`Technology Startups, Innovation, and the Market for Venture Capital

Financing Entrepreneurship and Innovation in Emerging Markets.

https://doi.org/10.1016/B978-0-12-804025-6.00008-3
© 2018 Elsevier Inc. All rights reserved.

Entrepreneurial firms rely heavily on external debt sources. These can be personal loans from the balance
sheet of the entrepreneur, who then holds levered equity claims in their firm (Robb and Robinson, 2012),
resources borrowed from friends and family, or bank financing. Notwithstanding fintech’s potential impact
on external debt financing it generally remains challenging for entrepreneurial firms to gain access to bank
credit. Banks are usually reluctant to lend to startups that have few, if any, tangible assets, little repayment
history, and negative cash flows. This is true in the United States and other advanced economies; for startups
in emerging economies, this challenge is often insurmountable. As a result, the success of entrepreneurial
firms often depends on whether they are able to find external investors willing to fund their projects.

1. What are the sources of capital for an entrepreneur?

2. Why banks are reluctant to finance start-ups?

we look at the role that independent venture capital (IVC) firms can play in connecting entrepreneurs who
have good ideas, but little capital, with investors who have money and are looking for good ideas. Investors
in IVC funds are generally institutions, such as endowments, foundations, pension funds, and sovereign
wealth funds (SWFs), HNI, whose commitments to IVC funds are motivated by expected financial returns.
These investments should be distinguished from corporate venture capital groups (CVC) that invest in start-
ups to complement their internal Research and Development (R&D) programs. CVC is an important form of
corporate venturing that is usually driven primarily by strategic considerations. Venture capital (VC), IVC,
as well as CVC are exceptional sources of entrepreneurial finance; very few start-ups are backed by VC
funding.

1. What do you mean by Independent Venture Capital Funds?

2. Then who are Corporate Venture capital groups?

In the United States, the cradle of venture investing and by far the deepest VC market worldwide, only about
one start-up firm out of 500 receives venture capital. On the other hand, those companies that do receive VC
funding make up a disproportionally large share of companies that undergo initial public offerings (IPOs).
Of all the U.S. companies that made it to the public stage between 1980 and 2015, 37% were VC-backed;
for technology IPOs, this ratio was 58% (Ritter, IPO database, 2016). Gornall and Strebulaev (2015)
estimate that public companies in the United States that previously received VC funding account for one-
fifth of the market capitalization and 44% of the R&D spending of U.S. listed companies. This set of
companies includes some of the world’s largest and most innovative companies, such as Adobe Systems
Inc., Amazon.com Inc., Apple Inc., Cisco Systems Inc., eBay Inc., Facebook Inc., Genentech Inc., Google
(Alphabet Inc.), Microsoft Corp., Skype, and Yahoo! Inc. While all these companies are publicly listed,
venture capitalists have also funded today’s “unicorns”—tech companies such as Uber Technologies Inc.,
Airbnb Inc., Palantir Technologies Inc., and Pinterest Inc. that are still privately held but whose valuations
have already reached $1 billion or more.

1. Why do you thing VC capital is exceptional source of capital for start-ups?and what
percentage of US Co. made to public stage that were backed up by VC?
2. Which companies in US received VC funding that accounted for one-fifth of the market
capitalization and 44% of the R&D spending?
3. Are all these companies publicly listed today? Then what about the stake holding of VC?
4. What do you mean by Unicorns?
5. Which are those unicorns funded by VC and valuations have already reached $1 billion or
more and are they privately held or listed?

Thus, although VC funding is small, its macroeconomic impact is significant. While young firms contribute
disproportionately to aggregate output growth, Haltiwanger et al. (2016) note that only a small fraction of
young firms accounts for this contribution. Of these, a significant share is VC-backed. The United States
remains the world’s dominant destination for VC investing. However, in recent years VC has also played an
increasingly important role in backing emerging market startups. Tencent Holdings Ltd., was initially
funded by VC. So was Alibaba Group Holding Ltd., the Chinese e-commerce company that went public in
2014 in the largest initial public offering (IPO) in history ($25 billion). Encouraged by Tencent’s and
Alibaba’s success, venture capitalists have backed a growing number of emerging market tech startups.
Several of these companies became unicorns as well. Prominent examples include Xiaomi Inc. and Didi
Chuxing (China); Flipkart Online Services Pvt. Ltd. and ANI Technologies Pvt. Ltd., known as Ola (India);
Lazada Group SA (Malaysia); Avast Software (Czech Republic); Coupang (Korea); and Avito.ru (Russia).
Other companies are not far behind and aspire to become the next generation of unicorns, including Jumia
(Egypt/ Nigeria) and Nubank (Brazil).
1. Do you find domination in a select Country or in recent times we see changing scenario for
VC?
2. Can you give few names/examples of such VC funding in emerging markets start –ups and
which are in pipe line?
What Do Venture Capitalists Do?
Venture capital is intermediated through an institutional market, in which VC firms form limited
partnerships that raise capital to invest in startups.1 The limited partnerships are closed-end investment
vehicles in which the VC firm serves as the general partner (GP) who raises and manages a fund. As Limited
Partners (LPs) in a VC partnership, investors agree to provide a certain amount of capital (capital
commitments). Their liability structure allows these investors, most of whom are pension funds, insurance
companies, Sovereign wealth funds (SWFs), endowments, foundations, HNIs and family offices, to take a
long-term view of their investments. In a fund’s investment phase, which usually covers the first three years,
the GP acquires assets by drawing down on the capital originally committed by the fund’s LPs. The fund
holds its investments in portfolio companies for around four to seven years before the funds are liquidated
through an IPO or a trade sale to a strategic buyer. VC funds typically have a fixed lifespan of 10 years, with
possible extension periods of one or two years. During the life of the partnership, LPs have virtually no
access to liquidity for their investments. 2 The limited partnership’s legal structure provides an important
advantage for investors because their capital commitments expose the investors to a diversified VC
portfolio. Investing in start-ups is inevitably prone to substantial risks, and it is not uncommon for even the
most successful venture capital funds to write down or write off a nontrivial number of their investments.
Instead of consistent moderate successes, fund returns are often driven by a small number of exceedingly
successful investments in companies.

1. What do you mean by Limited Partnerships?

2. How are VC firms are constituted?
3. How are the funds held and for how long? And how are they withdrawn?
4. What is the life span of VC and during the period can they liquidate their holdings?
5. Advantage and Disadvantage of limited partnership legal structure?

Stages of Venture Capital Funding: It is common to differentiate between four different investment
stages, which are defined by the maturity of the start-up company that receives funding. At the seed stage,
external financiers typically provide a relatively small amount of capital to an inventor or entrepreneur to
prove a concept. This involves market research as well as building a management team and developing a
business plan, if the initial steps are successful. Early-stage financing entails product development and
investments in product development, where products are mostly in testing or pilot production. In some cases,
products may have just become commercially available. Companies may be in the process of organizing or
they may have been in business for three years or less. Usually, such companies will have performed market
studies, assembled the core management team, developed a business plan, and are ready to start or have
already started conducting business. At the expansion/capital stage, financing provides working capital for

1
We can trace the roots of this market to 1946, when American Research and Development (ARD) was formed in the U.S. Widely considered as
the first true VC firm, ARD was a publicly traded closed-end fund. The first VC limited partnership—Draper, Gaither, and Anderson—formed
in 1958. This legal structure is now the norm for VC investing as well as for other forms of private equity. For a discussion of the history of VC
in the U.S., see Gompers and Lerner (2001a). Gompers and Lerner (2006) and Da Rin et al. (2013) also provide good surveys of the VC industry
and research on this asset class
2
Although a secondary market for stakes in limited partnerships has emerged, the turnover in that market is a fraction of the capital managed by
GPs.
a company’s initial expansion; the company is already producing and shipping and has growing accounts
receivables and inventories. It may or may not be showing a profit. Some of the capital’s uses may include
further plant expansion, marketing, working capital, or improving a product. Institutional investors are more
likely to participate at this stage along with initial investors from previous rounds. The investor’s role in this
stage evolves from a supportive role to a more strategic role. Finally, later-stage financing is typically for
companies that have already reached a fairly stable growth rate, that is, not growing as fast as the rates
attained in the expansion stages. These companies may not be profitable but are more likely to be than in
previous stages of development. These companies ‘financial characteristics may include well-known product
or service offerings, expansion of offerings into adjacent markets, significant revenue growth in excess of
Gross Domestic Product (GDP), and positive cash flow. This also includes companies considering an IPO.
Build the stages of the VC funding on the following plot provided.

Prototype of a VC backed company life cycle

An efficiently designed VC contract will allow for the staged infusion of capital. This process allows
venture capitalists to increase the duration of funding and reduce the frequency of revaluation as the
company becomes better established (Gompers and Lerner, 2001b). Consistent with this process, individual
financing rounds are commonly classified as Round A, Round B, Round C, and so on. Furthermore, VC
transactions are usually syndicated, with the originating VC firm bringing in other VC investors to share in
the investment and oversight. This syndication process has important advantages for the firm, enabling it to
diversify and thus reduce the risk in any individual investment, improving the due diligence process by
letting the VC firm gather additional opinions on investment opportunities (Gompers and Lerner, 2001a),
and affirming the network sharing effect.
1. An efficiently designed VC allows _______________
2. How are the VC rounds classified? 3. How are VC transactions formed?

The Logic of the Deal: venture capitalists also act as mentors, adding value by assisting the entrepreneur
with strategy, hiring other executives, and introducing management to potential customers and other
partners.
The logic of the deal is always to give investors in the VC fund both ample downside protection and a
favourable position for additional investment if the company proves to be a winner. In a typical start-up
deal, for example, the VC will invest $3 million in exchange for a 40% preferred-equity ownership
position, although recent valuations have been much higher. The preferred provisions offer downside
protection. For instance, the venture capitalists receive a liquidation preference. A liquidation feature
simulates debt by giving 100% preference over common shares held by management until the VC’s $3
million is returned. In other words, should the venture fail, they are given first claim to all the company’s
assets and technology. In addition, the deal often includes blocking rights or disproportional voting rights
over key decisions, including the sale of the company or the timing of an IPO.
1. Do they only invest?
2. What they demand in their deal?
Attractive Returns for the VC
In return for financing one to two years of a company’s start-up, venture capitalists expect a ten times return
of capital over five years. Combined with the preferred position, this is very high-cost capital: a loan with
a 58% annual compound interest rate that cannot 1. What is the usual ROC expected? And how
be prepaid. But that rate is necessary to deliver much the investor get on an average.
average fund returns above 20%. The real upside
lies in the appreciation of the portfolio. The
investors get 70% to 80%of the gains; the venture
capitalists get the remaining 20% to 30%. The
amount of money any partner receives beyond
salary is a function of the total growth of the
portfolio’s value and the amount of money
managed per partner. (See the exhibit “Pay for
Performance.”)

https://hbr.org/1998/11/how-venture-capital-works

Between the late 1990s and the mid-2000s VC

invested in emerging markets showed interest
as emerging markets have become the world
economy’s growth engine, accounting for a
rising share of global output. With the financial
sector still underdeveloped in most emerging
markets and the financial needs of many
companies exceeding what “friends and
family” were able to provide, private equity
looked like the logical choice. At the same
time, U.S. private equity and VC funds saw a
large inflow of capital as they showed strong
returns. Thus, several Chinese and Indian
entrepreneurial firms absorbed around 95% of
all VC investments in emerging markets from
VC funds typically focus on funding tech start-ups
2004 onwards till 2014–16.
in two broad industry groups (1) information
In China, there are more than 400 VC firms
technology (IT) and (2) medical/health/life
providing entrepreneurial finance to start-ups.
science. Investments in start-ups operating in
In India’s considerably smaller economy,
these areas accounted for 88% of all VC deals in
young companies can seek funding from more
the United States in 2015, although these sectors .
than 200 VC firms. Several of the top U.S.
represented less than 20% of U.S. GDP.
venture capitalists who backed some of today’s
2. What does this graph represent?
largest U.S. companies have opened offices in
The Emergence of VC Hotbeds in China & India: China and India and are among the most active
VC firms that spearheaded the globalization process investors. More recently, increasing amounts of
usually chose to open foreign offices to interact more VC funding have been provided by non-
closely with potential entrepreneurs in other markets.
They ventured in the economies in Europe. and the
1990s tech-boom provided additional impetus to
source attractive investment. Opportunities. But they
couldn’t scale up. Exporting the VC model to Israel
has been more successful. while with a close
symbiosis between innovative entrepreneurs, venture
capitalists, universities, the military, and a
government providing substantial VC firms looked
at opportunities in new markets that were
technologically less advanced but had the potential
to achieve rapid economic growth.