Venture Capital

 

Venture Capital is a form of over-the-counter equity capital that an investment company provides for participation in companies that are considered to be particularly risky. Business ideas that are still in their infancy but show high growth potential are particularly risky ventures. As compensation for the risk taken, investors receive shares in the company. The venture capital is brought into the company in the form of fully liable equity or equity-like financing instruments such as mezzanine capital or convertible bonds, often through a venture capital company specializing in this business model (also known as a venture capital company or VCG for short).

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A Venture Capital investment is characterized by the following points:

 

• The participation mainly flows into young, unlisted, mostly technology-oriented companies (start-ups).

• Since such companies are usually unable to raise sufficient collateral for conventional external financing, fully liable equity and hybrid forms of financing are in the foreground. In Germany, minority holdings of 20 to 35% are common.

• It is true that the financial resources are in principle made available indefinitely; The aim of the equity stake is not dividend or interest payments, but rather the profit from the sale of the stake.

• Participation is associated with a very high risk, which can lead to the total loss of the capital invested. At the same time, however, very high returns are possible if successful.

• Not only capital, but also business know-how is made available in order to help the usually inexperienced company founders or to make the investment successful. This is why we also speak of intelligent capital in this context. The investor can actively intervene in the entrepreneurial activities (management support) and help with his network, for example, in establishing business relationships or hiring staff. This represents a further advantage compared to financing with outside capital, because banks, as donors, may provide financial resources but not the knowledge required to run a company.

• In return, the investor often receives information, control and participation rights that go beyond the usual rights from a participation.

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Financing phases

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Even before venture capital companies invest, company founders often receive funding from friends and relatives, from funding programs or from so-called business angels (start-up financing). In order to make high-risk investments in young companies more attractive, funding programs are now offered not only for start-ups, but also for business angels who receive additional venture capital subsidies when they buy shares. Such a funding program, which is provided by the German Federal Ministry for Economic Affairs and Energy (BMWi), is z. B. INVEST.

 

The type and scope of the venture capital participation is differentiated according to the phases in the life cycle of the financed company. Such phases are shown below; however, there is no uniform definition of these phases and other types of classification are also in use.

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Early phase

 

The early phase is divided again into the pre-foundation phase and the foundation phase.

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Pre-foundation phase

 

In the pre-founding phase, there are initially ideas or unfinished prototypes of the product or service. In this phase, preparations for the foundation are in progress and a business plan is drawn up. The venture capital made available in this phase enables activities such as research and development and the construction of a prototype with the aim of making the product or service ready for the market. This phase is regularly characterized by a very high risk, as there is no finished product and the possible commercial success at this stage is very difficult to estimate. The investor will accordingly claim a higher participation quota compared to the later phases, ie the purchase in the company takes place at a low price with a high risk.

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Foundation phase

 

In the start-up phase, the steps from company foundation to market launch as well as from research and development to production and sales are carried out. Areas of activity in this phase are production planning and preparation, weighing up your own and external production, building up the sales network, marketing activities and initial customer acquisition. In the pharmaceutical or biotechnology industry, for example, capital is required for tests (e.g. clinical studies) in this phase. The risk for the investor is already lower here than in the pre-foundation phase, since the functionality can already be demonstrated. However, there is still a great risk of loss, since the commercial success is difficult to estimate even in this phase.

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Growth phase

 

The growth phase or expansion phase (English growth stage) follows on from the foundation phase. It can be further subdivided into the actual growth phase (also known as the “first growth phase”) and the bridging phase.

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First growth phase

 

In the first growth phase, the young company is ready for the market with the developed product and generates revenue from the sale of products. To ensure economic success, rapid market penetration is indicated and additional capital is required for the expansion of production and sales capacities. The risk for the investor is much lower in this phase than in the previous phases, so that he buys relatively expensive.

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Bridging phase

 

In the bridging phase the decision is made for a far-reaching expansion - features of this phase can be a diversification of the product range, the expansion of the sales system and the expansion abroad. A possible impetus for this "increase in speed" can be the entry of competitors into the market niche.

The capital required for the expansive plans is often sought by going public. For this, the company needs bridge financing until the expected proceeds from the IPO arrive.

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Late phase

 

In the late phase or final phase, the company may have such different needs as further diversification, further expansion, but also reorganization, restructuring or replacement or addition to the founding team. The forms of financing are correspondingly different in this phase. Examples are management buyouts, development of funding or the use of the proceeds from the IPO.

 

After two to seven years (later depending on the risk capital strategy), the aim is to exit; that is, the investor withdraws from the company. He sells his shares on the stock exchange, to other companies, to venture capital companies or offers them to the company owner for repurchase. Specifically, the following exit strategies are common:

 

• IPO (initial public offering, abbreviated IPO): Usually this is where the company is listed and the shares are sold on the market.

• Trade Sale: The start-up is taken over by another company, usually from the same industry.

• Secondary sale: The venture capitalist sells its stake to a third party

• Company buy-back: the entrepreneur buys back the shares of the venture capitalist.

• Liquidation: This reflects the worst-case scenario: the company has to be liquidated if it cannot hold its own in the market.

 

The targeted average returns that can be achieved are 15 to 25% annually, which is above average - but the investor also bears the increased risks of the young company. In a scientific study of European venture capital funds, an average return (IRR) of 10% for the investment period 1980 to 2003 could be determined. If only the funds that were founded in 1989 and later are taken into account, returns of around 20% result - however, these figures are shaped by the euphoria on the growth exchanges such as the German Neuer Markt. When investing in a venture capital fund, the risk is significantly reduced with an average holding period of 7 years.

 

From an economic point of view, venture capital is a form of financing that is particularly fraught with incentive problems between venture capital companies and entrepreneurs, since the venture capital company cannot precisely observe whether the entrepreneur actually uses the money made available to increase the company value in the interests of investors.

 

To mitigate these incentive problems, venture capital companies have established various typical contractual structures and control rights:

 

• The capital is made available in several tranches, with continued funding only if certain milestones have been reached.

• Convertible bonds are preferred in order to give venture capital companies the opportunity to participate in good corporate results and still receive ongoing interest and, if necessary, priority in the event of bankruptcy in the event of poor performance.

• Venture capital companies have extensive rights of intervention and can even fire the entrepreneur in the event of poor performance.

 

The origins of venture capital lie in the USA. It was there that venture capital investment firms such as the American Research and Development Corporation (ARDC) began on a larger scale after the Second World War.   In the Federal Republic of Germany, the first venture capital company was founded three decades later, in 1975, and by 1988 there were already 40 companies. In 1987, DM 1.2 billion in venture capital was accumulated, of which around DM 540 million were invested primarily in the areas of high technology, electronics and microelectronics.

 

In December 1987, 12 venture capital companies in West Berlin merged to form the German Venture Capital Association (DVCA), which had around 600 million DM and invested 120 million DM. The main financiers were the banks and industrial companies. In December 1989 the DVCA merged with the Bundesverband Deutscher Kapitalbeteiligungsgesellschaft (BVK), which was also founded in West Berlin on January 29, 1988.