VENTURE CAPITAL AND THE SMALL BUSINESS

Chapter summary

A consistent theme running through this chapter has been that the informal venture

capital market and the institutional venture capital market play complementary roles

in supporting entrepreneurial activity. This is evident in terms of the size and stage of investments made by business angels and venture capital funds (Freear and Wetzel, 1990). The boundary between business angels and venture capital funds was around $500,000: business angels dominated when the size of round was under $500,000 but

their involvement fell away rapidly as deals got bigger and were replaced by venture

capital funds. Business angels also dominated at the seed round but declined rapidly

from the start-up stage when venture capital firms took over. A further dimension of

this complementary relationship is that venture capital funds often provide follow-on

funding for firms that were initially funded by business angels (Harrison and Mason,

2000; Madill et al., 2005).

However, these complementarities are now breaking down because venture capital

funds in North America and Europe have raised their minimum investment size to more than 11m in the UK and SSm in the US, and continued to shift their investment focus to later-stage investments (Jensen, 2002; Sohl, 2003). This stems from the growing popularity of venture capital as an asset class, which has resulted in an increase in the size of funds under management. As there has not been a commensurate increase in the number of venture capital executives each one is managing more money but with the same time scale in which it has to be invested. The inevitable outcome is that deals have become larger. Moreover, at least in Europe, the shift to making later-stage deals has increasingly drawn venture capitalists into corporate finance and away from fostering entrepreneurial businesses.

These trends have several potential consequences. First, they create a funding gap

for projects that are too large for business angels but are still too small for venture capital funds. As a result, some businesses may be constrained in their growth, others that have raised initial funding but whose investors are unable to provide further funding might fail, and some entrepreneurs may be deterred from starting. Second, business angels are forced to undertake more follow-on investing, thereby reducing their ability to make new investments.

However, in response to these trends there has been the emergence of angel syndicates which Sohl et al. (2000) claim are 'the fastest growing segment of the early stage equity market' in the US. There are currently estimated to be around 200 angel syndicates located throughout the US and growing evidence of specialisation by industry sector (e.g. healthcare angel syndicates) and type of investor (e.g. women-only angel syndicates) (see May and O'Halloran, 2003, for some case studies). The same trend is also clearly evident in the UK although at an earlier stage, and it has not attracted the same degree of attention from researchers or commentators.

Angel syndicates have emerged because individual angels found advantages in working together, notably in terms of better deal flow, superior evaluation and due diligence of investment opportunities, and the ability to make more and bigger investments, as well as social attractions. They operate by aggregating the investment capacity of individual high-net-worth individuals. Some groups are member-managed while others are manager-led (May and Simmons, 2001; May and O'Halloran, 2003; Preston, 2004).

The emergence of angel syndicates is of enormous significance for the development

and maintenance of an entrepreneurial economy. First, they are helping to address this 'new' funding gap roughly the 250,000 to 2m+ range in the UK and the $500,000 to $5m range in the US, which covers amounts that are too large for typical '3F' (founder, family, friends) money but too small for most venture capital funds. Indeed, angel syndicates are increasingly the only source for this amount of venture capital in this range. Second, angel syndicates have the ability to provide follow-on funding. With the withdrawal of many venture capital funds from the small end of the market individual angels and their investee businesses have increasingly been faced with the problem of the absence of follow-on investors. Because angel syndicates have got greater financial firepower than individual angels or ad hoc angel groups they are able to provide follow-on financing, making it more efficient for the entrepreneur who avoids the need to start the search for finance anew each time a new round of funding is required.

Third, their ability to add value to their investments is much greater. The range of

business expertise that is found among angel syndicate members means that in most

circumstances they are able to contribute much greater value-added to investee businesses than an individual business angel, or even most early-stage venture capital funds.

Fourth, angel syndicates have greater credibility with venture capitalists. Venture capital funds often have a negative view of business angels, seeing them as amateurs whose involvement in the first funding round of an investment could complicate subsequent funding rounds because of their tendency to over-price investments, use complicated types of investment instruments and make over-elaborate investment agreements (Harrison and Mason, 2000). Venture capitalists may therefore avoid deals in which angels are involved because they are too complicated. However, because of the professionalism and quality of the membership of angel syndicates venture capital funds hold them in much higher esteem. Finally, syndicates reduce sources of inefficiency in the angel market. They are visible and easier for entrepreneurs to identify and approach, and have stimulated the supply side, enabling high-net-worth individuals who want to invest in unquoted companies but lack the time, referral sources, investment skills or ability to add value. Other attractions of syndicates for investors are the ability to reduce risk by spreading their investments more widely, the ability to participate in investments that they could not have invested in as individuals, access to group skills to evaluate opportunities and add value and the opportunity to learn from more experienced investors (Mason, 2006).

Angel syndicates are therefore increasingly becoming the only source of finance,

other than government-supported funds and schemes, for growing businesses that have exhausted '3F' funding. In this sense, venture capital is returning to its 'classic' roots.

Many of the early venture capital funds in the US started on the basis of investing

funds supplied by wealthy individuals and families (Gompers, 1994). Indeed, Bygrave and Timmons (1992) argue that it was the flow of institutional money into venture capital that has led to its shift to bigger and later-stage deals. The emergence of angel syndicates and the boost that it gives to classic venture capital therefore augurs well for future level of entrepreneurial activity.

Questions

1. How are different sources of funding important to businesses at different stages of growth ?
2. What is the role of business angels in the development of growth firms?
3. Describe the process by which venture capitalists enter and exit into financial relationships with businesses?