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Financing Viewpoints

Seeding Future Growth: Venture Capital Funding

by William Kay

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Introduction

This article was first published in Quantum magazine.

At a time of severe financial restraint, venture capital (VC) is the one bright spot amid the gloom for enterprises seeking start-up funding or investment, and also offers exciting opportunities for investors. But there may be limits to its scope.

Venture Capital Success

The continuing global recession has intensified the search for potential catalysts to kick moribund economies into much-needed activity. That search has turned renewed attention onto venture capital, which conveniently pumps life into start-ups and smaller businesses, sectors that have the potential in aggregate to be major employers.

VC can also satisfy the parallel hunt by investors for outlets offering more excitement than floundering stock markets and bonds which, at the most secure end, offer the poorest of returns. The big question is whether VC can attract finance on a sufficient scale to achieve what its supporters claim. On this question, the controversial May 2012 initial public offering (IPO) of shares in Facebook has led governments and investors to reassess its potential.

Facebook raised US$16 billion, making it the largest tech IPO in history and the third-largest American IPO ever, outstripped only by Visa’s US$19.7 billion in March 2008 and the US$18.1 billion raised by General Motors in November 2010, according to Thomson Reuters. Of the total amount raised for Facebook, Accel Partners, one of the early VC investors, turned US$12.7 million into US$7 billion. With fellow backers Greylock Partners and Meritel Capital, Accel can expect to bask for years in the enhanced credibility and deal flow from that one transaction.

While Facebook waved the flag for VC, it is a sector that has traditionally financed the early-stage enterprises that politicians see as engines of job creation, increasing spending power and therefore economic regeneration. President Obama signed his Jobs Act into law in April 2012 with the observation relating to entrepreneurs that “when their ideas take root, we get inventions that can change the way we live. And when their businesses take off, more people become employed.” In Britain, this argument has convinced the government to increase the capital Venture Capital Trusts can invest in each prospect.

Providing Economic Growth

As VC often provides the fuel for those take-offs, it should logically be center-stage in the search for ideas to regenerate economies that have been flat-lining. A report by Experian for the British Venture Capital Association (BVCA) indicated that VC-backed businesses showed stronger turnover growth between 2006 and 2010 than other enterprises, trebling sales compared with their benchmark. Profit growth and job creation were also much stronger within VC-backed companies, with an 80% rise in employment over the four-year sample period. Other enterprises saw very little change in overall employment numbers.

Colin Ellis, chief economist of the BVCA, said: “This study shows that VC-backed businesses have outperformed their peers, but without enjoying vastly higher margins, suggesting that these companies are good at winning market share, thereby putting themselves on a sustainable footing going forwards.”

That is sweet music to entrepreneurs who have been struggling to obtain bank finance, as capital adequacy rules make loans scarcer and the banks become more preoccupied with fighting off legislators and regulators. Even though VC finance can be demanding in terms of boardroom representation and share of the exit cake, business founders are more willing to consider it.

The message is spreading. Deloitte and the US National Venture Capital Association’s (NVCA) 2012 global venture capital confidence survey show surges of interest in countries as far-flung as Brazil. The overall economic performances of Germany and India have inspired their VC sectors too, but in absolute terms they still lag far behind the United States and the United Kingdom. Yet the widely perceived image of the sector remains, by and large, that of a bit-part player with a small-scale business model that can have only a marginal impact.

Wealthy Investors

Nevertheless, Frederick Adler, the doyen of venture capital, said: “The biggest change is the enormous amount of capital coming into the industry, which has precipitated many people into looking for new prospects. But VC has been moving slowly, surprisingly so to me. The people in it are capable of doing much more.”

A few leaders of VC firms, such as Jim Breyer at Accel, have already been making personal fortunes rivaling those of top bankers and private equity managers, without suffering anything like as much public opprobrium. The reason is that in most cases, unlike the bankers, they have risked their own capital and—more pertinently—their operations are relatively transparent.

The search by wealthy investors for reliable alternatives to crisis-hit traditional bonds and equities led many into VC. But as more money poured into the sector and trading conditions became tougher in the global recession, the tendency grew to favor larger, more-established, safer bets at the expense of out-and-out blue-sky start-ups. The approach is in effect becoming closer to that in the investment spectrum traditionally occupied by private equity.

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