Venture Capital Finance - Essay Example

There are principally two sources of capital for small start-up businesses. These are the internal sources and the external sources. Internal sources of capital are sources like bootstrapping. This source utilises methods like deliberately delaying payments to suppliers, buying used equipment instead of new ones, hiring instead of employing personnel on a permanent basis, using interest on overdue payment from customers etc. (Cornwall et al, 2005). External sources are sources like equity financing, venture capital financing, bank loans, family and friends, angel investors, private placement and so on. (Cornwall et al, 2005). The main aim of this paper is to compare two of the external sources of finance for a small firm, that is bank lending and venture capital financing. Venture Capital Finance Venture capital is equity investment made for the launch, early development or expansion of a business. It has a particular emphasis on entrepreneurial undertakings rather than mature businesses. (EVCA, 2007) It can be said to be a subset of private equity. Venture capital is required when entrepreneurs with limited funds have the ability to start a new venture. This type of capital financing is also referred to as risk capital for its providers are willing to take more risk than would bankers and other institutional capital providers, that is, they usually engage in ventures with higher risk and as such, require higher returns than other institutional capital providers. (Cornwall et al, 2005). This mode of financing has three main characteristics: They take an active participation in the management of the firms that they fund using their experience and expertise, contacts and reputation to advice the entrepreneurs particularly on issues like deals with suppliers and personnel hiring. They inject the capital in stages based on information gathered and matching investment decisions with the growth of the business. They rely on equity-like and convertible securities. (Rapullo and Suarez, 2004). These firms are typically composed of professional private equity managers representing large institutional investors such as mutual funds, and pension funds. The limited partnership is the dominant form of intermediation in the venture capital market with the institutional investors acting as limited partners and the professional mangers acting as general partners. (Cornwall et al, 2005). General partners are those firms that have a high esteem in funding and managing equity investments in closely held private firms. In most cases, these firms end up converting their invested capital into equity capital. (Cornwall et al, 2005) There are four main types of venture capital providers. These include old-line wealthy families such as the Rockefeller family have traditionally provided start-up capital to promising businesses and have been actively involved in venture capital financing for a better part of the 21st century. The second type of venture capital firms include a number of private partnerships and corporations that have been formed to provide investment capital to budding entrepreneurs. (Cornwall et al, 2005). The main people behind this form of venture capital include institutional investors such as insurance companies and pension funds who provide the necessary finance to the partnerships (Ross et al, 2002). Examples of these partnerships include the American Research and Development (ARD), formed in 1946. The most recent venture capital partnership is the Arthur Rock & Co. of San Francisco which has achieved near mythic stature in the venture capital industry following its investment in Apple Computer and other high-tech firms. (Ross et al, 2002). There are six main stages of venture capital financing as seen by (Dollinger, 2003). Seed-money Stage: Start-up. First-Round Financing:. Second-Round Financing: Third-Round Financing: Fourth-Round Financing: Bank Financing Banks play a major role in the financing of start-up businesses. Bank finance takes form of overdrafts for existing customers as well as bank loans for a fixed or specified term and other forms of borrowing. (Cornwall et al, 2005). Banks usually provide start-up finance to businesses in the form of loans, which carry a fixed rate of interest payable on an annual basis (Cornwall et al, 2005). There is usually also a fixed term within which the principal and any accrued interest must be paid back to the bank. (Cornwall et al, 2005). While some bank loans may require that the borrower have sufficient liquid assets that can be put up as collateral, others can be granted without such a requirement. It all depends on how the bank evaluates the risk of the venture in which the borrower intends to invest the loan. The bank generally will require three principal documents for the loan: Loan Proposal, loan document and personal guarantees. (Cornwall et al, 2005). It usually uses certain criteria such as the ability of the business to generate enough cash flows to easily make interest and principal payments, entrepreneur’s ability to personally pay back the loan and assets to serve as collateral in issuing out the loan.(Cornwall et al, 2005). In the United Kingdom, High street banks have recently introduced a number of innovations to attract new small business customers. (Ross et al, 2002). UK high street banks for example are now more interested in providing both business and financial advice to clients so as to ensure that the businesses they invest in have good plans and therefore limit the rejection rate of loan applications. (Ross et al, 2002). There is also the availability of the Small Firms Loan Guarantee Scheme, which is designed to improve access to bank finance for businesses experiencing financial hardship as a result of lack of collateral security of trading record, or a combination of both. Having looked at the two alternatives of external small firm financing, the question arises whether which of the two forms is preferable to the other. Venture capital finance will be chosen by the entrepreneur if it is feasible and if it dominates bank finance (Bettignies and Brander, 2007). Generally, the venture capitalist has differential preference for risky projects with high success probabilities because they share the surplus. (Bettignies and Brander, 2007). Venture capitalist usually invest in deals that are newer and smaller, often without enough collateral. This makes their risks higher than that of loan packages offered or funded by banks. (Fiet and Fraser, 1994). Hence, the venture capitalist will also expect a higher return on his investments than would the banker. The venture capitalist tries to hedge this risk by investing in risk-reducing information and sharing his portfolio among co-investors. (Fiet and Fraser, 1994). Bibliography Bettignies J. E., Brander J. A. (2007) Financing entrepreneurship: Bank finance versus venture capital. Journal of Business Venturing Vol 22 pp 808–832 Cornwall J. R., Vang D. O., Hartman M. J. M (2005). Entrepreneurial Financial Management. An Applied Approach. Pearson Prentice Hall. Dollinger M.J (2003) Entrepreneurship: strategies and resources. Upper Saddle River: Prentice Hall European Private Equity and Venture Capital Association (EVCA), (2007). A guide on Private Equity and Venture Capital for Entrepreneurs. Available on website: www.evca.eu Fiet, J. O., Fraser, D. R. (1994) Bank Entry into the Venture Capital Industry. Managerial Finance. Vol 20, Issue 1, pp 31-42. Repullo R., Suarez J. (2004). Venture Capital Finance: A Security Design Approach. Review of Finance Vol 8 pp 75–108. Ross, S.A., Westerfield, R.W., and Jaffe, J.F (2002) Corporate Finance, Boston: McGraw-Hill Irwin. Read More