8.1.3 Equity investment: venture capital

Venture capital provides financial support to a company in the form of a participation in its equity or an option to convert a loan to equity. The relatively high risks are compensated by the possibility of high returns. It focuses on industries with high growth potential.

Investment stages
It is important to understand that some funds specialise in certain aspects of the investment business and it is hopeless to talk to one which is not focused on your particular type of opportunity. Most important is the stage of development of your project/company. The following outlines the various stages recognised by equity investors:

  • Seed finance or Seed Capital (SC): finance offered to research, assess and develop the initial conception of a business before it has reached the start-up stage.
  • Start-up: finance provided to companies for product development and initial marketing before selling their products commercially.
  • Other early stage: financing to companies that have completed the product development stage and require further funds to begin commercial manufacturing and sales. They will not yet be generating a profit.
  • Expansion (or Development): financing provided for the growth and expansion of a company which is breaking even or trading profitably. Capital may be used to finance increased production capacity, market or product development and/or to provide additional working capital.
  • Mezzanine (Bridge finance): finance made available to a company in the period of transition from being privately owned to being publicly quoted.
  • Management Buy-out: finance provided to enable current operating management and investors to acquire an existing product line or business.
  • Management Buy-in: finance provided to enable a manager or group of managers from outside the company to buy into the company with the support of venture capital investors.

Venture capitalists1
In a general way, venture capitalists can be divided into three types, each appropriate to a given range of investments. They may specialise in one or several or the above investment stages and they may also concentrate their attention on specific industrial or geographic sectors.

Business angels (Private investors)2
These are wealthy individuals who are prepared to use their own financial resources to make risk investments based on their own experience and interests. They are often retired senior executives of major enterprises.

Typically, business angels tend to invest locally in business sectors in which they have some experience. Individually, their investments may be quite small (around 50.000 €) but in syndication, considerably larger sums may be available. They make quick decisions.

Please stop and think: after reading this piece of information about business angels, can you find some pros and cons of this type of investors?

Fund management companies
This is the conventional venture capital sector. The Venture Capital Fund Management Company manages the funds of its investors (shareholders) and returns the profits, after deduction of expenses and fees, to those investors.
Some of these companies manage quite small sums (a few million of Euros) while the biggest of them handle many billions of Euros. All of them have a clear goal for their investments.
Most of these funds have an established period of time, usually ten years, after which the fund is closed and the profits distributed.

Public sector funds
These are funded from regional or national sources, sometimes with private money as well and their purpose is often not for profit and their objectives are regional development and job creation. Public sector funds are usually found in less developed areas.

The main principle of every venture capital fund should be the creation of wealth (profit). It may have other focuses, such as the environment or regional development, but unless the policy is to invest in companies capable of producing a sustained growth and therefore a return on the investment, the money will be wasted.3

1 For further information you can go to EVCA Yearbook 1997. The economic impact of venture capital.
2 For further information you can go to  www.eban.org/

3 The chapter is based on Gate2Growth. A guide to financing innovation. European Communities 2002.