Venture Capital Firms: Efficiency of Portfolio Companies and Market Analysis
This is a review article of two papers.
Paper-1: Rajan AT. (2010) Venture Capital and Efficiency of Portfolio Companies. The Indian Institute of Management Bangalore (IIMB) Management Review Volume 22, Issue 4, ScienceDirect.
Abstract:
Venture Capital (VC) has emerged as the dominant source of finance for entrepreneurial and early-stage businesses, and the Indian VC industry, in particular, has clocked the fastest growth rate globally. Academic literature reveals that VC funded companies show superior performance to non-VC funded companies. However, given that venture capitalists (VCs) select and fund only the best companies, how much credit can they take for the performance of the companies they fund? Do the inherent characteristics of the firm result in superior performance or do VCs contribute to the performance of the portfolio company after they have entered the firm? A panel that comprised VCs, an entrepreneur and an academic debated these and other research questions on the inter-relationships between VC funding and portfolio firm performance. Most empirical literature indicates that the value addition effect dominates the selection effect in accounting for the superior performance of VC funded companies. The panel discussion indicates that the context, as well as the experience of the General Partners in the VC firms, can influence the way VCs contribute to the efficiency of their portfolio companies.
Keywords: Venture Capital, Portfolio Company, Funding, Entrepreneurship.
Paper-2: Teker D., Teker B., Teraman O. (2016) Venture Capital Markets: A Cross Country Analysis. Procedia Economics and Finance Volume 38, ScienceDirect.
Abstract:
Venture capital (VC) may be defined as a support to entrepreneurial talents and appetite by turning ideas and basic science into products and services which are expected to envy the world. Venture capital funds are able to build companies from the simplest form to mature organizations. Venture capital investors generally actively engage with management of the company by typically taking place on the board. Through the due diligence process the venture capital firms concentrate on the founders, the management team, the concept, the marketplace, the revenue model, the value-added potential of the firm, the amount of capital needed to heal the business and whether all these fit to the fund’s objectives. Over the next three to eight years, the venture firm works with the founding entrepreneur/s to grow the company. Once a company funded by venture capital matures and becomes successful, venture funds generally exit by taking it public through an initial public offering (IPO) or by selling it to big companies. This allows the venture funds to be free from the previous investment and invest in the next generation of companies. United States, Europe, Israel, Canada, China and India have the most developed markets for venture capital environment. The size of the venture capital market is nowadays about $50 billion and the United States has the most funds for venture capital of $33.1 billion in 2013. Venture capital firms may invest in promising firms in stages of seed, first round, second round or later.
The median investment amounts in the United States in 2013 are $0.5 million for seed, $2.5 million for first round, $5.7 million for second round and $10 for later stage. The most attractive sector for venture capital is information technology for the United States, Israel and Canada, invested over $10 billion in 2013, while the most attractive sector is consumer products for Europe, China and India, invested over $4.8 billion in 2013.
Keywords: Venture capital, risk capital, high risk projects, angel investors.
Introduction
Both the papers are Primarily focused on the Venture Capital Fund and their impact on the Firm’s performance. Let’s start with what exactly is Venture Capital? Venture capital is financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. Venture capital fund help small and deserving companies or startups to grow fast and become mature organizations. Venture capital is in fact a unique investment for institutional investors. Institutional investors is a nonbank person or organization that trade large amount of money that it qualifies for preferential treatment and lower commissions. For example, Flipkart’s cofounder Sachin Bansal has invested Rs 650 crore in home-grown ride-hailing platform Ola.
The VC investment cycle consists of four phases, namely, fundraising, selection and investment, monitoring, and exit. In the fund-raising phase, VC firms also commonly known as general partners or GPs, raise capital from various investors commonly known as limited partners or LPs such as financial institutions, corporations, university endowments, family offices, and wealthy individuals. Through the due diligence process the venture capital firms focus on the founders, the management team, the concept, the marketplace, the revenue model, the value-added potential of the firm, the amount of capital needed to heal the business. Generally, the VC funds have a close ended structure and have a fund life of around 10–12 years. Nevertheless, venture capital is a long-term and risky investment which may have very little or no value unless the company is acquired or goes public.
Conceptual framework
Paper 1 shows some data that concludes that VC funded companies show superior performance to non-VC funded companies. But then there is a question, given that venture capitalists (VCs) select and fund only the best companies, how much credit can they take for the performance of the companies they fund? Results indicate that the value addition effect dominates the selection effect in measuring the performance of the company. Also, the experience of the General Partners in the VC firms can influence the way VCs contribute to the efficiency of their portfolio companies.
Paper 2 mostly discusses and analyses the Venture capital markets in five countries — United States, Europe, Israel, Canada, China and India. These countries have the most developed markets for venture capital environment. The statistics indicate that international venture capital behaviour varies over countries. The analysis shows that the US is the leading country in venture capital investments with a total amount of $33.1 billion in 2013. It also discusses the average time to exit, number of funding rounds, VC Investments by Sectors etc.
The context, as well as backgrounds of the VC, can influence the way VCs contribute to the efficiency of their portfolio companies. The concept of venture capital in the sense of risk or start-up capital is quite old in India.
Summary
Paper 1 indicates that VC funded companies perform better than comparative companies that are not VC funded. This then led to the subsequent question of what capabilities of VCs contribute to the performance variation. There has been more research evidence to indicate that managerial and value-added capabilities of VCs dominate the selection capabilities in explaining the performance.
Section 2 provides an overview of the Venture Capital investment — four investment cycle discussed above, data from National Survey of Small Business Finance finds that commercial bank loans provide 19% of all financing for small businesses where VC investment provide only 2%. VC has several features that distinguish it from other sources of financing. The differences between VC and bank financing, a major source of financing for businesses, are also highlighted.
Section 3 discusses the performance of VC funded and non-VC funded companies. The study indicates that VC backed IPOs are associated with higher institutional holdings and lower levels of underpricing than non-VC backed IPOs. Underpricing is the listing of an initial public offering below its market value. When the offer price of a stock is lower than the price of the first trade, the stock is considered to be underpriced. Also, the presence of VC in the issuing firm lowers the total costs of going public and VC backed firms show superior post IPO operating performance than non-VC backed companies.
Section 4 discusses the reasons behind the superior performance of VC companies. Two main ideas are whether the better performance can be attributed to better screening and selection of investment opportunities or because of managerial inputs and value addition provided by VCs after investment. That is, are VCs able to identify, before investment, the firms that would be able to achieve superior performance? Or, can the superior performance be attributed to the value addition and managerial inputs that VCs provide to their portfolio companies after investment?
The answer is whether the characteristics that attract VC funding such as alliances, intellectual and human capital (top management) are also associated with future performance after the investment. The results indicate that alliances and intellectual property have a similar effect on attracting VC investment and subsequent firm performance. However, human capital or top management characteristics of the firm that was associated with VC investment had little effect on subsequent firm performance. This suggests a combination of both the selection and value addition roles in influencing portfolio company performance. VCs are able to select companies that have strong technology and relationships, but those that are at an increased risk of short-term failure. They then provide management inputs that enhance the long-term survival of the firm and contribute to superior performance.
Another method to address the selection vs value addition issue is by studying the performance of syndicated VC investments. Syndication is often observed in VC investments when more than one VC investor jointly makes an investment in the company. Risk diversification and the inability to fund a larger investment size are often considered the reasons for syndication among VC investors. The authors, therefore, propose that the most
promising opportunities would be taken up without any syndication, while those that offer moderate promise would be syndicated.
One more method discussed in this paper to address the problem of selection and value addition was the study related to efficiency gains in VC investment. They use Total Factor Productivity (TFP), i.e., the residual
growth in output after accounting for changes in production factors as a measure to analyze the efficiency of portfolio firms. They find that the efficiency of VC backed firms prior to receiving VC funding is higher than that of non-VC backed firms. Further, the growth in efficiency after receiving VC financing is greater for VC backed firms as compared to the growth of non-VC backed firms. This indicates the evidence for both screening/selection and the value-added role for VCs in improving firm efficiency. They are also able to find that contribution to portfolio firm efficiencies differ between high and low reputation VCs. While the TFP of firms prior to VC financing was higher for low reputation VC backed firms, the growth in TFP subsequent to financing was higher for firms backed by high reputation VCs. Their results suggest that while low reputation VCs rely on selecting more efficient firms, high reputation VCs are better able to improve the efficiency of the firms they invest in.
Paper 2 Mostly contains data, tables and insights from them. In the period of 1991 and 2014, a total of 11,686 companies funded by venture capital in the United States over time in which 14% went public, 33% acquired, 35% still private and 18% failed. The most attractive sectors for US venture funds are software (41%), biotechnology (12%), media & entertainment (12%), IT services (7%), media devices (5%) and industrial energy (5%).
Section 2 talks about the working system of Venture capital. Venture capitalists involve more than putting money into risky business. Venture capital investors in general actively engage with the management of the company by typically taking place on the board. Although the venture capital investors have high hopes for all companies funded, statistically only one company in six ever goes public and one company in three is acquired.
A business concept promising a 10 or 20% improvement on returns is not likely to grab the attention of venture capital firms. Once a company funded by venture capital becomes successful, venture funds generally exit by taking it public through an initial public offering (IPO) or by selling it to big companies. This allows the venture funds to be free from the previous investment and invest in the next generation of companies.
Section 3 discusses the cross-country aspects of venture capital. United States, Europe, Israel, Canada, China and India have the most developed markets for venture capital environment. The size of the venture capital market is nowadays about $50 billion and the United States has the most funds for venture capital of $33.1 billion in 2013. Venture capital firms may invest in promising firms in stages of seed, first round, second round or later. The median investment amounts in the United States in 2013 are $0.5 million for seed, $2.5 million for the first round, $5.7 million for the second round and $10 million for the later stage. The most attractive sector for venture capital is information technology for the United States, Israel and Canada, invested over $10 billion in 2013, while the most attractive sector is consumer products for Europe, China and India, invested over $4.8 billion in 2013. The statistics indicate that international venture capital behaviour varies over countries. The median round size is $4.20 million in the US, $1.98 million in Europe, $7 million in China and $4 million in India. The median time to exit in the US is 6.8 years while 6.3 years in Europe and 3.9 years in China. Moreover, the median time to M&A is 5 years in the US, 6.3 years in Europe, 3.5 years in China and 2.6 years in India.
Comments I will give my views on both the paper on the basis of three criteria i.e. on the validity of the papers, the impact of the paper in the research field and originality of the paper. Paper 1 gives us some idea about the impact of VCs on the companies and startups. It gives some great insights backed by some data. It has compared Venture capital-backed companies and bank financing backed companies and the results are quite original and fascinating. The comparisons are based on Monitoring, Form of investment, Extent of Monitoring, Control rights, Ownership rights, Return Expectations. And obviously, VC firms have a lot more role to play in a company than Banks. The Impact of this research is quite significant as it can help entrepreneurs to decide whether to go to a VC firm or to the bank. The paper also discusses the impact of VC investment on the company and how to measure the impact of selection vs monitoring. It suggested three methods to determine this as discussed in the summary of Paper 1. Overall the paper is quite good and helpful for many as the author of this paper is professor A. Thillai Rajan Department of Management Studies, IIT Madras, one of the most renowned colleges of India. Paper 2 is not so famous paper as it has been published in 2016, quite recent. It has compared venture capital markets of 5 countries as discussed in the summary of paper 2. The idea is quite original and with the comparisons, we can clearly justify the current condition of the Indian market. This paper has opened many areas which required further research like why the most attractive sector for venture capital is information technology for the US but consumer products for China and India? What policies should be implemented in India to increase its VC Market size and comparison with the US market and policies?
Learning outcomes
• Complete Functioning of VCFs (four stages)
• Impact of VCs on startups compared to normal banks — efficiency improvement
• Methods to measure the impact of VC investment on a company — broadly three methods
• Current scenario of the VC market in five countries including India and the US.
