Organized private equity: Formal venture-capital market

The organized private-equity market includes the formal venture-capital market together with direct investment by institutional investors in private companies. The formal venture-capital industry consists of firms and organizations that professionally manage and invest in private small and emerging companies. Included in the industry are Small Business Investment Companies and private venture-capital firms.

Small Business Investment Companies (SBICs):

Licensed and regulated by the federal government’s Small Business Administration (SBA), Small Business Investment Companies (SBICs) are private, for-profit investment firms. SBICs provide equity capital, long-term loans, and management assistance to qualifying small businesses. They make these venture-capital investments with their own funds plus funds obtained by borrowing at favorable rates with an SBA guarantee. There are two types of SBICs — original, or regular, SBICs and Specialized Small Business Investment Companies (SSBICs). SSBICs are specifically targeted toward the needs of entrepreneurs who have been denied the opportunity to own and operate a business because of social or economic disadvantage. With a few exceptions, the same rules and regulations apply to both “regular” SBICs and SSBICs. The principal difference between regular SBICs and SSBICs is that SSBICs receive additional help from the SBA to support their mission of financing entrepreneurs suffering from a social or economic disadvantage.

SBIC financing is specifically tailored to the needs of each small business. An SBIC can lend money to a small business, make an equity investment in it, or both. However, in making their investment decisions, SBICs strongly prefer equity investments and use the same analysis as purely private equity investors. They generally require the entrepreneur to provide a business plan, which they evaluate in the same way other venture capitalists do. An SBIC, however, is limited in how much of its funds it can invest in any one small business. Without written approval of the SBA, an SBIC cannot invest more than 20 percent of its private capital in securities, commitments, and guarantees of any one small business. (For SSBICs, the limit is 30 percent.) Moreover, under normal circumstances, an SBIC must hold less than half the equity in a company. Compared with other segments of the capital markets, the SBIC industry is small. Nevertheless, because of their focus on the equity needs of small and growing businesses, SBICs are an important segment of the financial service industry.

The SBIC program fills the funding gap for younger and smaller new businesses, particularly those that are not high-technology based or are not located in the traditional venture-capital strongholds. Unlike other professional venture capitalists, SBIC investments are not concentrated in high-technology investment. Only one-quarter of the SBIC investments are in high-technology companies. Over half the SBIC-backed companies are located outside high-volume venture-capital areas such as “Silicon Valley” in California or the “Route 128 Circle” in Massachusetts. SBICs tend to make investments in the $300,000 to $5 million range. With an average investment size of slightly over $1 million and median investment size of closer to $700,000, SBICs provide critical smaller amounts of venture capital that their larger private-equity counterparts do not.

KEY POINT: For many entrepreneurs and small business owners, SBICs present the best opportunity for getting a formal venture-capital investment in their company.

Banks play a very significant role in the SBIC program. Because banking regulations limited banks’ ability to make equity investments except through an SBIC subsidiary, SBICs provide an attractive avenue for banks to make venture investments and to enhance the equity of firms to which they wished to lend. A bank can invest up to 5 percent of its capital and surplus in partially or wholly owned SBICs. Some banks have established and run their own SBICs; others have simply invested in SBICs with other private investors. Overall, bank-owned SBICs account for about half the SBIC capital and are the biggest source of capital for the SBIC program.

Private-Venture Capital

From the late 1950s, with the passage of the Small Business Investment Company Act of 1958, to the late 1970s, SBICs dominated the formal venture-capital industry in the United States. Then the passage of the Employee Retirement Income Security Act (ERISA) in 1974 changed the environment by allowing private pension plans to invest up to 10 percent of their assets in venture capital. This landmark legislation fueled the growth of the private venture capital industry in the United States through the 1980s and 1990s.

Because they occupy the high ground of the private capital investment process, venture-capital investments receive much attention from the press. This press coverage masks the, reality that formal venture-capital investment occupies a very select niche in the panorama of private capital, both in the relative number of companies that receive venture-capital funding and in the specific industries for which formal venture-capital provides funds.

KEY POINT: Formal venture capital is invested in about 2,500 companies annually in the United States. These companies are overwhelmingly in high-technology industries, with information technology and medical technology (including biotechnology and drugs) being the primary industries receiving this investment.

Formal venture capitalists prefer to invest in small companies that are already established and in which others have already invested rather than in brand new business startups. Generally, less than 5 percent of annual venture capital investment goes to startups. The real role that formal venture capital plays is to fund a company as it begins to commercialize its innovation. Venture-capital money goes predominantly into the expenses (manufacturing, marketing, and sales) and assets (fixed assets and working capital) required to commercialize innovations and grow the business. Venture capital fills the void in a company’s development between the time the RAD is completed and the company becomes eligible for institutional lenders and public-market equity financing.

Once they have invested, venture capitalists actively work with the company’s management by contributing business experience and industry knowledge gained from helping other young companies. During the first few years, before significant revenues are generated, about two-thirds of the average venture-capital-backed company’s total equity is supplied by venture financing. The average U.S. venture-backed company raises about $16 million of venture capital during its first five years.

From your standpoint, a venture-capital investment has both positive and negative aspects. Positive elements include substantial amounts of hard-to-get equity capital, credibility in the marketplace with other financing sources such as commercial banks, a broad range of helpful contacts, and professional advice and expertise on issues relating to your company’s growth including advice about raising additional capital. On the negative side, the types of deals venture capitalists normally seek can have substantial adverse impact on the company’s capital structure. You and the other existing owners may have to give up elements of control and future upside gains, sacrifices that are the normal result of an equity financing. In addition, the firm may lose some of its flexibility and increase its risk, the normal results of a debt financing.

Direct Investment:

Direct investment is carried out by both non financial corporations and financial institutions. Non financial corporations typically invest in private capital through their own direct venture-capital programs. They normally invest in risky early-stage developmental ventures that fit their strategic objectives. Industries with the most active private-capital investment by non financial corporations include the medical and health care, industrial products, chemicals, and electronics and communications industries.

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