Enterprise and Small Business Principles

Venture capital and the small business

Colin Mason

19.1 Introduction

Firms pursuing significant growth opportunities are likely to find that their financial needs exceed their capability to generate funds internally while their ability to attract bank loans is restricted by their lack of collateral and negative cash flows. Indeed, the faster a firm grows the more voracious is its appetite for cash - investments in research and development (R&D), product development and testing, recruitment of key team members, premises, specialised equipment, raw materials and components, sales and distribution capability, inventories and marketing all add up (Bygrave and Timmons,

1992) . These firms will need to turn to venture capital in order to achieve their growth ambitions. Venture capital can be defined as finance that is provided on a medium - to long-term basis in exchange for an equity stake. Investors will share in the upside, obtaining their returns in the form of a capital gain on the value of the shares at a ‘liquidity event’, which normally involves a stock market listing, the acquisition of the company by another company or the sale of the shares to another investor, but will lose their investment if the business fails. Venture capital investors therefore restrict their investments to businesses that have the potential to achieve rapid growth and achieve a significant size and market position because it is only in these circumstances that they will be able to achieve both a liquidity event and a capital gain. However, very few businesses are capable of meeting these demanding investment criteria. So, as Bhide (2000: 16) observes, venture capital-backed firms ‘represent an out-of-the ordin­ary phenomenon’.

Although the number of companies that are successful in raising venture capital is small they have a disproportionate impact on economic development in terms of innova­tion, job creation, R&D expenditures, export sales and the payment of taxes (Bygrave and Timmons, 1992). The injection of money and support enables venture capital-backed companies to grow much faster than the proceeds from sales revenue alone would allow. Moreover, this superior growth rate is sustained over the long run (Gompers and Lerner, 2001b). Venture capital-backed companies are faster in developing pro­ducts and bringing them to market, pursue more radical and ambitious product or process innovation, and produce more valuable patents (Hellman and Puri, 2000). It is because venture capital-backed companies play such an important role in economic development that venture capital attracts the attention of both scholars and policy makers.

As a final introductory point, it needs to be acknowledged that this chapter takes an ‘Anglo-Saxon’ perspective focusing largely on the US and UK literature. Venture capital was pioneered in the US immediately after the Second World War and it was not until the early 1980s that it began to develop in Western Europe, initially in the UK and subsequently on the Continent. During the 1990s embryonic venture capital industries began to appear in emerging markets such as Asia and central Europe, and these regions are now beginning to attract attention from researchers (e. g. see Lockett and Wright, 2002, and Wright et al., 2002). However, venture capital in Europe and Asia is rather different from its namesake in the US, being less technology-oriented and focused on more mature and later-stage deals rather than young, rapidly growing entrepreneurial companies. These differences are reflected in terminology. In Europe the term ‘venture capital’ and ‘private equity’ are often used interchangeably to cover all types of equity investment from start-up through to management buy-outs (MBOs) and buy-ins (MBIs), that is, the funding of incumbent or incoming management teams to buy companies from their owners to run as independent businesses. However, in the US the venture capital and MBO/MBI investments (termed leveraged buy-outs, or LBOs) are regarded as entirely different industries, with the term ‘venture capital’ restricted to investments in new or recently started companies (Campbell, 2003). This chapter follows the US definition of venture capital, focusing on the financing of the seed, start-up and early-growth stages of business development.

19.2 Learning objectives

This chapter has three learning objectives:

1 To consider the demand side in order to highlight the sources of finance available to companies at different stages in their development

2 To understand the role of business angels (or informal venture capital) and venture capital funds (or formal venture capital) as they are potentially available to any firm that offers the promise of rapid growth.

3 To consider the characteristics of investors, their investment activity, sources of deals, investment criteria, deal characteristics, post-investment involvement and harvest.

Key concepts

■ finance for small firms ■ business angels ■ venture capital

19.3 Financing entrepreneurial companies: a demand-side perspective

Entrepreneurial companies typically evolve through multiple stages of growth and development, with attendant changes in their capital requirements and the source of the finance (Roberts, 1991a). At the seed stage (or zero stage) a business will be in the pro­cess of being established, is undertaking R&D, solving key product development issues and moving to an operating demonstration prototype of the initial product. This phase typically occurs in the founder’s home while the founder is working full-time. There may not be a formal business plan at this stage. Financial needs are likely to be fairly minimal and will be met by a combination of the founder’s own personal savings, family and friends (the three F’s) and ‘bootstrapping’ techniques - where bootstrapping can be defined as strategies for marshalling and gaining control of resources at minimal or no cost (see Bhide, 1992; Freear et al., 1995a; Winborg and Landstrom, 2001; Harrison et al., 2004).

Commercial investors will regard such ‘pre-ventures’ as being too high risk. How­ever, government support may be available in the form of R&D and proof-of-concept grants for technology-based firms. The start-up stage begins with the founding of the company, demonstration of commercial applicability, securing of initial sales and seek­ing new sales channels. The financial needs increase as the company invests in capital equipment, begins to employ staff and for working capital. Investment in businesses at this early stage is very high risk - the management is unproven and the product or ser­vice has yet to demonstrate widespread acceptance - and any return may not materialise for five to ten years. Thus, businesses are likely to continue to rely upon a combination of ‘love money’, bootstrapping and government support, although those with growth prospects may be able to raise finance from business angels. Particularly in Europe, few venture capital funds will be interested in investing at such an early stage unless they have been established with an economic development mandate. Companies that come through the start-up stage with a product or service which is in demand enter the initial growth stage. The business will be seeking to improve product quality and lower its unit costs and develop new products. The business may be reaching profitability but this is insufficient to fund the growth that is required to expand plant and equipment and obtain bigger premises and additional staff to fill out each of the functional areas and increased working capital requirements. Risk and uncertainty have declined. By this stage the business will no longer be reliant on 3F money. The main source of fund­ing will be business angels but they typically make relatively small investments (less than £250,000), so larger funding requirements and follow-on financing are likely to be met by venture capital funds. Companies that continue to grow enter the sustained growth stage. These companies are often termed ‘gazelles’, and can expect to grow to beyond £10m/$20m in sales and 100 employees. Profits and cash flow are sufficient to meet the majority of their capital requirements but additional finance may be required to grasp new growth possibilities (including acquisitions). Such companies will look to venture capital funds specialising in development capital and even to more esoteric financing instruments, and ultimately to a stock market listing where shares are avail­able to the public (Roberts, 1991a; Sohl, 1999).

Thus, there are a variety of potential funding sources available to finance new busi­nesses through these stages of growth and development.

19.3.1 Personal savings of the entrepreneur or team

This is typically the primary source of initial funding. Even though the amounts involved are usually quite small, this funding is important for two reasons. First, subsequent investors will expect to see that entrepreneurs have committed themselves financially to the business. Second, the effect of raising outside capital will be to dilute the propor­tion of the business owned by the original entrepreneurs. Thus, the bigger the amount that they are able to invest, and the longer that they can survive on this and other non­equity sources of funding and bootstrapping, then the less dilution they will experience when they come to raise external capital. The entrepreneur is also likely to contribute ‘sweat equity’ by working for no salary or at a level below what could be obtained by working for someone else until the business is on a solid financial footing.

19.3.2 Family and friends

Recent research by the Global Entrepreneurship Monitor (GEM) consortium, an inter­national consortium of 38 countries that collect data on entrepreneurial activity on a consistent basis by means of large-scale household surveys, reports that close family members, friends and neighbours are by far the biggest source of start-up capital after the founders themselves (Bygrave et al., 2003). Such investments typically take the form of short-term loans which may be converted into equity at a later stage. This form of finance is relatively easy to obtain, although the amounts involved are relatively small. The providers are unlikely to regard their investment as a commercial one and, indeed, may not expect it to be repaid. However, entrepreneurs may be reluctant to ‘take advantage’ of kinship and friendship ties and may feel under emotional pressure not to lose the money (Roberts, 1991a).

19.3.3 Business angels

These are wealthy private individuals, generally with a business background, and often cashed-out entrepreneurs, who invest their own money - either on their own or with a syndicate of other angels - in new or recently started businesses with growth poten­tial. Their motives are economic but not totally so. Non-economic motivations include the fun and enjoyment that come from an involvement with a young, growing com­pany and social responsibility. Their investments are typically at or soon after start-up and range from under £10,000 to over £250,000, although the norm is £50,000 to £100,000. These investors do not normally seek a controlling interest or management position in the business but it is usual for them to perform an advisory role and they would expect to be consulted on major management decisions.

19.3.4 Venture capital firms

Venture capital firms are financial intermediaries that attract investments from finan­cial institutions (banks, pension funds, insurance companies), large companies, wealthy families and endowments into fixed life investment vehicles (‘funds’) with a specific investment focus (location, technology, stage of business development). The money is then invested in young, growing businesses that offer the prospects of high reward. The function of the fund managers (the general partners) is to identify promising invest­ment opportunities, support them though the provision of advice, information and networking and ultimately exit from the investment. The proceeds from the exit - or liquidity event - are returned to the investors (the limited partners). Most venture capital firms are independent organisations. Some are subsidiaries of financial institu­tions (termed ‘captives’). A few large non-financial companies, particularly technology companies, have their own venture capital subsidiaries that invest for strategic reasons to complement their own internal R&D activities (corporate venture capital). Venture capital firms rarely invest in basic innovation. Rather, venture capital money assumes importance once the business model, product and management capabilities have been proven, market acceptance has been demonstrated and uncertainties about the size of the market and the profitability of the business have been reduced (Bhide, 2000). Companies at this stage are looking to commercialise their innovation and need fund­ing to create the infrastructure to grow the business (Zider, 1998). Thus, venture cap­ital firms tend to invest significantly larger amounts than business angels and invest at later stage in business development.

19.3.5 Government-backed investment organisations

In most countries governments have created investment vehicles to fill what are per­ceived to be gaps in the supply of venture capital that results in funding difficulties for particular types of company. In the past it was common for governments to use their own money to provide the investment funds. However, it is now common practice for governments to create investment funds under private management by leveraging private sector money by using the tax system or other financial incentives to alter the balance of risk and reward for the private investor. Examples of venture capital funds that have been created as a result of tax incentives are Venture Capital Trusts (VCTs) in the UK and Labor-Sponsored Venture Capital Funds in Canada (Ayayi, 2004). Examples of investment funds created as a result of government co-investment along­side private money but on less favourable terms, thereby improving the investor’s return, include Small Business Investment Companies (SBICs) in the US, the KfW and DtA programmes in Germany and the Regional Venture Capital Schemes in England (Sunley et al., 2005).

Gaining a listing on a public stock market may be the logical final step for a fast - growing company to fund its ongoing growth. Further shares in the company can be sold to institutional and private investors to raise additional finance. Raising debt finance also becomes easier with a public listing. Public companies can also use their shares to make acquisitions. And a listing is also an important way in which existing shareholders - notably the founders and their families, business angels and venture capital funds - can realise their capital gains. However, the costs of obtaining and maintaining a stock market listing mean that it is only an option for larger companies.

Amazon. com provides a good example of a company that has drawn on these vari­ous sources of finance as it has grown (Table 19.1). However, while most companies will utilise 3F money, only a minority will go on to raise second - and third-round funding from external sources. For example, in Manigart and Struyf’s (1997) study of young, high-tech Belgian companies, all had relied on funding from the founder or founding team for start-up capital. Most had also raised funding from other sources, notably family, banks and private investors, whereas only two firms had raised ven­ture capital. Eight firms went on to raise a second round of finance: six firms attracted investments by venture capital funds (including the two firms that had raised venture

capital at start-up, which raised larger amounts of funding from venture capital syn­dicates), and two firms raised finance from corporate venture capital sources. None of the firms raised further finance from founders or family.

The remainder of this chapter examines the two main sources of external equity finance - business angels and venture capital firms. Agency theory provides a frame­work to study their investment process. An agency relationship is said to exist when one individual (the principal) engages the services of another individual (the agent) to perform a service on their behalf (Jensen and Meckling, 1976). This involves the dele­gation of a measure of decision-making authority from the principal to the agent. Both are assumed to be economic-maximising individuals. The central concern of agency theory is opportunism - the separation of ownership and control creates the risk that the agent will make decisions that are not in the best interests of the principal. This creates two types of risk for the principal (i. e. the investor). The first is adverse selec­tion, which arises as a result of informational asymmetries: the agent is better informed than the principal about his true level of ability. However, agents may deliberately mis­represent their abilities to the principal. The second risk is moral hazard. In situations where it is not possible for the principal to observe the behaviour of agents the latter may shirk, engage in opportunistic behaviour that is not in the interests of the prin­cipal or pursue divergent interests that maximise their economic interests rather than those of the principal. Fiet (1995) argues that every investment decision also includes market risk - the risk that the business will perform less well than anticipated on account of competitive conditions (e. g. competition, demand, technological change). A key theme running through the remainder of this chapter is how business angels and venture capital fund manage these sources of risk.

19.4 Business angels

19.4.1 Definition and characteristics

Business angels are conventionally defined as high-net-worth individuals who invest their own money directly in unquoted companies in which they have no family con­nection in the hope of financial gain and typically play a hands-on role in the busi­nesses in which they invest. Several aspects of this definition need to be emphasised. First, having wealth is a prerequisite for becoming a business angel. Business angels invest upwards of £10,000 per deal (sometimes in excess of £100,000) and typically have a portfolio of between two and five investments. However, because this is high risk most business angels will only allocate between 5% and 15% of their overall investment portfolio to such investments. Second, the fact that business angels are investing their own money means that they do not have to invest if they are unable to find suitable investment opportunities. They can also make quick investment decisions and have less need for specialist professional input so their transaction costs are low. It also means that they can have idiosyncratic investment criteria. Third, investing dir­ectly means that business angels are making their own investment decisions rather than investing in a pooled investment vehicle in which investment decisions are made by a manager. This implies that people who become business angels have both the networks that will provide a flow of investment opportunities and the competence to undertake the appraisal of these opportunities. Indeed, the majority of business angels are suc­cessful cashed-out entrepreneurs, while the remainder either have senior experience in large businesses or have specialist professional expertise. Fourth, business angels are active investors in unquoted companies, playing a hands-on role in supporting their growth. Fifth, business angels are investing for a financial return.

However, psychic income is also important. Business angels derive considerable fun and enjoyment from being involved with entrepreneurial businesses. Indeed, for suc­cessful entrepreneurs becoming a business angel is a way in which they can recapture this experience and use the skills and intuition that they have developed as entrepre­neurs to the benefit of their investee companies.

The typical business angel therefore has the following profile:

■ Male: typically around 95% of business angels are males. This reflects the fact that relatively few women have built up successful companies or hold senior positions in the corporate sector.

■ Successful cashed-out entrepreneurs: most business angels have had experience of business start-up and growth. This provides them with the skills and competence to evaluate investment opportunities and add value to those business that they invest in.

■ In the 45-65 year age group: this reflects the length of time required to build signi­ficant personal net worth, the greater discretionary wealth of this age group and the age at which successful entrepreneurs may choose, or be forced, to disengage. Becom­ing a business angel is often a way in which such individuals remain economically active. Indeed, some cashed-out entrepreneurs become business angels because they find that a life of leisure is boring.

These characteristics are remarkably consistent across countries. However, this typical profile masks considerable heterogeneity in the business angel population, notably in terms of their motivation, the size and frequency of their investments, and their involve­ment with their investee companies (Coveney and Moore, 1998; Kelly and Hay, 1996; 2000; S0rheim and Landstrom, 2001). What this underlines from the entrepreneur’s perspective is that angel funding is a differentiated commodity and that they must iden­tify the appropriate type of investor who is both willing and capable of contributing the financial and other resources that they require.

19.4.2 Size of the market

It is impossible to be precise about the number of business angels, the number of invest­ments made and the amount invested. This is because there is no obligation for business angels to identify themselves or register their investments. Indeed, the vast majority of business angels strive to preserve their anonymity and are secretive about their investment activity, not least to avoid being inundated by entrepreneurs and other indi­viduals seeking to persuade them to invest or provide financial support for other causes (Benjamin and Margulis, 2000). Thus, measures of the size of the informal venture capital market are only crude estimates. Sohl (2003) suggests that there are 300,000 to 350,000 business angels in the US, investing approximately $30bn in almost 50,000 ventures. Venture capital funds, in contrast, invest $30-$35bn in fewer than 3,000 entrepreneurial ventures. The equivalent estimate for the UK is 20,000 to 40,000 busi­ness angels investing £0.5bn to £1bn in 3,000 to 6,000 companies. They make eight times as many investments in start-up companies as venture capital funds (Mason and Harrison, 2000). However, these calculations of the amounts invested by business angels are an underestimate of the size of the informal venture capital market. First, most busi­ness angels have further funds available to invest (Coveney and Moore, 1998; Mason and Harrison, 1994, 2002a) but cannot identify appropriate investment opportunities. This uncommitted capital is substantial: one study reported that it exceeded the amount invested by the respondents in the three years prior to the surveys (Mason and Harrison, 2002a). Second, there is a substantial pool of potential, or virgin, business angels who share the characteristics of active angels but have not entered the market (Freear et al., 1994a; Coveney and Moore, 1998). Sohl (1999) has estimated that in the US these potential angels exceed the number of active investors by a factor of five to one.

19.4.3 Investment characteristics

We have already noted that business angels occupy a crucial place in the spectrum of finance available to growing businesses, providing amounts of finance that are beyond the ability of entrepreneurs to raise from their own resources and from family, and below the minimum investment threshold of venture capital funds. Business angels, investing on their own or in small ad hoc groups, will typically invest up to £100,000, while the larger angel syndicates will make investments of £250,000 and above. This investment is usually provided in the form of equity or a combination of equity plus loans. However, all-loan investments are by no means unusual. (As Gaston (1989) notes, the financial needs of new and young businesses are not neatly boxed into separate loan and equity categories. Their capital needs frequently shift between these types. Angels make their investments in the form of loans (usually unsecured), loan guarantees, equity and combinations of these types of finance.) In terms of stage of business development, investments by business angels are skewed towards the seed, start-up and early-growth stages whereas venture capital funds focus on business expansion.

The geographical characteristics of business angel investments are also important. This has two dimensions. First, ‘angels live everywhere’ (Gaston, 1990: 273). Gaston’s research suggests that the proportion of business angels in the US adult population is fairly constant at around four angels in every 1,000 adults. Certainly, research has docu­mented the presence of business angels in various economically lagging regions, such as Atlantic Canada (Feeney et al., 1998; Farrell, 1998; Johnstone, 2001). Second, however, there is a greater chance of a mismatch between the needs of the entrepreneurs and the preferences and value-added skills of potential investors in such regions. Johnstone (2001) notes that, in the case of Cape Breton, demand for angel finance is concentrated among IT businesses and they want investors to provide marketing and management inputs whereas the investors typically have no knowledge of the sector and so have limited ability to add value.

In contrast, institutional sources of venture capital are disproportionately concen­trated in leading economic regions, such as Silicon Valley and New England in the US, and south east England in the UK (Mason and Harrison, 1999). Second, various studies indicate that the majority of investments by business angels are local. This reflects both the localised nature of their business and personal networks through which they iden­tify most of their investments and their hands-on investment style and consequent need for frequent contact with their investee businesses. Two implications follow. First, in most areas outside major financial centres and technology clusters business angels are the only source of risk capital (Gaston, 1989). Second, the informal venture capital market is an important mechanism for retaining and recycling wealth within the region that it was created.

19.4.5 The investment process

Following Riding et al. (1993) and Haines et al. (2003) a number of discrete stages in the investment process can be identified:

■ deal origination;

■ deal evaluation: this can, in turn, be sub-divided into at least two sub-stages: initial screening and detailed investigation;

■ negotiation and contracting;

■ post-investment involvement;

■ harvesting.

As we will see later, this sequence is similar in most respects to the investment decision-making model of institutional venture capital funds (Tybjee and Bruno, 1984; Fried and Hisrich, 1994). However, the approach of business angels is less sophisticated.

19.4.6 Deal origination

The evidence is consistent in suggesting that business angels adopt a relatively ad hoc and unscientific approach to identifying investment opportunities. Informal personal contacts - business associates and friends - are the most significant sources of deal flow. Professional contacts are much less significant: of these, accountants are the most frequent source whereas few business angels receive deal flow from lawyers, bankers and stockbrokers. Those angels who are known in their communities also receive approaches from entrepreneurs. Information in the media is another source of deal flow for a significant minority of business angels. Some business angels also undertake their own searches for investment opportunities. Those business angels who are members of Business Angel Networks (BANs), which provides a mechanism for entrepreneurs who are looking to raise finance and investors who are looking for deals to connect with each other, also report that these organisations are significant sources of deal flow (Mason and Harrison, 1994, 2002a). In some cases, especially in the case of ad hoc investors, the entrepreneur is not a stranger but a business associate who is known to the angel (e. g. client or supplier) (Atkin and Esiri, 1993). Kelly and Hay (2000) observe that the most active investors rely less on ‘public’ sources (e. g. accountants, lawyers, etc.) and place more emphasis on ‘private’ sources that are referred by individual and institu­tional sources in their extensive and long-standing networks of relationships.

However, these various sources of information differ in their effectiveness. Freear et al. (1994b) have calculated yield rates for different information sources (i. e. com­paring investments made against deals referred for each information source). This points to the informal personal sources of information - business associates, friends and approaches from entrepreneurs - as the ones that have the highest probability of leading to investments whereas non-personal sources such as accountants, lawyers and banks have a low likelihood of generating investments. These findings are largely corroborated by Mason and Harrison (1994) for the UK. However, in their study the highest yield rates are recorded by some of the infrequently used professional contacts, notably banks and stockbrokers. This study also notes the low yield ratio for BANs.

Investing in businesses that are referred by trusted business associates and friends is an obvious way in which business angels can minimise adverse selection problems. As Riding et al. (1995) comment, ‘even if the principals of the firm are unknown to the investors, if the investor knows and trusts the referral source risk is reduced.’ Deal referrers are passing judgement on the merits of the opportunity and so are putting their own credibility and reputation on the line.

19.4.7 Deal evaluation

The process of evaluating investment opportunities involves at least two distinct stages - initial screening and detailed evaluation (Riding et al., 1993). The initial step of business angels is to assess investment opportunities for their ‘fit’ with their own personal investment criteria. The investment opportunity will also be considered in terms of its location (how close to home), the nature of the business, the amount needed and any other personal investment criteria (Mason and Rogers, 1997). Business angels will then typically ask themselves two further critical questions: ‘Do I know anything about this industry, market or technology?’ and ‘Can I add any value to this business?’ Clearly, the ability to add value is very often a function of whether the angel is familiar with the industry. If the answer to either of the questions is no, then the opportunity is likely to be rejected at this point.

Angels then undertake a quick review of those opportunities that fall within their investment criteria to derive some initial impressions. Although most business angels expect a business plan, they are unlikely to read it in detail at this stage. Their aim at this point in the decision-making process is simply to assess whether the proposal has sufficient merit to justify the investment of time to undertake a detailed assessment. This stage has been the subject of a detailed analysis by Mason and Rogers (1996, 1997) using verbal protocol analysis, an experimental-type technique which asks sub­jects (in this case business angels) to think out loud as they perform a task (in this case evaluating a real investment opportunity). They observe that angels approach this stage with a negative mindset, expecting that the opportunity will be poor (because of the opportunities that they have previously seen) and looking for reasons to reject it. This approach has been termed ‘three strikes and you’re out’ (Mason and Rogers, 1996, 1997) and is supported by evidence that the rejection of opportunities is gen­erally based on several factors rather than a single deal killer (Mason and Harrison, 1996a). The market and the entrepreneur are the key considerations at this stage. Less significant are the product/service and financial factors. Indeed, angels exhibit con­siderable scepticism about the value of financial information in the business plan of start-ups (Mason and Rogers, 1997). Nevertheless, investors want to see that there is the potential for significant financial return, that the principals are financially commit­ted and what the money that is invested will be used for. Some angels will be flexible, willing to treat some of these criteria as compensatory (e. g. a strong management team would compensate for a distant location), whereas others will regard them as non­compensatory (Feeney et al., 1999).

The purpose of the initial screen is to filter out ‘no hopers’ in order to focus their time on those opportunities that appear to have potential, which are subject then to more detailed appraisal. The investor will read the business plan in detail, go over the fin­ancial information, visit the premises, do some personal research to gather additional information on market potential, competition and so on, and assess the principals. Indeed, getting to know the principals personally (by a series of formal and informal meetings) is the most vital part of the process (May and Simmons, 2001). Most angels emphasise their intuition and gut feeling rather than performing formal analysis (Haines et al., 2003) - although more experienced angels, and angel groups adopt more sophist­icated approaches (e. g. see Blair, 1996).

Once the opportunity has passed from the initial screen the importance of ‘people’ factors becomes critical (Riding et al., 1995), with investors emphasising management abilities, an understanding of what is required to be successful, a strong work ethic, integrity, honesty, openness and personal chemistry (Haines et al., 2003; Mason and Stark, 2004). This reflects the long and personal nature of the angel - entrepreneur relationship. Rewards, realism of the projections and potential also assume greater importance while ‘investor fit’ becomes less of a consideration (Riding et al., 1995).

This stage ends when the investor has decided whether or not to negotiate a deal with the investor. In their Canadian study Riding et al. (1993) found that 72.6% of opportunities were rejected at the initial impressions stage, a further 15.9% were rejected following more detailed evaluation, and as this stage proceeded another 6.3% were eliminated, a cumulative rejection rate of 94.8%. Thus, business angels proceed to the negotiation stage with only 5% of the investment opportunities that they receive.

The key role of the entrepreneur/management team in the decision whether or not to invest is confirmed in other studies. Using conjoint analysis - a method to measure quantitatively the relative importance of one decision-making criterion in relation to another (see Shepherd and Zacharakis, 1999) - Landstrom (1998) found that business angels attach the greatest importance to the leadership capabilities of the principals, followed by the potential of the firm’s market and products. Feeney et al.’s (1999) approach was to ask business angels, ‘What are the most common shortcomings of business opportunities that you have reviewed recently?’ This highlighted shortcomings in both the management (lack of management knowledge, lack of realistic expectations, personal qualities) and the business (poor management team, poor profit potential for the level of risk, poor fit, undercapitalised/lack of liquidity, insufficient information pro­vided). Asking investors, ‘What are the essential factors that prompted you to invest in the firms that you have chosen?’ Feeney et al. (1999) highlighted three management attributes - track record, realism and integrity and openness - and four attributes of the business - potential for high profit, an exit plan, security on their investment and involvement of the investor. However, while the primary deal killer is the perception of poor management, the decision to invest in an opportunity involves a consideration of management ability, growth and profit potential. In other words, angels are look­ing for businesses that show growth potential and have an entrepreneurial team with the capability to realise that potential (Feeney et al., 1999). Both these studies also emphasise that investment criteria are personal, with angels using different criteria in their assessment of investment proposals. For example, Feeney et al. (1999) suggest that the decision processes of more experienced investors differ from that of less experienced investors.

This emphasis on the entrepreneur reflects the view of angels that agency risk is more of a threat than market risk. Fiet (1995) argues that business angels lack informa­tion or the tools and resources to evaluate market risks effectively. As a consequence, they specialise in evaluating agency risk - assessing whether or not the entrepreneur can be relied upon as a venture manager - while relying upon competent and trust­worthy entrepreneurs to manage market risk. This contrasts with venture capital funds which, as we will see later, attach more importance to market risk than agency risk because they have learnt how to protect themselves using stringent boilerplate con­tractual provisions that allow them to replace an entrepreneur who is not performing or is found to be incompetent (Fiet, 1995).

19.4.8 Negotiation and contracting

Having decided, in principle, to invest, the business angel must negotiate terms and conditions of the investment that are acceptable both to themselves and also to the entrepreneur. There are three main issues - valuation, structuring of the deal (share price, type of shares, size of shareholding, timing of the exit) and the terms and con­ditions of the investment, including the investor’s role. In agency theory terms, deal structuring - mechanisms for allocating the rewards to the investor and entrepreneur - are an attempt to align the behaviour of the entrepreneur with that of the investor, while the terms and conditions attempt to control the behaviour of the entrepreneur.

In the study by Riding et al. (1993) half of the investment opportunities that reached this stage were not consummated. The most frequent reasons for not making an invest­ment were associated with valuation, notably ‘inappropriate views by entrepreneurs (in the opinion of the investors) regarding the value of the firm as a whole and, within the firm, the value of an idea compared with the overall value of a business. Most investors note that potential entrepreneurs overvalue the idea and undervalue the potential con­tributions (both financial and non-financial) that are required to grow and develop a business’ (Haines et al., 2003: 24). Putting a value on the ‘sweat equity’ of the entre­preneurs is also problematic.

There is no universally agreed method of valuing a small company. Market-based valuations are inappropriate because small businesses are not continually valued by the market and appropriate comparator stocks are unlikely to be available. Asset-based valuations are more commonly used although finance theory prefers earnings or cash­flow based valuations because they value the business in terms of the future stream of earnings that shareholders might expect from the business. However, these approaches are complex. Valuation of new and early-stage businesses adds further complications because they may only have intangible assets (e. g. intellectual property). It is therefore not surprising, especially since most angel investments are concentrated at start-up and early stage, that methods of pricing and calculating the size of shareholdings is remark­ably imprecise and subjective (Mason and Harrison, 1996b), based on rough rules of thumb or gut feeling. As investors May and Simmons (2001: 129) note, ‘the truth about valuing a start-up is that it’s often a guess.’ Where an attempt is made to price the investment on a more rigorous basis, then the earnings-based approach is the most common (Lengyel and Gulliford, 1997).

Angels draw up contracts as a matter of course to safeguard their investment, although their degree of sophistication varies. Contracts specify the rights and obliga­tions of both parties and what will be done, by whom and over what time frame. Their objective is to align the incentives of the entrepreneur and the investor by means of performance incentives and direct control measures. Kelly and Hay (2003) note that certain issues are non-negotiable: veto rights over acquisitions/divestments, prior approval for strategic plans and budgets, restrictions on the ability of management to issue share options, non-competing contractual commitments required from entrepre­neurs on the termination of their employment in the business, and restrictions on the ability to raise additional debt or equity finance. These issues give investors a say in material decisions that could impact on the nature of the business or the level of equity holding. However, there are also a number of contractual provisions to which angels attach low importance, and which might be considered to be negotiable, for example forced exit provisions, investor approval for senior personnel hiring/firing decisions, the need for investors to countersign bank cheques, management equity ratchet pro­visions and the specification of a dispute resolution mechanism in writing up front. Less experienced investors place relatively greater emphasis on the need to include a broad array of contractual safeguards to protect their interests. However, experienced investors are more likely to include specific provisions that can impact on the level of their equity stake (share options, ratchets) and the timing of exit (forced exit provi­sions). In other words, with experience business angels become more focused on those elements that can impact on their financial return.

Investors recognise that the investment agreement must be fair to both sides (May and Simmons, 2001): contracts that favour the investor will be detrimental to the entrepreneur’s motivation. In Mason and Harrison’s (1996b) study, two-thirds of investors and entrepreneurs considered that the investment agreement was equally favourable to both sides, and half of the investors reported that this was their objec­tive. Indeed, a significant minority of investors believed that the agreement actually favoured the entrepreneur. Thus, the available evidence suggests that in most cases entrepreneurs are not exploited by investors when raising finance.

The inclusion of contractual safeguards does not indicate whether investors will be willing to invoke them to protect their interests. Moreover, contracts are, of necessity, incomplete by their very nature. This is because it is costly to write complete contracts, it is impossible to foresee all contingencies and because of the presence of asymmetric information (van Osnabrugge, 2000). Thus, in practice, investors place a heavy reliance on their relationship with the entrepreneur to deal with any problems that arise (van Osnabrugge, 2000; Kelly and Hay, 2003). Indeed, Landstrom et al. (1998) argue that one of the purposes of establishing a contractual framework at the outset is to provide a basis for the development of a relationship between the parties to develop. In other words, the contract is less a protection mechanism per se; rather, it is a means by which mutual behaviour expectations of all parties in the transaction can be clarified.

Most angel investments involve input from professional advisers, although this is relatively limited compared with their involvement in venture capital fund transactions. For example, lawyers would normally review, and might draw up, the investment agreement, but would not be involved in the negotiations. Similarly, accountants may be consulted for advice but would rarely play a more prominent role. Thus, transac­tion costs are low (Mason and Harrison, 1996b). In Lengyel and Guilliford’s (1997) study the entrepreneur’s costs amounted to an average of 5.1% of the funds raised (and 29% reported no costs) while for the investor the average costs were 2.8% of the amount invested (and 57% reported no costs).

The time taken by business angels to make investments is much shorter than that of venture capital funds (Freear et al., 1995b). Mason and Harrison (1996b) report that in their study the entire investment process rarely extended over more than three months, and often takes less than a month. Most negotiations took less than a week to complete whereas the evaluation could take up to three months or more. Thus, in nearly half of the investments less than a month elapsed between the entrepreneur’s first meeting with the investor and the decision to invest; in 85% of cases the elapsed time was under three months.

19.4.9 Post-investment involvement

From an agency perspective, monitoring is the main way in which principals attempt to mitigate the risk of opportunistic behaviour on the part of the agent going undetected. In line with this expectation, most business angels play an active role in their investee businesses. However, in contrast to agency theory the involvement of angels in their investee businesses is not motivated by monitoring considerations. First, as noted ear­lier, angels derive psychic income from their involvement in their investee businesses in the form of fun and satisfaction from being involved with new and growing businesses and their belief that their experience, know-how and insights can ‘make a difference’. Second, angels see themselves as ‘offering help’ rather than ‘checking up’ on their investee businesses by acting as mentors, providing contacts, guidance and hands-on assistance (Haines et al., 2003). Third, as Kelly and Hay (2003: 309) comment, ‘from the outset, the relationship between the business angel and the entrepreneur appears to be more positive and trusting in character than the inherently adversarial one implied by agency theorists.’

There is a spectrum of involvement: at one extreme are passive investors who are content to receive occasional information to monitor the performance of their invest­ment while at the other extreme are investors who buy themselves a job. However, most angels do not want day-to-day involvement hence the typical involvement ranges from one day a week (or its equivalent) to less than one day a month (Mason and Harrison, 1996b). Nevertheless, S^tre (2003) emphasises that some angels are so involved, and involved so early, that they are indistinguishable from the entrepreneurs, and are seen by the entrepreneurs as being part of the entrepreneurial team. In similar vein, Politis and Landstrom (2002) see angel investing simply as a continuation of an entrepreneurial career.

Madill et al. (2005) identify a number of roles that business angels play in their investee businesses: advice about the management of the business, contacts, hands-on assistance (e. g. legal advice, accountancy advice, provision of resources), providing business and marketing intelligence, serving on the board of directors or advisory board, preparing firms to raise venture capital and providing credibility and validation. The nature and level of involvement is influenced by geography. Landstrom (1992) notes that frequency of contact between angels and their investee companies is inversely related to the geographical distance that separates them. It will also be influenced by the performance of the business, with angels more involved at particular stages of busi­ness development and in crisis situations.

A majority of entrepreneurs and angels regard their relationships as productive and consensual - although entrepreneurs have a more favourable view of their pro­ductiveness than angels (Freear et al., 1995b; Mason and Harrison, 1996b). However, there has been no rigorous study to assess whether this involvement of business angels has a favourable impact on the performance of their investee businesses. Such research has formidable methodological difficulties and Harrison and Mason (2004) propose critical incident analysis as an alternative way in which to assess the contribution of investors.

One study reported that half of the entrepreneurs who had raised finance from busi­ness angels regarded their contributions as being helpful or very helpful (Mason and

Harrison, 1996b). Another study reported that entrepreneurs considered that the most valuable contribution of their business angel has been as a sounding board (Harrison and Mason, 1992). There is a suggestion that entrepreneurs want their investors to be more involved in certain areas, especially financial management (Ehrlich et al., 1994). Criticisms by entrepreneurs who have raised finance from angels are mainly concerned with those who lack knowledge of the product or market (Lengyel and Guilliford,

1997) . Finally, most business angels report that they have derived fun and enjoyment from their investments, often more than expected, in cases where the investment is still trading, but not when the business has failed. Psychic income returns are therefore related to business performance rather than compensating for financial loss (Mason and Harrison, 1996b).

19.4.10 Harvesting

Investing in unquoted companies is regarded as being high risk. Diversification is the main strategy for reducing risk. However, this is not an option for most business angels. First, typically they have just a handful of investments in their portfolios. Second, they often restrict their investments to sectors which they know and understand, so their portfolios are unbalanced. Third, as the first external investor in a business, and gener­ally lacking the financial resources to make follow-on investments, they are vulnerable to being diluted in the event that further funding rounds are required.

A UK study of the investment returns of business angels (Mason and Harrison, 2002b) highlights the highly skewed distribution of returns, with 40% of investments making a loss (34% a total loss), and another 13% only breaking even or generating bank-level returns. However, there was a significant subset of investments, some 23% in total, which generated returns in excess of 50%, although it is important to note that these studies only measure multiples achieved on the amounts invested. However, many angels also attempt to draw back at least part of their investment in the form of a director’s fee or interest on loans provided, either now or at some stage in the future when the business is financially stronger. This could be quite a significant pro­portion of the investment in smaller deals (Mason and Harrison, 1996b; Lengyel and Guilliford, 1997).

A Finnish study, in contrast, sought to identify differences between the most, and least, successful investors. The most successful investors were more likely to be motiv­ated by the fun and interest of making such investments, have a large deal flow and have a lower estimation of the value of their hands-on involvement. The least success­ful investors were more likely to be motivated by altruism, have a low deal flow and make few investments, rely to a greater extent on friends for deal flow and were more likely to make investments in friends’ businesses and have a different pattern of hands - on involvement, over-emphasising contributions that other research has suggested are least important in adding value (Lumme et al., 1998).

Business angels are thought to be relatively patient investors, willing to hold their investments for up to seven years or more (Wetzel, 1981; Mason and Harrison, 1994). In reality, angels hold their investments for a much shorter time. The median time to exit in the UK is four years for high-performing investments and six years for moderately-performing investments, while failures appear, on average, after two years (Mason and Harrison, 2002b). In Finland, investments that had a positive outcome were five years old whereas those that failed had an average holding time of 2.8 years. In both studies a trade sale (i. e. sale of the company to another company) was the most common exit route for successful investments, with an IPO only accounting for a small minority of cases. Trade sales, along with sale to existing shareholders, were the most common exit routes for investments with little or no value.

19.5 Venture capital funds

19.5.1 Definitions and characteristics

Venture capital firms are professional investment organisations that raise finance from financial institutions (e. g. banks, insurance companies, pension funds) and other investors (e. g. wealthy families, endowment funds, universities, companies) attracted by the potential for superior returns from this asset class to invest in businesses with high-growth prospects. These funds are established with a fixed life and will normally have a specific investment focus, for example in terms of stage of business, industry and location. The investors in the fund (termed ‘limited partners’) lack the resources and expertise to invest directly in companies, and are only allocating a small propor­tion of their investments to this asset class (typically a maximum of 1-2%) and so find it more convenient to invest in funds managed by venture capital firms (or general partners) who have specialist abilities that enable them to deal more efficiently with asymmetric information than other types of investor (Amit et al., 1998, 2000). The following points apply:

■ The potential for adverse selection is reduced by investors’ information-gathering skills, specialist knowledge of particular industries and expertise in selection, which enables them to identify and select projects with the potential for high returns.

■ Moral hazard problems are minimised by their skills in structuring the transaction and monitoring the investment.

■ Their skills in providing value-added services to their investee businesses and secur­ing an exit for the investment maximise returns.

Under this limited partnership model the venture capitalists have discretion over the management of the fund, which is normally established with a ten-year life. The major part of the cash is invested over the initial three years, with the rest held back for follow-on investments. These investments are then harvested in the later years so that by the end of the fund’s life it can be liquidated and the proceeds (initial sum and profits) returned to the limited partners. For performing this role the venture capital firm normally receives an annual fee (2-3% of the value of the fund), which covers running costs, and a ‘carried interest’, or profit share (normally 20% of the profits generated), which is distributed among the general partners (Zider, 1998; Campbell, 2003). The general partners would normally seek to raise a new fund some two to four years into the life of an existing fund so that they always have at least one fund that is in invest­ing mode.

Across Europe there are over 900 specialist venture capital companies (www. evca. com), of which around 170 are in the UK (www. bvca. co. uk). The National Venture Capital Funds Association (www. nvca. org) in the US has 450 members. There are also venture capital associations covering Asia, Australasia and Latin America. Although the lim­ited partnership model is the most organisational form in the venture capital industry it is not the only one. Some venture capital firms are public companies quoted on stock markets; others, termed ‘captives’, are the in-house venture capital subsidiaries of finan­cial institutions (e. g. banks), and some have been established by public sector agencies.

19.5.2 Source of investment opportunities

Venture capital firms receive investment opportunities from two main sources. The first source is unsolicited deal flow. Venture capital firms are very visible, being listed in various directories and websites. Indeed, most countries and regions have venture capital associations that publish membership directories. The second source of deal flow comes through the personalised networks of venture capitalists from intermediaries such as bankers and lawyers, entrepreneurs and other venture capital funds (Florida and Kenney, 1988). Not surprisingly, most venture capitalists ignore the unsolicited deal flow and focus on those investment opportunities that come through their net­works of trusted intermediaries. The quality of this deal flow is superior because it has been filtered by these intermediaries who know what kinds of deals will be of interest and to eliminate poor quality. A recommendation from such a source is seen by the venture capitalist as a positive signal about its quality. Steier and Greenwood (1995) highlight the need for an investment proposal to attract endorsement from one or more key players in a venture capitalist’s network if it is to be seriously considered. Roberts (1991b) also emphasises the importance of trusted sources of referral on the prospects of a deal attracting finance. From an analysis of one firm’s files he was able to conclude that: ‘the more projects a source had brought to Atlantic Capital’s attention, the more likely its new project would get accepted. Similarly, and even more strongly, the source of the accepted company had significantly higher percentage acceptance rates in their previous referrals than did the sources of newly rejected companies’.

19.5.3 Deal evaluation

Venture capital funds operate a two-stage evaluation process similar to the approach of business angels, comprising an initial screening process followed by a detailed evalu­ation process for those deals that pass the initial screening. Most of the research on the investment criteria of venture capital fund managers relies upon questionnaires and surveys. However, Shepherd (1999) argues that these approaches have significant limitations on account of their retrospective nature and the biases and errors inherent in self-reporting. Specifically, they tend to overstate the least important criteria and understate those that are most important. Zacharakis and Meyer (1998) further argue that venture capitalists are poor at introspecting about their own decision processes. A further limitation of questionnaires and surveys is that they also fail to differentiate between the criteria used at different stages in the evaluation process (Elango et al., 1995). Shepherd (1999) (see also Shepherd and Zacharakis, 2002) therefore argues that studies should use real-time methodologies such as conjoint analysis (Muzyka et al., 1996), verbal protocol analysis (Hall and Hofer, 1993; Zacharakis and Meyer, 1995) and participant observation (Silva, 2004).

However, this second stage is much more exhaustive, time-consuming and, for the entrepreneur, expensive than the equivalent process in the business angel’s investment evaluation. The initial screening, which is undertaken quite rapidly and intuitively, has two purposes: first, an investor specific-screens to ensure that the investment proposal fits the investment focus of the fund (e. g. location, stage, sector, size) and second, a generic screen is applied to search for features in the proposal that would indicate closer invest­igation is likely to be worthwhile (Tyebjee and Bruno, 1984; Fried and Hisrich, 1994; Boocock and Woods, 1997). Entrepreneurs can improve their chances of getting fund­ing if they are able to send credible signals to potential investors about the likelihood of success of their business. This can assist the venture capitalist in overcoming the asymmetric information that surrounds a deal (Busenitz et al., 2005). Financial analysis is not important at the initial screening stage (Dixon, 1991). However, the amount of equity held by the entrepreneurial team and the amount of their personal wealth com­mitted to the business are examples of signals that might influence a potential investor (Busenitz et al., 2005). Boocock and Woods (1997) note that missing information in the business plan is a major reason for rejection at the initial screening stage.

Those deals that pass the initial screening stage will be scrutinised in detail in a pro­cess involving the gathering of information from both inside and outside sources, a series of meetings with management, a review of the financial statements, and may also involve interviews with suppliers, customers, bankers, other investors and industry experts. Financial analysis will also be undertaken, first to come up with a valuation for the business (although in practice this is often quite subjective: O’Shea, 1995), and second to assess whether the investment is likely to generate the required rate of return. The minimum return would be around 30% but venture capitalists would apply an additional risk premium to more risky investments, notably the stage of the business and whether it is technology-based (Dixon, 1991; Murray and Lott, 1991; Lockett et al., 2002). Dixon (1991) argues that the risk premium is mainly related to the financing stage whereas Lockett et al. (2002: 1023) argue that ‘technology remains a more important risk factor than the stage of investment.’

Venture capital funds invest at a later stage than business angels - when the risks and uncertainties have been reduced - and commit larger amounts. The business model and the product will have been proven and exhibited market acceptance, and uncer­tainties about the size of the market, the profitability of the business and the quality of the management team have been reduced. Hence, ‘even the founders of companies. . . who eventually turn to venture capitalists to secure the funds and management expert­ise they need to grow, start out on credit cards and sweat equity’ (Bhide, 2000: 16). Venture capitalists are also looking for higher returns and so are even more selective than business angels. Their key considerations are the size of the opportunity and the time to cash-out (ideally no longer than five years). Consequently venture capitalists will favour investments addressing large, growing markets and that have proprietary technology or processes and seasoned management teams (Bhide, 2000).

Fried and Hisrich (1994) suggest that an attractive investment proposal will rate highly on three components:

■ The concept: a project that has significant potential earnings growth, where the idea has already been demonstrated to work and so can be brought to the market quickly or, better still, has already demonstrated a degree of market acceptance (Fried et al.,

1993) , where there is a substantial competitive advantage and with reasonable cap­ital requirements.

■ Management: who possess personal integrity, have done well in previous jobs

(although failure is not an automatic disqualification - see Cope et al., 2004), are

realistic, are hardworking and flexible, and exhibit leadership.

■ Returns: the project has to have an exit route and offer the potential for both a high

rate of return and also a high absolute rate of return.

However, Zider (1998) argues that because it is difficult to distinguish between the eventual winners and losers (their financials look similar at an adolescent phase) the critical challenge for venture capitalists is to identify competent management that can execute. Empirical studies of venture capital decision making similarly emphasise that it is the quality of the entrepreneur that ultimately determines the investment decision (MacMillan et al., 1985; Dixon, 1991; Muzyka et al., 1996). As Macmillan et al. (1985: 119) note: ‘there is no question that irrespective of the horse (product), horse race (market), or odds (financial criteria), it is the jockey (entrepreneur) who fundamentally determines whether the venture capitalist will place a bet at all.’ Smart (1999) explores how venture capitalists actually appraise management teams.

Most businesses do not meet the investment criteria of venture capital funds - they have limited revenue potential because they do not have proprietary products, are not the first or second entrant into a market, are offering a ‘me-too’ product or service, operate in niche markets, and their management teams lack the experience that is thought to be necessary to build and manage a growing company (Bhide, 2000). Thus, it is not surprising that rejection rates are high. In one study it was noted that 75.5% of opportunities were rejected at the initial screening stage, a further 21.1% were either rejected or withdrawn at the evaluation stage and only 3.4% attracted invest­ment (Dixon, 1991). Lockett et al. (2002) found that the acceptance rate for general­ist funds was 3.6% and for technology funds was 2.6%. Boocock and Woods’ (1997) case study of an English regional venture capital fund in its first two years of opera­tion found that its acceptance rate was even lower, at 1.46%.

One consequence of the venture capitalist’s search for high-growth ventures is that it can lead to ‘investment bubbles’ characterised by over-investment in attractive indus­tries as exemplified by the recent dot. com boom and bust. Investment decision making by venture capitalists occurs within an environmental context of competitive and co­operative behaviour with other venture capitalists. Venture capitalists are aware of the investments pursued and made by other investors and of the relative success of these investments (Valliere and Peterson, 2004). However, what Sahlman and Stevenson (1985) term ‘myopia’ is fuelled when investors fail to consider the wider implications of their individual investment decisions and so end up investing in too many com­panies in these sectors. The process starts with the success of some early investments in an emerging (and hence unfamiliar) sector. This creates a ‘hype’ that drives other investors to invest in the same sector and attracts new capital and new investors. The consequence is that too many companies are started and this drives up valuations.

Many of these new companies will subsequently fail both because of lax investment appraisal induced by the ‘hype’ (or the perception that normal risk assessment is inap­propriate for this new technology) and because the market is not sufficiently large to support all of the new companies that have been started. The bubble eventually bursts at high cost to investors. This has the effect of driving valuations down and encour­ages investors to return to making more rigorous investment appraisals. Sahlman and Stevenson (1985) describe this process in the hard-disk-drive sector in the 1980s while Valliere and Petersen (2004, 2005) develop a model of ‘irrational’ investment beha­viour during the Internet bubble.

19.5.4 Deal structures

Having decided to invest, the next stage is for the venture capitalist and the entrepre­neur to negotiate the terms and conditions of the investment. The venture capitalist’s key consideration is to minimise risk. A typical investment agreement for a venture capital fund will involve the following elements (Sahlman, 1990). First, it will give the investor control over key decisions, notably to replace the management team and to approve any expenditure above a certain limit. However, in practice venture capital­ists may be reluctant to use their power because of the adverse impact that it will have on the relationship with the entrepreneurial team. Second, it will give the investor involvement in the company, typically in the form of one or more seats on the board of directors. Third, it will specify a compensation scheme for the management team to align their interests with that of the investor, typically by means of a combination of low salaries and stock options. Fourth, the investor will use investment instruments that give downside protection and a favourable position to make additional investment if the company is successful. In practice this means that they will invest in preferred shares rather than ordinary shares (Norton and Tenenbaum, 1992) because this cre­ates a mechanism for deriving some income from the investment if it is only marginally successful. (Preference shares (of which there are several types) command a higher prior­ity over ordinary shares in the event of a liquidation. Since the entrepreneurs (and other early investors) invest in ordinary shares the effect of the venture capitalist tak­ing preference shares is that it pushes risk to the entrepreneur.)

This mechanism will include a liquidation preference, which gives the investor first claim to all of the company’s assets and technology, and anti-dilution clauses, which protect against equity dilution if subsequent rounds of financing occur at lower valu­ations (Zider, 1998). Finally, rather than providing the entire sum of money at the out­set, it will be staged over time as various milestones are met. This provides the investor with the option to revalue or abandon the investment if new information emerges which suggests that the business appears unlikely to be successful, thereby reducing losses from bad investment decisions. (Birmingham et al. (2003), however, suggest that venture capitalists are actually rather poor at disengaging, noting that they continue to make investments in companies that subsequently are shown to be on a failing trajec­tory.) However, milestones also enable the investor to increase the capital committed in the light of positive information on the company’s prospects. Equally it enables the entrepreneur to raise capital at a higher valuation and thereby minimise dilution. Staging also keeps the entrepreneur on a ‘tight leash’. The prospect of running out of money creates strong incentives for the management team to meet targets and create value (Sahlman, 1988, 1990).

The venture capitalist therefore adopts a much more sophisticated approach to the investment agreement and deal structures than business angels. This provides pro­tection against agency risk and enables venture capitalists to focus on market risk which they have the skills to assess (Fiet, 1995). Business angels, on the other hand, are less able to protect themselves from agency risk by means of boilerplate contractual terms and conditions because of the cost. Consequently, they place greater emphasis on becoming personally acquainted with the entrepreneur (Fiet, 1995; Mason and Stark, 2004).

Another aspect of venture capital investments is that they are likely to be syndicated with other funds, especially in second and subsequent funding rounds. There are several reasons for this. First, this strategy avoids over-committing the fund to a small num­ber of investments in situations where large follow-on funding rounds occur and so enables diversification. Second, it provides the original investor with a second opinion and helps to establish a fair price for the next round. Third, it provides complement­ary sources of value-added. For example, in the case of Canadian technology com­panies, it is quite common for Canadian investors to fund the initial funding round but to bring in US investors at subsequent rounds because of the perception that they can provide valuable contacts to help the company gain market share in the US (Mason et al., 2002). Finally, it decreases the load on individual partners as they will only play a significant hands-on role when their fund is the lead investor (Bygrave 1987, 1988; Lockett and Wright, 1999).

19.5.5 Post-investment involvement

Venture capitalists spend around half their time monitoring and supporting the com­panies in their portfolio through a combination of telephone and e-mail conversations, video-conferences and on-site visits, with the remainder of their time allocated to sourc­ing and evaluating potential new investments (Gorman and Sahlman, 1989; Zider, 1998; Gifford, 1997). Sahlman (1990) reported that a typical venture capital invest­ment executive would be responsible for nine portfolio companies and sit on the boards of five of them. He (or, more rarely, she, as Brush et al. (2002) have found fewer than 10% of women professionals in the US venture capital industry) would visit each com­pany 19 times per annum and spend 100 hours in contact. This is very similar to Zider’s (1998) estimate of 80 hours per year with each portfolio company - equivalent to just two hours per week. Venture capitalists use their expertise and networks to make a variety of contributions to their investee companies (Sahlman, 1990):

■ They help recruit and compensate key individuals in the firm.

■ They work with suppliers and customers.

■ They help establish tactics and strategy.

■ They play a major role in raising capital.

■ They help structure any transactions (e. g. mergers and acquisitions) that the com­pany might make.

Steier and Greenwood (1995) emphasise the emotional support that a venture capital­ist can provide to an entrepreneur, and to make this point they provide the following quote from a venture capitalist: ‘Who can an entrepreneur talk to about his problems? He can’t talk to his wife - she’ll leave. He can’t talk to his employees - they’ll quit.’

Venture capital funds place more emphasis on control and reporting requirements than business angels (Ehrlich et al., 1994). MacMillan et al. (1988) add an important caveat, noting that venture capital firms have variable patterns of involvement with their investee companies and that this is related to choice of investment ‘style’ rather than investment focus. However, other studies suggest that the degree of involvement is related to contingent factors, notably stage, degree of technology innovation, dis­tance, experience (Manigart and Sapienza, 2000) and the performance of the investee business. Venture capitalists may change the management if the performance of the business is unsatisfactory (Bruton et al., 1997) and, in extreme situations, may even take over day-to-day control of the business (Sahlman, 1990).

Various studies have sought to explore the importance of this hands-on involvement by venture capitalists in their investee businesses to determine which types of contri­bution are the most significant. According to Sapienza and Timmons (1989), the high importance roles are as a sounding board and business consultant; of medium import­ance are coach/mentor, financier and friend/confidant roles; while the least important roles are as management recruiter, industry contact and professional contact. However, even the low-importance contributions score near the middle of a five-point scale. Macmillan et al. (1988) also identify ‘serving as a sounding board’ as the most import­ant contribution of venture capitalists but find that ‘obtaining alternative sources of equity finance’ is the second most important value-added contribution. Other studies suggest that the provision of strategic support is the most important value-added con­tribution of venture capital funds (Sapienza et al., 1996; Busenitz et al., 2004). How­ever, Rosenstein et al. (1993) report that entrepreneurs did not value the venture capitalists on their board higher than any other board members, although the boards of venture capital backed firms are generally more active than those of non-venture capital backed firms (Fried et al., 1998).

However, there is no evidence that greater involvement is a necessary condition for adding value nor whether involvement produces enhanced business performance (Fried et al., 1998; Sapienza and Gupta, 1994). This may be because the involvement of ven­ture capitalists is with their poorly performing firms, determining whether and how they can be turned around, or even whether continued support is desirable (Zider, 1998). This is the view of Higashide and Birley (2002) who argue that the involvement of ven­ture capitalists starts to increase when they perceive the performance of the business to be unsatisfactory and where they feel that they can make a contribution. This analysis therefore suggests that venture capitalist involvement is negatively associated with per­formance, with the direction of causality going from firm performance to involvement and not the other way. In contrast, Sapienza et al. (1996) argue that venture capitalists adopt a ‘home run strategy’ of focusing their attention on likely winners rather than those businesses in their portfolio that are likely to yield little return.

There is a recognition that studies that have sought to find a direct link between the venture capitalists’ involvement and firm performance are too simplistic. Attention has therefore turned to the nature of the relationship between the venture capitalist and the entrepreneurial team as an important intermediary variable influencing the impact of the venture capitalist’s involvement. Various studies have observed the value of cooperative behaviour in successful investing, as opposed to an agency perspective that emphasises control (Cable and Shane, 1997). Cooperative behaviour leads to perceptions of fair­ness, the creation of mutual trust, thereby mitigating the fear of opportunistic behaviour, and open and frequent communication. These are prerequisites if the involvement of venture capitalists is to have a favourable impact on the performance of their investee businesses (Sapienza and Korsgaard, 1996; Sapienza et al., 1996; Busenitz et al., 1997, 2004; Shepherd and Zacharakis, 2001).

19.5.6 Harvesting

As noted earlier, venture capital involves investing for capital gain and not for dividend income. Thus, the end-game is to secure profitable exits for venture capitalists’ invest­ments. However, this highlights an important difference between venture capital funds and business angels. The objective of venture capitalists is to maximise the returns of the fund rather than seeking every investment to be successful. Indeed, there is a rule of thumb in the industry that anticipates two or three investments will fail, between four and six will be economically self-sustaining but fail to achieve expected levels of growth or exit opportunities (the so-called ‘living dead’) (Ruhnka et al., 1992), and a further two or three investments will be spectacular successes. It is the presence or absence of these winners that determines the performance of the fund. However, most business angels make too few investments to be able to adopt this portfolio approach and so have to seek a positive return from every investment that they make. There are three other key influences on venture capital returns:

■ The stage of investment focus - in Europe, the average returns have been higher for funds specialising in later-stage and, in particular, management buy-out funds than early-stage funds (which typically have a technology focus), whereas in the US the pattern is the exact opposite.

■ The timing of the fund’s launch - as venture capital returns are cyclical, the returns are sensitive to the year in which the fund was launched.

■ The type of fund - Manigart et al. (2002) suggest that in Europe independent funds have higher rates of return than either captive or government funds.

There are three main mechanisms for harvesting:

■ A public offering in which the shares of the venture capitalist, and potentially other shareholders, are sold on the stock market. A public listing generally produces the highest returns but this is not unconnected with the fact that only the best companies in a venture capitalist’s portfolio go down this route (Bygrave and Timmons, 1992). However, public markets are cyclical and so cannot be relied upon to produce the most profitable exit. Being a publicly listed company brings prestige to the company, enables the company to raise further amounts of finance by issuing new shares, and provides liquidity for employees who have been given shares to compensate for a low, or no, salary in the early stages of the business. However, there are constraints on how soon and how quickly existing shareholders can sell their shares. Specifically, there is normally a ‘lock-up’ period that prevents existing shareholders from selling their shares for a pre-specified period after the flotation (usually six months). The share price would collapse if existing shareholders sold most or all of the shares as soon as the company obtained a listing because the market would assume that as insiders they had negative information about the future prospects of the com­pany. There are also concerns about whether the stock market fully values the firm. Publicly listed companies are also subject to much greater public attention. Other disadvantages include the costs of maintaining a listing and the need for investor communications and relations (Bleakley et al., 1996).

■ A trade sale in which the business is sold to another company. This type of exit has the advantage that investors can sell all of their shares immediately (indeed, are likely to be required to do so) and get paid straight away (in cash or shares of the acquiring company). However, it is likely to require the entrepreneurs to exit along­side the venture capitalist and so is inappropriate if the entrepreneur wants the busi­ness to retain its independence and to continue to run it. A trade sale may also be an option for companies in distress since their assets may have value to a competitor.

■ A private placement involving the purchase of the venture capitalist’s share by another investor. This is less common although there are some secondary purchase funds that specialise in buying the portfolios of existing venture capital funds rather than making their own individual investments.

The previous section discussed the value-added contribution of the venture capital fund, and specifically whether it has an effect on the firm’s performance. Some studies have examined the venture capitalist’s value-added contribution from the perspective of the harvest, suggesting that the venture capital firm plays a certification role during the IPO process resulting in a higher price compared with non-VC backed companies. However, the evidence is mixed (Megginson and Weiss, 1991; Brav and Gompers, 1997; Espenlaub et al., 1999; Lange et al., 2001).

19.6 Chapter summary

A consistent theme running through this chapter has been that the informal venture capital market and the institutional venture capital market play complementary roles in supporting entrepreneurial activity. This is evident in terms of the size and stage of investments made by business angels and venture capital funds (Freear and Wetzel,

1990) . The boundary between business angels and venture capital funds was around $500,000: business angels dominated when the size of round was under $500,000 but their involvement fell away rapidly as deals got bigger and were replaced by venture capital funds. Business angels also dominated at the seed round but declined rapidly from the start-up stage when venture capital firms took over. A further dimension of this complementary relationship is that venture capital funds often provide follow-on funding for firms that were initially funded by business angels (Harrison and Mason, 2000; Madill et al., 2005).

However, these complementarities are now breaking down because venture capital funds in North America and Europe have raised their minimum investment size to

more than £1m in the UK and $5m in the US, and continued to shift their investment focus to later-stage investments (Jensen, 2002; Sohl, 2003). This stems from the grow­ing popularity of venture capital as an asset class, which has resulted in an increase in the size of funds under management. As there has not been a commensurate increase in the number of venture capital executives each one is managing more money but with the same time scale in which it has to be invested. The inevitable outcome is that deals have become larger. Moreover, at least in Europe, the shift to making later-stage deals has increasingly drawn venture capitalists into corporate finance and away from fos­tering entrepreneurial businesses.

These trends have several potential consequences. First, they create a funding gap for projects that are too large for business angels but are still too small for venture cap­ital funds. As a result, some businesses may be constrained in their growth, others that have raised initial funding but whose investors are unable to provide further funding might fail, and some entrepreneurs may be deterred from starting. Second, business angels are forced to undertake more follow-on investing, thereby reducing their ability to make new investments.

However, in response to these trends there has been the emergence of angel syndicates which Sohl et al. (2000) claim are ‘the fastest growing segment of the early stage equity market’ in the US. There are currently estimated to be around 200 angel syndicates located throughout the US and growing evidence of specialisation by industry sector (e. g. healthcare angel syndicates) and type of investor (e. g. women-only angel syndicates) (see May and O’Halloran, 2003, for some case studies). The same trend is also clearly evident in the UK although at an earlier stage, and it has not attracted the same degree of attention from researchers or commentators.

Angel syndicates have emerged because individual angels found advantages in work­ing together, notably in terms of better deal flow, superior evaluation and due diligence of investment opportunities, and the ability to make more and bigger investments, as well as social attractions. They operate by aggregating the investment capacity of indi­vidual high-net-worth individuals. Some groups are member-managed while others are manager-led (May and Simmons, 2001; May and O’Halloran, 2003; Preston, 2004).

The emergence of angel syndicates is of enormous significance for the development and maintenance of an entrepreneurial economy. First, they are helping to address this ‘new’ funding gap - roughly the £250,000 to £2m+ range in the UK and the $500,000 to $5m range in the US, which covers amounts that are too large for typical ‘3F’ (founder, family, friends) money but too small for most venture capital funds. Indeed, angel syndicates are increasingly the only source for this amount of venture capital in this range. Second, angel syndicates have the ability to provide follow-on funding. With the withdrawal of many venture capital funds from the small end of the market indi­vidual angels and their investee businesses have increasingly been faced with the prob­lem of the absence of follow-on investors. Because angel syndicates have got greater financial firepower than individual angels or ad hoc angel groups they are able to pro­vide follow-on financing, making it more efficient for the entrepreneur who avoids the need to start the search for finance anew each time a new round of funding is required. Third, their ability to add value to their investments is much greater. The range of business expertise that is found among angel syndicate members means that in most circumstances they are able to contribute much greater value-added to investee busi­nesses than an individual business angel, or even most early-stage venture capital funds. Fourth, angel syndicates have greater credibility with venture capitalists. Venture cap­ital funds often have a negative view of business angels, seeing them as amateurs whose involvement in the first funding round of an investment could complicate subsequent funding rounds because of their tendency to over-price investments, use complicated types of investment instruments and make over-elaborate investment agreements (Harrison and Mason, 2000). Venture capitalists may therefore avoid deals in which angels are involved because they are too complicated. However, because of the pro­fessionalism and quality of the membership of angel syndicates venture capital funds hold them in much higher esteem. Finally, syndicates reduce sources of inefficiency in the angel market. They are visible and easier for entrepreneurs to identify and approach, and have stimulated the supply side, enabling high-net-worth individuals who want to invest in unquoted companies but lack the time, referral sources, invest­ment skills or ability to add value. Other attractions of syndicates for investors are the ability to reduce risk by spreading their investments more widely, the ability to partici­pate in investments that they could not have invested in as individuals, access to group skills to evaluate opportunities and add value and the opportunity to learn from more experienced investors (Mason, 2006).

Angel syndicates are therefore increasingly becoming the only source of finance, other than government-supported funds and schemes, for growing businesses that have exhausted ‘3F’ funding. In this sense, venture capital is returning to its ‘classic’ roots. Many of the early venture capital funds in the US started on the basis of investing funds supplied by wealthy individuals and families (Gompers, 1994). Indeed, Bygrave and Timmons (1992) argue that it was the flow of institutional money into venture capital that has led to its shift to bigger and later-stage deals. The emergence of angel syndicates and the boost that it gives to classic venture capital therefore augurs well for future level of entrepreneurial activity.