Custom Writing Service http://StudyHub.vip/AN-OVERVIEW-OF-VENTURE-CAPITAL

1. Page 1 of 9
AN OVERVIEW OF VENTURE CAPITAL
By Kennedy Mulenga, BBA (CBU); MBA (MsM)
Introduction
Small and medium size enterprises (SMEs, hereafter) play an important role in the economy of any
nation. However, SMEs all over the world are faced with a number of challenges that derail their
expansion. The major challenge that SMEs face is that of acquiring financing from traditional financiers
such as banks and capital markets. Lack of collateral and lack of financial records characterise SMEs
generally (Ferrer, 2010). Zambian SMEs also cannot raise money on the Lusaka Stock Exchange (LUSE,
hereafter) because they are not listed. Moreover, the SMEs cannot meet the stringent rules that LUSE
has put in place for firms to be listed on the exchange. The inability of SMEs to raise capital from
conventional financial institutions means that they have to find other sources of financing. In many
countries, the only source that is available to supply capital to unquoted companies with growth and
profit prospects is venture capital (VC, hereafter).
Definition of Venture Capital
Several scholars have defined venture capital differently. According to Kortum and Lerner (1998)
e tu e apital is defi ed as e uit o e uit li ked i est e ts i ou g, p i atel held o pa ies
p. . Bal oa a d Ma ti defi e e tu e apital as the p ofessio alised fi a ial a ti it o sisti g
of investing in companies which are in the start-up o e pa di g stages p. . This defi itio is
consistent with the definitions of Megginson (2001); Da Rin, Hellmann and Puri (2011); Aizenman and
Ke dal . Ve tu e apital is a t pe of fi a ial i te edia that is spe ialised i the fi a i g
e t ep e eu ial o pa ies Hell a & Pu i, , p. . Gilso a d Bla k defi e e ture capital
o siste t ith A e i a u de sta di g as i est e t spe ialised o ga isatio s e tu e apital
funds in high growth, high risk, often high- technology firms that need equity capital to finance product
de elop e t o g o th p. .
In the United States of America (USA, hereafter), VC is made up of three types of investing and these are
seed, start-up and expansion investment (Jeng and Wells, 1998). Metrick and Yasuda (2011) conclude
that venture capital is a form of private equity, which is an investment that cannot be traded in public
markets. This view is shared by EVCA (2007) and Jeng and Wells (1998). EVCA adds that VC focuses on
innovative firms in early (seed and start-up) and expansion stages of their existence.
There is a lot confusion surrounding the meanings of VC and private equity (PE, hereafter). Several
autho s defi e p i ate e uit i diffe e t a s. Je g a d Wells defi e VC as o e t pe of PE
i esti g p. . PE e o passes the pa ti ipatio of p ofessio al i esto s, generally on a temporally
asis, i the e uit apital of o pa ies that do ot uote o the sto k a ket Ma ti & Bal oa, ,
p.3).

2. Page 2 of 9
Fe , Lia g a d P o se ote that the p i ate e uit a ket is a i po ta t sou e of fu ds fo
start-up firms, private middle-market firms, firms in financial distress, and public firms seeking buyout
fi a i g p. . Fe e o se es that hile VC is iased to a ds seed a d sta t-up financing, PE
i eases po tfolio fi s’ le e age.
To avoid confusion, throughout this paper, the term VC is used to refer to seed, start-up and expansion
investment in unquoted companies. This is consistent with the way the term is used in the USA.
The Historical Perspective of venture capital
The modern VC industry traces back to the formation of the firm called American Research and
Development (ARD, hereafter) in 1946 in Massachusetts. Massachusetts Institute of Technology (MIT)
President Karl Compton, Harvard Professor Georges F. Doriot and local business leaders were
responsible for the formation of ARD (Jeng & Wells, 1998; Gompers & Lerner, 1999, 2001; Bottazzi & Da
Ri , ; Met i k & Yasuda, . ARD as fo ed ith the sole a date of aisi g fu ds f o
wealthy individuals and college endowments and invest in entrepreneurial start- ups in technology
ased a ufa tu i g Bottazzi & Da Ri , , p. .
However, it is worth noting that ARD was structured as a corporation and was publicly traded (Metrick &
Yasuda, 2011). They add that in the 1960s, VC industry in the United States saw a landmark in terms of
the introduction of the limited partnerships for VC funds. Furthermore, they point out that customarily,
VC investments have focused on the health and IT sectors in the USA.
Overview of the world venture capital industry
The last 30 years have witnessed the impressive expansion of the world VC industry (Da Rin et al. 2011).
The City UK 2010 (as cited in Metrick and Yasuda, 2010) reports that global PE industry is responsible for
$ 2.5 trillion of which half to two thirds is accounted for by buyouts, while VC accounts for the most of
the number of investments deals . Preqin (as cited in Da Rin et al., 2011) report that an average of over
200 new VC firms have been formed per annum beginning the year 2000 and this has led to the raising
of over US $ 50 billion.
VC is deep rooted in the industrialised countries. However, it is important to note that the USA is
responsible for half of the VC activity globally (Metrick & Yasuda, 2011). This is consistent with Da Rin et
al., (2011) though they add that Europe and Asia account for half of VC investment. In the year 2000,
North America accounted for 77 percent of the global PE funds. However, 2010 saw the fall of North
A e i a’s sha e of glo al PE fu ds f o pe e t to 44.5 percent; while Europe accounted for 34.1
percent, Asia accounted for 10.1 percent and the Rest of the world accounted for 10.1 percent (SAVCA
& KPMG, 2011).

3. Page 3 of 9
The venture capital business model
A lot of literature exists about the structure of venture capital industry. The venture capital industry
provides finance and other services to entrepreneurial firms with high growth prospects with a view of
attaining a high rate of return on funds that have been invested in portfolio companies (Timmons &
Spinelli, 2007). The VC business model is made up of portfolio firms, investors, VC firm and the VC fund.
The diagram below represents a venture capital model:
Figure 1.1: The venture capital business model
Disbursement Distribution
Management fee and carried interest
Small equity contribution
Investment Exit proceeds
Source: Da Rin et al. (2011)
Limited partners: Investors
Venture Capital Fund
Companies: Entrepreneurs
General Partners:
VC firms
The VC firm
Scarborough (2011) defines venture capital o ga isatio s as p i ate, fo p ofit o pa ies that
assemble pools of capital and then use them to purchase equity positions in young businesses they
believe have high-growth and high- p ofit pote tial p. . I o de to i est i po tfolio o pa ies
VC firms who are known as general partners have to raise capital from investors such as pension funds,
insurance firms, endowments and foundations and wealthy individuals (Da Rin et al., 2011).

4. Page 4 of 9
The capital that is raised is put into a special purpose vehicle (SPV) called VC fund. Investors also known
as limited partners because they are not involved in the day to day affairs of the VC fund. On the other
hand, general partners are actively involved in the management of the fund (Da Rin et al., 2011). The
function of active participation of VC firms in portfolio companies is at different levels in different
countries. For example, Japanese and German VC firms are less active than their USA counterparts in
managing the portfolio companies they have invested in.
In addition, VC firms in these two countries do not have board representation and are not involved in
the day-to-day running of portfolio firms (Jeng & Wells, 1998).
Structure of VC firms
I te s of VC fi s’ legal st u tu e, Ma e , “ hoo s & Yafeh 2002) find that most VC firms in Japan are
organised as joint stock companies and more often than not are affiliated to banks or securities
companies. They add that in Germany, 25 percent of VC firms are listed companies; while in the UK the
most common type legal structure for VC firms is limited partnerships. However, it is important to note
that about 5 percent of VC firms in the UK are organised as public corporations (Mayer et al., 2002).
Types of investments undertaken by VC firms
Mayer et al. (2002) report that in Germany and Israel, equity financing is the most common type of
investment and in the USA, convertible debt financing is regarded as the most prevalent type of VC
investment. Lerner and Hardymon (as cited in Mayer et al., 2002) assert that equity financing is the most
prevalent among VC firms in Japan. Lerner and Hardymon (as cited in Mayer et al., 2002) indicate that
the VC industry in Japan focuses on investing in older firms as opposed to the American VC industry that
focuses on emerging firms. Mayer et al. (2002) find that Israeli VC firms focus on supplying finance to
o pa ies i ea l phases of e iste e. O the othe ha d, the add that Ge a a d UK VC fu ds
provide financing to companies in all stages, though there is a slight bias towards later stages of
de elop e t p. . Co pa ed to the Is aeli, Japa ese, a d Ge a VC I dust ies, the UK VC I dust
is more global as it has 25 percent of its capital invested abroad. Japanese VC firms have invested 24
percent abroad; while their German counterparts have invested only 15 percent (Mayer et al., 2002).
The VC fund
After fundraising, the VC firm invests in selected entrepreneurial firms and is actively involved in daily
affairs of the firms they have invested in. When the life of the VC fund comes to an end, the VC firm
exits the VC fund and proceeds are distributed to the limited partners who are the investors (Da Rin et
al., 2011; Berlin, 1998). The VC firm is compensated in two parts. One part is called management fee and
the other part is called carried interest (Da Rin et al., 2011; Berlin, 1998).

5. Page 5 of 9
Berlin adds that the management fee is fixed and is typically 2 to 3 percent of money invested. Whereas,
carried interest is variable and is 20 percent of the returns made by the fund. This is consistent with the
view of CVCA (2009). Investors or limited partners get the remaining 80 percent. Da Rin et al. add that
carried interest is based on performance.
According to Metrick and Yasuda (2011) a VC fund has five main characteristics:
. A VC fu d is a fi a ial i te edia , ea i g that it takes the i esto s’ apital a d i ests it di e tl
in portfolio companies.
2. A VC fund invests only in private companies. This means that once investments are made, the
companies cannot immediately be traded on a public exchange.
3. A VC fund takes an active role in monitoring and helping the companies in its portfolio.
. A VC fu d’s p i a goal is to a i ise its fi a ial etu e iti g i est e ts th ough a sale o a
initial public offering (IPO).
5. A VC fund invests to fund the internal growth of companies (p.3).
Structure of venture capital funds
Several authors discuss the structure of venture funds. Venture capital funds are mostly organised as
limited partnerships with fixed lives (Da Rin et al., 2011; Berlin, 1998; Gompers & Lerner, 1999; Metrick
& Yasuda, 2011; Kaplan & Stromberg, 2008) but can be extended if need be by a few years (Berlin,
1998).Traditionally, the general or lead partner supplies at least 1 perce t of the fu d’s apital Kapla &
Stromberg, 2008).
Financing of venture capital funds
The major sources of funds for VC are different in different countries. For example, Fineberg (as cited in
Megginson, 2001) describes the Canadian VC industry as unique because it draws funds from labour
unions. Mayer et al. (2002) point out that in Germany, Israel, Japan and the UK; banks are a significant
source of funds for VC firms.
However, they note that pension funds provide more capital in the UK than in Germany, Israel and Japan
and corporations represent a major contributor of capital in Israel than in the three countries mentioned
above.
In Japan, all VC firms included in the research conducted by Mayer et al. (2002) indicate that they are
joint stock companies and as a result owners provide capital used to invest in portfolio companies.
Mayer et al. (2002) and Gilson and Black (1999) state that pension funds in Germany do not supply
capital or financing to venture capital funds. In the USA, pension funds provide 40 percent of the capital
acquired by VC funds (Gilson & Black, 1999).

6. Page 6 of 9
On the other hand, in the UK, local authorities play a critical role in VC industry than they do in Germany
and their role in Japan and Israel is insignificant (Mayer et al., 2002). The research by Gilson and Black
also indicates that in Germany, banks are the largest contributor to VC funds and while endowments
and foundations provide funds to VC funds in the USA; this is not the case in Germany.
Investors (Limited partners)
Investors in VC funds are known as limited partners because they do not participate in the daily running
of the VC fu d Go pe s & Le e , ; CVCA, . CVCA adds that the ai a age e t
parameters of the fund (management fees, carried interest, investment strategy and restricts) are
defi ed i the li ited pa t e ship ag ee e t p. . O di a il , li ited pa t e s i lude pe sio fu ds,
insurance companies, endowment funds and private individuals (Kaplan & Stromberg, 2008). Kaplan and
Stromberg (2008) observe that provided the general partner is following what is contained in the fund
ag ee e t, li ited pa t e s ha e little to do ith the ge e al pa t e ’s i est e t st ateg .
Portfolio companies
Portfolio companies are firms with high growth prospects in which the general partner invests capital
that has been raised from limited partners. Portfolio companies are also known as investee companies.
Conclusion
Venture capital is still a new asset class in many countries including Zambia. However, in countries like
the United States of America, venture capital has contributed a great deal to the development of SMEs
and capital markets. Venture capital firms provide capital to unquoted companies that would otherwise
find challenges getting funding from conventional capital sources such as banks and capital markets. In
addition to capital, venture capital firms provide expertise to investee companies in form of coaching,
mentoring and counseling.
In Zambia, the venture capital industry is beginning to take shape. 1996 saw the formation of the
ou t ’s fi st e tu e apital fu d alled the )a ia Ve tu e Capital Fu d )VCF . Cu e tl , e ha e a
number of venture capital firms such as Kukula Capital and Aerios Capital. Kukula Capital is currently
running Kukula Fund I and the fund has invested in three portfolio companies namely More Beef,
PostDotNet and Jabulani Sawmills.
The Zambian venture capital industry is destined for growth as the economy is poised to grow at more
than 7 percent in 2013. A growing economy leads to an increase in the demand for venture capital. It is
believed that as the economy continues to grow, the rate of start-up formation will go up and this will
result in high demand for venture capital.

7. Page 7 of 9
References
Aizenman, J., & Kendal, J. (2008). The Internationalization of Venture capital and private equity.
Retrieved June 12, 2012, from
Balboa, M., & Marti, J. (2003). An integrative approach to the determinants of private equity fundraising.
Retrieved July 16, 2012, from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=493344
Berlin, M. (1998).That thing venture capitalists do. Retrieved June 7, 2012, from
http://ideas.repec.org/a/fip/fedpbr/y1998ijanp15-26.html
Bottazzi L., & Da Rin M. (2001). Venture Capital in Europe and Financing of Innovative Companies.
Retrieved July 24, 2012, from http://ecoxs02.eco.unipmn.it/eventi/innovarepercompetere/bottazzi-
darin-vcfic.pdf
CVCA. (2009). Why venture capital is essential to the Canadian economy: The impact of venture capital
on the Canadian economy. Retrieved June 12, 2012, from
http://www.cvca.ca/files/Downloads/CVCA_VC_Impact_Study_Jan_2009_Final_English.pdf
Da Rin, M., Hellmann, T. & Puri, M (2011). A survey of venture capital research. Retrieved July 20, 2012,
from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1942821&rec=1&srcabs=1723882
EVCA (2007) Guide on Private Equity and Venture Capital for Entrepreneurs. Retrieved April 5, 2012,
from http://www.evca.eu/
Fenn, W.G., Liang, N., & Prowse, S. (1995). The economics of the private equity market. Retrieved June
7, 2012, from http://ideas.repec.org/p/fip/fedgss/168.html
Ferrer, A.M., (2010) Effects of venture capital and private equity on investment – cash flow sensitivity of
Spanish firms. Retrieved June 6, 2012, from http://eprints.ucm.es/12865/1/T32627.pdf
Gilson, J. R., & Black, B. (1999). Does venture capital require an active stock market? Retrieved July 20,
2012, from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=219174&rec=1&srcabs=103948
Gompers, A.P., & Lerner, J (1999). What drives venture capital fundraising? Retrieved June 7, 2012, from
http://ideas.repec.org/p/nbr/nberwo/6906.html

8. Page 8 of 9
Gompers, A.P., & Lerner, J. (2001). The Venture capital revolution. Journal of Economic Perspectives, 15.
(2), 145- 168. Retrieved June 7, 2012 from
http://www.aeaweb.org/articles.php?doi=10.1257%2Fjep.15.2.145
Hellmann, T., & Puri, M. (2000). Venture capital and professionalization of start-up firms: Empirical
evidence. Retrieved July 24, 2012, from http://leeds-faculty.colorado.edu/Bhagat/VC-
ProfessionalizationStartup.pdf
Jeng, A. L., & Wells, C. P (1998). The Determinants of Venture Funding: Evidence from countries.
Retrieved July 20, 2012, from
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=103948&rec=1&srcabs=253798
Kaplan, S.N., and Stromberg, P. (2008). Leveraged Buyouts and Private Equity. Journal of Economic
Perspectives, Vol. 22 (number 4), Page 147 – 166. Retrieved June 4, 2012, from
http://faculty.chicagobooth.edu/
Kortum, S., & Lerner, J (1998). Assessing the contribution of venture capital to contribution. Retrieved
May 27, 2012, from http://www.people.hbs.edu/jlerner/VCInnov.pdf
Marti, J. & Balboa, M. (2004). A framework for self- regulation in the venture capital and private equity:
evidence in European markets. Retrieved June 7, 2012, from
www.ucm.es/info/jmas/finemp/dt/0404.pdf
Mayer, C., Schoors, K., & Yafeh, Y. (2002). Sources of funds and investment activities of venture capital
funds: Evidence from Germany, Israel, Japan and UK. Retrieved July 24, 2012, from
http://sapir.tau.ac.il/papers/sapir-wp/3-02.pdf
Megginson, L. W. (2001). Towards a global model of venture capital. Retrieved July 24, 2012, from
http://www.milkeninstitute.org/pdf/Megginson.pdf
Metrick, A & Yasuda, A (2010). Venture capital and other private equity: A survey. Retrieved July 20,
2012, from ttp://www.nber.org/papers/w16652.pdf?new_window=1
Metrick, A & Yasuda, A (2011). Venture capital and the finance of innovation. Retrieved July 20, 2012,
from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=929145
Scarborough, N. M. (2011). Essentials of Entrepreneurship and Small Business Management. 6th Ed.
New Jersey: Person Education Publishing

9. Page 9 of 9
SAVCA & KPMG., (2011). Venture Capital and private equity industry performance survey of South Africa
covering the 2010 calendar year. Retrieved May, 4 2012, from
www.savca.co.za/downloads/savcakpmgprivateequitysurveyfor2010.pdf
Timmons, J. A & Spinelli, S (2007). New Venture Creation: Entrepreneurship for the 21st Century. 7th ed.
New York: McGraw-Hill Education