Term Paper: Capital

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[. . .] This stimulates venture capitalists to be more than just a financier and involve deeply in management, strategy and operations of the companies they invest in. It is the entrepreneurial spirit in venture capitalists that separate them from the convention financers such as banks and financial institutions. Although they involve in the affairs of the investee companies, most venture capitalists seek to exit from the ventures once they realize the desired rate of return. This enables them to continue investing in other young companies and continue to make higher returns.

Evolution of Venture Capital in the U.S.:

In the United States, venture capital has been in vogue right from the early stages of industrialization, with wealthy individuals, families or closed groups funding companies or projects, which could provide attractive returns. In 1946, Georges Doriot, recognized as the 'father of venture capital', promoted the first venture capital firm in the name and style of American Research and Development. However, the progress in venture capital funding was slow in the early years. J.H. Whitney, hailed as one of the founders of the VC industry, established his own VC firm in 1946 and one of its best known deals was the Minute Maid Juice. The Rockefeller family was known for their interest in VC funding and one of their major investments was in Eastern Airlines.

The sixties saw rich individuals in California investing money in technology companies that were in the early stages and struggling to find capital. The returns on these investments proved to be so good that more and more people started to invest systematically in start-up ventures. These investors were, perhaps aptly, referred to as 'angels', as they seemed to come from nowhere and provide capital to newborn companies with great ideas but little or no money. In 1971, a few successful angels got together and raised the first 'venture capital fund', with support from other rich people and institutions. There was a growing conviction that venture capital funding is the ideal option for super normal profits for the investors and it also provided the much-needed platform for evolution and growth of new companies.

But barely thee years down the line, the stock market crash of 1974 pulled the winds out of venture capital firms. While this slowed down investments, it did not stop altogether. In the mid-seventies, Tandem Computers commenced operations with USD 1 million from a VC firm and proved to be a big success. It grew into a USD 2.6 billion company and Compaq bought it in 1997. The second half of the seventies saw a few VC firms making handsome returns on their investments. The United States government supported the VC industry in many ways and in 1978; it reduced federal taxes on profits made from venture capital financing. The VC firms in America did a whopping USD 750 million business in 1978, which is viewed by many as the first milestone for the so-far fledgling industry.

Venture Capital trends in the U.S.:

Studies conducted by PricewaterhouseCoopers, Thomson Venture Economics and the National Venture Capital Association, venture capital activity in the U.S. showed signs of rebounding in 2003, with total investments pegged at U.S.$18.2 billion in 2,715 companies. While this was lower than the U.S.$21.4 billion investment level in 2002, the rate of decline was lowest in last three years, indicating that the venture capital industry is moving towards realistic and sustainable levels. Investments were fairly consistent on quarter-to-quarter basis in 2003, which could mean greater stability in the years to come. Bio-technology and health sectors are fast emerging as the leaders, ahead of software and information technology companies. For the full year 2003, the Life Sciences Sector comprising of biotechnology and medical devices, were able to attract U.S.$4.89 billion or 27% of the total venture capital. This trend was more evident in the last quarter of 2003, when the biotechnology sector alone garnered U.S.$1.1 billion, relegating software sector, which accounted for U.S.$978 million.

However, the software sector continued to the single largest sector, taking up U.S.$3.6 billion in 2003, representing 20% of the total investments, with biotechnology a close second at U.S.$3.4 billion. Other major segments namely telecommunications and networking cornered U.S.$2 billion (11%) and U.S.$1.7 billion (9%) respectively, a shade lower than the previous year, while the semiconductor industry was stable with investment of U.S.$1.2 billion or 6% of the total investments in 2003. Year 2003 saw a reduction in first-time financings with only 624 companies totaling U.S.$3.4 billion, compared to 792 companies and funding of U.S.$4.3 billion in 2002. The survey pointed out the change in investment strategy of venture capitalists in first time deals, with increasing focus on Life Sciences sector, which represented 20% of all first time financings in 2003.

Software continued to dominate accounting for 20% of the first-time deals. A notable shift is the decline in first-time financings of telecommunications and networking industry, while there seemed to be a surge in electronics and instrumentation sectors. The survey reported a substantial increase in later-stage financings during 2003, indicating that the existing companies who received funding in the past were moving towards maturity stage. The later stage funding in 2003 was U.S.$4.7 billion, equivalent to 26% of all venture capital. This led to reduction in investment for both expansion stage and early stage companies. Expansion stage firms managed U.S.$9.9 billion in 2003, as against U.S.$12.7 billion in 2002.

The trend of increasing later stage financing is expected to be on the rise for the next 1 or 2 years, till a good proportion of the existing companies move out of the venture capitalists' portfolio. (PricewaterhouseCoopers, Thomson Venture Economics and National Venture Capital Association MoneyTree Survey).

According to Tracy Lefteroff, global managing partner of the venture capital practice at PricewaterhouseCoopers, venture capital firms are in for good times due to increased activity in capital markets, initial public offerings and mergers and acquisitions. Venture capital investments, if managed properly, are likely to return impressive profits. Mark Heesen, President of the National Venture Capital Association echoed similar sentiments and claimed that good opportunities are opening up for venture capitalists in many sectors. Commercial information technology sector is back on the growth trajectory and this is providing many options and exit avenues for venture capital firms.

Venture capital in the Europe:

Unlike the U.S., venture capital financing in the Europe has not been very popular and is still considered to be an emerging market. While the U.S. is considered the very epitome of a matured venture capital market, the European market is dubbed as a one which is lagging behind in funding innovative firms. It was only as late as the latter half of the nineties that venture capital took a serious step towards start-up and early-stage financing. The aggregate VC investment level up to the year 1999 was barely one-fourth of the U.S. venture capital market in the same year. In the last four years, Europe has made significant strides in VC funding, but still yet to blossom into a developed market. Research has identified significant gaps in the performance of European venture capital markets in comparison, to say a developed market like the U.S., in terms of rate of return and exit alternatives. (Hege et al., Determinants of Venture Capital Performance: Europe and the United States).

Such gaps can be best understood with comparison to the United States, wherein three major differences are often described. One, the European venture capitalists are not as aggressive or assertive as their American counterparts, especially when it comes to management of poor performance. American investors have shown more willingness to exercise their residual control on defaulting firms or replace entrepreneurs who do not measure up to the expected standards. Two, European VC firms have lagged in employing the real options in stage financing - in other words, American venture capitalists have displayed greater tendency to increase the frequency of stage financing, which increases the probability of higher returns. Three, while European VC firms have shown strong tendency in ensuring investor continuity from one stage to the other, they have failed to fully capitalize on the contractual relationship with the entrepreneur teams, which is an indication of inadequate VC specialization. In essence, while European VC firms are better in concluding financing deals but do not seem to show finesse in controlling and monitoring the performance of the funded companies. In the overall context, this points to the fact that European firms can do a let better in adding value to firms that show promise.

In 2003, about Euro 2.5 billion was raised through venture capital by 599 European companies, steeply lower by 50% to the Euro 4.9 billion coughed up in 2002 over 743 financings. However, the silver lining is that the dipping trend has started reversing from the second quarter 2003 and the trend is expected to continue. Like the U.S., the Life Sciences sector (biotechnology and healthcare) was the flavor of investors, managing deals… [END OF PREVIEW]

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