Financing Innovation: Venture Capital

Innovation

It has been over 60 years since Nobel Prize laureate, Robert Solow, first established the link between innovation and long term growth (Lerner, 2012; McKinsey Quarterly, 2014; OECD, 2012; Rosenberg, 2014). Solow found that ‘inputs’ only account for 15% of actual growth in the economy and that 85% came from technology innovation i.e. how you transform those inputs (Rosenberg, 2014). Thus innovation is now widely recognised as the driver of long term growth and living standards.

More recently, the innovation agenda has become a stronger focus of economic growth due to the increased understanding that start-ups and investors play a significant role in generating and commercialising innovations.

Why start-ups matter

Innovation is not just the outcome of R&D in a university laboratory or at large corporate. While important, start-ups (that is, new and small ventures) actually generate half of the innovations in young industries or in industries that rely on technology (Lerner, 2012). This due to reasons such as:

  • Less barrier to entry;
  • large firms can be incumbent and ineffective from a focus on existing products;
  • new firms choose higher risk strategies and can ‘pivot’ more easily to adapt to the markets demands or gaps; and
  • the rewards for successfully starting a business and commercialising an innovation (Acs & Audretsch, 1988; Koutroumpis, Leiponen & Thomas, 2017; Lerner, 2012).

Yet it is also hard work and high risk starting a new firm, with 90% of start-ups failing (Forbes, 2015). However, if those new firms can commercialise their ideas and grow, then they tend to be more competitive, create higher skilled jobs and generate spill overs that grow the innovation ecosystem. In fact, if they go on to become a high growth firm, they will disproportionately generate a greater share of all new jobs than any other business sector (OECD, 2014).

Governments around the world widely now recognise the powerful link between new firms and innovation, job creation and international competitiveness (European Commission, 2012). Most are now actively reviewing policies, laws and taxes to support new firms to start and grow; and this includes support for investors (Capital Pitch, 2018).

Start-ups and venture capital

Academic research has found that entrepreneurs and venture capital play a significant role in stimulating innovation (Awuah & Ulu, 2008; Lerner, 2012; and OECD, 2012). Venture capital is an important source of equity that start-ups need to commercialise their ideas. This is because venture capital is prepared to invest in untested business models with no track record – and essentially, fill a void in traditional finance (Zider, 2008). Therefore venture capital is considered an important component in the innovation pipeline (OECD, 2016).

Venture capital: is money provided by professionals who invest alongside management in young, innovative rapidly growing companies that have the potential to develop into significant economic contributor (Awuah & Ulu, 2018). Venture Capital is a subset of private equity (i.e. equity is capital is not listed on a stock market) and provides support for pre-launch, launch and early stage development phases of a firm (Invest Europe, 2018). Investments are typically high risk and short to medium term from 3-10 years, with the intended return on investment is mainly in the form of capital gains (rather than long-term investment involving regular income streams) (ABS, 2018).

Research shows venture capital backed firms  have “higher survival rates than non-VC- backed firms” and are more likely to evolve into gazelles AKA high growth firms which create 50% of all new jobs (Awuah & Ulu, 2008; and OECD, 2014). While Lerner (2012) notes that dollar for dollar, venture capital returns 3 to 4 times as much as corporate R&D; and is associated with a significant time reduction in taking a product to the market.

Selecting a Start-ups

Due to the high risk nature of the investment, venture capitalists need to be very strict in how they select firms to ensure they are able to generate a return (Awuah & Ulu, 2018). Venture capitalists typically need a return of 25% to 35% per year over the life of their investment (Capital Pitch, 2018; Zider, 2008). However the reality is that they might invest in 10 firms and around four will fail, three will breakeven, one-two will have a reasonable outcome and at least one will hopefully return the whole fund, plus more. Thus the following criterion is generally applied:

  • “market attractiveness (size, growth and access to customers)’
  • product differentiation (uniqueness, patents, technical edge and profit margin);
  • managerial capabilities (skills in marketing, management, finance, and the reference of the entrepreneur);
  • environmental threat resistance (technological lifecycle, barriers to competitive entry, insensitivity to business cycles, risk); and
  • cash-out potential (future opportunity to realise capital, gains by merger, acquisition or public offering (cited in Lerner, 2012)”.

Most venture capital investments also provide intensive oversight of the firm to ensure a return. They will “actively work alongside start-ups as coaches and advisors, assisting founders in developing their businesses and curating their strategic direction (Capital Pitch, 2018).” Therefore in addition to capital, other benefits include:

  • mentoring, strategic direction and sometimes leadership;
  • specific industry expertise and business advice across a number of business decisions, including financial management and human resource management;
  • connections to new market access, contacts and can attract new investors if required
  • incentives and accountability to help founders to succeed; and
  • facilitation of exit strategy (ACCAL, 2018; Capital Pitch, 2018; Lerner, 2012).

All of support provided by venture capitalists has been found to substantially strengthen and modernise certain industries and accelerate growth, through their focus on the market and incentives offered for ‘revolutionary’ products and services (Capital Pitch, 2018).

Investing in Start-ups

Venture capitalists typically invest a $1 million plus in a firm and this will be dispersed in stages known as rounds. These rounds include pre-seed, seed, start-up and other early stage and then later stage (OECD, 2016). Staggering investment in this manner improves the outcomes of venture funding through creating invectives and milestones but also allow greater control for the venture capitalist to manage risk and continue to have oversight strategic direction of the firm.

Venture capitalists hold preferred stock in firms rather than common stock. While both represent a part of ownership in a firm, the difference is that preferred stock holders have a greater right to a firm’s assets and earnings if the company is liquidated. That is, preferred stock is paid out before common stock providing a greater security for limited partners (Investopedia, 2018; Lerner, 2012).

Returns are generated only through a “liquidity event” or exit and include:

  1. Share Purchase: when investors equity in a firm is purchased;
  2. Acquisition or merge (M&A): when a firm buys another firm to support its strategic direction and competitiveness; and
  3. Initial Public Offerings (IPO): when a firm raises funds by offering its stocks to the public for the first time (Investopedia, n.d; Medium, 2015).

You can read more at the ABS about how venture capitalists establish their fund, governance structures and lifecycle of investments.

The Status Quo

Though not a new concept, in the past two decades, the venture capital industry has shown an incredible growth and become recognised as an important part of a well-developed innovation ecosystem. Venture capital should also not be at the expense of focus areas, such as universities, corporate R&D, and STEM but does need to be recognised as an important component of the ecosystem (OECD, 2012). This is because venture capital:

  • provides start-ups with capital and expertise not otherwise available;
  • supports the creation of firms and knowledge spill overs;
  • is necessary to support commercialisation of innovations; and
  • supports creation of new industries and help to mature industries to adapt and become more competitive (AVCAL, 2017).

Despite these benefits, in the majority of countries venture capital remains a significantly underdeveloped market, generally less than 5% of GDP. The two major exceptions are Israel (39%) and the United States (33%) and are widely acknowledged to be global innovation leaders (OECD, 2016).

Over the last 10 years, the Australia venture capital market has grown substantially but it is still in its infancy. In 2015, venture capital in Australia represented only 2.3% of GDP, a rate less than half of all other OECD nations. While Australia ranks last in the OECD for commercialising this research (ABS, 2018; Lerner, 2012; AVCAL, 2017).

So what can government do to support and ignite the venture capital market?

 

Reference:

Lerner, J (2012) Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have failed–and What to Do About It. Princeton University Press: New Jersey.

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