions, since this would inhibit the possibility to do comparisons (Lundahl & Skarvad, 1999). 2. 3. 2. Scope of Study Eisenhardt (1989) say the number of studied cases decides the balance between depth and scope of the study. For my purposes I believe the method of a relatively large number of cases was the better approach.
Comparing different views provides good value for my thesis. Venture capitalist are also often employing only a few investment managers and the information you cannot get from one of them in the context of an interview, is probably information they do not want to share with you anyway. In a case study you can acknowledge that a phenomenon exists and that processes etc. work. However, you do not know if they are common. (Wallen, 1993) Because of this the empirical information presented in the thesis and used in the study is probably not an exact picture of overall views.
However, studying the number of venture capitalists investing in seed capital which I have, the study will hopefully reflect reality pretty well. I build this on the basis that the number of seed investing VCs is limited, and that I have interviewed quite a few of them. This is also in line with Lundahl & Skarvad (1999) and Wallen (1993) who mean that it is possible to draw some general conclusions from a limited number of observations. Wallen mean that detailed results of a specific case cannot simply be applied to other cases. However the basics of processes and procedures can.
According to Merriam (1994) the extra input of a case studied will be decreasing with an increasing number of cases. Prior answers are confirmed by new answers, but not much more comes out of the interview. I could feel this decreasing input effect, which tells me that my understanding for and information about the venture capital activity have reached far. After having studied cases in Sweden I studied a couple in Germany as well as Denmark in order to broaden the sample a little further, and hopefully increase the extra input of each case studied. 9
Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 2 2. 3. 3. Sample of Interviewees When I decided for which venture capitalists to interview I used a couple of guides. Firstly I studied the homepage of the European Venture Capital Association (www. evca. com). Member companies of this association provide information of e. g. the stage of investments they do. This was therefore helpful in identifying some interesting companies. Secondly, my supervisor Sascha Hoecherl could provide input to which seed venture capitalist in Germany and Denmark that would be of interest.
Thereafter I searched for venture capitalists through accessing the homepages of Swedish universities, since most seed investing VCs are connected to universities. The methods I used to find appropriate interviewees may seem a little ad hoc but I hope that, by using different channels, I managed to reach a broad range of seed investing venture capitalists. I where aware of the risk that some venture capitalists might not want to participate in the study, therefore I contacted many venture capitalists from the beginning. I contacted about double the amount of which in the end was interviewed.
I contacted the venture capitalists asking if they agreed to an interview. The initial contact was generally via email. If I had got no response within a week I called the respective company. The sample was changed via the contacts with venture capitalists. After having explained the focus of my thesis I was several times provided with additional sources that they believed to be valuable for me. This method is by Lundahl & Skarvad (1999) referred to as the snowball selection. They also say that with a sample like this, which is not randomly selected, you can not in a statistical sense draw general conclusions.
However as discussed before, due to the relatively small number of seed investing venture capitalists and a reasonably large number of interviews, I believe I will be able to draw some conclusions of value in a broader sense then only within the exact context of my study. The study includes interviews of 13 organizations investing partly in early stages. All of them, except for one, consider themselves to be investing in the seed stage. The reason that an organization that is not investing in the seed stage was interviewed is that the distinction between seed stages and later stages is not always clear.
Some information from this interview could still be used. All organizations but one, who is an incubator, are venture capitalists. I saw the incubator as an interesting organization investing at the seed stage and considered the denomination of the organization less important. In 7. 4 Interviews only 12 organizations are included since an organization requested 10 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 2 anonymity. This organization responded by e-mail questionnaire, which add up to four questionnaires, one telephone interview, and eight face-to-face interviews.
Some of the organizations are entirely or in part owned by a government, while others are entirely private owned. All consider the commercial orientation in investing important. Once the sample of venture capital organizations was set, deciding whom to interview within the organizations was for me a straightforward matter. Generally, all employed individuals were working with management of the fund and therefore any employee would be interesting. As seen in 7. 4 many are CEOs. 2. 3. 4. Interview Execution During the interviews it would have been preferred to have a companion in order to absorb all the information.
Still, I preferred taking notes to using a tape recorder because I felt that the interviews would be more relaxed. I would also save valuable time by taking notes at once. During interviews I discovered another advantage. The time I took notes worked as a break for extra consideration for the interviewees. Many valuable opinions where explained during this extra breather. However there is still the problem that I can have missed information. To limit this risk I always took an hour directly following the interview to think trough all the questions. I tried to remember additional information and clarified my notes.
Right after the interview I asked for permission to come back with additional questions. Everyone accepted this and the option have been used for clarification reasons as well as one time when time ran out before all questions were answered. Generally the interviews took a little more than an hour. The telephone interview took 45 minutes. There are a couple of effects that can skew the information acquired from interviews. One effect mentioned by Ericsson & Weiedersheim-Paul (1999) is that the interviewee can sometimes realize, by the way the questions are asked etc. , what answers that are expected from them.
Another effect, that adversely effects the information is when the interviewee provides a dishonest answer (Lekwall & Wahlbin, 1993). This can happen if the interviewee wants to give a positive picture of him or herself and the company. If this is the case the validity of the investigation can be questioned. Validity concerns whether or not the investigation is measuring what it is meant to (Lundahl & Skarvad, 11 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 2 1999). If venture capitalists are lying, then the answers are not a good indicator of what I, as the researcher, am investigating.
In this case an interview and the questionnaire are the wrong instruments for the study. Naturally, it is hard to see whether these two effects have played any role in my investigation. However, asking additional questions, controlling for answers as described above has been used to try and control for the latter effect. 2. 3. 5. Information Composition After the telephone- and regular interviews were accomplished and emailquestionnaires were received, I started to assemble the data. I used a method of focusing on specific areas reading through the selected information from each venture capitalist.
On a separate sheet the information from all VCs were recorded. This information was then condensed to show general patterns as well as differences in venture capital views. I have chosen to provide the source of each opinion only in the case of quotations. The reason for this is that it would very hard for me to get access to interviews if I would not give respondents this degree of anonymity. I am also sure that some of the information from investment managers never would have been shared, if I were to provide sources continuously through the empirical chapter.
Hopefully the way I have managed the information from the beginning with formulating the questionnaire to last part of composing the information have guaranteed, to the extent possible, the credibility of presented information. 12 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 3. VENTURE CAPITAL FRAMEWORK In this chapter I present venture capital from a couple of perspectives. I firstly define seed and venture capital. Secondly, I describe why and how venture capitalists participate in managing the ventures and then their investment strategies.
The following section describes the relation to other investors, after which risk and venture capital is discussed in depth. I conclude the chapter describing a couple of aspects about technology and venture capital. 3. 1. Defining Venture Capital Venture capitalists facilitate the flow of both funds and information between providers and users of capital, and, like any provider of risk capital, they monitor and advice ventures on strategic issues. Venture capitalists are usually organized in partnerships primarily focused on the financing of developing high growth firms that do not have access to public securities or institutional lenders.
There is a gap between these sources of finance and finance from family, friends etc. This gap is where venture capitalists normally position themselves. The involvement of the venture capitalists can be very early in an idea stage or much later in the form of one or to rounds of finance. These are all, to some degree, uncertain and risky stages, and the cost of venture capital is therefore high. The ending of the involvement usually takes place by the sale of the company in the public market or through a merger. (Amason & Sapienza 1993, De Clerque & Sapienza 2000). • Funding • Cash
Investors • Returns Venture capitalist • Equity Firm Figure 3: The Venture Capital Process. (Gompers & Lerner, 1999, p. 9) Fredriksens (1997, p. 16) definition of venture capital is: 13 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 Venture capital firms are organizations, which invest equity capital in high-risk projects and supply management resources. The investment is time limited. This definition is applicable to my study. This is for two reasons, firstly because high-risk is highlighted and secondly because the time limited feature is mentioned.
These are both important factors for the particular niche of venture capital seed capital, which is the focus of this study. Seed capital is defined as investments in companies in the earliest stage of their development prior to having produced a commercially sold product or service. (Murray, 1994, p. 440) The European Private Equity & Venture Capital Association (EVCA) uses a narrower description separating seed capital from start-up capital. Seed capital is defined as: Financing to assess and develop an initial concept before a business has reached the start-up phase.
Start-up financing is provided for product development and initial marketing. Companies may be in the process being set up or may have been in business for a short time, but have not sold their product commercially. (EVCA, 2002, p. 304) After the start-up stage the next stage is other early stage capital. This stage is defined as: Financing provided to companies that have completed the product development stage and require further funds to initiate commercial manufacturing and sales. They will not yet be generating profit. (EVCA, 2002, p. 04) Investments in later stages than these are not part of my study and I do not provide those definitions. For the interested, EVCA (2002) provides definitions for all venture capital stages. 14 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 3. 2. Venture Capitalist Intervention 3. 2. 1. Venture Capitalist Activities Venture capitalist activity can be divided into pre- and post-investment activities. Pre-investment activities include raising money, the search and selection of investment opportunities, and structuring the deal.
The postinvestment activities are also called the management phase. The venture capitalist assists and monitors the ventures and later on exits the investment. Venture capitalists spend a high proportion of their time performing post investment activities. (Fredriksen & Klofsten, 2001) Wells (1974, in Fredriksen, 1997) study showed that 2/3 of the time is spent on postinvestment activities. In the post-investment activities the most important role of the venture capitalist is the role as a financier, however several other roles are important too.
Venture capitalists are important discussion partners, mentors, and coaches. The communication between the venture capitalist and entrepreneurs are in form of board meetings as well as informal contacts and financial reports. Venture capitalists follow the ventures closely since they constitute the possibility for future returns. The more they can assist the venture the more they hope to gain from their investment. Through active participation the venture capitalist acts as a consultant to the venture. This separates venture capitalists from many other passive investors.
That venture capitalists really do work actively, shows in the reliance from entrepreneurs to trust the venture capitalist as the primary source of external competence. (Fredriksen & Klofsten, 2001) Gupta & Sapienza (1992) found venture capitalists use less geographic and industry diversification, when investment risk is high. Instead they increase monitoring and involvement. Venture capitalists utilize special expertise e. g. relevant technical and managerial experience on their staff in an attempt to alter the risk/reward relation.
De Clerque & Sapienza (2000) mean that venture capitalists who spread significant costs of monitoring high-tech investments over similar lines of business become specialists in these related areas. The specialized knowledge can then be utilized in current and future investments and improves abilities in evaluation and selection of ventures as well as assistance towards them. By specializing in industry the venture capitalist can develop a crucial understanding for the technology. Of course venture capitalists never become specialists in the technologies; their core 15
Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 competence is still in the areas of strategies, finance etc. However in order for the cooperation between venture capitalist and entrepreneur to be fruitful for both parties, a shared base of knowledge is very helpful. For example the venture capitalist will be able to use its network better by providing the entrepreneur with the correct contacts. On the other hand, the entrepreneur will be able to communicate its view about future developments of the technology more effectively.
Therefore, by specialized investments, the venture capitalist can benefit from synergies. Gupta & Sapienza (1994) mean that specialization benefits lead to the existence of a fundamental limit to the number of diverse ventures and industries that venture capitalists effectively can invest in. 3. 2. 2. Frequency and Openness Fredriksen & Klofsten (2001) mean there is a benefit/cost tradeoff to consider when deciding the degree of frequency in communication. Greater involvement is not always cost effective, the benefits has to be balanced against the costs.
Sapienza & Timmons (1989) claim that the venture capitalist involvement may have positive as well as negative effects, they mention the costs: • Slower decision making and loss of autonomy for entrepreneurs • Venture capitalist sacrifices time that could be spent on e. g. raising money, finding investment opportunities or helping troubled ventures And the benefits: • Help facilitate implementation of idea • Buffer entrepreneur in difficult periods • Help manage risk by hands on involvement Two factors seem to influence the degree of involvement of the venture capitalist.
They are the level of technology and the stage of development of the venture. In ventures pursuing high levels of technological innovation the entrepreneur often believe that a superior product and technology compared to competitors is all that is needed for success of the venture. It is very hard for the venture capitalist to fully understand the technology. The entrepreneur is therefore likely to have the primary responsibility for formulating strategies. Studies 16 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 have shown that conflicts are more likely to occur between the venture capitalist nd the entrepreneur in cases with high technological innovation. Conflicts are generally associated with lower venture capitalist effectiveness. Since conflicts are less likely to occur between parties frequently interacting, information sharing is in the case of high tech ventures extra important. A positive relation between information sharing and technological innovation has a result in several studies. (Amason & Sapienza, 1993, Sapienza & Gupta 1994) Venture capitalists are also more involved in ventures in the earliest stages.
For instance, because of their uncertain circumstances, entrepreneurs managing early stage ventures are likely to turn to venture capitalists more often for advice and informal counseling than established ventures do. The venture capitalist helps the entrepreneur to overcome the liabilities of newness (Fredriksen, 1997). Studies have shown that the frequency of interaction between venture capitalists and venture is higher in early stages. (Amason & Sapienza 1993, Sapienza & Timmons 1989, Sapienza & Gupta 1994) The geographic distance from venture capitalist location to the venture location affects the degree of involvement.
Due to the transaction costs involvement are more efficient when the distance is short. Personal interaction provides a central mechanism for acquiring information and physical contact enhances the interaction. Therefore geographic proximity lowers the cost of monitoring ventures. The quality and amount of assistance that a venture capitalist can provide is higher when investing in ventures located close. Since venture capitalists want to monitor early stage ventures a little extra they prefer to invest nearby in order to facilitate the involvement.
Later stage investments, presumably more viable, need not be watched so carefully and ventures can be located further away. (Gregorio & Shane 2002, Sapienza & Timmons, 1989) Amason and Sapienza (1993) found a somewhat frightening result about openness in the entrepreneur–venture capitalist relation. It seems like there is less openness between early stage high-tech ventures and the venture capitalist then later stage high-tech ventures and venture capitalists. Korsgaard & Sapienza (1996) give a possible explanation for this. They say that the entrepreneur might feel that sharing information would possibly endanger their position.
Therefore, for the time being, keeping information might be in their best interest. 17 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 3. 2. 3. Reasons for Intervention There are two theoretical points of view as to why VCs mediate in the management of their portfolio companies. They are firstly to reduce business risk and secondly to reduce the threat of opportunism. (Sapienza & Timmons, 1989) Business risk is defined as the uncertainty of receiving adequate returns on investments due to the competitive environment.
Entrepreneurial companies often explore markets where competition is in an infant phase, where the nature of buyers, suppliers, competitors, products and so on is still not developed and established. This means that they are subject to more business risk than larger companies. (Porter, 1980) Venture capitalists are financial intermediaries investing in the special circumstances described above. Why is this role then suited for venture capitalists? Generally financial intermediaries are considered to have an important role in alleviating moral hazard and information asymmetries (Lerner J, 2002).
There are information asymmetries in two directions in the relation between the young entrepreneurs and the venture capital firm. Entrepreneurs generally have a more technology-oriented background while they lack commercial experience (Murray, 1994). Entrepreneurs are provided funds from venture capitalists in return for part of the ventures equity stake. Since there is an information asymmetry between the parties there is the risk that the entrepreneur can use the situation and acts in his own interests. Jensen & Meckling (1976) call this opportunistic behavior.
Opportunism leads to agency costs on the hands of the venture capitalist. There are different views on whether there really is a risk for opportunistic behavior in the venture capitalist – entrepreneur relation. Sahlman (1994) builds a lot of his theories on the bases of agency costs and believes that shirking from the entrepreneurs’ side is a real threat that needs to be dealt with. Sapienza & Gupta (1994) on the other hand represent the view that the relation venture capitalist and entrepreneur has to be built upon trust. They say neither of the parties has much to win from deceiving the other.
Instead the role of agency costs is in form of unintended conflicts such as lack of goal congruency. Venture capitalists are first and foremost concerned with increasing the value of the venture. Entrepreneurs on the other hand might seek other organizational and personal goals. (De Clerque & Sapienza, 2000) Amason & Sapienza (1993) mean that it is important to consider that many entrepreneurs are strictly innovators. They are motivated primarily to develop their technology. Therefore financial goals are often considered less urgent to 18 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 fulfill.
While this is an example of how incentives of entrepreneurs can be harmful for venture capitalists, the opposite situation is as easy to imagine. Consider a venture capitalist in need of money for other investments. He has an incentive to try and bring the portfolio firm public as soon as possible, while this might harm the entrepreneur if the venture is not ready for an IPO. 4 (Barry, 1994) These are only two of many possible situations where the incentives of venture capitalists and entrepreneurs can differ. Admati & Pfeiderer (1994) identify what they call the over-investment problem.
The entrepreneur has put a lot of time and effort into the business and therefore he tends to go along with the project as long as there is a chance of success. This is rational for him since others provide the new capital. If the business is a failure he gets no payoff. However, he does not financially lose either, since he is not providing the additional capital. The entrepreneur has an option-like position. These possible incentive differences are important for the venture capitalists to consider when deciding for strategies to use in their investments.
Fredriksen (1997) share the view of Sapienza and Gupta (1994) that opportunism is not a major concern. He means that the entrepreneur – venture capitalist relation should be looked upon as a coalition, with entrepreneurs and venture capitalists on the same level as partners. Several studies have tested the existence of opportunism in the venture capitalist entrepreneur relation. Barney et al (1989, in Fredriksen & Klofsten 2001) found support while many other found weak or no support. Two examples are Sapienza & Timmons (1989) and Fredriksen & Klofsten (2001).
Fiet (1995, in Fredriksen & Klofsten 2001) have showed that venture capitalists generally are more concerned with the business risk than the threat of opportunism. However, Fredriksen & Klofsten (2001) found weak support for venture capitalist governing their ventures in order to control for business risk. Fredriksen & Klofsten (2001) therefore claim that venture capitalist involvement cannot be explained by either the threat of opportunism nor business risk. They mean venture capitalists intervene not to govern and monitor but to provide assistance, especially to troubled and/or inexperienced ventures.
This is a more positive view of the venture capitalist role intervening 4 IPO = Initial Public Offering: The sale of shares to public investors of a firm that has not hitherto been traded on a stock exchange. (Gompers & Lerner, 1999, p. 345) 19 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 to add value. Most studies support the view that venture capitalists do add value to ventures (Fredriksen 1997, Sapienza & Timmons 1989) De Clerque & Sapienza (2000, p. 64) believe differences in backgrounds, expertise and values between the venture capitalists and entrepreneurs can, in some cases, make up for a great combination.
They found value added by venture capitalist to be positively related to: • The level of innovation pursued by a venture • The frequency of interaction between the investors and the entrepreneurial CEO • The openness of communication between the two • Similarity of perspectives on the importance of key venture objectives They also mention conflicts playing an important role. The existence of different approaches lead to better decision making, however decisions are harmed if the different approaches lead to conflicts on a personal level.
Amason and Sapienza (1993) claim that when circumstances are demanding, and uncertainty high, greater information processing can improve performance. Interaction between venture capitalist and entrepreneur can stimulate creativity and enhance decision making in ambiguous conditions. As time passes and difficulties are overcome by the two a deeper relation can develop. Trust and shared knowledge streamlines the interaction process. Korsgaard & Sapienza (1996) identify the ability to quickly build trust as a possible source of cooperative advantage to competitors.
They mean that trust can mitigate fears of opportunism and thereby build a much-needed open relationship. 3. 3. Venture Capitalist Investment Strategies Venture capitalists use a number of strategies to create value in their portfolio. First, only a very small fraction of entrepreneurs looking for financing are accepted. Venture capitalists often demand a business plan from ventures seeking funding. Receiving many plans they only accept the most promising ones. (Ruhnka & Young, 1991) There are many mechanisms used by venture capitalists to alleviate the agency problem and reduce the risks after the initial investment has occurred.
The mechanisms I will describe are high rate of return, structuring incentives, staging of capital, stage focus, diversification and syndication. 20 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 3. 3. 1. High rate of Return Venture capitalists use a high rate of return, which for the entrepreneur mean a high cost of capital. The high cost of capital imposes a strong incentive for the entrepreneur to use it wisely. It also forces the entrepreneur to only accept money from investors who will increase the value of the venture.
The relation has to increase the value so much that the change makes up for the cost of capital. (Sahlman, 1994) 3. 3. 2. Structuring Incentives The compensation of the entrepreneur and the venture capitalist is set up so that both the entrepreneur and the venture capitalist benefit when the venture is doing well. However if the venture does poorly the entrepreneurs bear a disproportionate part of the risk. Deals are set up so that upon liquidation the venture capitalist receives the proceeds and the entrepreneur have worked for very low compensation levels. Sahlman 1994, Brealey & Myers 2000) The venture capitalist might also use anti-diluting clauses to protect itself from excess dilution should the value of the venture sink before upcoming financing rounds. (Ruhnka & Young, 1991) Prices for shares in earlier rounds are adjusted down so that they match current valuation. The use of these clauses has increased following the collapse of the information technology boom. Venture capitalists are desperately trying to protect themselves from the decreases in valuation. (Braunsweig 2001, Campbell 2001) 3. 3. 3.
Staging of Capital Staging of capital is the idea that the venture capitalist provides capital based on set milestones, in contrast to providing a lump sum from the beginning. By providing a modest amount up front for the completion of e. g. a business plan, the venture capitalist reserves the right to invest more in a second round, if the business plan sounds interesting. By staging the commitment of capital the venture capitalist gathers new information about the project and its environment. Therefore VCs can make more informed stage by stage decisions on whether to invest more or not. Sahlman, 1994) Directing future funding to prior “winners” is called parlaying of funding. Winners refer to the ventures able to achieve the set objectives and that are showing good prospects. Ruhnka & Young (1991) claim that specifying objectives for a specific round of funding help facilitate measures of venture performance. It is a means of directing maximum venture effort on critical objectives that must be achieved before the venture can move forward. 21 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 3. 3. 4.
Stage Focus Ruhnka & Young (1991) found that Venture Capitalists tend to use what they call a portfolio failure avoidance strategy. The idea is to allocate a larger portion of money in later, safer, stages. They have higher probability of positive returns and also producing earlier cash flow. However this strategy reduces the chances of finding the “big hits” among early stage ventures. According to venture capitalists the strategy has evolved since the ability to attract future institutional funding would be inhibited if final portfolio return were negative.
However, there is also a discussion as to whether VCs really are investing in the earliest stages. Gregorio & Shane (2002) and De Clerque & Sapienza (2000) claim that VCs in general are late stage investors. It is believed that this trend is even stronger in Europe compared to the US. Other sources of funds, such as business angels and government agencies may be more important in the earliest stages. Muzyka (2003-02-27) claim that the returns for venture capitalists in first round on aggregate have been very poor.
In fact they show moderate losses in spite of the fact an acceptable return should be high, due to higher risk in the earliest stages. Risk will be further discussed in section 3. 5 in which Figure 4 illustrate the high risk of early stages. Campbell (1998) claim extracting decent returns from seed investments are hard, which can explain why even venture capitalists active in the early stages tends to shy away from the seed stage. Bowman (2001) mean before the tech-boom, seed capital was the arena of business angels and not VCs.
This changed during the tech-boom, but now VCs, burnt by their experiences, are turning back to later stage investments. Campbell (1998) says that the small number of dedicated seed funds is probably the reason why so little data on seed fund performance is available. 3. 3. 5. Diversification Diversification is a means of reducing risks by investing in a number of ventures. This way each individual investment risk becomes less important in the portfolio. The diversification can include investing in different industries, geographic areas, and stages. In Figure 4 it can be seen that the risks vary widely across different stages.
The idea with industry and geographic diversification is that if a region or an industry stalls, the portfolio can be able to perform anyway. It is less likely that all industries and regions are troubled at the same time. (Ruhnka & Young, 1991) 22 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 3. 3. 6. Syndication Syndication is a joint investment between venture capitalists. 5 According to Gompers and Lerner (1999) an advantage with syndication is the opportunity it presents to compare views of target companies with other venture capitalists.
If several independent observers agree to invest, it should be more likely that the decision to invest is correct. Syndication can also be a way to avoid risks through risk sharing. By investing in many syndicated deals, the venture capitalist can achieve a greater diversification than without syndication. Admati and Pfeiderer (1994) suggested a fixed fraction contract to solve for the insider problems that can occur (3. 4. 1). This fixed fraction contract implies that future investments must be syndicated. However, in 2001 only 29% of venture capital investments were syndicated. (EVCA, 2002, p. 0) Gompers and Lerner (1999) give a possible explanation when they discuss specialization. In highly technological areas venture capitalists can develop special skills as described in 3. 2. 1. Not wanting to share the benefits of the skills can be a reason to making investments single-handedly. 3. 4. Venture Capital Society 3. 4. 1. Venture Capitalists as Insiders Venture capitalists are as discussed active investors in the companies they finance. They sit in the board of directors, provide advice, hire key managers, etc. Having this position they possess information not publicly available.
The venture capitalists have an opportunity to use its excess information to their advantage at expense of other venture capitalists. Venture capitalists do, if they can, time their distributions of shares to when they consider them overvalued. (Gompers & Lerner, 1998b) Admati and Pfleiderer (1994) mean that the insider position can lead to suboptimal investment decisions. If the inside investor is the only one to provide new capital he will be inclined to under-invest. The investor provides all the new capital but only receives a fraction of the payoffs.
By acquiring inside information he can also get bargaining power that enables him to put pressure on the entrepreneur. Thirdly, and perhaps most important, sub-optimal 5 Syndication is defined as the joint purchase of shares by two or more venture capital organizations or the joint underwriting of an offering by two or more investment banks. (Gompers & Lerner, 1999, p. 348) 23 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 decisions can be made when including new outside investors. The entrepreneur and the investor have got information not available to other investors, which can be used to their advantage e. . by overpricing. The suggested solution to these problems is a contract under which the inside investor always owns a fixed proportion of the firm. The contract is called the fixed fraction contract. However venture capitalists frequently cannot invest through all stages and in these cases the insider position can become a burden. If the insider, venture capitalist, who knows most about the venture, do not invest, this sends warning signals about the venture to other investors. (Brealey & Myers, 2000) 3. 4. 2. Investors Venture capitalists are dependent upon investors to provide funds.
Reputation plays an important role when investors choose funds. Older and larger venture capitalists have higher possibility of raising funds. When venture capitalists are raising additional capital for funds, experience say, young firms are less fortunate. Mutual funds have been studied extensively and poor previous performance does not seem to inhibit the raising of capital for most funds, only the young funds are restrained. Good previous performance is a positive factor determining the access to capital for all funds seeking money. However tracking the performance of venture capital funds is not as easy as mutual funds.
Because the companies in the fund are not valued in a public market accounting principles are used in performance measurements and the statistics can be ambiguous. (Gompers & Lerner, 1998a) The introduction and steady increase of institutional investors in venture capital has supported growth in the industry. However it has also changed the nature of the venture capital business. There are speculations that venture capital activity is becoming more impersonal which alters the venture capitalist – entrepreneur relation. These changes could have serious implications on entrepreneurial activity. (Amason & Sapienza, 1993) . 5. Risk and Venture Capital The highly risky nature of early stage investing has been mentioned a couple of times above. I will now look into the uncertainty and risks of early stages. I also discuss the origins of risks. 24 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 3. 5. 1. Risk or Uncertainty There is a theoretical distinction between risk and uncertainty. Decision making under risk appear when the person who will make the decision knows the possible outcomes as well as the probability of occurrence attached to each outcome, but not what action that leads to which outcome.
Decisions are made under uncertainty when the possible outcomes are known but not the probabilities. Entrepreneurial activity involves decision making under true uncertainty since, often, neither the outcome nor the possibilities are known. (Ruhnka & Young, 1991) However, forecasts of turnover and probabilities are means of handling the uncertainty for venture capitalists. A theoretical perspective of risk is therefore of essential value for the thesis, even if the decisions really are made under uncertainty. 3. 5. 2. Risk Assessment The dominating explanation to how people assess risk is based upon expected utility.
People evaluate risk by a quantitative process of choosing between different prospects by weighing the values of possible outcomes by their probability to occur. They then select the option with the highest expected utility. This method of describing decision making under risk has proved to be useful. However, there have been studies done, showing that there are anomalies in special situations. The certainty effect means that when an individual have the choice of a certain gain and a higher almost certain gain, the choice is often the certain gain even if the expected value of the almost certain option is higher.
The individual becomes risk-averse and values the certainty higher than potential gain. Another anomaly is the reflection effect and in this case the individual becomes risk seeking. The effect means that if an individual is facing a loss he would choose an almost certain loss over a certain loss, even if an expected value calculation would indicate the certain loss as a better choice. This choice is made in order for the individual to have the chance of not losing at all. (Ruhnka & Young, 1991) 3. 5. 3. Risk Tolerance According to Ruhnka & Young (1991) three factors determine the venture capitalists sensitivity to risk.
They are: • Minimum portfolio target rates of return the venture capitalist reasonably needs to achieve • The potential gain and loss relationship in the current portfolio, to which new investments are added 25 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 • The venture capitalists general tolerance for risk The existence of an ideal level of risk, depending upon the factors above, is the foundation of Ruhnka & Youngs (1991) two-step process in venture capitalists screening for prospects. The first step consists of identifying those prospects with acceptable probability and magnitude of potential loss.
These probabilities and magnitudes are different for each venture capitalist dependent upon their ideal level of risk. The second step is to, among the prospects, find those with the highest expected gain should they succeed. 3. 5. 4. Risk Experience and Stage A survey made in 1986 venture capitalists was asked to estimate the typical risk of loss of their investment in different stages. It was found that the estimated risk of loss is very high for seed and start-up stages but then steeply declines. The same pattern goes for the expected return in the various stages. Ruhnka & Young, 1991) 80% 70% 60% 50% 40% 30% 20% 10% 0% Seed Start-up Third Stage Fourth Stage Exit Stage Expected rate of return Risk Figure 4: Risk and Expected Return. (Ruhnka & Young, 1991. p. 123) The shape of these curves can in part be explained by what is often referred to as the liability of newness. It concerns the idea that because of untested markets, management, channels of distribution, etc. new businesses are less viable. (Stinchcombe, 1965 in Fredriksen, 1997) This is part of the reason why venture capitalists have such an important role in new ventures. Fredriksen, 1997) It is likely that investors with low levels of ideal risk will invest for the 26 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 most part in later stages. Investors with higher levels of ideal risk will invest more in earlier stages. In earlier stages there are higher returns to gain if the venture is a success. (Ruhnka & Young, 1991) 3. 5. 5. Identifying Risks Ruhnka & Young (1991) divide risks into two kinds based on where they originate. There are internal and external risks facing companies.
Internal risks are for example technical difficulties developing the product or technology, poor management, inability to attract finance, high capital burn rate etc. External risks are for example potential market to small, technological shifts, unanticipated competition, no exit opportunities for venture capitalist etc. The external risks are in many cases uncontrollable for the venture capitalist. Interestingly the decline in risk is almost exclusively due to reductions in internal risks. These reductions occur when ventures through time overcome technical problems, build management competencies etc. 0% 60% 50% 40% 30% 20% 10% 0% Seed Startup Third Stage Fourth Exit Stage Stage Internal External Figure 5: Risk Sources. (Ruhnka & Young, 1991. p. 126) Risk estimates for early stages include all the probable risks a venture will face, both internal and external. Therefore external risks are always included but do not predominate until the later stages. This is when the venture really gets exposed to the competitive market forces. Especially important for the venture capitalist in the exit stage is the liquidity risk of the venture. The final return on the investment is highly dependent upon a good exit climate.
Sapienza & Timmons (1989) suggest that there are two key determinants of risk to a venture. The risks depend on: 27 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 • The entrepreneurs experience with task environment, e. g. the market and technology • The entrepreneurs experience with managing new ventures Entrepreneurs with lack of experience with task environment or managing new ventures are likely to be the ones in most need of venture capitalist assistance. This is a somewhat unfortunate combination since venture capitalists value experience to a high degree when selecting ventures.
Sapienza & Timmons (1989) mean that when venture capitalists increase ownership their risks might be doubly increased. They face greater exposure to business risk since their stake rises. On top of that they face increased risk of opportunism since the return incentives of the entrepreneur are lower due to decrease in ownership. 3. 5. 6. Venture Capital Experiences Statistics show that around one sixth of venture capital investments are complete losses. Close to half either break even or show moderate losses. The very best investments play an important role if the venture capitalists are to show positive returns. Lerner, 2002) According to Ruhnka & Young (1991) the rule of thumb is that 30% of investments ultimately turn out to be winners. Not surprisingly venture capitalists only invest in companies with very high growth potential. (Amason & Sapienza, 1993) Venture capital investments are therefore focused into a few industries believed to have this great potential. Increased fundraising increases competition for transactions in these industries, rather than provides diversification to other industries. 3. 6. Technology and Venture Capital High-technology ventures often show a couple of patterns other ventures do ot. For high technology ventures it often takes longer time for the development and commercialization of products to be finalized. Therefore it is important for the venture capitalists to be patient concerning the timing of returns. De Clerque & Sapienza (2000) also mentions a general trend towards rising costs of R&D, combined with shorter life cycles for new products. Burn rates of technology ventures are generally higher than for non-technology ventures. Expenditures in high-tech ventures are also highly intangible and knowledge based, therefore finding the value of the ventures assets is very difficult.
Thorough investigation and monitoring is needed. These three factors are of course all negative in the eye of a potential investor in high-tech 28 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 3 ventures. However, high technology investments are still what venture capitalists are most interested in. Perhaps this is because they have developed expertise in handling these difficulties. 29 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 4 4. VENTURE CAPITALISTS AND SEED INVESTING This chapter presents the empirical findings from venture capitalists.
In the first section I describe the venture capital organizations. Following is a presentation of overall industry views and definitions of seed capital, after which the venture capitalists identify difficulties of seed investing. I then report the venture capitalist ideas about environmental factors affecting their activity. The chapter is concluded by venture capitalists investment strategies. 4. 1. The Venture Capital Organization 4. 1. 1. Structure There are two basic formations in which the venture capitalists set up their business.
Knowing about these two structures is valuable to understand the context venture capitalists are in. The difference between the structures lies in whether or not the capital under management is on the balance sheet of the organizations or not. If capital is held inside the VC I call the structure a holding structure. If capital under management is outside the VC this is called fund structure. This is a venture capital fund, as described in 1. 5. Holding Structure: This structure, Figure 6, is used often when the number of investors is few. The structure makes a difference for income streams of venture capital organization.
With the holding structure the venture capitalist is using its funds raised for two purposes. Firstly investing in promising companies, but the funds also pay management costs. The income of the venture capitalist depends solely on the success of its investments. Investor 1 Investor 2 Investor 3 Venture Capitalist Portfolio Companies Figure 6: Holding Structure. (Own Illustration) 30 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 4 Fund Structure: In this structure (Figure 7) the funds raised is held in a fund. The fund usually only contain the funds and no personal.
The venture capitalist is assigned to manage the fund. Managing the fund the venture capital organization receives compensation. Normally the seed stage venture capitalists acquire a management fee of around 3. 5% of the fund volume. 6 The idea of the fee is that it should cover the costs of management. 7 The venture capitalists also receive an income based on the performance of the fund. This possible income stream is called carried interest. 8 Seemingly a normal percentage of the increase in fund value, that venture capitalists claim, is 20%. Investor 1 Investor 2 Investor 3 Venture capitalist
Fund Portfolio Companies Figure 7: Fund Structure. (Own Illustration) Choice of Structure: It seems to be more common for venture capitalists that have more investors, to choose the fund structure. Venture capitalists managing more money also seem to be keener on this structure. Reasons 6 Management fee is the fee, typically a percentage of committed capital or net asset value that is paid by a venture capital fund to the general partners to cover salaries and expenses. (Gompers & Lerner, 1999, p. 346) 7 In my sample sometimes only parts of the management costs are covered by the management fee e. . administration and screening for new ventures. At other times it also compensates for costs of the management of current portfolio companies. 8 Carried interest is the share of profits that are allocated to the general partners of a venture capital partnership. (Gompers & Lerner, 1999, p. 343) 31 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 4 mentioned to have the fund structure are tax- and compensation of management purposes. Venture capitalists managing less money, often in the earliest stages, are more often structured according to the holding structure.
One reason to have this structure is that the fund structure has a predetermined life of 7-10 years. Venture capital organizations using the holding structure claim they can be more patient towards their portfolio companies. Next I will provide a set of technical data of the interviewed of venture capital organizations. Thereafter the management is discussed. 4. 1. 2. Technical Data This section of technical data from the seed investing venture capitalists aims to provide a picture of the venture capital organizations and activity. Basics: Fund size is the amounts of funds available for investing.
I also provide information on number of investment managers. • • • • Fund size range: 5. 5 to 33 million Euro Average fund size: 12 million Euro No. of investment managers: 1 to 6 Average No. of investment managers: 3 Investments: I provide information on the number of investments in the portfolios of selected venture capital organizations. I thereafter provide a measure of the normal ratio between investments and investment managers. Total investments refer to the amounts venture capitalists can invest in one single venture. First investment size relates to typical amounts invested in the primary investment.
As will be discussed in 4. 5. 5 venture capitalists invest in a varying number of rounds. • • • • • • • No. of investments: 4-26 Average No. of investments: 10 Average No. of investment managers / investment: 3 to 4 Total investment size range: 200. 000 Euro to 3m Euro Average total investment size: 500. 000 Euro First investment size range: 50. 000 to 750. 000 Euro Average first investment size: 200. 000 Euro 32 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 4 Management costs: The management costs refer to the operational costs of running the fund per year.
Management salaries are a considerable part of costs. The management cost range (%) relates the costs to the size of the fund. • Management cost range: 330. 000 to 1 million Euro • Management cost range (%): 3 to 6 % of fund volume Exemplification: I will provide some examples of a couple of funds size and cost relation. The first is a relatively large fund, thereafter a relatively small and then a normal sized fund. (1) 33 million Euro Fund • No. of investment managers: 6 • Management costs: 1 million Euro • Management costs of fund volume: 3% (2) 5. 5 million Euro Fund • No. f investments managers: 1 • Management costs: 330. 000 Euro • Management costs of fund volume: 6 % (3) 11 million Euro Fund • No. of investment managers: 3 • Management costs: 400. 000 Euro • Management costs of fund volume: 3,6% 4. 1. 3. Management The experiences and expertise of the investment managers in the venture capital organizations are diverse. There are VCs with primarily financial background. Others are more specialized towards technological knowledge. Many venture capital organizations however try and get a mix of the two, ultimately adding some legal expertise.
There is a wide acceptance that industry experience is more important than academic expertise. Experience in building organizations, understanding for entrepreneurial environment and working in boards of companies is considered important. What do venture capitalists then see as their most important contribution? I have chosen to divide contribution into form of contribution and area of contribution. 33 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 4 With form of contribution I mean channels used to help manage the portfolio companies. Three different forms emerge.
Firstly, all venture capitalists are working in the boards of their companies. They say this direct contribution is time demanding and there is a limit to how many companies one investment manager can effectively assist. Three to four companies per investment manager are generally what venture capitalists say is possible in the active investment period, see 4. 5. 5. Venture capitalists also recruit individuals who they think can provide competencies needed, to the young venture. Thirdly, using an extensive network venture capitalists claim they have access to special expertise when needed.
The areas of contribution that venture capitalists believe to be most important are to do with building the organization, strategic advice, and future fundraising. Building the organization refers to providing structure and responsibilities within the company. Strategic advice involves understanding the market for the product and directing the development thereafter. This is claimed important since within the company, the focus generally is on technology. By keeping close contact with later stage venture capitalists and other later stage investors, venture capitalists increase the companies’ access to future fundraising.
This is also achieved by setting up the objectives for the young ventures, so that they will fit into what later stage investors want. 4. 2. Seed Stage Capital 4. 2. 1. Different Views My focus in this thesis is to study the seed stage investing by venture capitalists. When talking to venture capitalists a scattered picture of what seed really means appear. Many VCs have their view but agree that this is not the only way to look at it. Other VCs do not consider the definition to be very important. The importance lay in what we do, not what we call it, are their opinion.
In industry it seems acceptable to define stages according to many variables. Used variables are the valuation of the venture, the number of financing rounds occurred, lifetime of the venture, turnover of the venture and stage of technology development. Definitions also tend to change and over time new terms are invented. 34 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 4 4. 2. 2. Defining Seed Capital Taking into account all different views, the most common way to try to define seed capital is by using the stage of technology development. Many mention that this stage is about achieving a proof-of-concept.
A descriptive definition that at the same time positions many of the venture capitalists view of seed is that: A formal business plan exists; the aim at this stage is (1) to obtain proof of concept at the technological level which at the same time serves as a commercial proof-of-concept, (2) to develop the company to be to the tune of 1. 5 to 3 million Euro pre-money valuations. 9 (Andersson, 2003-04-13) Generally the venture in the seed stage has no turnover. If there is some turnover it is in the form of early test sales. Stage of technology development in these stages are highly correlated to what value the venture can claim (4. . 4). Within the seed stage, a commercial acceptance has not been demonstrated. The goal of the stage is a technologically working prototype and some form of commercial acceptance. However, when this is fulfilled it marks the end of the seed stage. This also means that the investments cannot be too high, in order for the entrepreneur to remain the majority owner. The group with this view of seed capital is therefore typically investing between 50. 000 and 200. 000 Euro in a seed round. Other venture capitalists have a slightly different view of seed capital. They mean that sale can have occurred.
They invest when the technology has had some acceptance from the market; technological development is no longer the essence of the business. These venture capitalists look upon their role predominately as helping for the venture to reach the market. Since technological development has come further the typical first investments are higher. A first investment for these later stages of development can be 9 Pre-money valuation is the product of price paid per share in a financing round and the shares outstanding before the financing round. (Gompers & Lerner, 1999, p. 347) 35
Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 4 between 200. 000 and 750. 000 Euro. The figures vary depending on whether investments are syndicated or not. 10 (4. 5. 2) The other way to position the seed stage is to look at when the seed stage can be said to start. In industry terminology a stage before seed exists. This stage is called the pre-seed stage. Persons with ideas come to us for funding, not companies. (Hansson, 2003-03-25) In the pre-seed stage you start from the very beginning with starting up the company, working out a business plan and develop management.
Some mean that this stage can be overcome largely without additional funding. Others mean additional capital of up to 100. 000 Euro is needed in the pre-seed stage. 4. 3. Seed Investment Difficulties When discussing the difficulties of seed investment, a range of difficulties arise. They are to do with Risk, Lack of Information, Recruiting, Investment/Cost Ratio, Goal Divergences, and Bargaining Power 4. 3. 1. Risk Almost all venture capitalists see the high risks of investing in the seed stage as the biggest problem and challenge to overcome.
Some even claim that the risks themselves are so high that investing in the seed stage over time cannot be profitable. There are simply so many potential problems to overcome for the venture before a trade sale or IPO is realistic. It is important to, as early as possible, try and foresee where problems can arise and find out if they can be solved. (Andersson, 2003-03-25) If foreseen problems are not believed solvable, as mentioned before, venture capitalists see abandoning bad projects early as important. In the optimal case, these projects would not be funded in the first place.
One venture capitalist 10 Not all venture capitalists I have interviewed say they do seed investments. Only that they are investing in early stage. Therefore, this venture capitalist’s view of seed capital has no relation to the amount of its earliest investments. 36 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 4 says that the only way to have a profitable commercial seed fund is to invest with extreme selectivity. Engaging in perhaps one investment per year when the circumstances are extraordinarily good is a way to increase the probability of profitability.
However identifying which companies that would fit into this strategy would be problematic and largely has to do with lack of information. 4. 3. 2. Lack of Information Because of the early stage of entrepreneurial activity the venture capitalists do not have access to much information. In later stages the venture has got a history and there are financial reports etc. In the seed stage the decision to invest is based upon a “gut-feeling”. A more structured method is, if possible, naturally preferred by venture capitalists. Many VCs as an important tool mention a proper due diligence investigation when selecting ventures. 1 On the other hand, many say that that you cannot demand as much information as you might like to, from seed stage ventures. Often development of technologies and companies tend to take longer and cost more than the initial expectation. This is nothing strange since the initially so little information is available. If a project either takes longer or costs more than expected, the return of the seed investments often suffer, because when the share price in the next round is negotiated, an increase in value from the seed round cannot be supported.
The return of the seed stage itself is therefore low or maybe non-existent. 4. 3. 3. Recruiting The risky nature of the seed stage companies is also a problem for venture capitalists wanting to recruit competent personal to ventures. Coming to a risky venture without much money is not exactly the desire of every competent manager. However this is mentioned problematic not by all venture capitalists and one solution suggested is to hire specialized part time staff. 4. 3. 4. Investment/Cost Ratio Many VCs mention the problem of high costs of management in comparison to investment.
The seed stage ventures need a lot of management help in comparison to their need for money. 11 Due diligence is the review of a business plan and assessment of management team prior to a venture capital investment. (Gompers & Lerner, 1999, p. 344) 37 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 4 What you invest in seed stage companies is 95% time and 5% capital. (Segerborg, 2003-03-26) The seed stage ventures can not defend a very high valuation. Venture capitalists also want the entrepreneur to keep his motivation and cannot claim at too much ownership.
The investments in seed are therefore always moderate to their amount. For venture capitalists in this stage this means they have high costs of management per invested amount of capital. This is a clear disadvantage to later stage rounds where investments are higher and costs of management lower per invested capital amount. 4. 3. 5. Goal Incongruence Some VCs mention a difference in the mind-set of entrepreneurs compared to their view. Sometimes there is a clash between the entrepreneur’s wishes to fulfill ambitions in science and the commercial orientation of the venture capitalist.
VCs generally have a certain way of going about their business. If the entrepreneur is not ready for this commercially oriented leading actor to enter the organization, the involvement can do more bad than good. VC-management at its worst may seem like screaming at a flower to grow. (Svardstrom, 2003-03-28) 4. 3. 6. Bargaining Power The venture capitalists investing in seed generally have a limited ability to participate in later rounds of financing. They are focused on investing in the earliest stages. This means that when additional funding is needed, new investors eventually have to provide all the funding.
The venture capitalist ends up in a situation where his credibility can be questioned. If the VC, who knows more about the company than most, is not investing, why should others do? Some interviewed venture capitalists believe that this is a disadvantage in terms of the valuation and therefore the profitability of seed investments. Other factors which are also highly important for the profitability of seed investments are environmental forces, and these will be discussed in the following section. 38 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 4 4. 4. Seed Investment Environment
The ability for successful seed funding is according to the venture capitalists dependent upon a number of outside factors. Mentioned factors include society view of entrepreneurial activity, seed funding history, general market conditions, and access to soft financing. 4. 4. 1. Society View of Entrepreneurial Activity It is important that there is an acceptance from the society towards failing start-up a business. It is often considered something bad having started and been forced to liquidate. This can lead to fewer entrepreneurs going for a commercialization of their inventions.
In the long run it inhibits the deal flow for seed investors. It is also considered very important that universities, in the areas that venture capitalists want to invest, are driven in the direction towards commercialization. The importance lays not so much in the numbers of researchers as it does in their minds. Naturally quality research is also a requirement for success in seed stage investing. 4. 4. 2. History of Venture Capital The high-tech boom and collapse have changed the minds of investors in early stages. Firstly there where a quite large number of investments that showed exceptional returns.
They have set the target for investments, which have lead to extreme requirements towards seed stage companies. After the collapse many investors learned a lesson and are now choosing to invest in later stages in order to limit the risks. This has lead to difficulties in exiting investments and finding follow-on funding for seed stage VCs. A disbelief in technology has developed after the high-tech boom. Companies are distant to buying new technology from young ventures. Since the ventures do not sell their products, new investors are hard to attract.
If no new funding is provided, the young companies are considered even more risky. Therefore even more resistance towards buying their products develops. 4. 4. 3. General Market Conditions Some say that seed investing can be a profitable business since investing this early mean you acquire the option to invest in the more profitable later stages. However, if true, this can only be true for the cases when there is some competition among investors to invest in the stages after seed. This is not the 39 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 4 case when the market conditions are poor.
Valuations are generally low and no one either sells or buys. Today you can calmly wait and invest in later more profitable rounds with lower risks. (Olofsson, 2003-03-25) In these poor conditions many investors prefer later stage investments. Valuations have dropped for innovative companies who have already come far in their development. Venture capitalists see logic in investing in these stages instead. They mean that why should investors pay almost as much for something so much more risky and undeveloped. It is therefore hard for the venture capitalists investing in seed capital to find follow-on investors.
It is also hard for the venture capitalists to find opportunity to exit their positions at acceptable levels of valuation. One venture capitalist says that if the market does not improve, they have an impossible task in succeeding to reach required rates of return in their current fund. The movement towards later stage investments is considered a problem in the long run. Someone has to do the work in the early stages in order if there are to be any later stage ventures. However, not many venture capitalists choose to do much about it. There is a broad consensus that so called soft money is needed in the earliest stages. . 4. 4. Access to Soft Funding Soft money is government-funded investments in very early stage ventures. Usually when the venture capitalist make a seed investment, based on the amount invested, the venture capitalist can get an additional amount invested in form of a government-funded loan to the venture. This is called soft funding and in cases when ventures are successful interest on the loan and the principal is repaid. If the venture fails and is liquidated, the government claims no retribution. Because of all the difficulties in seed investing (4. ) most venture capitalists claim this kind of money is a necessity. Soft funding is provided to a varying degree to ventures in which interviewed venture capitalists invest. One venture capitalist sees the danger of too much soft money, since it can inhibit the possibilities to get further funding later on.
Too much financial aid is 40 Venture Capitalists on the Seed Stage Arena – A Fit or Misfit Chapter 4 believed harm the focus and efficiency in the young ventures. However, the consensus is that soft money is needed and it is of extra importance in times of poor market conditions with low valuations. . 5. Seed Investment Strategies In this chapter I will describe the relationship between the seed investing venture capitalists and entrepreneurs. 4. 5. 1. Ownership Two features are to be described. Firstly the form of ownership and secondly the ownership share claimed by venture capitalists. Ownership form: By definition, venture capital, mean the investment somehow leads to equity or equity linked position. There are however many different solutions for contracts that do this. Used alternatives are e. g. preferred stock, common stock, convertible debt, and options. 2 There are different opinions as to whether using all these different solutions or not is positive for the venture capitalist and its’ ventures. Some say that a mix is good and that different situations call for special solutions. It seems to be a common strategy to use convertible debt when the venture needs a little more money in order to be ready for the next financing round. The reason for this is that the valuation of the venture is postponed until the later round. These small extra “rounds” are often not planned and if a valuation were to take place it could be low.
So, postponement of the valuation saves the venture capitalist from sending warning signals to future investors. However, almost all venture capitalists say that the valuation and set up of ownership is what they fight most often about with their portfolio companies. Some mean that the more complicated the structure of this, the more problematic it becomes. Rounds that create stock with different values are a common source of conflict. My experience tells me that as soon as you put the owners in different boats, you are laying the foundation for problems. (Olofsson, 2003-03-26) 12