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     Venture Capital

This page looks at venture capital funding.

It covers -

• introduction
• the VC sector
• VC investment criteria
• Australian and New Zealand VC funds
• information
• government support

     introduction

Venture capital is sometimes characterised as 'risk capital' and offering investors a higher return than that from safer investments such as money market deposits, fixed interest or equities.

Debt financing (eg through banks) is not a viable option for many new enterprises, particularly in internet and other new technology sectors, because

• nonspecialist lenders such as banks do not understand or trust new ventures
• banks require collateral, usually in short supply in new ventures (esp in knowledge-based ventures)
• debt financing seriously inhibits growth because an enterprise needs to repay loans rather than invest in future growth
• debt financing puts entrepreneurs at the mercy of changes in the economy, the bank's financial performance and bank auditors/regulators.

Figures about those concerns and banking practice in Australia are provided in Anthony Stanger's A Review of Recent Developments in SME Banking Services & Debt Financing (PDF). Few startups meet requirements for listing on the stockmarket. Financial support from venture capital funds and business angels is therefore attractive.

Much of the literature on recent venture capital activity has adopted a mystique promoted by individual funds and enthusiasts. That mystique overemphasises returns to investors and benefits to the 'innovation economy' or broader economic growth, typically

• concentrating on a handful of spectacular successes
• downplaying the larger number of failure
• reporting notional valuations rather than money actually received through sale of a stakes
• understating concerns about abuse of privileged positions

It has been illustrated by dazzling statistics. Some 439 dotcoms went public in the US between 1995 and 2001, raising over US$33 billion. As noted in discussion elsewhere on this site regarding the internet bubble, much of that capital evaporated but VC funds enjoyed a substantial return. It is reported that Silicon Valley funds had notional returns of 53% in 1995, 58% in 1996 and 31% in 1997.

Kleiner Perkins Caufield & Byers for example paid US$4 million in 1994 for around 25% of Netscape. Netscape for practical purposes has disappeared but Kleiner Perkins apparently did well during Netscape's IPO and subsequent US$4 billion acquisition by AOL. Kleiner Perkins US$8 million stake in Cerent was worth around US$2 billion when the optical equipment maker was sold to Cisco for US$7.2 billion in 1999. In that year Kleiner Perkins and Sequoia Capital paid around US$25 million for 20% of Google. Draper Fisher Jurvetson's US$0.7 million stake in Kana Communications was subsequently valued at over US$1 billion. Initial supporters of Amazon.com would have scored notional returns of over 55,000% at its December 1999 peak. US$2 million put into Cisco in 1987 would be worth over US$6 billion in 1997.

In 1997 the boosters at the US National Venture Capital Association reported that US enterprises backed by venture capital from 1970 to 2005 employed nearly 10% of private-sector workers, had US$2.1 trillion revenue, accounted for 16.6% of total gross domestic production and "generally outperformed non-venture-funded counterparts" in 2005. California claimed 42% of investments over the period. The enterprises included FedEx, Starbucks, Home Depot, eBay, Google and Apple.

     the sector

Venture capital funds are run by professional managers and pool money from individuals, institutions, superannuation funds, insurance companies and other businesses. Most nations offer generous tax concessions for the funds and/or the investors in those funds, with the result that some are perceived primarily as vehicles for tax avoidance rather than true investment bodies.

The funds gain equity in a company in return for providing capital, generally seeking long term capital gain rather than immediate and regular interest payments and offsetting the risk of corporate failure by investing in a spread of companies with the potential for rapid growth and greater than average returns.  

As part owners of an enterprise, the fund representatives typically require board membership but usually do not take day to day control, instead offering advice on management and technical issues.

Although a particular fund may be long-lived and have a wide ambit, many are sector-specific and typically operate for seven to ten years. Most aim to reward the investors (and the fund managers) by taking the companies that they fund to the stock market or an industry sale. Fund managers typically receive a management fee and between 15 to 25% of the capital gains when the investment is liquidated.

In contrast to North America, venture capital investment in Australian internet companies tends to be small; several of the funds identified below have total portfolios of well under a million dollars. A 2002 report by Axiss, a Commonwealth government finance sector specialist, suggested that only around 230 of an estimated 13,000 ITC enterprises received VC funding since 1992. US fund raising in 2000 was 115 times greater than in Australia; when adjusted for population differences US and EU fund raising exceeds Australia's by a factors of eight and 1.6 respectively.

Overall, the Australian venture capital sector with $6.3 billion under management in 2001 was the largest in the region. Local funds raised $1.4 billion in 2001, up 18.5% on raisings in 2000. Investment in 2001 was $2.2 billion ($1.6 billion new funding and $635 million follow-on funding).

The third ABS Venture Capital survey suggested that as of June 2003 investors had $7.5 billion committed to venture capital funds or associated financial institutions, with $4.8 billion of committed funds having been drawn down. New and follow-on investments during 2002-03 contributed $658 million to around $4.4 billion previously invested in around 850 companies. Management fees were around $110 million.

The NZ Venture Capital Monitor suggests that VC funds under management in New Zealand in 2003 was an aggregate NZ$1.12 billion, with some NZ$568 million available for investment and 51 deals (with an investment value of approximately NZ$88 million) reported. Expansion and later stage investments accounted for 90% of investment by value (some 82% by activity). Health and Biosciences accounted for the highest value of capital invested during that year. ICT was the most active sector by number of investments. Average and median deal sizes during 2003 were NZ$1.7 million and NZ$0.5 million respectively.

The 1997 Coopers & Lybrand Economic Impact of Venture Capital study under Commonwealth sponsorship suggested that only 2% to 3% of SME equity was derived from venture capital; most funding came from the owner's personal funds or bank finance.

     VC investment criteria

Criteria for investment by VC funds vary but generally encompass

• a proprietary technology product/service that is market ready or will be in in the immediate future after access to funds
• orientation to a global market
• clear ownership of intellectual property
• a strong commercial management team with pertinent experience and personal attributes ("chemistry" or "personality")
• a viable business plan with the commitment of the enterprise's principals and key staff
• likelihood of substantial sales (esp substantial growth in gross and net revenue) within x years
• high gross margins and requirement for modest expansion capital
• satisfactory valuation and investment terms
• a clear exit path for the investor (eg will be able to liquidate the investment within x years)
• potential for substantial gains to the investor through an IPO or trade sale. Australian Venture Capital Journal (AVCJ) data in August 2000 suggests that the Internal Rates of Return sought by Australian fund managers ranges between 25% and 60%, with a mean of 34%).

The 2000 Australian Bureau of Statistics (ABS) report suggested that a small fund will receive between five and 20 approaches per month for funding. Of those two or three may receive a thorough examination, with one per quarter gaining funding. Medium sized funds receive up to 400 approaches per month, with investigation of five to 10 proposals per month and funding of two or three proposals per quarter. The major funds, which probably account for most money under management, receive upwards of 400 approaches per month and tend to invest in five to seven enterprises per quarter.

The 2003 ABS survey reported that in Australia during 2002-03 some 133 venture capital managers reviewed 9,512 potential new investments. There was further analysis of 1,088 investees, with only 132 (1% of those initially considered) being funded. These managers supposedly spent a total of 163,000 hours considering and dealing with investees.

     Australian and New Zealand VC funds

There is considerable disagreement about the number and viability of VC funds in Australia. Estimates of the size of the sector and number of participants vary widely. Some observers have suggested that around 10% of funds cease each year.

We have selected some of the bodies that are interested in online or other digital developments. The major VC fund managers are located in Melbourne and Sydney: the 2001 ABS report suggested that NSW-based funds accounted for around 46.9% of Australian VC under management and Victoria for 24.1%. In contrast to overseas counterparts (probably because of the small size of the local market) most of the funds have a high proportion of their investments outside their home city.

One New Zealand study quipped that

While a powerful engine of wealth creation, venture capital also ruthlessly ignores any sentiment about income distribution or balanced regional economic development. ... the operation of venture capital may widen the gap between the "haves" and "have-nots" by concentrating investment capital in a few select regions and in a few select industries.

Australian and New Zealand funds are identified in a separate note here.

More information is available from investment advisers and from bodies such as the Australian Venture Capital Association Ltd (AVCAL) and the New Zealand Venture Capital Association Inc (NZVCA)

An offshore perspective is provided by suggestions that the number of US VC firms grew from 87 in 1980 to over 690 in 2000, with employment rising during that time from 1,035 to 8,368.

Other points of reference are the OECD's 2003 reports Venture Capital Policy Review: Canada (PDF), Venture Capital Policy Review: United Kingdom (PDF) and Venture Capital Policy Review: Sweden (txt).

     information

The AVCAL Directory is available on its site, along with papers from the 6th AVCAL Conference and an Australian venture capital survey prepared by Venture Economics in conjunction with Arthur Andersen. 

It suggests that  the most popular sectors are biotechnology, medical/health devices, communications and information technology.

The site also contains Guidelines for the Valuation and Disclosure of Venture Capital Portfolios, modelled on the British Venture Capital Association (BVCA) guidelines. AVCAL members are bound by its Code of Conduct; the site contains a model Confidentiality Agreement.

Pollitecon Publications publishes an annual Australian Venture Capital Guide and the Australian Venture Capital Journal.

Overseas venture capital associations are identified here.

     government support

Tensions within the Commonwealth government bureaucracy about the most effective mechanisms for encouraging innvovation and commercialisation are reflected in two basic types of iniatives.

The 'industry' departments have tended to favour a direct injection of government money. The Treasury department, perhaps with a more macroeconomic approach, has favoured a small range - from A to C - of tax incentives, ie indirect funding.

The Innovation Investment Fund (IIF) involves government participation in nine private sector venture capital funds. The expectation is that those funds will thereby be better able to "assist small companies in the early stages of development to commercialise the outcomes of Australia’s strong research and development capability". It is claimed that Australian firms receiving venture capital experienced 20% annual growth in the 1990s, compared with growth of 2% in other areas.

Pooled Development Funds (PDF) program aims to increase the supply of equity capital for growing Australian SMEs by encouraging PDFs - private sector investment companies established under the PDF Act to raise capital for investment in Australian companies.

The Venture Capital Limited Partnerships (VCLP) program provides for registration of limited partnerships as venture capital limited partnerships (VCLPs) and is

designed to increase the supply of venture capital to Australian companies by addressing a tax impost to the flow of foreign venture capital to Australian companies.

In New Zealand the government established the Venture
Investment Fund (VIF) during 2001, with NZ$100 million to accelerate development of the "VC industry". Investment is handled by private sector fund managers who match government money two to one with private funds. The expectation is that managers will ultimately establish their own "fund of funds".







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