Table of Contents
Acknowledgments
Abstract
Section I -- Preface
Section II -- The Executive Summary
Section III -- Analysis and Interpretation
of Basic Fund Data
Definition of Three Classifications of Early-Stage Funds
Purposes for Existence of Early-Stage Funds
Current Ages of Funds in Survey
Sources of Capital for the Funds
Investment Strategies
Funds with Investment Specialties
Typical Investment Amounts
Preferred Methods of Harvesting Investments
Regional Geographical Variations Among Funds
General Trends Over Survey Years
Summary of Basic Data from Survey
Section IV -- Performance Record of Early-Stage
Funds
Attributes of Success
Determination and Measures of Investment Failures
Harvesting the Investments
Return on Investments: Industry Perceptions and Performance
Facility and Job Creation
Performance Summary
Section V -- Criteria For Making Investments
Risk Reduction
Economic and Technology Investment Sectors
Factors in Selecting Investments
Portfolio Investment Size Distribution
Summary of Investment Criteria
Section VI -- Fund Administration: Operations
and Services
Management Assistance and Oversight
Services Provided by Funds
Sources of Operating Monies
Backgrounds and Interests of Fund Managers
Involvement with Government Programs
Fund Administration Summary
Section VII -- State Constitutionality, Legislative
and Policy Barriers
Extent and Types of State Prohibitions
Permitted Mechanisms for Direct Investments
Additional Barriers to State-Funded Investments
State Pension Funds as a Source of Capital
Summary
Section VIII -- Best Models for Early-Stage
Funds
Key Defining Parameters
Responses by Classification of Funds
Best Model Summary
Section IX -- Seed Capital from Strategic Alliances
The Study Methodology
Sample Characteristics
Existence of "Champions"
Seed Capital Acquired
Alliance Benefits other than Capital
Characteristics of the Alliance Partner
The Process of Obtaining a Seed-Capital-Providing Alliance
The Alliance Relationship
Perceived Success from the Alliance
Perceptions of the "Seed Capital Gap"
Strategic Alliance Summary
Section X -- The Entrepreneurial Capital Gap
Unfunded But Viable Early-Stage Investments
Reasons for Capital Gap
Width and Depth of Capital Gap in Dollars
Capital Gap Summary
List of Tables
Selected Geographical Composite Results
Selected Composite Results
Successful Fund Characteristics--Percentage
As First Choice
Status of States on Barriers to Investment
of State Funds
Status of States on "Prudent Man" Rule
for Investments of State Pension Funds
Key Defining Parameters for a "Best Model"
Early-Stage Capital Fund
Number of Early-Stage Firms Receiving Funds from
Other Sources in addition to Alliance Partners
List of Charts
Fund Ownership 1993 & 1995
Original Purpose of Fund
Typical Fund Investment as % of Total Funds
Range/Typical Amount in Individual
Investment
Primary Causes of Company Failure
Preferred Harvesting Mechanism
Fund Financial Performance Calculation Method
Portfolio ROI Determination
Fund Investment Economic Sectors
Fund Investment Technology Segments
Portfolio Distribution by Investment Size
Staff, Services, Facilities Provided to
Investments
Reasons for Managing Early-Stage Ventures
Government Economic Development Programs
State Funding Barriers to Early-Stage Financing
Best Model - Purpose
Best Model - Initial Size
Best Model - ROI Form
Best Model - Economic Sectors Invested
Best Model - Average Initial Investment
Fundraising Goal Sizes for New Early-Stage Funds
Percentage Uses of Capital Infused through Alliances
Benefits Received from Alliances beyond Capital
Seed Capital Correlation for Rating Groups
Seed Capital Source Desirability Rank
August 1995
Copyright 1995 by Orion Technical Associates, Inc. All rights reserved.
Acknowledgments
The authors wish to acknowledge the University of New Mexico Anderson Schools of Management (ASM) for its financial support and assistance in the research and preparation of this document. Michael David and James G. Butler received financial assistance as MBA students/graduates throughout their participation on the project; their funds were provided by grants to the ASM by New Mexico Industry Network Corporation, Sandia National Laboratories, Technology Ventures Corporation, and UNM Center for the Study of Japanese Industry and Management of Technology.
Considerable value was derived from the participation of two New Mexico venture capitalists in direct trial evaluation of the draft questionnaire: Clint Bybee with the AB Ventures and David Fleischhauer with Mesa Venture Partners. Their assistance helped to focus the questions and to streamline its form for fast responses.
Final manuscript reviews were provided by Bob Gibson of Technology Ventures Corporation and Clint Bybee of AB Ventures. Their review comments were highly constructive, helping to clarify numerous findings of the study.
Assistance with project coordination and document printing was provided by Marla Malin in Albuquerque. Adrienne Ewing-meyer helped with final assembly of the documents and provided immense moral support once again throughout the entire project.
Orion Technical Associates, Inc. is the private consulting firm of Richard T. Meyer, Ph.D. It specializes in strategic business planning, management recruitment, market research, technology financial projections, and capital formation services.
Abstract
The 1995 Census is the fifth edition of a report on private, public,
and combination (public-private) venture capital funds that examines the
structures, management, capitalization, investment criteria, investments,
economic impacts, and returns on investment of funds that provide equity,
debt, and/or grant financing to early-stage business enterprises. Thirty-six
early-stage capital funds in the United States participated in the census
study, composed of 11 private funds, 13 public funds, and 12 combination
funds, as classified by the fund managers.
The 36 funds, whose average age was 7.8 years, reported that their aggregate
amount of current funds under management was $1,005 million, having increased
from their initial capitalization of $628 million. They have collectively
invested $502 million in 1,098 company investments, and they have experienced
295 company failures (26.9% by number) with a total dollar loss of $198
million (16.5%); of this amount, $146 million was in early-stage investments
(12.4%). On the positive side, their successful enterprises produced $26.8
billion in revenues in 1994 and supported 33,150 jobs. In addition, the
overall average ROI was 11.6% for all their investments and 14.5% for their
seed/start-up stage investments. A comparison of the returns for all funds
in the survey against average annual returns over a five-year period for
indices such as the S&P 500 (5.4%), Short-Term U.S. Bond Yields (5.6%),
and Long-Term U.S. Bond Yields (7.7%) showed that the early-stage capital
funds surveyed had a greater average return than the lower risk investments.
The higher risk VC 100 Index showed an average annual return of 19.6% over
the five-year period ending 12/31/94. This VC 100 Index had a much higher
return when compared to the average of all funds in the survey.
Private funds reported the best ROI, with 87% stating that their performance
equaled or exceeded an industry standard of 15-20% and a better than average
cost per job created of $8,146. Public funds showed the lowest ROI, with
62% reporting that they were below the 15-20% figure; but their cost per
job created was the best at $1,639. Seventy-one percent of the combination
funds reported that their ROI equaled or exceeded to industry standard.
Public funds also were the smallest in current capitalization at an average
of $24.8 million, compared to private funds at $32.2 million and combination
funds at $73.9 million. The typical investment by a combination fund was
$2.1 million versus $841 thousand for a private fund and $385 thousand by
a public fund. Seventy percent of the private and public funds targeted
their investments at technology-based enterprises, compared to 45% for the
combination funds.
The reporting funds were also briefly characterized by their size (funds
under management), by the number and percentage of early-stage investments,
by their degree of investment specialization or diversification, and by
four aggregated Federal Reserve Regions. For the first time, The 1995 Census
examines the "best model" for an early-stage capital fund, the
political barriers to the creation of public funds, and the actual breath
and depth of the "entrepreneurial capital gap. The dimensions of the
"gap," first defined in 1992, were confirmed for a depth of approximately
$500,000, corresponding to the shortfall in capital for day-to-day cash
flow requirements, and a breadth gap from $75,000 to $1,000,000, corresponding
to the difference between capital available from private "angel"
investors and the minimum preferred investment level of the venture capital
industry.
In addition, a study of the impact that strategic alliances have on providing
financing to early-stage companies is presented. The results indicate that
seed capital for early-stage firms is being successfully acquired through
strategic alliances with established firms. Indeed, significant amounts
of early-stage capital were being secured by the young firms--over $2 million
on average. Most of the early-stage companies found their partners through
their initiative, but they depended upon a champion with the larger firm
for their successful relationship. A listing of all funds solicited (over
200 in number) for The 1995 Census, with contacts, addresses, and telephone/fax
numbers, is included.
Section I -- Preface
This 1995 National Census of Early-Stage Capital Financing is the fifth
stage of an on-going research project which was initiated by Dr. Richard
T. Meyer at the Advanced Technology Development Center (ATDC) of the University
System of Georgia in 1987. The project was born out of an ATDC effort to
create a public-private seed capital fund in Georgia. The first stage was
performed in 1987-88 with a survey of only ten state-sponsored seed capital
funds. The results of that survey were used by the ATDC to achieve passage
by the Georgia General Assembly in 1988 of an Assembly Resolution to permit
voter action on a State Constitutional Amendment: the Amendment was necessary
to authorize State investments in private for-profit enterprises and was
approved by the voters in November 1988.
The second stage was conducted in late 1988 and early 1989 on an expanded
basis to include a larger number of both public and private funds. Its two
purposes were:
1. to demonstrate to the Georgia General Assembly the performance of seed
capital funds across the nation in business and job creation; and
2. to produce a comprehensive research report that would be useful to all
public and private participants in seed capital financing.
In February 1989, the Georgia General Assembly passed enabling legislation
(H.B. 151) to create the Georgia Seed Capital Fund; however, efforts in
the 1990 Legislative Session to achieve an initial appropriation of state
funds were unsuccessful due to opposition by the private sector. The private
sector maintained that it was not the domain of state government to provide
financing for start-up private enterprises. While no further action has
been taken by the Georgia General Assembly through 1993, the Georgia Research
Alliance, a public/private consortium of research universities, private
industry, and state government, has succeeded in establishing a $40 million
private, for-profit venture capital fund. The goal of the fund is to increase
the number of start-up companies in several strategically-focused technology
areas. The fund made its first investment in 1994.
The third stage of the research project was conducted during the period
of January through May 1991. Dr. Meyer transferred the project with him
from the ATDC to the Emory Business School, when he joined the Emory faculty
in September 1990. Once again, the project was expanded -- this time from
a "survey" scale to a "census" scale; in other words,
an effort was made to collect and analyze information on all seed capital
funds across the nation. To do so, the research included funds which are
fully dedicated to seed and start-up financing and some venture capital
funds which earmark a percentage (typically 10 to 15 percent) of their investments
to seed/start-up financing. The third stage captured 72 percent of all existing
funds that were fully dedicated to "seed" financing and, therefore,
was considered to represent a "census" rather than a survey of
such funds.
During the period of October 1992 to May 1993, the fourth phase of this
on-going project was undertaken. The 1993 survey was expanded to capture
trends occurring within the seed capital segment of the venture capital
industry. By expanding the scope of questions, fund managers were asked
not only to report on their charter and investment performance but also
to express views on the current state of seed capital investing and its
future. The expanded survey also covered the services that fund managers
provide for their investments and the political issues affecting seed financing.
The number of funds solicited was increased for the 1993 survey. Over 150
funds were contacted. A total of 67 funds responded. This reporting represented
a 15% increase over the 1991 survey and more than doubled the 1989 survey
response. Several of the funds that were contacted indicated that their
investments at the seed stage were insignificant and, consequently, were
not participants in this research activity. The authors believed such a
response helped to preserve the validity of the findings, since this has
allowed the study to focus on the seed capital segment of venture capital
investment.
The non-responding funds included a few public and combination funds which
had participated in the 1991 Census but which either had not received additional
funds to invest or had exhausted their existing funds in advance of the
1993 survey period. It was also known that a couple of the responding private
funds had not made any new company investments since the 1991 Census.
In March 1994, Dr. Meyer returned to New Mexico after 19 years in Denver
and Atlanta and established a new research relationship with Prof. Ray Radosevich
of the University of New Mexico Anderson Schools of Management. Dr. Radosevich
had performed numerous studies of entrepreneurship and technology management
and arranged for the Anderson School to provide MBA students to assist with
the fifth phase of the seed capital research project. At his initiative,
a new component of the research was added to study the role that strategic
alliances played in providing seed capital to early-stage firms.
The 1995 Census project was organized in part to be responsive to informational
requests of attendees at the October 1994 Second Annual Conference of Early-Stage
Technology Financing held in Salt Lake City; this conference and the first
had been organized by Dr. Karl Snow of the Utah Technology Finance Corporation.
Many of the 70 attendees, representing both existing and to be established
seed capital funds, requested more detailed information on the operating
characteristics of funds, on state government barriers and solutions to
making investments in private companies, on a "best model" for
an early-stage fund, and on confirmation of "The Entrepreneurial Capital
Gap." Hence, these topics were added to the 1995 survey of data.
Only 36 fund managers out of 180 solicitations responded to the 1995 survey
compared to the 67 responses in 1993. At least five separate requests by
telephone, fax, and mail were made to the fund managers to gain 15 to 20
minutes of their time to complete the six-page survey form. Most
disconcerting was the fact that many fund managers that had responded in
earlier years did not take the time to respond to the 1995 survey, even
after the authors reduced the survey to four pages in the final solicitation.
However, eighteen early-stage funds reported data for the first time ever
to the 1995 survey, thus increasing the total historical database.
The validity of The 1995 Census as a true study of early-stage funds has
been confirmed by the collected body of data. Section III of this report
includes a chart entitled "Typical Fund Investments as % of Total Funds;"
it demonstrates that over 50% of all investments by the participating funds
were "early-stage" investments. Section IV contains data revealing
that 50% of all funds made their investments with companies having less
than $100,000 in revenues. Finally, in Section VI one finds that 37% of
the fund managers are actually mandated by their fund charters to invest
at the early-stage level.
This research project will be continued in future years on an biannual basis,
as it has in the past. The new component on strategic alliances will be
broadened to a nationwide scale and may evolve into a separate biannual
report, but in years alternating with the report on early-stage venture
funds. The authors hope that the importance of the study results will stimulate
more early-stage fund managers and more early-stage alliance partners to
become active participants in the surveys.
Section II -- The Executive Summary
Basic Data
The 1995 National Census of Early-Stage Capital Financing is the fifth report
in a series of biannual studies on the state of seed and start-up capital
financing in the United States. Fewer private and combination fund managers,
but more public fund managers participated in The 1995 Census than in The
1993 Census; overall 67 separate fund managers responded in 1993 compared
to 36 in 1995. Of the 36, eighteen either responded for the first time in
1995 (15) or did not respond in 1993 (3). As a consequence, the basic data
collected in 1995 represents a significantly different cross-section of
early-stage funds. The average fund age was younger and both the number
and total amounts of investments were fewer, as were the number of failures
and the number of jobs created. Measurably greater were the initial fund
capitalizations, the total amounts lost to failures, the average revenues
from the invested companies, and the amount invested per job created.
One must reason that the increased participation by public fund managers
has strongly influenced the findings. While the public funds are the oldest
of the three fund types in the 1995 survey, they invest the smallest average
amounts in the greater number of companies to produce economic development/diversification
and business/job creation. By spreading their investments over companies
in various stages of development, these public funds apparently yield more
jobs at a lower investment cost per job created. Both the private and combination
funds exhibit the opposites on each characteristic.
Performance Data
All funds believe that management supervision, either close or regular,
constitutes the greatest factor towards success or failure of an investment.
Active management supervision of investments by the fund should increase
the chance for positive returns from investments. While the funds participate
in direct management investment, there are still a considerable number of
failed investments. Overall, the surveyed combination funds had a 25.4%
failed investment rate since the fund's inception for a total dollar loss
of $137 million. Public funds had a failure rate of 24.8% of investments
for a total loss of $31 million. The private funds had a 17.9% failure rate
and lost a total of $29 million since the fund's inception. In determining
an investment's failure, the private and combination funds classify within
a period not longer than two years after failing to meet the expected return
target. Public funds are more lenient and usually wait up to five years
after failing to meet the expected return target before classifying the
investment as a failure.
All categories of funds perceive the industry ROI to be below the goal set
for industry ROI. In calculating the actual fund ROI, over 60% indicated
they use a quarterly period for the calculation. When comparing a fund's
actual ROI to a standard 15 to 20% ROI, the private funds had 62% at the
standard and 13% below; while public funds had 30% at the standard and 62%
below with combination funds having 42% at the standard and 29% below. The
lower performance by public funds can be partially explained by their constitutional
constraint against equity ownership. They use lower percentage basis financing
instruments such as debt and grant financing with annual returns provided
by interest and royalty payments. In some cases, other success measurements
are used in addition to ROI, such as creation of buildings and facilities
along with associated jobs.
The following listing shows the average yearly return of selected indices
over a five-year period ending 12/31/94:
S&P 500 Stocks 5.4%
Short-Term U.S. Bond Yield 5.6%
Long-Term U.S. Bond Yield 7.7%
VC 100 Index 19.6%
As can be seen, all early-stage funds had an annual return on investment
greater than the lower risk investments of S&P 500 and U.S. bonds. When
comparing to the Venture Capital 100 Index, many private and combination
early-stage funds had similar return on investment results.
Investment Criteria
A majority of funds believe a portfolio risk reduction strategy should employ
a portfolio of diversified investments in more than three specific industries
or technologies. The primary area for fund investments is the technology
sector. The private and public funds invested approximately 70% of their
portfolio in technology, while combination funds invested only 45% in technology.
The management team was chosen as the primary factor when choosing an individual
investment. Other important investment factors were market potential and
ROI potential. All funds responded that the private manufacturing industry
was the largest source for entrepreneurial teams.
Approximately 50% of all funds made their initial investments with companies
having less than $100,000 in revenues. No respondents indicated that initial
investments were made in companies with revenues greater than $2.5 million.
Investment size varies by type of fund. Over 60% of investments by public
funds are within the range of $100 thousand to $500 thousand, while private
and combination funds vary greatly in their investment sizes.
Fund Administration
Over 40% of all funds were involved in monthly reviews of their investments.
Twenty-three percent and 30 percent of the public and combination funds,
respectively, were knowledgeable of daily operations, while only 8% of the
private funds participated at this daily level of detailed management. On
average, 16% of all funds reported Board-level involvement only. Many early-stage
funds provided the more generic type of services such as general management,
strategic planning, finance and accounting, and human resources. A few funds
provided more specialized services such as legal, contractual and patent
service. The greatest number of funds reported that their annual operating
costs were less than $500,000. The source of these operating costs were
a percentage of monies under management for the private funds and an allocation
of monies from their sponsor's budget or cost sources for public funds.
The average years of relative professional experience for the fund managers
were 16+ years for the private and combination fund managers and 14+ years
for the public fund managers. Educational background of the fund managers
varied greatly, although a large number have an MBA. Thirty-seven percent
of the fund managers managed early-stage ventures because it was mandated
within their fund charter. Seventeen percent chose "high risk/high
return" as their motivation for managing early-stage investments. Popular
government economic programs are research parks, business incubators and
SBIR-STTR-TRP programs. Twenty eight percent of the private funds and 15%
of the combination funds indicated no involvement with government economic
development programs.
State Government Barriers
Constitutional barriers prohibit many state governments from financially
supporting the start-up business enterprises that are being hatched by their
local government subsidized business incubators. And in those states where
private venture capital funds and a track record of successful entrepreneurial
developments do not already exist, it becomes a real question of what comes
first--"the chicken or the egg"--namely, the incubator with both
management support and early-stage capital or the entrepreneur that needs
the capital to grow, develop, and survive. Many states that have faced this
situation have concluded that state governments must provide the "seed
capital" for both the business incubator and the seed capital fund.
This "seeding" process convinces the private sector that the state
is truly serious about sponsoring the creation and growth of new enterprises
by "putting its money where its mouth is." Then the private sector
is willing to move forward and share the risk of early-stage investments.
Best Model for a Fund
The "best model" for an early-stage capital fund, as recommended
by thirty-three fund managers (nearly equally distributed among private,
public, and combination funds), is a limited partnership funded with both
public and private dollars to approximately $32 million; it has financial
ROI as its principal purpose and invests primarily in technology enterprises
with five to ten initial equity investments per year averaging $400,000
for investments periods of five to seven years or less.
A direct application of this model to the $275 million of projected fund-raising
by the responding fund managers would yield 8.6 new funds of $32 million
each, making 50 to 86 new investments each year and creating from 860 to
5100 new jobs per year. Since many of our nation's large corporations and
military bases are currently downsizing by these job numbers, this potential
achievement by the private and public sectors certainly deserves to be pursued
to the fullest extent possible.
Strategic Alliances
Seed capital for early-stage firms is being successfully acquired through
strategic alliances with established firms. Significant amounts of early-stage
capital were acquired by the survey firms--over $2 million on average. This
was a larger sum than typically provided to embryonic firms by early-stage
venture capital funds. Of special note was the high level of satisfaction
with the partnership as expressed by the capital recipient. The terms, such
as restrictions on capital usage, appear to be generous. The benefits from
the alliance beyond the funding were reported to be prevalent. The time
required to establish an alliance, however, was surprisingly long. In most
instances, various rights, rather than equity, were acquired by the larger
partner.
The prescriptions from the normative literature on alliance formation and
operation appear mostly valid in the experiences of the surveyed firms.
Most firms found a champion within the partner. Potential competitors became
partners to strengthen their mutual positions in the market place. The early-stage
firms were most often active participants in defining the contractual relationship.
Surprisingly, the use of experienced intermediaries was not the norm. Unless
equity was acquired by the capital provider (in which case board seats were
also acquired), the alliance was managed without substantial bureaucracy.
The funding alliances tended to evolve into long-term relationships.
In spite of the successful acquisition of early-stage capital through strategic
alliances, the early-stage firms universally reported that a serious seed
capital gap exists in this country. Nevertheless, the survey results suggest
that partnerships with established companies may well be a viable source.
Entrepreneurial Capital Gap
The 1995 Census and The 1993 Census, combined, firmly confirm that an "Entrepreneurial
Capital Gap" exists in the United States. Eighty percent of the respondents
in both survey years stated that viable early-stage investments were going
unfunded, largely because the established venture funds had become too big
to make the smaller investments in early-stage firms. These responses contradict
the viewpoint expressed by many venture capitalists that "every good
deal will get funded." The contradiction rests in one's definition
of a "good deal." The requisites that every "good deal"
venture investment must experience annual growth rates of 100 percent and
revenues of $50 million to $100 million in five years are achievable realistically
by only one-tenth of one percent or less of the firms applying to venture
firms. Yet hundreds of thousands of new companies are formed each year in
the United States that grow into firms with revenues of $10 million to $25
million, adding significantly to the employment base and the general economy
of their states and the nation.
These firms are the very ones that directly encounter "The Grand Canyon
of Seed Capital Financing." That canyon now is established to have
a cash flow working capital depth of $500,000 and an initial growth and
market entry capital width (gap) spanning from $75,000 to $1,000,000. This
need for seed and start-up capital is being ignored by the large venture
firms but is being partially filled by the relatively few public, private,
and combination funds that engage in early-stage financing. If the number
of respondents to the 1995 survey is any indicator, when compared to the
number of 1993 respondents, then the availability of early-stage financing
from venture firms is decreasing very rapidly, particularly among the private
venture capital sector. This conclusion should stimulate state and local
government entities to move aggressively to fill "The Entrepreneurial
Capital Gap." The diminution of available private capital should be
viewed and dealt with by state governments as many have had to in the past
when their steel, automobile, textile, and oil industries have downsized
or shut down; a current example of consequence is the downsizing the nation's
military establishment due to the end of the Cold War. Are our state governments
fully prepared for that impact or for the next global consequence? Most
states, including California and New Mexico, are not!
Section III -- Analysis and Interpretation of Basic Fund Data
Definition of Three Classifications of Early-Stage Funds
The 1995 Census recognizes three basic modes of fund creation: 100% private,
100% public, and a combination of private and public means. Responding fund
managers designate their classification based on the original capitalization
of the fund and how the fund was established. Specifically, a fund is classified
as public if it was established by a state or local law and the source of
its original and continuing capitalization is federal, state, or local appropriations.
A fund is classified as private if it was established by private initiatives
and its source of capitalization is primarily private sector investment.
A fund is classified as combination if its original capital structure consisted
of both private and public sector matching funds.
Of thirty-six total respondents to The 1995 Census, 31% (eleven funds) were
established by the private sector, 36% (thirteen funds) were established
by state or local government, and 33% (twelve funds) were combination funds
capitalized by both sectors. The participation by private and combination
funds was down significantly from The 1993 Census, as illustrated in the
following chart; many of the funds are no longer responding to surveys.
However, it is important to note that the number of respondent public funds
increased from eight to thirteen and their percentage response rose from
twelve percent to thirty-six percent from the last survey in 1993. Public
funds are increasing their presence and role in the early-stage capital
market. The chart illustrates a comparison between the numbers of responding
fund managers in the 1993 and 1995 surveys.
Purposes for Existence of Early-Stage Funds
Most funds continue to enter the venture capital market for the purpose
of making money for their investors. Forty-one percent sought ROI greater
than or equal to other market opportunities. A surprising 41% of all funds
invested for job and business creation and for economic development and
diversification, as opposed to focusing primarily on monetary return. An
additional 13% of funds try to accomplish both job creation and greater
than market return. As one might expect, 63% of public funds expressed their
purpose as both job/business creation and economic development/diversification.
Sixty-four percent of combination funds sought ROI greater than or equal
to other market opportunities, whereas only 50% of private funds were motivated
strictly by this purpose. The remaining 50% of private funds were distributed
among all of the stated purposes. The chart below illustrates the distribution
of fund purposes by fund type.
Current Ages of Funds in Survey
The 1995 Census continues to illustrate the youth of early-stage capital
investment. Ninety-seven percent of the responding funds have been established
since 1982 and the average fund age is 7.6 years. Private funds are the
youngest at 6.1 years, public funds are the oldest at 9.3 years, and combination
funds are in the middle at 7.2 years in average age. Sixty-three percent
of private funds have been formed since 1990. Most public funds (70%) were
formed between 1982 and 1985. And most combination funds (55%) were formed
between 1984 and 1989. However, thirty-six percent of combination funds
have been formed in the past two years. Over half of all funds were created
between 1982 and 1987.
Sources of Capital for the Funds
Corporations (23%), private individuals (14%) and public agencies (37%)
comprised the largest contributors to total capital. Pension funds provided
twenty-seven percent of the total capital in 1993, but now provide only
thirteen percent. The jump in public agency fund contributions to capital
may be explained by increased combination fund participation and attractiveness
to public investors. Other sources of capital were institutional investors
(13%) and mutual funds (0%). Various types of stock (60%) are the preferred
investment instrument, with loans (13%) and convertible debt (10%) following
in size.
The stock instruments varied in percentile for each of the fund types. Private
funds invested very little (3%) in common stock, while putting the largest
amounts into preferred stock (42%) or convertible preferred stock (33%).
Combination funds were similar to the private funds. They invested 5% in
common stock, 37% in preferred stock, and 46% in convertible preferred stock.
Public funds avoided stock generally with only 11% in common stock, 4% in
preferred stock, and 6% in convertible preferred stock. On average, common
stock accounted for 7%, preferred stock for 26%, and convertible preferred
stock for 27% of the investment instruments used by all funds; these generally
low percentages were principally driven by the practices of the public funds.
Convertible debt was used 13% by private funds, 12% by public funds, and
7% by combination funds.
Investment Strategies
The 1993 Census indicated a shift in investment strategy away from early
and first stage investments from the 1991 Census. Those results indicated
a decrease from 77% to 66%. This may have been an aberration, since The
1995 Census indicates investment levels have returned to 77%; but the number
of respondents is significantly different between the two years with more
in 1993 and fewer in 1995. Private funds invested 61% of their monies in
early-stage companies and 23% in first round, while combination funds invested
46% in early-stage companies and 21% in first round investments. Also, 83%
of total private investments are early-stage, while only 42% of total combination
investments are early-stage. Public funds have changed from a hands-off
policy to investing beyond first stage by investing eighteen percent, as
much as combination funds, into second stage investments. This could indicate
an interest to see public monies create jobs and so continue to support
them through another round, especially since their effective ROI is based
69% on royalties, interest, and principal and interest on loans, while only
30% is based on equity valuations or recovery. Combination funds base 100%
of their effective ROI on equity valuations or recovery. The chart below
illustrates the dominance of early-stage investors in The 1995 Census.
Funds with Investment Specialties
Several early-stage funds are identified as specialized - that is, those
which target their investments in three or fewer industry categories. Specialized
funds are between six and eleven years old. Their average investment is
$1.8 million with aggregated revenues of $96 million. Funds under management
are $9.1 million. Specialized funds had an average ROI of 13%. Seventy-five
percent of the funds thought fewer seed projects went unfunded. Meanwhile
they had funds available in the range of $50,000 to $250,000. All of the
specialized funds invested in medical technologies. The funds differed with
half investing in the computers and software technologies and half investing
in biological and energy technologies.
Typical Investment Amounts
Average minimum and maximum investment amounts were $264,000 and $2,600,000,
respectively. Minimum investment amounts have decreased since 1993, while
maximum amounts have increased slightly. A typical investment was $1,100,000,
nearly identical to typical 1993 investments. Public funds invested the
smallest average amounts with the minimum around $116,000, the maximum $1,000,000,
and the typical investment around $385,000. Surprisingly, combination funds
outspent private funds in minimums - $400,000 vs. $300,000, maximums - $5,200,000
vs. $1,800,000, and typical investments - $2,100,000 vs. $840,000. Some
differences between combination and private fund sizes may originate in
the investment stage distribution. Those funds who invest in later-stages
as well as early-stage may have more money and be larger since the survey
didn't distinguish how much money was invested in individual early-stage
or later-stage investments.
Preferred Methods of Harvesting Investments
Funds harvest primarily through IPOs (60%), while the next most preferred
form is acquisition (11%). These harvest methods exhibit a continued trend
seen in the last two surveys. This year, however, IPOs have increased by
ten percent and acquisitions have declined by twenty-one percent, indicating
that IPOs are gaining in preference. Overall, funds have harvested 26% of
their investments, down from 31% in 1993.
Regional Geographical Variations Among Funds
Census results were broken into four geographical sections along the lines
of Federal Reserve Districts and bound by the requirement of needing several
funds in each section for statistical validity. The sections include the
Western Coast and Mountain states integrated into the Western states, the
Plains states, the Midwestern states, and the Southern, Eastern and Northern
states together as the East Coast states. The table below summarizes characteristic
data from each area.
Table: Selected Geographical Composite Results
The Western states had significantly poorer returns (5% average ROI)
than the other groups (about 12% average ROI), while the East Coast had
the highest cash revenues ($13.2 million average per fund). Plains states
invested a larger amount of money for each job created ($12,500 for 86 jobs),
while job creation was the most expensive in the high-tech West ($16,800)
and least expensive in the East ($1,356). Midwest states invested nine times
the funds the East Coast invested for each job created. The Plains states
invested aggressively with initial fund capitalization exceeding twice the
average of the other areas. The Plains states had the youngest funds at
3-year-old average. Plains and Western states used shorter failure determination
periods (less than two years), compared to the Midwest (more than two years)
and East Coast (more than three years).
The Western states invested more heavily in telecommunications and defense
companies. Eastern states invested more in medical and information processing
companies. Plains states avoided telecommunications while concentrating
on computers and software companies. The Western states imitated the political
atmosphere (the strong environmental sentiments and regulations in the West)
and avoided environmental and chemical companies. Midwestern states focused
heavily in chemicals, biotechnology and energy and avoided defense companies
altogether.
General Trends Over Survey Years
Composite results from three prior surveys (1989, 1991, 1993) and 1995's
survey are presented in the following table. The table includes average
and aggregate data for basic characteristics in each survey. Observations
from data in this table indicate that the number of average investment failures
are decreasing overall, while the average number of dollars lost is increasing;
but the company revenues are increasing as well. These indicators may mean
that the managers are improving their investment selections, that funds
invested are rising per individual investment, and that individual investments
are losing a greater amount of money when they fail than losses in prior
years.
Another observation is that job creation is far below the past two surveys.
This may be a mirror of the economy in general. But if one includes the
ratio of dollars invested per job created, one may conclude that the jobs
being created are higher wage and skill level jobs. This conclusion, along
with the higher losses per investment, and data presented later in this
report indicating investment emphasis in technology and information industries
helps bear out the idea that investments are creating "good jobs."
However, the actual number of investments is half of that in prior years
indicating the difficulty of either picking good investments or finding
investment opportunities. It is likely that the increased efficiency of
fund managers in picking winning investments has resulted in the closer
scrutiny of opportunities and, therefore, slowed the rate of investment
considerably.
The value of initial capital investment is increasing. These investments,
concentrated in the technology and information industries, indicate the
need in these industries for larger start-up sums, also drawing the increased
scrutiny to reduce the failure and loss rate. A last observation is that
the funds are getting younger, a trend away from the previous years. This
may be understood by two reasons: either older funds are closing and harvesting
their investments, or younger fund managers are more willing to respond
to the survey than their more established peers in the industry.
The following table represents data per fund as opposed to per investment
or management company. Thirty-six respondent companies have seventy-two
funds with a total 1,098 investments. All the numbers for prior and present
years have been adjusted to the same "per fund" relationship.
Table: Selected Composite Results
Summary of Basic Data from Survey
Fewer private and combination fund managers, but more public fund managers
participated in The 1995 Census than in The 1993 Census; overall 67 separate
fund managers responded in 1993 compared to 36 in 1995. Of the 36, eighteen
either responded for the first time in 1995 (15) or did not respond in 1993
(3). As a consequence, the basic data collected in 1995 represents a significantly
different cross-section of early-stage funds. The average fund age was younger
and both the number and total amounts of investments were fewer, as were
the number of failures and the number of jobs created. Measurably greater
were the initial fund capitalizations, the total amounts lost to failures,
the average revenues from the invested companies, and the amount invested
per job created.
One must reason that the increased participation by public fund managers
has strongly influenced the findings. While the public funds are the oldest
of the three fund types, they invest the smallest average amounts in the
greater number of companies to produce economic development/diversification
and business/job creation. By spreading their investments over companies
in various stages of development, these public funds apparently yield fewer
jobs but at a higher investment cost per job created. Both the private and
combination funds exhibit the opposites on each characteristic.
Section IV -- Performance Record of Early-Stage Funds
Attributes of Success
The performance section of the 1995 survey tackled several issues related
to fund and/or investment performance. One category of performance dealt
with the characteristics that attribute to the success of the fund. Since
most respondents were established funds, the question asked for the success
attributes of five years ago and the success attributes of today. The following
table summarizes the results of this survey question:
Table: Successful Fund Characteristics -- Percentage As First Choice
| Private | Public | Combn | Private | Public | Combn | |
| Close Management Supervision | ||||||
| Regular Management Supervisio | ||||||
| Environmental Factors | ||||||
| Luck | ||||||
| Close Technical Supervision | ||||||
| Financial Decision Controls | ||||||
| Other | ||||||
As shown in the table, 67% and 50% of the private funds chose either regular or close management supervision as their number one attributes for the five year ago and today periods, respectively. Likewise, 100% and 83% of the combination funds chose regular and close management supervision as first choice for the five year ago and today periods, respectively. The public funds chose close technical supervision as their first choice for the five year ago period. For the today period, 55% of the public funds chose regular management supervision and financial decision controls as their first choices. While the choices between the various funds differ, one theme emerges; active management supervision by the fund, either close or regular, has a major influence on whether an investment will succeed or fail.
Determination and Measures of Investment Failures
Another category of performance dealt with issues relating to failure. When
asked "How quickly do you usually determine if your investment is a
failure?", the responses showed that private and combination funds
generally classify an investment a failure within a period not longer than
two years after failing to meet the first expected return target. Thirty
percent of the public fund respondents chose the period of within five years
after failing to meet the first expected return target. These responses
seem to indicate that public funds are willing to carry their failing investments
for a longer period of time than the private or combination funds carry
their failing investments. When asked about the primary causes of company
failure, 30% of the private funds responded their first choice was business
plan flaws and another 30% chose management failure as their first choice.
The public (80%) and combination (66%) funds chose management failure as
their first choice for the primary cause of company failure.
| Private funds | 17.9% |
| Public funds | 24.8% |
| Combination funds | 25.4% |
Harvesting the Investments
The responses to collection method for investment earnings prior to harvest
showed that private and combination funds generally do not take current
income prior to harvest. Public funds, on the other hand, do collect earnings
through debt principal and interest, royalty, and debt interest only.
The private funds have harvested 47% of their investments since fund inception.
The public funds have harvested 10%, while the combination funds have harvested
33%. The preferred harvesting mechanism was the Initial Public Offering
(IPO).
Returns on Investments: Industry Perceptions and Performance by Funds
The funds were asked to give their perceptions of industry annual net ROI.
When asked for their estimates for current industry average ROI, the responses
were: private funds -- 14.63%, public funds -- 15.22%, and combination funds
-- 13.78%. Then the funds were asked their estimates for the current industry
ROI goal. These estimates were as follows: private funds -- 20.25%, public
funds -- 24.56%, and combination funds -- 19.22%. Comparing these two ROI
perception survey questions, all categories of funds perceive the industry
ROI to be below the goal set for industry ROI.
In determining a fund's ROI, several methods can be used for the calculation.
When asked which financial performance calculation method each fund used,
the results were mixed. The private fund responses showed 44% used Venture
Economics Inc. formula for IRR. Another 44% of the private funds used net
ROI over investment term, weighted for investment. The remaining 12% of
the private fund responses used National Venture Capital Association Benchmark.
The public fund responses showed that 47% used "Just In Time"
cash in/cash out method and 37% use net ROI over investment term, weighted
for investment. The combination funds responded that approximately 46% use
the Venture Economics Inc. formula for IRR. The remainder of the combination
funds responses showed a spread among all of the other methods.
In response to survey questions related to the timing of the determination of portfolio ROI, the majority of all funds surveyed chose either periodically or at harvesting as the timing criteria. Of the funds that chose periodical timing for the ROI calculation, over 60% indicated they used a quarterly period for the calculation. An annual periodic ROI calculation was used as the other primary reporting period by respondents choosing this timing method. Other portfolio ROI determination criteria which were chosen to a lesser extent are valuation change triggered by equity and write-off or write-down of investments.
Survey questions pertaining to actual ROI performance of the funds were
kept to a range rather than specific numbers. This allowed each fund to
respond without stating a specific number, which many funds desired to keep
private. Thus, the general question was: "Compared to a standard 15
- 20% ROI, how did your fund's portfolio perform?" The private funds
responded 25% were above the standard, 62% at the standard, and 13% below
the standard. The public funds responded with 8% above the standard, 30%
at the standard and 62% below the standard. The combination funds responded
with 29% of the funds above the standard, 42% at the standard and 29% below
standard.
The much lower performance by the public funds may be due to the financing
attributes of these funds. Many public funds have a constitutional constraint
against equity ownership; thus they use lower percentage-basis financing
instruments such as debt and grant financing with returns provided by interest
and royalty payments. This type of public fund financing generally yields
a lower return than financings employed by the private and combination funds.
A comparison of the returns on investment of the early-stage funds surveyed
to other types of investments showed mixed results. The early-stage funds
performed better than three different types of investment with lower risk.
The three lower risk investments had average annual returns over the five-year
period ending 12/31/94 as follows:
S&P 500 Stocks 5.4%
Short-Term U.S. Bond Yield 5.6%
Long-Term U.S. Bond Yield 7.7%
Even the public funds with their lower return on investment of 9 percent
performed better than the average return of the lower risk investments.
This comparison result is expected since a higher return is generally associated
with a higher risk investment. The question is whether the differential
in returns between the lower risk investments and the early-stage funds
is in the correct proportion to the differential in associated risk. If
the difference in returns is less than would be expected when observing
the differences in risk, then the early-stage funds surveyed are not being
fully compensated for the risks that they are assuming.
The Venture Capital 100 Index is representative of companies with a significant
venture capital interest that have been trading for at least one year but
less than ten years. These VC 100 companies were early-stage investments
that have grown beyond the early-stage cycle. Thus, the VC 100 Index should
be expected to have a lower risk level. The average yearly return over the
previous five years for the VC 100 was 19.6 percent. While some of the private
and combination funds equaled or exceeded the VC 100 performance, the public
funds performed substantially lower. This is most likely the result of the
public funds having goals and measures of success that are different from
a strict financial return on investment. It appears that most public funds
are willing to assume degrees of risk in return for achieving goals such
as business and job creation.
Facility and Job Creation
Aside from fund ROI, other benefits have been derived by these fund investments.
Between the period 1990 - 1994, the private funds created 62 buildings and/or
facilities. While the public funds created 32 and the combination funds
created 260 buildings and/or facilities. Most funds responded that the number
of jobs they created between the period 1990 - 1994 ranged from less than
100 to 500 full-time jobs. Ten funds responded with greater than 500 full-time
job creations during this five year period, of which three of these funds
each created more than 5,000 full-time jobs.
The 1995 Census was designed to obtain an approximation of jobs created
between 1990 and 1994. Two questions allowed respondents to differentiate
between full-time and part-time jobs within ranges. Since the Census did
not request specific numbers, the analysis assumed that the number of jobs
created was equal to the number of respondents times the median in every
range. Based on this assumption the following observations were made. Private
funds created approximately 3,950 jobs over five years, or about 800 jobs
per year. Public funds were responsible for 15,100 jobs, or about 3,000
jobs each year. Combination funds created the least number of jobs at 5,240,
or about 210 jobs per year. The money invested to create these jobs ranged
from the least amount per job in public funds ($1,640) to the greatest per
job in private funds ($8,150), while the combination funds were in the middle
($5,240).
Since public funds had a primary purpose of job creation much of the time,
they clearly
achieved this end by a factor of at least three over the other funds. The
nature of those jobs is not known; however, the majority of public fund
investment was in the technology and manufacturing sector. It might be concluded
that many of these publicly-funded investments created low-skill manufacturing
jobs with low-wage levels given the dollars invested per job. Private funds,
by investing nearly five times as much into each job as public funds and
by investing more in medical technology and biotechnology, may be creating
high-skilled, high-wage jobs. Combination funds invested three times as
much into each job as public funds. Combination funds also invested more
broadly across investment sectors and probably created a mix of high-skill,
high-wage and low-skill, low-wage jobs because of this diversification and
lower dollar investment.
Using the same methodology to calculate part-time jobs, it appears that
combination funds created only 500 part-time jobs. This may indicate that
the median investment and diverse sector investment creates more stable
full-time jobs. Private funds, in contrast, created 1,800 part-time jobs,
indicating a large temporary force supporting a proportionately smaller
full-time force. Public funds created a large temporary force of 9,150 jobs.
These numbers are in line with the fluctuating nature of manufacturing.
Expressed as multiples, private funds created about 2 full-time jobs for
each part-time job, public funds created about 1.5 full-time jobs for each
part-time job, and combination funds created about 28 full-time jobs for
each part-time job.
Performance Summary
All funds believe that management supervision, either close or regular,
constitutes the greatest factor towards success or failure of an investment.
Active management supervision of investments by the fund should increase
the chance for positive returns from investments. While the funds participate
in direct management of investments, there are still a considerable number
of failed investments. Overall, the surveyed combination funds had a 25.4%
failed investment rate since their inception dates for a total dollar loss
of $137 million. Public funds had a failure rate of 24.8% of investments
for a total loss of $31 million. The private funds had a 17.9% failure rate
and lost a total of $29 million since inception. In determining an investment's
failure, the private and combination funds classify within a period not
longer than two years after failing to meet the expected return target.
Public funds are more lenient and usually wait up to five years after failing
to meet the expected return target before classifying the investment as
a failure.
All categories of funds perceive the actual industry ROI to be below the
goal set for industry ROI. In calculating the actual fund ROI, over 60%
indicated they use a quarterly period for the calculation. When comparing
a fund's actual ROI to a standard 15 to 20% ROI, the private funds had 62%
at the standard and 13% below; while public funds had 30% at the standard
and 62% below with combination funds having 42% at the standard and 29%
below. The lower performance by public funds can be partially explained
by their constitutional problem with equity ownership. They use lower percentage-basis
financing instruments such as debt and grant financing with annual returns
provided by interest and royalty payments. In some cases, other success
measurements are used in addition to ROI, such as creation of buildings
and facilities along with associated jobs.
A comparison of the returns for all funds in the survey against average
annual returns over a five-year period for indices such as the S&P 500
(5.4%), Short-Term U.S. Bond Yields (5.6%), and Long-Term U.S. Bond Yields
(7.7%) showed that the early-stage capital funds surveyed had a greater
average return than the lower risk investments. The higher risk VC 100 Index
showed an average annual return of 19.6% over the five-year period ending
12/31/94. This VC 100 Index had a much higher return when compared to the
average of all funds in the survey.
Section V -- Criteria For Making Investments
Risk Reduction
The survey section on "Criteria For Making Investments" dealt
with risk reduction, economic sectors of investment, factors influencing
investments, and size of investments. When asked about a strategy for portfolio
risk reduction, the majority within all categories of funds chose to invest
in a portfolio of diversified investments. The second most popular strategy,
receiving approximately 35% of the total responses, was to specialize in
firms of two or three specific industries or technologies. The least popular
strategy for risk reduction was to specialize in firms within one particular
industry. In general, the funds have been applying a long-used investment
theory for risk reduction through diversification in their investments.
However, it must be recognized that the limited partner investors often
practice their own means of diversification by investing in several funds
that individually specialize in their investments.
Economic and Technology Investment Sectors
The funds were next asked to list by percentage the economic sectors where
they prefer to invest. As shown on the graph titled Fund Investment Economic
Sectors, the majority of investments from all funds were made within the
technology sector. Of the responses received, the private and the public
funds invested approximately 70% of their portfolio in technology, while
the combination funds invested a lesser percentage of approximately 45%
of their total portfolio.
To isolate further where the funds are making their investments within the technology sector, a survey question listed many individual technology segments. The following chart shows the percentage of responses by fund type that invest in each technology segment. As would be expected, very few funds currently invest in the area of defense and space, and few investments are made in energy and environment. Medical and health care investments dominate by a small margin over other technology segments.
Factors in Selecting Investments
The primary factors in choosing an individual investment were investigated.
The management team factor was chosen first as being the most important.
This management team factor, as being the number one choice, supports the
responses to the survey found in the performance category. In this performance
area (discussed in Section IV), the fund respondents believed that the most
common reason for investment failure was poor management. Likewise, the
funds responded that good management was the greatest factor in a investment's
success. Thus, it is not a surprise that the fund managers rate the management
team as a primary factor in making an investment. Other important investment
factors were "market potential" and "ROI potential."
The fund managers were asked to identify the source of the entrepreneurial
teams in which they
invest. All three categories of funds responded that the private manufacturing
industry was the largest source for entrepreneurial teams. Private service
companies along with universities and colleges were chosen as a lesser primary
source. No funds chose non-profit R & D entities, national/federal research
laboratories, or governmental agencies as a principal source for such teams.
While all areas may provide entrepreneurial teams, the survey responses
indicated the primary source for these teams was the private manufacturing
industry.
A survey question was designed to determine the development stage of each
company and the size of revenues when the initial investment was made by
a fund. Approximately 50% of all funds made their initial investment in
companies with less than $100,000 in revenues. Twenty percent of the funds
made their investment in firms with revenues of $100,000 to $500,000. Approximately
30% of the funds responded that their first investments were made in companies
with revenues between $500,000 and $2.5 million. No responses indicated
that initial investments were made in companies with revenues greater than
$2.5 million.
Portfolio Investment Size Distribution
The final element explored under the section on Criteria For Making Investments
dealt with the portfolio distribution by investment size. The specific survey
question requested the respondents to list the percentages of their portfolio
that fit into ranges of investment size. The following chart shows the results
by percentage. Notice that over 60% of the investments held by public funds
are within the range of $100,000 to $500,000, while the private and combination
funds are spread throughout all investment size categories. This difference
in size of investments may be explained by differences in investment criteria
used by the public and private funds, by major differences in the total
funds under management and available to invest, and, in some cases for public
funds, by caps placed on the amount of investment per company.
Summary of Investment Criteria
A majority of funds believed a portfolio risk reduction strategy should
employ a portfolio of diversified investments in more than three specific
industries or technologies. The primary area for fund investments was the
technology sector. The private and public funds invested approximately 70%
of their portfolio in technology while combination funds invested only 45%
in technology. The management team was chosen as the primary factor when
choosing an individual investment. Other important investment factors were
market potential and ROI potential. All funds responded that the private
manufacturing industry was the largest source for entrepreneurial teams.
Approximately 50% of all funds made their initial investments with companies
with less than $100,000 in revenues. No responses indicated that initial
investments were made in companies with revenues greater than $2.5 million.
Investment size varies by type of fund. Over 60% of investments by public
funds are within the range of $100,000 to $500,000 while private and combination
funds vary greatly with their investment sizes.
Section VI -- Fund Administration: Operations and Services
Early stage fund managers are interested in how their own operations and services compare to their peers in the industry; so fund administration at the early-stage level was explored. First, the degree of hands-on management and the types of services provided by the funds are discussed, then the size and source of their operating budgets. Questions regarding the fund manager's education, professional experience, and reasons for being involved in early-stage investments were asked of each fund manager. Finally, the fund administration section determines which government economic development programs were integrated with the fund strategies.
Management Assistance and Oversight
The responses to the survey question: "How involved are you in hands-on
management of your early-stage investments?" showed that over 40% of
all funds were involved in monthly reviews. Approximately 23% and 30% of
the public and combination funds, respectively, were knowledgeable of daily
operations, while only 8% of the private funds responded that they were
aware of the daily operations. Twenty-six percent of the private funds and
20% of the combination funds had "board level involvement only."
Twenty-nine percent of the public fund responses indicated that they used
a "substantially hands-off management approach." It appears from
the survey that the dominant approach was to be "involved in monthly
reviews," with other types of management approaches being used in specific
circumstances or under warranted conditions.
Services Provided by Funds
Many early-stage funds are known to provide assistance with staff, services
and facilities for their investments. A survey question was asked in order
to determine which services were actually provided by the funds. The following
graph shows the percentage of responding funds that provided each type of
service.
An obvious observation is that the more generic type of services such as
general management, strategic planning, finance and accounting, and human
resources were provided by all funds. The nature of these generic services
permits a fund to modify standard practice for the specific requirements
of each investment. A few funds were able to provide more specialized services
such as legal, contractual, and patent service, probably due to the education
and expertise of the fund management.
Sources of Operating Monies
The source of annual operating funds for private funds was primarily a percentage
of monies under management. The source for public funds was generally an
allocation of monies from their sponsor's budget or cost sources. The size
of the total fund operating cost per year ranged from less than $100,000
to $5 million, with the greatest number of funds reporting less than $500,000.
Backgrounds and Interests of Fund Managers
The educational background of the 36 fund managers showed that 31 had a
B.S. or B.A. degree. In addition, 14 had a MBA, 8 had another type of masters
degree, 3 had a Ph.D or M.D., and 2 were attorneys with a J.D. The average
years of relative professional experience for the fund managers were: private
funds -- 16.5 years, public funds -- 14.1 years, and combination funds --
16.9 years of experience.
On the query about the fund manager's reason for managing investments in
the early stage, 37% of the fund managers managed early-stage ventures because
it was mandated within their fund charter; they had not chosen early-stage
firms as the investment of choice. Approximately 17% of the respondents
chose "high risk/high return;" this implies that many fund managers
willingly accepted high risk as a challenge while attempting to gain high
return.
Involvement with Government Programs
Finally, the relationship between government economic programs and the early-stage
capital funds was examined. Interestingly, 28% of the private funds and
15% of the combination funds indicated their funds had no involvement with
government economic development programs. Another 28% of the private funds
responded that they were involved with research parks, and 14% responded
that they work with Business Incubators, SBIR-STTR-TRP programs, and SBDCs.
The combination funds showed a preference for Business Incubators (23%),
then SBIR-STTR-TRP programs (23%) and SBA Loans (15%). The public funds
showed a preference for R&D (16%), SBIR-STTR-TRP programs (16%), Federal
Grants (11%), and SBA Loans (11%). The following chart shows the percentage
of total responses that utilize a government economic program.
Fund Administration Summary
Over 40% of all funds were involved in monthly reviews of their investments.
Twenty-three percent and 30% of the public and combination funds, respectively,
were knowledgeable of daily operations, while only 8% of the private funds
participated at this daily level of detailed management. Many early-stage
funds provided the more generic type of services such as general management,
strategic planning, finance and accounting, and human resources. A few funds
provided more specialized services, such as legal, contractual and patent
service. The greatest number of funds reported that their operating costs
were less than $500,000. The source of these operating funds were a percentage
of monies under management for the private funds and an allocation of monies
from their sponsor's budget or cost sources for public funds.
The average years of relative professional experience for the fund managers
were 16+ years for the private and combination fund managers and 14+ years
for the public fund managers. Educational background of the fund managers
varied greatly, although a large number have an MBA. Thirty-seven percent
of the fund managers managed early-stage ventures because it was mandated
within their fund charter. Seventeen percent chose "high risk/high
return" as their motivation for managing early-stage investments. Popular
government economic programs are research parks, business incubators and
SBIR-STTR-TRP programs. Twenty-eight percent of the private funds and 15%
of the combination funds indicated no involvement with government economic
development programs.
Section VII - State Constitutionality, Legislative
and Policy Barriers
Among public funds, which are predominately state-chartered and state-funded
operations, the most common operational issue to surface in recent years
has been the question of constitutional, legislative, and/or administrative
policies which limit the management, funding, and investment practices of
those funds. This issue has been at the focus of discussions at both of
the Conferences on Early-Stage Financing for High-Tech Growth held in Salt
Lake City in 1993 and 1994. Therefore, the participants at the 1994 conference
requested that the 1995 survey gather information that might be helpful
in resolving their practical problems. This request was carried out by posing
a series of six questions to the public, private, and combination fund managers.
Extent and Types of State Prohibitions
The table below lists the 22 states represented by the 36 responding fund
managers and also identifies which states have and do not have constitutional,
legislative, or administrative prohibitions against state funds being invested
in or used to recruit, create, develop, or expand private businesses by
a direct subsidy or investment in individual business enterprises; some
respondents did not know. Among the 36 fund managers, 48% reported that
their states did not have prohibitions, 33% reported the existence of prohibitions,
and 18% did not know. Forty percent of the private fund managers did not
know, whereas 94% of the public fund managers did know whether or not their
states had prohibitions.
Table: Status of States on Barriers to Investment of State Funds
| States with Prohibitions: | |||
| Constitutional | Legislative | Administrative | Not Identified |
| Arkansas Iowa Missouri Oklahoma Utah |
Arizona | Massachusetts | Indiana Montana |
| States without Prohibitions: | |||
| California Connecticut Georgia Illinios |
Maryland Minnesota New York Pennsylvania |
Oregon Texas |
|
| States which were Unknown or with Conflicting Answers: | |||
| Kansas | Ohio | South Carolina | |
Permitted Mechanisms for Direct Investments
Among those states that did permit direct investments of state funds, all
available mechanisms are being used, with the decreasing order for form
of investment being loans (45%), grants (34%), and equity (21%). State agencies
(43%) and state-chartered organizations (24%) are the predominate entities
of investment administration, followed by non-profits, universities, and
private entities. It should be noted here that it is the form of investment
predominately used by state funds that limits the "financial return
on investment" to levels substantially less than that of private and
combination funds. Low interest loans and royalty payback on grants simply
do not yield the higher percentage ROI that are typically garnered by most
"patient money" equity investments
Additional Barriers to State-Funded Investments
The next chart shows the broad distribution of other barriers that exists
for making state funds available for early-stage financing of new enterprises.
These same barriers restrict the prospective entrepreneurs working in business,
industry, government, and universities from making the move into the high
risk arena of start-up enterprises. The lack of venture capital was the
most prevalent barrier identified, while the lack of business incubators
was the least. Since most business incubators across the country are city-
or county- funded, one might draw the conclusion that state governments
have not
followed the lead of their local governments to promote business and job
creation by providing the early-stage capital funds to support the enterprises
hatched by the incubators. Alternatively, business and government combined
have not promoted the establishment of private or combination funds in their
states.
State Pension Funds as a Source of Capital
As far back as 15 years ago, a handful of state governments recognized that
state permanent funds and/or state pension funds might be a source of capital
for investing into venture capital firms/funds. Those states were following
the lead of the federal government when in 1976 new ERISA regulations provided
for an updated "prudent man" investment .rule. The new regulations
permitted the investment of private pension funds into high risk investments
such as venture capital funds so long as that amount of investment in a
total portfolio of investments by a pension fund represented a small impact
percentage on the total fund. Several state legislatures authorized small
percentages (e.g. 0.5%, 1.0%, 2.0%, or even 5%) of the state pension funds
to be so invested.
The question posed to the fund managers on this topic was whether or not
their state governments had authorized a similar "prudent man"
rule. Unfortunately, 40% of the respondents did not know, equally distributed
among the three categories of fund managers. Thirty percent answered "yes,"
27% said "no," and 3% stated that the matter was "under consideration."
These states are identified in the following table.
Table: Status of States on "Prudent Man" Rule for Pension Fund Investments
| States with "Prudent Man" Rule | States without "Prudent Man" Rule |
| Massachusetts Oklahoma Oregon (1 or 2%)* Pennsylvania (2%)* Utah (3%)* Texas |
Arizona Arkansas Georgia Indiana Iowa Missouri Montana New York |
Summary
Overall one can conclude that constitutional barriers prohibit many state
governments from financially supporting the start-up business enterprises
that are being hatched by their local government subsidized business incubators.
And in those states where private venture capital funds and a track record
of successful entrepreneurial developments do not already exist, it becomes
a real question of what comes first--"the chicken or the egg"--namely,
the incubator with both management support and early-stage capital or the
entrepreneur that needs the capital to grow, develop, and survive. Many
states that have faced this situation have concluded that state governments
must provide the "seed capital" for both the business incubator
and the seed capital fund; examples include Michigan, North Carolina, Ohio,
and Pennsylvania. This "seeding" process convinces the private
sector that the state is truly serious about sponsoring the creation and
growth of new enterprises by "putting its money where its mouth is."
Then the private sector is willing to move forward and share the risk of
early-stage investments.
Section VIII -- Best Models for Early-Stage
Capital Funds
Over the past two years since the 1993 edition of this report was published,
numerous questions have been addressed to the principal author about what
existing funds are the most successful and what makes for a successful early-stage
fund. Most frequently these questions have come from persons associated
with state agencies that are examining for the first time the prospects
of establishing a fund to promote economic development. In some cases the
states in question are experiencing economic downturns from the defense
conversions that are impacting this country after the end of the Cold War.
In other cases the states are playing catch-up with neighboring states that
earlier put in place various types of financing tools for the support of
entrepreneurship and small business development. Still other states are
working with their universities and federal laboratories to fulfill the
promises of technology transfer and commercialization.
Key Defining Parameters
While the principal author, based upon his prior research and exposure,
provided answers and recommendations and even presented testimony to both
administrative and legislative hearings or studies, the subject of a "best
model" for an early-stage capital fund evolved as a worthy and important
topic for the research of this 1995 report. This proposition was confirmed
by attendees at the October 1994 Conference on Early-Stage Financing held
in Salt Lake City. As a consequence, a series of questions was posed to
the managers of private, combination, and public funds that participated
in the 1995 census project. Thirty-three fund managers responded to the
"best model" set of questions, which were cast in the context
of the following basic query: --- "If you were given the opportunity
to design and implement from scratch a new early-stage capital fund, what
would be the key defining parameters?" --- The parameters and majority/weighted*
response for each are given below.
Table: Key Defining Parameters for a "Best Model" Early-Stage Capital Fund
| Source of funds: | Both public and private dollars |
| Legal form: | Limited partnership |
| Purpose: | Financial ROI |
| Initial size*: | $32 million |
| Form of investments: | Equity |
| Form of "ROI": | Return on equity |
| Economic sector invested: | Technology |
| Average initial investment*: | $400,000 |
| Decision makers: | General partners |
| Typical investment duration: | 5 to 7 years, or less |
| Investments per year: | 5 to 10 |
| Jobs created per year: | 100 to 500 |
Responses by Classification of Funds
The tabulation of results given above is the summary over all three categories
of respondents: managers of public, private, and combination funds. Generally
speaking these three categories individually provided the same distribution
of responses for most of the key parameters. However, it is interesting
to observe how each category responded to certain topics.
On the subject of "best purpose," only one of the thirteen public
fund managers indicated "business/job creation" as the choice;
whereas five favored "financial ROI" and seven preferred both
"business/job creation" and "financial ROI." Twenty
of all the respondents chose "financial ROI" as the primary purpose,
but ten favored both purposes.
The public funds (nine) recommended smaller rather than larger initial fund
size in the $5 million to $25 million range, but the private and combination
fund managers favored the $10 million to $50 million range with none suggesting
initial sizes greater than $100 million.
A parameter that 88 percent of the respondents agreed upon was that "equity" was the best form of investment, strongly dominating over loans and grants. No doubt this is a consequence of the poor record that various state funds using grant and loan mechanisms have experienced in their early years of operation, as well as of the fact that private and combination funds only practice "equity" type investments. It follows that "return on equity" (71%) and "return on earnings" (12%) together led the recommended "form of return on investment." The public funds exhibited a liking for all forms of ROI: return on equity, principal and interest, royalties, return on earnings, and interest only (in decreasing order).
Perhaps from the influence of their existing fund charters, public fund managers revealed a propensity for recommending that the "best model" invest in a broad distribution of economic sectors, including agriculture, manufacturing, technology, service, and retail/wholesale. But collectively the fund managers favored, in decreasing order: technology (55%), manufacturing (23%), service (14%), agriculture (5%), and retail/wholesale (3%).
The "average initial investment" parameter yielded responses from $50,000 to greater than $1,000,000. However, the $100,000 to $300,000 range led their preferences (33%), followed closely by the $50,000 to $100,000 range (25%). A significant number (25%) favored initial investments greater than $750,000. The $300,000 to $500,000 range drew the smallest set of responses (5%), with only public funds managers (12%) picking this range. However, when all the responses are weighted first by the number of respondents and then averaged, the weighted average initial investment size was $410,000.
The private and combination funds favored a "typical investment
duration" of 5 to 7 years, whereas the public managers favored 3 to
5 years. Fifty-five percent of the respondents preferred 5 to 10 for the
"number of yearly investments," but 38 percent each of the private
and combination managers favored three investments per year.
In a final inquiry of these same fund managers, we asked whether any had
near term plans to raise moneys for additional early-stage funds and what
would be the sizes of such funds. Twenty of 33 respondents indicated "yes
or maybe;" fifty percent of the private funds answered "yes,"
and 60% of the combination funds answered "no." The total amount
of funding that these fund managers projected to raise was only $275,000,000.
Best Model Summary
In conclusion, the "best model" for an early-stage capital fund,
as recommended by thirty-three fund managers (nearly equally distributed
among private, public, and combination funds), is a limited partnership
funded with both public and private dollars to approximately $32 million;
it has financial ROI as its principal purpose and invests primarily in technology
enterprises with five to ten initial equity investments per year averaging
$400,000 for investments periods of five to seven years or less.
A direct application of this model to the $275 million of projected fund-raising
by the responding fund managers would yield 8.6 new funds of $32 million
each, making 50 to 86 new investments each year and creating from 860 to
5100 new jobs per year. Since many of our nation's large corporations and
military bases are currently downsizing by these job numbers, this potential
achievement by the private and public sectors certainly deserves to be pursued
to the fullest extent possible.
Section IX -- Seed Capital from Strategic Alliances
This section is a new thrust for the biannual seed and start-up capital survey report. It came about because two of the authors have had extensive experience with business incubators for technology-based start-ups, and in the process, noticed that significant amounts of seed capital were being acquired through alliances with operating divisions of established companies rather than traditional institutional investors.
The Study Methodology
A survey instrument was designed and pre-tested to gather data from early-stage,
technology-based firms that had received significant amounts of their seed
capital through an alliance with an established company. A number of companies
were known to the authors since management assistance had been provided
to them. Other firms who fit the desired sample characteristics were identified
by individuals involved in capital formation, incubators, etc. By the deadline
for the issuance of this report, 17 complete and appropriate responses had
been received. Since this is still a relatively small sample and the potential
alliance appears to be an important source of seed capital, the authors
will expand the study and provide more definitive conclusions in future
editions of this report. Since there is no established data base to identify
additional firms to sample, the study is limited to identifications made
through an informal network. Therefore, readers of this report who are
aware of firms that meet the study criterion (a majority of the seed capital
acquired from the operating division of an established firm as part of one
or more strategic alliances) are encouraged to contact one of the following
authors with leads to these firms.
Professor Ray Radosevich 505-277-5928
Professor Elias Carayannis 505-277-7114
Dr. Richard T. Meyer 505-343-9500
Initially firms were surveyed by mailing the instrument to them with a cover letter explaining the study and including instructions for completing the questionnaire. Firms known to the authors all responded but the response rate of others was only 18 percent. Attempts to determine a non-response bias revealed that many non-responders felt the information too proprietary or were simply too busy (not surprising for early-stage entrepreneurial efforts). A few more responses were solicited by the authors conducting telephone interviews with the questionnaire.
Sample Characteristics
The sample of 17 respondents represented a number of alliances with interesting
characteristics. Five respondents had more than one alliance which provided
early stage seed capital while the other twelve had only one. Of the five
with more than one alliance, there was an average of 2.6 alliances. In
each instance of multiple alliances, each alliance was developed separately
(as opposed to developed as part of a syndicate or consortium). When a
respondent had more than one alliance, they were requested to complete the
major portions of the questionnaire with respect to their "most significant"
alliance.
Existence of "Champions"
A number of sources in the alliance literature have suggested that most
successful alliances have key individuals in each partner who are enthusiastic
"champions" of the alliance formation. In all instances except
one, the respondents believed that such a champion existed in their partner.
In the majority of the cases, the partner's champion was a technical person
within an R&D group which suggests that the early-stage company was
performing interesting technical work or had acquired valuable intellectual
property. In several instances, the champion resided within senior management
of the partner, and in one instance, a marketing person served as the champion.
Seed Capital Acquired
Fifteen of the 17 respondents were willing to reveal the amount of the
seed capital received. For these 15 firms, the range of commitments for
seed capital was $300,000 to $6 million with an average of $2,798,000. At
the time of the survey, not all commitments had been fully met. For the
15 respondents, an average of $2,074,000 had actually been received from
their most significant partner. For eight of the respondents, there is
a continuing flow of capital beyond the initial commitment. The total incremental
capital received from alliances (beyond the initial commitment) was $26,460,000
although some of this was provided by alliances other than the most significant
one. Of this amount, one firm received a total of $12 million.
In three instances, the entity infusing the capital was a corporate function
(but not a venture capital function) while in all other instances it was
an operating division, functional unit (such as R&D), or separate strategic
business unit.
In one-half of the instances, the funding received was restricted to specific
uses. Whether restricted or not, the actual uses of the seed capital received
are shown in the following chart as the percentage of the total capital
acquired by all responding firms.
Alliance Benefits other than Capital
Sixteen of the 17 respondents reported receiving significant benefits from
their alliance partners beyond the seed capital funding. The table below
shows the composite rank ordering of these benefits from the most important
to the least.
Since the acquisition of proprietary technology was perceived by the
respondents as the least important benefit received, it appears that the
early-stage firm was the technical leader in the aspects of technology which
served as the basis for the alliance.
The respondents were also asked to describe what they gave up in exchange
for the seed capital. It is surprising to note that only six of the 17
reported that the partner received equity in their firm. In contrast, twelve
of the partners received technology or intellectual property; twelve also
received marketing rights and nine acquired manufacturing rights in exchange
for their seed capital. When equity was received, the average valuation
of the early stage company was an imputed $6.8 million.
Of the twelve partners who received technology, six acquired patent rights,
nine obtained licenses, two acquired copyrights and eight received trade
secrets or know-how. Of the twelve who obtained marketing rights, one had
those rights restricted to a specific application and seven were restricted
to particular geographic regions. Of the geographic restrictions to marketing
rights, four partners had only foreign rights and one acquired only domestic
rights. Five of the partners had rights to manufacture only domestically
and four others could only manufacture abroad.
Characteristics of the Alliance Partner
Of the 15 respondents who reported the nationality of their most significant
alliance partner, only four were foreign firms. When asked if their partners
had one or more previous successful alliances before becoming their partners,
five of 16 respondents did not know their partner's alliance history. Seven
respondents had found partners who had previously enjoyed successful alliances
and four had partners for whom the act of forming alliances was novel.
Only two of 16 respondents reported that the alliance resulted in the formation
of a new legal entity and in both instances, it was a new corporation.
The Process of Obtaining a Seed-Capital-Providing Alliance
The time from which the early stage firm started seeking a partner to provide
seed capital until the deal was consummated ranged from one month to three
years. The average was fourteen months. Only five of 16 were pursuing
a formal search process when initial contact with a potential partner was
established. One firm reported the identification of over 200 potential
partners but the average, excluding that firm, was fewer than four. On
average, formal negotiations were held with three potential partners and
eight respondents reported multiple, parallel negotiations.
Eleven respondents provided data with respect to the relationship that
might have evolved with their eventual partner had an alliance not been
consummated. Eight of the firms reported that the partner would have been
a competitor if the alliance had not succeeded. By eliminating a potentially
potent competitor through the alliance forming process, these firms may
well have strengthened their competitive position. One respondent declared
that the eventual partner would have been a customer, if not a partner,
and another revealed the possibility of the partner being a supplier had
the alliance not evolved.
The literature on strategic alliances suggests that often a large firm
will encourage an early-stage potential partner to initiate legal contracts
so that the large firm is not open to charges of unfairly dominating the
relationship. Indeed that was case with ten of these alliances. Six alliances
were formed with the large firm defining the contractual relationship.
The literature also suggests that a qualified intermediary can be of considerable
assistance in the process of forming an alliance. Five respondents reported
the use of an intermediary and eleven declared that none was used. Of the
five that used an intermediary, all were pleased with the assistance received.
On a scale of one to ten, with ten signifying "the intermediary was
critical to the successful creation of an alliance," the scores ranged
from six to ten. The average score of the five alliances using an intermediary
was 7.5. The most important uses of the intermediaries were: 1) in consultation
on the alliance forming process, 2) negotiations, 3) legal and contracting
assistance, and 4) post alliance consultation.
The Alliance Relationship
Only two of the alliances resulted in a new organizational entity being
formed. Five respondents reported that their partners had one or more seats
on their board of directors; ten declared that no seats were given up.
One of the six firms that gave equity in exchange for the seed capital from
their partner did not have the partner represented on the board. Of the
five firms that gave up seats, three gave up one seat and two firms gave
up two seats.
Four respondents stated that the alliance was managed with a joint managing
committee or some form of cross membership of managers. Ten said that no
such relationship existed. For seven respondents, the alliance is managed
through an informal relationship. Two reported that the partner is simply
a passive investor. Four replied that a contractual relationship spelled
out the respective decision prerogatives.
Fourteen of 16 respondents reported that they still have a formal relationship
with their partner at the time of the survey. Of these 14, only three stated
that their relationship had a schedule for termination.
Perceived Success from the Alliance
Sixteen respondents reported their perceptions of the degree of success
achieved through the alliance formation using a six point semantic scale
ranging from "excellent" to "disastrous." None reported
that the alliance was "disastrous" or "poor". While
surprising, this result appears valid given the high proportion of the alliances
still operating within this sample. Eight firms
reported that the results of the alliance were "excellent" and
five stated that the partnership was "very good." Two firms reported
the alliance as "good" and the one, least satisfied firm described
the partnership as "fair."
Fourteen firms responded to the question, "what degree of success
do you believe your alliance partner would assign to the alliance?"
Again, no respondent perceived the partner as dissatisfied to the extent
that they would describe it at "disastrous" or "poor."
They were on average, however, slightly less sanguine about their partners
likely perception of success. Three felt the partner would only perceive
the result as "fair" and two felt that "good" would
best describe the partners degree of satisfaction. Five respondents categorized
their partners' perception of success as "very good" and the remaining
four firms felt their partners would rank it as "excellent."
In order to understand the factors that correlate with perceived success
in the alliance, the respondents who thought the partnership was excellent
or very good (13 in all) were compared to the three that felt it was only
good or fair. Although the sample is too small to suggest statistical significance,
some interesting observations can be made. For example, the more satisfied
group received an average of $2.3 million in seed capital through the process
of forming strategic alliances. In marked contrast, the less satisfied
group received on average only $480,000. A majority of the members of the
more satisfied group did not have a restriction on the use of funds provided
by the partner, while two of three members of the less satisfied group did
have restrictions.
Two of the three less satisfied firms used an intermediary whereas only
three of twelve of the most satisfied group used one. This is surprising
given the reported satisfaction with the intermediaries described earlier.
The group members that were most satisfied with the alliance process appear
to represent earlier stages of development than members of the less satisfied
group. This inference is made by observing the use of funds for the two
groups. Technology development was considerably more frequent as a use
of funds for the more satisfied group whereas the less satisfied more often
used the funding provided by the partner to secure plant and equipment or
hire personnel.
Interestingly, all of the less satisfied group have maintained the alliance
while two of the more satisfied group have terminated the relationship.
None of the less satisfied group has a member of their board of directors
from their partner while four of the more satisfied group do.
No member of the less satisfied group had a foreign partner while four
members of the other group did. It appears that domestic partners would
perceive their alliances to be more successful than foreign partners but
little discernible difference exists between foreign and domestic alliances
with respect to satisfaction of the early-stage firm receiving the seed
capital. When viewing the success of the alliance from the perspective
of the early stage firm, two with foreign partners perceived the alliance
as excellent and two as very good. Among those with domestic partners,
six perceived the alliance as excellent, one as very good, one as good,
and one as fair. When viewing the success of the alliance from the perspective
of the capital-providing partner, the foreign firms represented one as excellent,
one as very good, one as good, and one as fair. In contrast, three of the
domestic partners were thought to perceive the alliance as excellent, four
as very good and one as good.
No member of the less satisfied group used a formal search process to locate
potential partners while almost one-half of the other group did.
A similar analysis was performed to seek correlations with success from
the reported perceptions of the partners' satisfaction. Nine respondents
thought their partners would perceive the alliance as excellent or very
good. Five thought their partners would perceive it as good or fair. In
the less satisfied group, a higher proportion of the partners were foreign
firms. Surprisingly, in the less satisfied group, there were no partners
that did not have a track record of successful alliances whereas in the
more satisfied group, only 60 percent of the partners had such a previous
record. None of the members of the less satisfied group had established
a separate legal entity as part of the alliance, whereas two of the more
satisfied group did. Four members of the more satisfied group received
equity in exchange for the seed capital; only one member of the less satisfied
group received equity. In the less satisfied group, none of the members
had seats on the board of directors of the early stage company, whereas
in the more satisfied group, four members had directors' seats.
Perceptions of the "Seed Capital Gap"
All of fourteen respondents to a question regarding the existence of a
seed capital gap reported that such a gap indeed was real. When asked for
what range of funds did such a gap exist, the averages of the reported ranges
were from $180,000 to $933,000. Since the average seed capital received
from their alliance partners was over $2 million, the principal gap was
more than surmounted through the alliance process.
When asked for their perception of the best source of early-stage seed
capital, strategic alliances were not surprisingly the first choice of fourteen
respondents when the rankings were averaged. The following table presents
the rankings in decreasing order of desirability.
In addition to the seed capital received from their strategic alliance partners, other sources of funds were used as well by many of the respondents. Table 4 presents a listing of other sources and the number of respondents who actually received funds from that source.
Table: Number of Early-Stage Firms Receiving
Funds from Other Sources
In Addition to Alliance Partners
| Angels | 6 |
| Family and friends | 5 |
| Institutional investors | 5 |
| Private offerings | 3 |
| Public offerings | 3 |
Strategic Alliance Summary
The results of this survey reveal that seed capital for early-stage firms
is being successfully acquired through strategic alliances with established
firms. Significant amounts of early-stage capital were acquired by the
survey firms--over $2 million on average. This was a larger sum than typically
provided to embryonic firms by early-stage venture capital funds. Of special
note was the high level of satisfaction with the partnership as expressed
by the capital recipient. The terms, such as restrictions on capital usage,
appear to be generous. The benefits from the alliance beyond the funding
were reported to be prevalent. The time required to establish an alliance,
however, was surprisingly long. In most instances, various rights were
acquired rather than equity by the larger partner.
The prescriptions from the normative literature on alliance formation and
operation appear mostly valid in the experiences of the surveyed firms.
Most firms found a champion within the partner. Potential competitors
became partners to strengthen their mutual positions in the market place.
The early-stage firms were most often active participants in defining the
contractual relationship. Surprisingly, the use of experienced intermediaries
was not the norm. Unless equity was acquired by the capital provider (in
which case board seats were also acquired), the alliance was managed without
substantial bureaucracy. The funding alliances tended to evolve into long-term
relationships.
In spite of the successful acquisition of early-stage capital through strategic
alliances, the early-stage firms universally reported that a serious seed
capital gap exists in this country. Nevertheless, the survey results suggest
that partnerships with established companies may well be a viable source.
Section X -- The Entrepreneurial Capital Gap
While serving as a Professor of Entrepreneurship at the Emory Business
School in 1992, the principal author of this report created a two dimensional
chart depicting "The Entrepreneurial Capital Gap (The 'Grand Canyon'
of Seed Capital Financing)." This chart was published as Appendix
4 in The 1993 National Census and is reproduced herein. Since its first
release in 1992, this depiction of the breadth and depth of the capital
gap for early-stage entrepreneurs has been used by various persons in state
and federal agencies to convey the message of the capital shortfall in numerous
settings.
The actual magnitudes of the breadth and depth of the capital gap used
in that representation were based largely upon information and experience
gained by the author over a number of years of working both with entrepreneurs
and with venture capitalists and private investors. The specified width
of the gap was nearly $1,000,000 and the depth was $500,000, with the later
figure more characteristic of the cash flow requirements of technology entrepreneurs.
The low-capital ledge of the gap exhibited widths ranging from $25,000
for personal savings to $100,000 when combined with private investors to
$250,000 when combined with formal seed capital funds.
Because of growing reference to "the entrepreneurial capital gap"
throughout the public and private sectors, the survey conducted for this
1995 study incorporated specific questions to confirm the existence and
to establish the dimensions of the gap. The results are displayed in the
several charts below.
Unfunded But Viable Early-Stage Investments
Of the 32 respondents, 81% indicated that a significant number of viable
early-stage investments were going unfunded in the United States; and the
same number believed that a "capital gap" does exist for the financing
of early-stage (seed and start-up) entrepreneurial firms. This is the very
same percentage from a larger number of participants in the 1993 study that
agreed with the real existence of a "capital gap." It is interesting
to note that private fund managers (90%) are slightly stronger believers
in the gap's existence than there counterparts with combination (89%) and
public funds (75%); in fact, two of the 12 public fund managers were the
only ones giving a "maybe" response to this query and one said
"no."
Reasons for Capital Gap
The most probable reason given for the existence of the capital gap was
that venture funds sizes have become too large to manage early-stage investments
(per 45% of the respondents). Other reasons given with nearly equal low
weightings were:
* cost of due diligence exceeds expected returns
* small investment amounts are difficult to manage
* insufficient awareness and participation by "business angels"
* other reasons
It is well known that the venture capital industry has been shifting its
investment practices to larger and fewer investments, as well as to later
stage investments, in order to achieve more effective management at lower
or fixed operating costs. It is also known that new capital flowing into
the venture industry has gone principally into larger funds of the size
of $100 million or more, whereas the preferred size for an early-stage fund
is $20 million to $50 million. Therefore, it is not unreasonable to conclude
that managers of the generally smaller early-stage funds not only witness
a significant number of viable early-stage investments going unfunded but
also readily admit that a "capital gap" really exists. By contrast
one often hears the partners of larger private funds frequently express
the viewpoint that "there is an adequate supply of venture capital
and that any deal that really deserves to be funded will get funded."
The findings of both our 1993 and 1995 surveys unequivocally contradict
this viewpoint!
Width and Depth of Capital Gap in Dollars
Two charts below provide the responses to a series of questions addressed
to establish the dimensions (width and depth) of the entrepreneurial capital
gap. The depth of the gap was defined as the typical amount of early-stage
capital needed by entrepreneurs that is most difficult for them to acquire
in order to proceed with planned operations and to maintain an acceptable
positive cash flow. The majority of respondents indicated a depth range
of $250,000 to $1,000,000, with more affirming the greater depth; however
a midpoint of $500,000 is probably representative of their expressions.
The lower boundary of the width of the gap was defined as the typical maximum
amount of capital available from single high net worth individuals (business
angels) for a specific early-stage investment; and the upper boundary was
defined as the typical minimum amount of capital that a typical, non-early-stage
venture capital firm prefers to commit as its first level of investment.
The respondents indicated a $75,000 to $100,000 amount for the lower boundary
and $500,000 to $1,000,000 for the upper boundary. Both boundaries are
consistent with "The Entrepreneurial Capital Gap" as set forth
in 1992 and ,therefore, confirm the validity of "The Grand Canyon of
Seed Capital Financing."
Capital Gap Summary
The 1995 Census and The 1993 Census, combined, firmly confirm that an "Entrepreneurial
Capital Gap" exists in the United States. Eighty percent of the respondents
in both survey years stated that viable early-stage investments were going
unfunded, largely because the established venture funds had become too big
to make the smaller investments in early-stage firms. These responses contradict
the viewpoint expressed by many venture capitalists that "every good
deal will get funded." The contradiction rests in one's definition
of a "good deal." The requisites that every "good deal"
venture investment must experience annual growth rates of 100 percent and
revenues of $50 million to $100 million in five years are achievable realistically
by only one-tenth of one percent or less of the firms applying to venture
firms. Yet hundreds of thousands of new companies are formed each year
in the United States that grow into firms with revenues of $10 million to
$25 million, adding significantly to the employment base and the general
economy of their states and the nation.
These firms are the very ones that directly encounter "The Grand Canyon
of Seed Capital Financing." That canyon now is established to have
a cash flow working capital depth of $500,000 and an initial growth and
market entry capital width (gap) spanning from $75,000 to $1,000,000. This
need for seed and start-up capital is being ignored by the large venture
firms but is being partially filled by the relatively few public, private,
and combination funds that engage in early-stage financing. If the number
of respondents to the 1995 survey is any indicator, when compared to the
number of 1993 respondents, then the availability of early-stage financing
from venture firms is decreasing very rapidly, particularly among the private
venture capital sector. This conclusion should stimulate state and local
government entities to move aggressively to fill "The Entrepreneurial
Capital Gap." The diminution of available private capital should be
viewed and dealt with by state governments as many have had to in the past
when their steel, automobile, textile, and oil industries have downsized
or shut down; a current example of consequence is the downsizing the nation's
military establishment due to the end of the Cold War. Are our state governments
fully prepared for that impact or for the next global consequence? Most
states, including New Mexico and California are not!