Venture Capital

What is Venture Capital?

Venture Capital (‘VC‘) exists to service a gap created by the structures and rules of capital markets. In essence, when an entrepreneur comes up with an innovative and novel idea, there are no other institutions to which the inventor can turn to in order to obtain funds to realise their concept into a viable commercial business.

First, the founder would often not have adequate funds personally, or from friends and family, to match the heavy costs associated with starting or expanding the business. Second, bootstrapping (using one period’s profits to fund growth for the next period) would fail to meet the demands of rapid growth. Last, usury laws limit the interest rate banks can charge on loans and due to the high-risk nature of start-ups who often have few assets which can be used as collateral, banks would require higher rates than would be allowed by law, meaning bank loans are also not an option.

How does a VC deal work?

The Venture Capitalist will usually offer to invest in the business in exchange for a large equity position. The invested funds generally go towards building the infrastructure required to grow the business – expense investments (manufacturing, marketing, and sales) and the balance sheet (provided fixed assets and working capital) – and only a relatively small proportion is used for research and development. VC investments are not long-term (around 5 years), with the premise of funding growth being geared towards lucrative exit events such as selling the invested firm to a corporation or enlisting an investment bank to push the firm towards an initial public offering (‘IPO’) and float the firm on the public markets.

*Source: Harvard Business Review

In reality, VC firms open ‘funds’ to pool money together from wealthy individuals, companies, pension funds, university endowments, etc. to invest into some number of companies. Each firm and each fund would have its own investment profile. For instance, a firm might specialise in biotechnology start-ups and has 2 funds set up with different risk profiles, one high-risk and one low-risk.

The Australian PE & VC index outperformed public markets by 200 to 400 basis points in Q3 2018, which signals strong potential for private capital to attract significant future inflows.

Trends

*Source: Cambridge Associates’ Private Investments Database, December 2018

Australia’s IPO market has followed the global trend of flat growth. More entrepreneurs are increasingly adopting the perspective that the costs associated with listing on a stock exchange are outweighing the benefits. These costs predominately arise from compliance and regulatory requirements which consume the firm’s financial resources and management time. Further, entrepreneurs are more sceptical of the short-term focus of equity markets – they believe in order to grow their venture in the long-run they are better off remaining private to avoid the public market’s constant focus on quarterly results. This has inverted the traditional notion that an IPO is the hallmark of success for a business venture.

*Source: EY Global IPO Trends, 4Q18

Case Study

In April of 2012, the popular photo-sharing application Instagram was acquired by Facebook for a total of $1 billion USD. To truly grasp the tremendous scope of this deal, we can turn to the VC firm Andreesen Horowtiz, whose initial $250,000 of seed money translated into $78,000,000 at acquisition, representing a 312 times return on investment.

Founded in 2010, Instagram quickly rose to the number one free photo-sharing app on Apple’s App Store by 2012. At the time, Facebook was facing a decline in its handset users and hoped to leverage the Instagram purchase to increase its share of that market. When Instagram eventually made its way to Android, it added millions of users in a matter of days, which spurred frenzied negotiations that culminated in the $1 billion acquisition. In hindsight, this valuation was relatively cheap, given that in 2019 alone, Instagram generated $20 billion in revenue and accounted for more than a quarter of its parent company’s total revenue (Bloomberg).

However, to put this into perspective, Horowitz emphasised these types of deals are exceedingly rare – for every company like that, they are literally thousands of failures.