I. Innovation
5. Market-based financing of innovation, a detailed introduction of
5.3. Venture capital
When a business is born and starts, the owner, or their immediate environ-ment and angel investors tend to provide funding initially. Empirical studies demonstrate178 that debt financing is not a viable option for this group of companies, the only option for them is (venture) capital financing. At this stage, different types of venture capital sources usually enter.
5.3.1. A historical perspective
Before World War II, banks and the public would buy shares in or lend money to companies with tangible assets or a recurring revenue derived from a retailing business. The problem is that technology-focused entrepreneurial ventures didn’t fall into either category. They couldn’t borrow from banks because their business model was unknown, and they still had everything to prove. And they couldn’t raise capital from the public because no financier could value them. This gap led to the emergence of private equity and venture capital.
The first self-proclaimed venture capital firm was the American Research &
Development Corporation (ARD), founded in 1946 by the famous Harvard Business School professor Georges Doriot. As a public company, ARD was able to attract institutional investors in private equity for the first time.
177 Hornuf, L., & Schwienbacher, A. (2014): Crowdinvesting – Angel Investing For the Masses?
Handbook of Research on Venture Capital.
178 Bethlendi, András - Urbanics, Roxána (2018): Critical financial and accounting issues of early-stage innovative enterprises. in Investment Management and Financial Innovations 15 : 4 pp. 144-157.
ture capital only emerged as an asset class in the 1970s when it came to fi-nancing a new industry: personal computing. As personal computing reached consumer markets for the first time, venture capital grew tenfold in the fol-lowing years. It was fortunate because a new competition was about to storm onto financial markets: leveraged buyouts—which during the 1980s attracted billions when venture capital deals were still counted in the millions. Fortu-nately, the 1990s tech bubble provided venture capitalists with a new, larger platform on which they could grow up and dance: the Internet179.
5.3.2. How does venture capital work?
Where venture money plays an important role is the stage when a company begins to commercialize its innovation. Venture money is not really a long-term funding. The idea is to invest in a company’s balance sheet and infra-structure until it reaches a sufficient size and credibility so that it can be sold to a corporation or so that the institutional public-equity markets can step in and provide liquidity. In essence, the venture capitalist buys a stake in an entrepreneur’s idea, nurtures it for a short period, and then exits with the help of an investment banker180.
The stages of venture capital
Even within venture capital, there are investors that focus on different stages therein.
• Seed-stage: it is the initial funding used to establishing a business, or cre-ating a new product or service. Obtaining seed capital is the first stage required for a start-up to become an established business.
• Early-stage: in this stage, venture investors focus on taking a company that has successfully proven its concept to accelerate its sales and mar-keting efforts. It becomes important to scaling commercial manufactur-ing and sales.
• Growth-stage: Growth of companies is often exponential by this stage and VC funding serves as a tool for enabling expansion to additional mar-kets and diversification of product lines.
179 Colin, N. (2016. May 04): https://salon.thefamily.co. Forrás: https://salon.thefamily.co/a-brief-history-of-the-world-of-venture-capital-65a8610e7dc2
180 Zider, B. (1998): How Venture Capital Works. Harward Business Review, 98611.
There is an extensive literature on the selection and decision-making process followed by venture capital investors.181 One element of this process is due diligence of financial and taxation issues in the past. In practice since inap-propriate financial management can make it more difficult for start-ups to raise capital and, thus, to continue to grow.182
The types of venture capital
Within the venture capital space, the two most typically used structures are equity and convertible debt. Equity is issuing common stock or preferred stock (with some type of liquidation preference rights). Once invested, equity is owned outright until some type of sale or liquidity event of the company.
Convertible debt, like its name suggests, is a debt instrument that technically has a maturity date and does need to be repaid at some point in the future.
That said, most sophisticated convertible debt investors in venture capital are treating their investment like equity and are prepared to "convert" their debt into equity of the company, upon the company's next equity round. It is often a "bridge" financing to an early stage or growth stage financing, in a way that doesn't have to set a formal equity valuation of the company183
5.3.3. What is the future of venture capital?
The amount of capital available for investment depends largely on the eco-nomic cycle. If the outlook is favourable, investors will be more open to risk-ier investments, but if recession approaches, safer investments will come to the fore. However, in the last few years, many changes have taken place with the advancement of the digital world, which can bring about significant changes in venture capital financing. The emergence of crowdfunding sites and blockchain-based platforms are the next steps in this development. They will make a significantly larger sample of companies and asset classes avail-able to a global investor base. It will also be an important challenge to pro-vide not only capital with the help of the online world but also the knowledge and support traditionally provided by venture capitalists to startups. Offer-ing platform services is the one way that VCs have to enhance their reputa-tion and enact positive influence upon their investments outside of the board-room. (examples of VC platform services include recruiting, marketing, de-sign support, inside sales reps, consulting, accounting services and so forth).
181 See, for example, Silva, J. 2004: Venture Capitalists’ Decision-Making in Small Equity Mar-kets: a Case Study Using Participant Observation. Venture Capital, 6(2-3), 125-145.
182 Bethlendi András (2019): IKT startup-ok pénzügyi kérdései. Információs Társadalom, 19(2), p. 7–22, 2019.
183 Deeb, G. (2016. July 18.): forbes.com. Forrás: What exactly is venture capital?
The global economy opened up by the Internet is expected to spark more startup ideas in the future, and the associated funding sources will have to adapt to these trends.
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