New resources and new ideas: Private equity for small businesses 1

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1 Journal of Banking & Finance 22 (1998) 1077±1084 New resources and new ideas: Private equity for small businesses 1 George W. Fenn, Nellie Liang * Board of Governors of the Federal Reserve System, Mail Stop 89, Washington, DC 20551, USA Abstract Private equity for rapidly growing small business is raised primarily from the organized venture capital market and the informal market, comprised of high-net worth individuals or ``angel'' investors. We discuss commercially and publicly available data on private equity, the research ndings of studies that use these data, and some of the more important questions that the available data have been unable to address. Ó 1998 Elsevier Science B.V. All rights reserved. JEL classi cation: G24; G32 Keywords: Private equity; Venture capital; Angel investors; Small business investment companies (SBICs) 1. Introduction The issue of private equity nancing for small businesses has received relatively little attention in the empirical literature. This is driven largely by the lack of publicly available data. The limited research on private equity for small businesses has been based on surveys collected by researchers, two databases on venture capital nancings, or data on the small sample of private rms that * Corresponding author. Tel.: ; m1jnl00@frb.gov. 1 The opinions expressed herein are those of the authors and do not indicate concurrence by other members of the research sta or by the Board of Governors /98/$19.00 Ó 1998 Elsevier Science B.V. All rights reserved. PII S ( 9 8 )

2 1078 G.W. Fenn, N. Liang / Journal of Banking & Finance 22 (1998) 1077±1084 eventually go public. 2 In this discussion we describe these and other data sources, how the available data have shaped research, and some important questions that the available data have been unable to address. Firms that get external private equity nancing are a small part of the universe of small businesses. Many more rms can nance growth with retained earnings and external debt, such as bank loans. For rapidly growing rms, such as high-technology rms, however, external equity is a major source of funds. Such rms lack tangible assets and cash ow. At the same time, they are attractive to investors because of their potential for high growth and pro ts. External equity nancing for these rapidly growing small businesses is raised primarily from the organized venture capital market and the informal market, comprised of high net-worth individuals or ``angel'' investors. Venture capitalists provide funds primarily to high-technology rms; over 80% of companies that get venture capital are in computer-related industries, medical-related industries, telecommunications, or health care services. Angel investors may also nance high-technology rms with seed capital, which is often followed by larger investments by venture capitalists. 2. How many small businesses raise private equity? Data from the recently completed National Survey of Small Business Finances (NSSBF) allows us to estimate the proportion of small businesses that get external equity nancing. The data indicate that 4% of corporations tried to raise private equity from new outside investors over a three year period and about one-third of these rms were successful. So the fraction of small business corporations that raise external equity each year is small, about one-half percent. Nevertheless, approximately 12,000 rms, not an insigni cant number, raise equity annually from new outside investors. The data also indicate that angel investors nance many more rms than do venture capitalists. Of the rms in the NSSBF that raised external equity from new investors, almost 10% raised it from venture capitalists and 60% raised it from angel investors. These estimates are consistent with other sources on venture capital. Data sources on organized venture capital investments, discussed below, indicate that between 1,200 and 1,500 companies raise venture capital per year. In addition, these estimates are consistent with the share of rms going public that had been nanced by venture capitalists. That is, of rms going public, approximately one-third had been nanced previously by venture capitalists, while close to two-thirds had been nanced by informal investors (with only a small 2 See Fenn et al. (1997) for an overview of the private equity market.

3 G.W. Fenn, N. Liang / Journal of Banking & Finance 22 (1998) 1077± share relying exclusively on debt and internal funds). Since a greater fraction of rms that had raised venture capital go public ± we speculate this is the case because nancial guidance and expertise is an important characteristic of venture capital nancing ± there must be at least twice as many rms that receive private equity other than venture capital. 3. Data on organized venture capital nancing Two organizations have developed databases that record venture capital investments of professional, institutional venture capital rms. Venture Economics, a subsidiary of Securities Data Company located in New York, has been collecting venture nancing data for about 20 years, while VentureOne, located in San Francisco, has done so for 10 years. Venture capital rms, as de ned by VentureOne, include: ``professional, institutional venture capital limited partnerships generally managing over $20 million in assets making investments in privately held companies generally with a technological or retail/consumer basis. The characterization `professional' refers to the partners' occupations. On a daily basis, the general partners or fund managers have the primary mission of managing the fund and investing the fund's assets. The characterization as `institutional' refers to the investors in the fund. Institutional investors include but are not limited to pension funds, university endowments, private trusts, insurance companies, corporations, 3 etc.'' Neither organization records nancing by angel investors. For each nancing round, Venture Economics and VentureOne obtain information on the amount raised, the nancing stage (seed, early-stage, laterstage, etc), and the identity of the venture capital rm(s) that provide the - nancing. VentureOne takes the process a step further and obtains information about the venture-backed rm's sales and employment and its pre- nancing valuation. In part, this re ects di erences in the data collection methods of VentureOne, whereas Venture Economics relies on the venture capital partnerships for its data, VentureOne obtains information from venture capital partnerships and the venture-backed rms. On the other hand, Venture Economics' database tends to have more detailed pro les of venture capital rms such as their age, the number of partnerships raised, etc. These databases are private, and access to these databases is relatively expensive. The data are not only costly to collect, but they are often collected 3 VentureOne, National Venture Capital Association 1996 Annual Report, p. 72.

4 1080 G.W. Fenn, N. Liang / Journal of Banking & Finance 22 (1998) 1077±1084 on a con dential basis. However, Venture Economics, through Securities Data Company, has made its data available through its Venture Intelligence database product, and VentureOne will make portions of its data available (for a price) to those that ``play a constructive role'' in nancing small businesses. 4 A comparison of total annual venture nancing underscores di erences in the databases. Both sources indicate steady increases in nancing over 1992± 1996, but the level of nancing is between 1.5 and 2 times greater according to the VentureOne database; in 1996, for example, nancing reached $10 billion according to VentureOne, as compared with about $5 billion reported by Venture Economics. The explanation for the di erence here may involve several factors. First, VentureOne probably has more complete coverage of the universe of venture-backed rms; second, VentureOne includes more leveraged buyouts in its database; and third, VentureOne includes nancing rounds involving only corporate investors. Whatever the source of the di erence, researchers need to be aware of such di erences and the possible biases they introduce. Venture Economics maintains a second database on the performance of venture capital partnerships. This database represents the only comprehensive source on returns in the private equity industry that we are aware of. Returns to over 400 private venture capital partnerships formed since the 1970s are included in their database, representing perhaps three-quarters of total funds raised. The return data are summarized by Venture Economics, and access to additional information by outsiders is di cult because returns to speci c partnerships are highly con dential. However, Venture Economics plans to make available for research purposes data on partnership returns identi ed by, for example, size class, type or stage of investment, and year in which the partnership was launched. Their analysis of the return data show that returns to partnerships formed in the 1970s, when the venture capital market was young and ine cient, are very high ± 20±30%. For partnerships formed since then, however, returns as of 1995 have been quite ordinary (with average returns of about 13%). A potential problem in Venture Economics' measurement of returns, in the view of many of those in the industry, is that some of the top funds do not make their performance data available. In any event, little research has been done on private equity returns. 4 Venture Economics can be reached at (+1) VentureOne can be reached at (+1) or at

5 G.W. Fenn, N. Liang / Journal of Banking & Finance 22 (1998) 1077± Data on nancing from angel investors and SBICs The NSSBF provides information about small rms that raise equity from a number of di erent sources (Wolken, 1997). While some rms report raising equity from angel investors and venture capitalists, a much larger number of rms raise equity from existing shareholders or friends and family. The available information on the rm, such as size, industry, and ownership characteristics, should allow for a number of di erent studies on the use of debt versus equity by small rms. Another source of information on small business ownership and equity nancing by angel investors is the Survey of Consumer Finances (Kennickell et al., 1997). Angel investors could be approximated by responses about business ownership, and the wealth of information about such investors could be used to identify the type of individual most likely to be interested in nancing small businesses. Information developed about the rms in which households invest suggests that perhaps 10% of the rms have outside shareholders. Although these surveys were not developed to address speci cally the provision of external equity, they are large and encompass a very wide range of rms and investors. In contrast, surveys that have provided data speci cally about angel investors of high-technology rms and characteristics of angel investors include fewer rms and investors. Looking ahead a couple of years, under a program designed by the SBA and Prof. Bill Wetzel, a larger database of angel informal investors who participate in technology networks that try to match entrepreneurs and investors will be available for research. Another source of data about private equity for small businesses is available from the Small Business Administration's Small Business Investment Company (SBIC) program. SBICs are privately owned investment companies which agree to limit their investments to long-term debt and equity securities in small businesses in exchange for the SBA's willingness to supplement their private capital with SBA guaranteed funding. Most SBICs are set up very much like private venture capital limited partnerships using SBA-guaranteed nancing to supplement private capital. The other type is that established by Bank Holding Companies (BHCs) to make equity investments that are not permissible under current regulations. 5 These BHC-a liated SBICs account for threequarters of the total private capital in SBICs. The major di erence is that they invest only the capital of their parent bank holding company rather than raising and investing funds from other institutional investors. 5 Banking organizations use SBIC subsidiaries to make equity investments because the Bank Holding Company Act of 1956 restricts a bank holding company from holding more than 5% of a company's equity shares.

6 1082 G.W. Fenn, N. Liang / Journal of Banking & Finance 22 (1998) 1077±1084 Over the past few years, SBICs have increased the amount of equity-type investments, particularly after the program was restructured in 1994 to make equity investments by SBICs more viable. 6 In 1996, SBICs invested roughly $1.4 billion in equity or debt-with-equity securities of small companies. These investment data are available from the SBA. The data are based on reports that SBICs are required to le shortly after they make an investment (primarily to show they are in compliance with regulations about the size of the rm in which they are investing). Basic data regarding the type and amount of investment, rm size, industry, and location are available. Also available from the SBA is nancial information about the SBICs, based on report forms led annually. These data potentially could be matched with the investment data. 5. Data and research questions Because of the nature of the data that are available, research on venture capital has focused on the functioning of the market rather than on external equity nancing of small businesses more broadly. This research subjects to a series of reasonable tests the notion that venture capitalists provide valuable oversight and guidance. One series of papers use the Venture Economics database to examine contracting between venture capitalists and entrepreneurs. The contracting features examined include: The staging of investments. Gompers (1995) nds that early-stage rms, rms with fewer tangible assets, and those with more R&D receive more frequent infusions of smaller amounts of capital, which is what one might expect if venture capitalists provide valuable types of monitoring. The syndication of investments. Lerner (1994) nds that syndication is common in early nancing rounds and that experienced venture capitalists o er syndication to other experienced venture capitalists, suggesting that multiple evaluations are considered important in the decision to nance start-ups. Security design. Convertible securities are widely used in venture capital - nancing (Gompers, 1997), suggesting that they are important tools for eliciting entrepreneurial e ort and mitigating risk-taking. 6 The most important modi cation was the creation of ``participating securities'' as a funding mechanism for those SBICs that concentrate on equity-type investing that may yield long-term capital gains but little current income to pay interest on debenture leverage. With participating securities, an SBIC defers paying interest costs until it realizes su cient gains through the sale of its investments to achieve cumulative pro tability. In exchange, the SBA receives approximately a 10% participation in the SBIC's pro ts.

7 G.W. Fenn, N. Liang / Journal of Banking & Finance 22 (1998) 1077± The determinants of board membership. Lerner (1995) nds that venture capitalists' presence on boards increases when CEOs lack entrepreneurial experience and around periods of CEO turnover, suggesting that venture capitalists exercise greater means of control when there is a greater need for their involvement. The bottom line is that venture capitalists are generally very active. Are business angels active in the same way? Much less is known about angel investors and the value they add, as most of our current knowledge is derived from just a few surveys. In one survey of 284 new technology-based rms founded in New England between 1975 and 1986, Freear and Wetzel (1990) nd that angel investors nanced more rms than did venture capitalists but in smaller amounts and at earlier stages. In a survey of 133 investors who t the description of a business angel, Wetzel (1983) nds that angel investors are likely to have an informal consulting relationship or serve on the board of directors. Consistent with being active, most angel investments are made in ventures located relatively close to home (Freear et al., 1994). A second area of research has focused on contracting between investors and venture capitalists. This research documents how venture capitalist compensation and the terms of partnership agreements vary with partnership characteristics such as age, size, and focus, as well as how they have evolved over time (Gompers and Lerner, 1994, 1996). An interesting aspect of this research is the authors' strategy for collecting data. Rather than obtaining data from hundreds of partnerships, the authors contacted a few large investors and gatekeepers who collectively had invested in hundreds of partnerships and had access to these data. A third area of research looks at the pricing of public and private securities of venture-backed rms. Research on the underpricing of venture-backed IPOs ± it is less than for non-venture-backed IPOs ± and on the long-term stock price performance of venture-backed IPOs ± there is no evidence of underperformance as there is for non-venture-backed IPOs ± furnishes additional evidence that nancing by venture capitalists indeed adds value (Megginson and Weiss, 1991; Barry et al., 1990; Brav and Gompers, 1997). On the other hand, recent research on private valuations and fundraising suggests that there can be too much of a good thing. Gompers and Lerner (1997), using valuation data from VentureOne, show that valuations are higher during periods when larger amounts of capital are committed to venture capital partnerships. To the extent that higher valuations are followed by lower returns, this evidence lends support to the popular notion that the market for venture capital is characterized by very pronounced cycles in fundraising and returns. In summary, research on small business private equity nancing is at a very early stage. While existing data have by no means been fully analyzed, e orts to develop new sources of data would be extremely valuable.

8 1084 G.W. Fenn, N. Liang / Journal of Banking & Finance 22 (1998) 1077±1084 References Barry, C.B., Muscarella, C.J., Peavy III, J.W., Vetsuypens, M.R., The role of venture capital in the creation of public companies. Journal of Financial Economics 27, 447±471. Brav, A., Gompers, P., Myth or reality? The long-run underperformance of initial public o erings: Evidence from venture-and nonventure-capital-backed companies. Journal of Finance 52, 1791±1821. Fenn, G.W., Liang, N., Prowse, S., The private equity market: An overview. Financial Markets, Institutions, and Instruments 6, July. Freear, J., Wetzel, W.E., Jr., Who bankrolls high-tech entrepreneurs? Journal of Business Venturing 5, 77±89. Freear, J., Sohl, J.E., Wetzel, W.E., Jr., Angels and nonangels: Are there di erences? Journal of Business Venturing 9, 109±123. Gompers, P., Optimal investment, monitoring, and the stages of venture capital. Journal of Finance 50, 1461±1489. Gompers, P., An examination of convertible securities in venture capital. Working paper. Harvard Business School, Cambridge, MA. Gompers, P., Lerner, J., An analysis of compensation in the US venture capital partnership. Working paper. University of Chicago and Harvard University. Gompers, P., Lerner, J., The use of covenants: An empirical analysis of venture partnership agreements. Journal of Law and Economics 39, 463±498. Gompers, P., Lerner, J., The valuation of private equity investments. Working paper. Harvard Business School, Cambridge, MA. Kennickell, A.B., Starr-McCluer, M., Sunden, A.E., Family nances in the US: Recent evidence from the survey of consumer nances. Federal Reserve Bulletin 83, 1±24. Lerner, J., The syndication of venture capital investments. Financial Management 23, 16±27. Lerner, J., Venture capitalists and the oversight of private rms. Journal of Finance 50, 301± 318. Megginson, W.L., Weiss, K.A., Venture capitalist certi cation in initial public o erings. Journal of Finance 46, 879±903. Wolken, J.D., 1997, ``New'' data sources for research on small business nance. Journal of Banking and Finance 22, 1067±1076, this issue. Wetzel, W.E., Angels and informal risk capital. Sloan Management Review 24, 23±34.