A Community-Based Venture Capital Model for Small Countries

Venture Capital 1

A Community-Based Venture Capital Model for Small Countries

Haven Allahar (DBA)

Arthur Lok Jack Graduate School of Business, University of the West Indies (Adjunct Lecturer)

Managing Director, APDSL (Consulting Development Planners)

Introduction

In the modern business environment the search for capital

remains a major preoccupation of firms because of the almost

universal claim that there is restricted access to capital,

especially for new or start-up companies. This paper will explore

the subject of venture financing by considering the options

available to firms, both new and established, for accessing

start-up and expansion funding. The main categories of venture

finance are debt and equity, but these are broad categories

within which lie a wide range of menu options, many of which are

unfamiliar to firms and entrepreneurs. Van Auken (2001) argued

that a good understanding of the various types of capital, is

vital to the effective raising of capital and successfully

developing a firm’s capital structure. Van Auken thus concluded

that “An inappropriate capital structure, a misunderstanding of

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the characteristics of the financing instrument, or a lack of

information about the availability of specific sources of capital

can result in suboptimal firm performance and financial distress’

(p.245). This paper will explore this information gap which can

lead to a financing gap and will also discuss venture capital

financing with particular emphasis on developing countries with

Trinidad and Tobago as an example.

Corporate Venture Financing

Corporate venture financing is traditionally obtained from

three sources, depending on the nature of the venture and the

stage of development, and comprise: own funds and funds from

family and friends, which is the main source for start-up firms;

debt financing by way of loans; or venture capital. This paper

will focus on the more formal sources of financing which are debt

and equity by way of venture capital. Debt finance is sourced

mainly from banks, insurance companies, and specific financial

institutions such as credit unions, but, worldwide, commercial

banks are the major source of debt financing. Bank financing

comes in the form of a variety of short-term and long-term loans.

Short term loans comprise traditional commercial loans, lines of

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credit, and floor planning. Long-term loans include term loans,

installment loans, discounted installment contracts, and

character loans. Debt financing options are also available from

nonbank sources such as commercial finance companies which

provide services such as: asset-based loans, discounting of

accounts receivable, inventory financing, and trade credit

(Scarborough & Zimmerer, 2006, pp. 467-474). This is not an

exhaustive list but provides an insight into the range of

possibilities of which firms should be conscious when seeking to

obtain venture financing.

Equity finance is obtained from personal investment which is

the entrepreneur’s stake in the business, or from venture capital

(VC) which comes in the form of angel financing or investments by

specialist venture capital firms, either privately held or state

sponsored. The subject of venture capital financing will be

explored more deeply later in this paper. The fundamental

differences between debt and equity financing are: debt financing

carries specific obligations regarding payment, which is

independent of the actual cash flow of the business, and are, in

effect, a fixed cost; and equity financing, on the other hand, is

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money that is used to purchase common stock of the business.

There is no fixed repayment schedule and dividends may be paid

when the fortunes of the company are good, but the company may

elect to waive this payment if it is appropriate to do so

(Kuratko & Hodgetts, 2004, pp. 479-482).

As pointed out by de Bettigines and Brander (2007), bank

finance leaves the entrepreneur with continued ownership of the

firm, avoiding dilution of business assets and loss of control,

but it deprives the firm of the venture capitalists’ managerial

input. De Bettigines and Brander concluded that “either bank

finance or venture capital finance might be preferred depending

on several factors, including the specific sensitivities of

effort and performance to variations in ownership structure” (p.

809).

Venture Capital Financing

The main focus of this paper is a consideration of the

appropriateness of venture capital as a financing option for

firms in developing countries, and will draw upon international

best practices. An assessment of what is required to stimulate a

VC industry in developing countries, using Trinidad and Tobago as

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an example, will also be examined. Rotheli and Grotzer (2000)

provided a simple definition of VC as “equity investments made

into new companies for launch, early development or expansion of

a business that entails some investment risk but offers the

potential for profits substantially above average” (p. 39).

Sherman (1990) stated that VC investments involved high risk but

venture capitalists were less risk averse than traditional

financiers, thus were prepared to consider financing proposals

that would be rejected by traditional financial institutions.

Venture Capital Investment Process

It is recognized in the literature that businesses pass

through a development cycle which Dollinger (1999) defined as:

the need for early stage financing for seed capital and start-up

financing, which is used to confirm feasibility and to get the

company organized; expansion or development financing, which

comes in three stages - second stage finance for supporting

first commercial sales, third stage finance for expanding

production, and fourth stage finance for making the transition

from a privately held company to a publicly owned firm (p. 210).

The funding process was elaborated by Barringer and Ireland

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(2008) as constituting: seed funding, start-up funding, first-

stage funding, second-stage funding, mezzanine financing, and

buyout funding (p. 293). This process is detailed in the Table 1

below.

Table 1. Stages of Venture Capital Financing

Stage or Round Purpose of Funding

Seed funding Investment made very early in a venture’s life

to fund the development of a prototype and

feasibility analysis.

Start-up funding Investment made to firms exhibiting few

commercial sales but product development and

market research are complete. Management is in

place, and the firm has completed its business

model. Funding is needed to start production.

First-stage

funding

Occurs when the firm has started production

and sales but needs additional financing to

ramp up capacity.

Second-stage

funding

Applies to a firm successfully selling a

product but needs to expand production

capacity and enter new markets.

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Mezzanine

financing

Provides for further expansion or to bridge

financing needs before launching an IPO or

before a buyout.

Buyout funding Provided to help a company acquire another.

Source: Bruce R. Barringer & R. Duane Ireland. (2008). Entrepreneurship successfully launching new ventures. Upper Saddle River, New Jersey: Pearson, p. 293.

The venture capital investment process is straightforward

but intense, and was described by Rotheli and Grotzer (2000) as

involving: preparation of an information memorandum by the firm

for preliminary evaluation; issue of a letter of intent by the VC

company setting out all the terms, rules and conditions

precedent; completion of a technical, business, financial, and

legal due diligence audit by the VC; and finally signing of a

shareholders’ agreement (p. 39-40). The shareholders’ agreement

is critical and covers: investment and investment mechanics, exit

mechanisms, dilution protection; representations and warranties;

covenants; representation on the board; conditions precedent to

closing; creation of a business plan; indemnification; and

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termination procedures (Rotheli & Grotzer, p. 41-42). The process

is therefore essentially one of negotiation and Sherman (1990)

stated that “the success or failure of the negotiations will

revolve around the need to strike a balance between the

legitimate concerns of the founders of the company…. and the

concerns of the venture capitalist” (p. 45).

Sources of Venture Capital

In Europe, banks have traditionally been the main source of

investment and many venture capital organizations in Europe are

subsidiaries of major banks. Increasingly, funds for venture

capital investment are being sourced from institutional

investors, such as pension funds and insurance companies, which

have set up their own private equity investment operations and

have formed their own venture capital firms. Some institutional

investors have invested in independent venture capital funds

managed by professional venture capital management teams

(Levitsky, p. 10-11). Additionally, venture capital is provided

by business angels but on a much lower scale.

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What Do Venture Capitalists Look for

The literature on VC investing confirmed that venture

capital companies vary in their investment interest and Elango,

Fried, Hisrich, and Polonchek (1995) studied the differences

among venture capital firms based on the venture stage of

interest, amount of assistance provided, the size of the VC firm,

and the regional location. Elango et al., found that there were

three different types of venture capital markets as follows:

early stage; local and regional area markets; and large, late-

stage investments at the national level (p. 170). Elango et al.,

concluded that local VC’s are vital if a region is to provide

either early-stage or small late-stage financing but not large

late-stage financing (p. 170). This position was supported by

Anonymous (2008) who studied cross-border venture capital

investing in Finland and observed that local venture capitalists

typically invest first, followed by foreign venture capitalists

in later rounds (p. 210). This finding is instructive for

developing countries like Trinidad and Tobago seeking to develop

a VC industry.

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A VC is very careful in assessing firms’ proposals for

financing and tends to focus on four main areas which were

described by Sherman (1990) as comprising: details of the

management team; uniqueness of the products or services and their

sustainability; the characteristics of the market targeted; and

the anticipated return on investment. These issues were

elaborated by Scarborough and Zimmerer (2006) to cover: competent

management; competitive edge of the firm; whether the firm was in

a growth industry; existence of a viable exit strategy; and

intangible factors such as the strategic planning process,

chemistry of management team, and the overall sense of direction

(p. 451). Firms in developing countries will have to gain a

deeper insight into the mind of the VC, if this form of financing

is to play a part of business development.

Angel Finance

An often neglected source of venture capital, mainly because

of lack of information, is angel finance. Levitsky (1994)

indicated that there are some private investors who invest

directly in small companies, either becoming involved directly in

management, or offering their expertise or experience as advisers

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to the managers. Such persons are referred to as “business

angels”, and are usually retired executives or entrepreneurs who

have sold their own businesses and are looking for both a

business or management interest and a rewarding investment for

their funds (p. 5).

There are different types of angel investors and Kuratko and

Hodgetts (2004) identified five basic groups: corporate angels

who are senior managers who received a large severance;

entrepreneurial angels who own and operate successful businesses;

enthusiast angels who are independently wealthy and use investing

as a hobby; micromanagement angels who are wealthy business

persons who usually seek a seat on the board; and professional

angels such as doctors and lawyers who invest in companies that

provide a product or service related to their business practice

(pp. 506-507). Riding (1997) added a type of angel called

“archangel” which is a person who marshals informal capital

through syndicates of other investors and pursues

commercialization of product ideas and technology (p. 110). There

is merit in promoting the role of the archangel approach of

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syndication as a means of tapping angel finance in developing

countries.

Sudek (2006) studied what business angels consider when

reviewing investment opportunities, and suggested that

entrepreneurs must appreciate that, apart from a good idea, they

need to: manage the presentation to investors, answer questions,

and facilitate the relationship; build an effective management

team that investors can trust to invest in; and clearly

communicate an exit strategy for investors. Investors, on the

other hand, must be wary of first impressions and not jump to

conclusions about entrepreneurs’ trustworthiness (p. 101). Angel

financing may not be easy to access in developing countries and

will not amount to a major source of equity funding, but cannot

be ignored as potentially important, as angels tend to target

specific investments.

State-sponsored Venture Capital

In several developing countries, VC companies are sponsored

by governments because of perceptions of the private sector being

risk averse. Lamman and Veldhuis (2009) examined the Canadian

situation and found that companies financed by government-

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sponsored VC’s were less likely to grow their businesses, and

tended to provide lower commercial value than privately financed

companies. They attributed this performance to weaker mentoring

services and managerial input by government venture capitalists

(p. 11).

Apart from the formal VC companies, large corporations are

increasingly entering the field of corporate venture capital

(CVC) which Anonymous (2009) considers a unique opportunity for

cash-rich firms to become providers of finance to the corporate

world in the face of the collapse of confidence in banks (p. 12).

Anonymous suggested that, in the current crisis, firms should

expect to see: “nonfinancial players plucking teams of investment

and risk experts from the wreckage of the financial services

industry”; the increasing prominence of sovereign wealth funds

and government creating more structured investment vehicles;

corporations working in partnership with acquired firms which

will act as an appealing corporate option; and the reemergence of

rights issues as a valuable source of funding (p. 12). McNally

(1995) viewed corporate venturing as crucial in the financing of

technology based firms and stated that the concentration of

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investment in early stage technology-based ventures reflected the

motives of corporate investors which are strategy oriented,

related to obtaining windows on new

technologies, and concerned with financial returns from business

growth (p.15).

Venture Capital in Trinidad and Tobago

Brief Profile

The entrepreneur in Trinidad and Tobago has traditionally

relied on debt financing to meet the needs of new start-up

venture or for expansion of an existing company. A relationship

is usually established with a bank and loans negotiated as the

business grows. This growth is limited in many instances by the

amount of capital that can be injected into the operation. The

amount of capital that is available from a debt financier is

limited basically by two factors, available collateral, and

projected cash flows sufficient to service the debt. While in

some instances the lending institution may give a character loan,

waiving a part of the collateral requirement, this is the

exception rather than the rule, and is contingent upon the

entrepreneur’s track record.

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As a middle-income developing country with a financial

sector growing in sophistication, it is appropriate to consider

the development of a venture capital industry in Trinidad and

Tobago can be a strategic development tool. The Venture Capital

Incentive Program (VCIP) was introduced, by way of formal

legislation, to address the lack of equity capital available for

small business financing in Trinidad and Tobago. The prime

objective of the VCIP is to increase the supply of risk capital

to the entrepreneurial small business sector, thus fostering the

expansion and preservation of small businesses as well as

creating new jobs. This objective is achieved by tax credits

that are granted to investors in qualifying companies.

An entity must register as a Venture Capital Company (VCC)

before it can make investments in a small or medium business

venture in order to receive tax credits available through the

Venture Capital Incentive Program (“Venture Capital”, n.d.).

There are only two venture capital companies are registered with

the VCIP, while one other operates independently and after almost

15 years only 15 investments have been made, dating from 1998 to

2002 (“Venture Capital”, n.d.). There is one VC company operating

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independently of the VCIP, and it has made five investments. It

can be concluded from this evidence that the VC industry has not

been vibrant and is not an effective source of equity for

businesses in Trinidad and Tobago despite no direct involvement

of the government in the investment process as compared with the

Canadian case described by Lamman and Veldhuis (2009).

Requirements for a Vibrant VC Industry

Ferrary and Granovetter (2009) identified 12 different

players involved in the successful operation of a traditional

venture capital industry as: universities, large firms, research

laboratories, VC firms, law firms, investment banks, commercial

banks, public accountants, consulting groups, recruitment

agencies, public relations agencies, and media. These 12 agents

are vital to the life cycle of start-up businesses which are the

potential target companies in developing countries. Ferrary and

Granovetter studied Silicon Valley listing a significant number

of players in all categories and concluded that the success of a

start-up is not based solely on “the quality of the entrepreneur

and its innovation, but also from its embeddedness in complex

social networks. The more connected an entrepreneur is, the

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better is his access to financial resources, to advice, to

partners and experts” (p. 337).

Acs and Szerb (2007), in their paper to the second Global

Entrepreneurship Research Conference, suggested that middle

income countries should concentrate on increasing human capital,

upgrading technology availability and promoting enterprise

development while developed countries need to focus on labor

market reform and deregulation of financial markets (p. 109). An

initiative that is relevant to developing countries such as

Trinidad and Tobago, is the Utah Fund of Funds which, in addition

to making VC investments, provides certain benefits which were

documented by Anonymous (2008) as comprising: actively counseling

entrepreneurs about fund-raising strategies; forging and

strengthening relationships with leaders in the national

investment and business communities; supporting the development

of key support infrastructure; increasing awareness and

credibility of companies and entrepreneurs in the investment

community; and boosting confidence among the entrepreneurial

community. Further the Fund promotes networking events,

workshops, industry-specific conferences, and introduces

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individuals with significant experience as limited partners, as

active participants in the Utah Capital Investment Corporation.

A model for promoting VC investments based on a community

approach, was developed by Van Auken (2002), and is presented in

adapted form in Figure 1. The model describes the need for the

involvement of community leaders and members in creating an

environment within which VC investments can be made successfully.

Further, the model demonstrates the need for an external

environment which provides investment opportunities, supporting

networks, and appropriate government policy. This paper

recommends the applicability of this model to small developing

countries and accepts Van Auken’s position that “The result of a

community effort that assembles each segment of the model can be

an environment in which members of the community contribute to an

investment fund, cooperate in attracting firms, and provide

networking assistance to the new business owners. Communities

benefit through job creation and economic stability, and

community members benefit through wealth creation” (p.291).

Figure1. Community Venture Capital Formation Fund

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Community Environment External Support Environment

Source: Adapted from Howard Van Auken. (2002). Journal of Small Business Management, 40(4), 287-301.

Conclusion

Vision of Community Leaders

Desire to Support Community

Opportunities for Good Investments

Support Network

A community environment that supports a coordinated effort to proactively pursue equity investments in early-stage dynamic

An external environmentthat supports communities in identifying, screening,and structuring investments in early-

Capital Formation

Public Investment: Job Creation,Economic stability

Private Investment: Wealth

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Based on the lessons learnt from several countries it has

been concluded that the provision of equity capital has a place

in the financing of businesses, but it can only fill a

particular niche, or what has been termed in the literature, a

‘financing or equity gap’. In order to create an environment

which can be successful in venture investing, specific conditions

must obtain and these were identified in the case of Africa by

Hart (1994) as constituting: an abundance of good proposals; a

history of rapid equity growth in new companies; adequate

business management and management consulting expertise;

expertise in financial and industry analysis; readiness of local

investors; appropriate tax incentives; transparency in company

valuation; and societal acceptance of entrepreneurship, profit

and wealth (pp. 38-39). In developing countries, a critical

factor is the availability of exit mechanisms which include a

functioning securities markets and methods of divestment, such as

mergers, private placements, management buy-outs and, most

importantly, acquisitions.

In order to enhance access to venture financing including

venture capital, the position espoused by Van Auken (2001) that a

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lack of information about the availability of specific sources of

capital can result in suboptimal firm performance and financial

distress is critical to the process. Further, Ferrary and

Granovetter (2009) have detailed all the players required to make

the VC system work and therefore, developing countries have to

ensure that the roles of these players are explicitly known and

promoted. The specific actions that need to be undertaken are

detailed by the Utah Fund of Funds which this paper considers

most relevant to developing countries and Trinidad and Tobago in

particular.

The overriding requirements, as pointed out by Acs and Szerb

(2007), are for developing countries to focus their efforts on

human capital development, upgrading of technology, and promotion

of entrepreneurship and enterprise development. In this context,

this paper supports the approach of creating a community based VC

fund as shown in Figure 1 which is considered appropriate to the

development circumstance of small developing countries.

April 28, 2014 [Original version written as a research paper on

October 7, 2009]

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A Community-Based Venture Capital Model for Small Countries

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