Venture capital is a form of investment in new small risky enterprises required to get them started by specialists called venture capitalists. Venture capitalists are therefore investment specialists who raise pools of capital to fund new ventures which are likely to become public corporations in return for an ownership interest. They buy part of the stock of the company at a low price in anticipation that when the company goes public, they would sell the shares at a higher price and therefore make a considerably high profit. Venture capitalists also provide managerial skills to the firm. Example of venture capitalists are pension funds, wealthy individuals, insurance companies, Acacia fund, Rock fella, etc. Since the goal of venture capitalists is to make quick profits, they will invest only in firms with a potential for rapid growth.
Venture capitalists, will only invest in a company if there is a reasonable chance that the company will be successful. Their publicity material states that successful investments have three common characteristics.
- There is a good basic idea, a product or service which meets real customer needs.
- There is finance, in the right form to turn the idea into a solid business.
- There is the commitment and drive of an individual or group and the determination to succeed.
Attributes of venture capital
- Equity participation – Venture Capital participate through direct purchase of shares or fixed return securities (debentures and preference shares)
- Long term investment – venture capital is an investment attitude that necessitates the venture capitalists to wait for a long time (5 – 10 years) to make large profits (capital gains).
- Participation in Management – Venture capitalists give their Marketing, Planning and Management Skills to the new firm. This hands – on Management enable them protect their investment.
Role of Venture Capital in Economic Development
The types of venture that capitalists might invest will involve:
a) Business start-ups – When a business has been set up by someone who has already put time and money into getting it started, the group may be willing to provide finance to enable it to get off the ground. With start-ups, venture capital often prefers to be one of several financial institutions putting in venture capital.
b) Business development – The group may be willing to provide development capital for a company which wants to invest in new products or new markets or to make a business acquisition, and so which so needs a major capital injection.
c) Management buyout – A management buyout is the purchase of all or parts of a business from its owners by its managers.
d) Helping a company where one of its owners wants to realize all or part of his investment. The venture capital may be prepared to buy some of the company’s equity.
Funding Venture Capital
When a company’s directors look for help from a venture capital institution, they must recognize that:
- The institution will want an equity stake in the company.
- It will need convincing that the company can be successful (management buyouts of companies which already have a record of successful trading have been increasingly favored by venture capitalists in recent years.
- It may want to have a representative appointed to the company’s board, to look after its interests.
The directors of the company then contract venture capital organizations, to try to find one or more which would be willing to offer finance. A venture capital organization will only give funds to a company that it believes can succeed.
Reasons for Significant Growth in Venture Capital in the Developed Countries
- Public attitude i.e a favourable attitude by the public at large towards entrepreneurship, success as well as failure.
- Dynamic financial system e.g efficient stock exchange and a competitive banking system.
- Government support – e.g taxation system to encourage venture capital e.g tax concessions and investment allowance taxes.
- Establishment of venture capital institutions e.g investors in the industry.
- Growth in the number of Management buyers (MBO) which have created a demand for equity finance.
Constraints of Venture Capital in Kenya
- Lack of rich investors in Kenya, hence inadequate equity capital.
- Inefficiencies of stock market – NSE is inefficient and investors cannot sell the shares in future. Prices do not reflect all the available information in the market.
- Infrastructural problems – this limits the growth rate of small firms which need raw materials and unlimited access to the market factors of production.
- Lack of managerial skills on part of venture capitalists and owners of the firm.
- Nature of small business in Kenya. There are 3 categories.
a. Large MNC – these are established firms and can raise funds easily.
b. Asian owned small businesses – They are family owned hence do not require interference of venture capitalists because they are not ready to share profits.
c. African – owned business – need venture capital but have little potential for growth.
- Focus on low risk ventures e.g confining to low technology, low growth sectors with minimum investment risks.
- Conservative approach by the venture capitalists.
- Delay in project evaluation e.g months or more hence entrepreneurs loose interest in the project.
- Lack of government support and inefficient financial system.
In sum, venture capital, by combining risk financing with management and marketing assistance, could become an effective instrument in fostering developing countries. The experiences of developed countries and the detailed case study of venture capital however, indicate that the following elements are needed for the success of venture capital in any country.
- A broad-based (and less family based) entrepreneurial traditional societies and government encouragement for innovations, creativity and enterprise.
- A less regulated and controlled business and economic environment where attractive customer opportunities exists or could be created from high-tech and quality products.
- Existence of disinvestments mechanisms, particularly over-the counter stock exchange catering for the needs of venture capitalists.
- Fiscal incentives which render the equity investment more attractive and develops ‘equity cult’ in investors.
- A more general, business and entrepreneurship oriented education system where scientists and engineers have knowledge of accounting, finance and economics and accountants understand engineering or physical sciences.
- An effective management education and training programme for developing professionally competent and committed venture capital managers; they should be trained to evaluate and manage high technology, high risk ventures.
- A vigorous marketing thrust, promotional efforts and development strategy, employing new concepts such as venture fair clubs, venture networks, business incubators etc. for the growth of venture capital.
- Linkage between universities/technology institutions, R & D. Organisations, industry, and financial institutions including venture capital firms.
Encouragement and funding or R & D by private public sector companies and the government for ensuring technological competitiveness.
Disadvantages of Venture Capital
- Dilute ownership position of a firm
- Dilute control of a firm