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Some basics on venture capital

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					Department of Urban and Regional Planning

Why care?

Some basics on venture capital

Of increasing interest to states, larger cities with emphasis on entrepreneurship and innovation Capital availability as a constant concern of start up businesses
Shift of political attention to start ups means capital questions front and center

Initial experimentation, by some jurisdictions, in VC support policies, programs What are the right policies and programs?
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Venture capital defined
Money invested in new ventures and developing businesses “More than money, synergy”: A significant form of financial intermediation that provides privately held entrepreneurial firms with equity or hybrid forms of financing, in conjunction with managerial expertise

Differences from traditional capital
Venture capital
Less fluid Requires high return rate Invested based on longerrun future Concerned with product and market potential Venture capitalist and partner are co-owners

Traditional
More fluid Bears lower return Invested based on immediate future Concerned with past performance Loaning bank is creditor
Requires collateral

Source: Hosmer (1982)

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The role of VC
Enables businesses that would not receive conventional bank funding to:
Start-up (pre-seed) Expand (seed)

Players in VC industry
Actor
Entrepreneur

Role
Provides innovative business idea

Profile
Little to no capital/business experience Commitment and preparation Knowledge and awareness Reasoned risk taker Ability to get things done Willingness to share ownership Friends/business partners of entrepreneur with high personal net worth Typically Invest less than $100,000 in the venture

Typically less developed, higher-risk entrepreneurial firms Entrepreneurs with innovative ideas, but no internal capital and no business track record Examples: SAS, Microsoft, Apple, Staples, TCBY

Angel

Provides initial money (mostly pre-seed), but no managerial service

Source: Gompers (1994)

Source: Barry (1994)

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Players cont…
Actor
Investors

VC investment process
Profile
Individuals/Families (17%) Commercial and specialized banking firms/Insurance (18%) Corporate sponsors (2%) Pension funds (38%) Foundations/Endowments (22%) Other (3%) Experienced with going public, selling/merging a portfolio firm, liquidating unpromising deals, replacement of management Providing access to key needed expertise

Role (in Limited Partnership)
Provide 99% of investment money Serves as limited partner (LP) Not allowed to be involved in dayto-day fund activities, but have some measures of control

Raise funds Identify options for investment Execute deal Monitor investments
Sell stake; achieve return on investment

Venture capitalist

General partner Contributes 1% of fund Responsible for deal origination, screening, evaluation & structuring as well as post-investment activities

Source: Barry (1994)

Source: Fried and Hisrich (1994)

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VC funding use at business stage
Start up First stage Second stage

Venture capital contracting problems
Uncertainty – the inability to predict future event Information asymmetry between entrepreneur and venture capitalist Agency costs –uncertainty and information asymmetry mean the entrepreneur is in a position to take advantage of the VC

Product development and initial marketing Establishment of product or service in commercial use and generation of early sales Operational expansion coverage for a company with growing sales Funding for major expansion of a profitable company, or bridge financing for a firm expecting to soon go public Financing the purchase of a business for companies or management teams
Source: Walter (1985)

Third stage+ Acquisition/buyout

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Solution?
Incentives
Shift of control from the entrepreneur to VC Intense monitoring The emphasis on exit to recycle VC contributions

Public sector rationale in VC?
Capital perfectly mobile, available everywhere?
Why might it not be?

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Boom & bust in VC market
What shifts VC market (supply/demand) Why is adjustment of VC industry slow, say to demand growth? Why does VC market have a tendency to overreact? What are the consequences of under- and overshooting? Appropriate government action?

Sources
Binder, R A, and L A Yow,”Venture capital: Do economic developers want a piece of the pie?”, PowerPoint presentation, Department of Urban & Regional Planning, University of North Carolina at Chapel Hill, April 2001. Perez, R. 1986. Inside Venture Capital: Past, Present and Future. Praeger: New York. Amit, R., J. Brander, and C. Zott. 1998. Why do venture capital firms exist? Theory and Canadian experience. Journal of Business Venturing 13 (6). Hosmer, L. T. 1982. A Venture Capital Primer for Small Businesses. Washington, DC: Small Business Administration. Berlin, M. 1998. That thing that venture capitalists do. Federal Reserve Bank of Philadelphia Business Review, January/February, pp. 15-27. Gompers, P. 1994. The rise and fall of venture capital. Business and Economic History 23 (2). Walter, D. 1985. Venture Capital: Where to find it, How to go after it. Seattle, Washington: Venture Source Publishers. Barry, C. B. 1994. New directions in research on venture capital finance. Financial Management. 23 (3): 3-15. Fried, V. H. and R. D. Hisrich. 1994. Toward a model of venture capital investment decision making. Financial Management 23 (3): 28-37. Growing New Businesses with Seed and Venture Capital: State Experiences and Options. National Governors’ Association www.nga.org, 2000. 13 Department of Urban & Regional Planning 14

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