In last month's Swimming with Sharks, the first article of our series focussing on issues around start-up businesses, we looked at some of the major methods of funding start-up business in Australia. In Part 2, we look at some of the sources of funding, in particular venture capital funding.
Recent statistics from the Australian Private Equity and Venture Capital Association Limited show that 2014 was a very successful year for venture capital in Australia, with 26 registered active fund managers responsible for more than A$2b in funds under management, and investments of over $516m. But what is venture capital? How does venture capital work? What are its advantages and disadvantages? And what other sources of funding are there for start-ups?
1. WHAT IS VENTURE CAPITAL?
Venture capital is the term generally used for money that is provided by outside investors to finance a new or growing business. Venture capitalists usually pool their investments into a venture capital fund (either through a partnership or trust) that then invests the pooled money through purchasing an equity interest in third party businesses.
Venture capital may often be directed at businesses which are generally considered too risky by banks and other institutional investors, since these ventures generally have the highest growth potential and can therefore provide strong financial returns. Venture capital funds also generally look for businesses which will provide them with a successful exit event within a certain timeframe (such as a trade sale of the assets or shares of the business, or an initial public offering of shares (IPO) following listing on a securities exchange like the ASX). As a result, venture capital funds can be very selective and may invest in less than 0.25% of the opportunities which are presented to them.
Due to these high-growth and timely-exit requirements, most venture capital funding goes towards businesses in dynamic fields such as information technology, intellectual property or biotechnology.
2. HOW DOES VENTURE CAPITAL WORK?
The general approach is for a venture capital firm (VC Firm) to open a fund (Fund), which is a pool of money obtained from wealthy individuals, companies, superannuation funds and other institutions. Once the Fund raises a certain amount of money, the Fund manager will then invest that money into a number of businesses.
Each Fund will usually have an investment profile – that is, a strategy for the type and timing of the investments it will make. For example, one Fund may only provide seed capital to biotechnology start-ups, while another will invest in businesses in various industries which are already established and are preparing to list the company and conduct an IPO within the next 6 months. The investment profile chosen by a Fund will have certain risks and rewards, and specific investments are selected on this basis.
Usually, a VC Firm will invest the Fund in its entirety, with the expectation that all of the investments will liquidate (that is, be sold or taken public through an IPO) and any profits will be realised within a set time period. The returns obtained from each exit-event are then placed back into the Fund and eventually, the Fund is distributed back to the investors based on the amount which each of them originally contributed to the Fund.
Despite VC Firms' careful due diligence process in relation to investments, the reality of course is that some of those businesses will fail, and others will continue without ever really flourishing. However, some investments will result in a trade sale or an IPO worth tens or even hundreds of millions of dollars, and will provide very strong returns to the Fund. As a result, Funds tend to operate on the basis of the law of averages, hoping that their big successes outweigh the (often many more) failures and provide a significant return on the original amount collected.
It is ultimately the Fund managers' skill in selecting the investments, their timing and the management of the investments undertaken that will decide the success of the Fund.
3. ADVANTAGES OF VENTURE CAPITAL FUNDING?
- For an entrepreneur
The main advantage of venture capital funding for an entrepreneur is that it strengthens the financial position of the business, which provides for faster growth and may actually assist the business in obtaining other forms of finance (such as a business loan from a bank).
Since venture capital funding is equity funding, it is unsecured and is also committed for the duration of the period up until the exit event (unlike debt funding, which needs to be repaid within a certain time frame).
Equity funding from a source such as a Fund adds credibility to the business and allows the entrepreneur to draw on the knowledge and experience of the VC Firm, including in relation to management and operations.
- For an investor
The main advantage for an investor of venture capital is the chance that it offers for high rewards.
Further, investing in a Fund allows the investor to gain the benefit of the Fund manager's skill and experience in selecting particular investments and their timing. In nearly all cases, the Fund manager will be better informed about potential target businesses than an investor acting alone, and as such has an improved chance of selecting a successful target.
4. WHAT ARE SOME DISADVANTAGES OF VENTURE CAPITAL FUNDING?
- For an entrepreneur
Venture capital funding carries the same disadvantages for a start-up entrepreneur as any other equity funding, including the need to value the business (both pre and post the investment by the Fund) and negotiate the amount of equity that the Fund will be issued in exchange for its investment. Venture capital funding also involves significant accountability to and board involvement by the Fund managers.
Venture capital funding may also involve the start-up entrepreneur and other managers being required to give warranties, making them potentially liable. The VC Firm may also seek to impose restraints over key employees of the business to ensure they do not compete.
Arguably the main disadvantage for an entrepreneur is that the investor is generally focussed solely on its exit from the business. Further, the investor is under pressure from its own investors to make a high return, and as such wants to build the business to a point that greatly increases the potential for a trade sale or IPO. As a result, venture capital investors are not necessarily focussed on the long-term operations of the business the way that an entrepreneur might be.
- For an investor
As always, the potentially higher rewards offered by venture capital funding carry with them a higher level of risk. There will certainly be failures – research conducted through the Harvard Business School of over 2,000 US companies that received venture capital funding of at least $1m between 2004 and 2010 found that greater than 75% failed to achieve the projected return on investment. Further, of the 6,613 US-based companies initially funded by venture capital between 2006 and 2011, only 11% were acquired in a trade-sale or made initial public offerings of stock.
Successful investing through a venture capital fund is dependent on selecting the right fund and the right fund manager. Otherwise there is a danger that the goals of the fund manager may not fully align with those of the investor.
5. OTHER SOURCES OF FUNDING
Where a start-up does not fit the usual venture capital profile, there are a number of other funding sources.
Two of the most well-known are personal savings and bank loans. Nearly all start-up entrepreneurs will use their personal savings initially to bring their idea to fruition, but chances are these will not be sufficient to meet the funding requirements of maintaining the business. Similarly, once their personal savings have been exhausted, nearly all start-up entrepreneurs will look to banks (whether through credit cards or business loans) for continued funding requirements.
Two less well-known funding sources are bootstrapping and angel investors.
Bootstrapping is where, following an initial small investment to get the business going (which covers expenses such as premises, furniture, equipment and supplies), the start-up entrepreneur uses any profits generated from sales to grow the business. This funding model works best for those start-ups where initial set-up expenses are low and the business does not require many initial employees.
However, when using the bootstrapping method, in order to maximise the profits and grow the business, start-up entrepreneurs will often not draw a salary from the business, and will expect any spouse or other family members working in the business to do the same. While the rationale behind this is understandable, particular care must to be taken to ensure the business complies with all relevant employment laws to reduce any potential liability exposure.
- Angel investors
Angel investors are wealthy individuals who usually have a personal interest in the opportunity. Current examples of angel investors which will likely be familiar are the "sharks" on the Network Ten series Shark Tank.
Typically, angel investors will make an equity or hybrid investment in industries where they have direct personal experience, or with people whom they have had a previous working relationship. However, they are far more flexible than Funds in making investment decisions and tend not to adhere strictly to an investment profile the way that a Fund does.
An advantage of angel investors over venture capital funding is that angel investors can make fast investment decisions, and usually require a lower rate of return than a venture capital firm. Angel investors are generally less selective than Fund managers in making investments and also less likely to be exit-focussed.
However, angel investors will still expect to make a reasonable profit on their investment, and their limited resources (when compared to a Fund) will impact their ability to provide ongoing funding to assist the business to expand further or to progress to the next stage.
The sources of funding for start-up business are varied, and each of them has certain advantages and disadvantages. Obtaining the right advice on which source(s) to choose and how best to implement that choice is critical in ensuring success.
For further information, please contact.
Andrew Draper, Senior Associate
Phone: +61 2 9233 5544
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.