The Role of Venture Capital in Financing

Small Businesses

Marjan Petreski

Abstract

Venture capital is an important alternative for companies that have difficulties

accessing more traditional financing sources and it is a strong financial injection for early-
stage companies that do not have evidence for persistent profitability yet. Firstly, deep pre-
screening process should be performed before investing in small, start-up business because of
the information asymmetries, which in turn are the main cause for adverse selection and
moral hazard problems. Well performed initial scan ensures good investment. Seed capital
provided than enables the firm’s set off.

But what is more important is the conclusion that there is much more than just capital
that flows from the investors to the organizations in which they invest. Indeed, fresh capital
inflow is accompanied with the process of value-adding which provides the company with
monitoring, skills, expertise, help and, basically, reputation for attracting further finance.
Consequently, the role of the venture capital in financing small business is tremendous. The
paper sheds light on these issues.

Keywords: Venture Capital, Small Business, Entrepreneurship, Financing

JEL Classification: G24, M13

 TABLE OF CONTENTS

Introduction..............................................................................................................................2

Why small start-up firms (must) choose venture capital financing? -Venture capital

primary role..............................................................................................................................3

Why invest in promising business? – Venture capitalist perspective..................................4

Venture capital – “rich services package” and innovation stimulator ...............................5

The “dark side” of the venture capital funding ....................................................................8

Conclusion ..............................................................................................................................11

References ...............................................................................................................................12

1
 Introduction

Financing opportunities for small businesses have grown in the last few decades. On

the other hand, entrepreneurships are crucial for the development of every national economy.

Therefore, financing a small business is an issue which continuously captures academic

interests.

Great part of the literature acknowledges that entrepreneurship is the fundament of the

economic growth and productivity performance (OECD, 2004) and, as such, it triggers

creating innovative small firms, which in turn add huge “blocks” in building the national

competitiveness (Pandey et al, 2003). But, on the other hand, because of the high start-up risk

and informational inconsistency, small firms are often highly vulnerable (Berger and Udell,

2002) and face with a harsh financing issues due to the investors’ refusal to “feed” the early-

stage business (Gans and Stern, 2003). In other words, “the problem is that once you have

bled your friends and family dry of cash, sold the cat and remortgaged the house, where do

you go in order to get the wad of cash needed to progress your get-rich idea further?”

(Reynolds, 2000, p.52).

This is the point where the role of venture capital becomes important in financing

small businesses. Moreover, economists agree that venture capital “provide[s] a boost of

adrenaline” (O'Brien, 2001, p.9) for small start-up, innovative and dynamic firms, especially

in the high-tech industry (Bottazzi and Rin, 2002). Therefore, it is said that venture capital

fuels the growth and development of entrepreneurships. This paper aims to evaluate the

contribution of venture capital for such entities and critically evaluate its role in financing

small businesses.

This is achieved by emphasizing the basic role of the venture capital in financing

small business in section one. Than, venture capital is viewed as a box of services which are

2
also important as the very capital provided is. Moreover, this is acknowledged as a main

contributor toward the firm’s professionalization. Finally, in the last part, certain space is

devoted to the less attractive side of the venture capital.

Why small start-up firms (must) choose venture capital financing? -

Venture capital primary role

Even though the process of brainstorming could be really productive and endless,

entrepreneurs must often think about the financial side of their idea. Indeed, one could have

brilliant idea for starting up a smart business, but launching that idea needs fuel – this makes

him troubles. Therefore, such “poor” entrepreneurs must rely on external financing in order

to start their business (Lulfesmann, 2000). Indeed, young, especially innovative and fast

growing businesses find it very difficult the access to traditional ways of financing (Gompers

and Lerner, 1999; cited in Giudici and Paleari, 2000). The latter is due to the fact that these

start-up firms are too small to be fed by public debt and equity markets, than, because of their

infancy, they can not collateralise eventually offered bank loans (Repullo and Suarez, 1998)

and they are associated with a “significant levels of business uncertainty” (Giudici and

Paleari, 2000, p.154), arising from the persistent information asymmetries and high risk

associated with the opportunity to cease. But, this does not mean that the majority of

innovative ideas must go away. A brilliant chance arises for such cases – venture capital.

“Venture capital is thought to be an important alternative for companies that have

difficulties accessing more traditional financing sources” (Manigart et al, 2002, p.103-104)

and it (venture capital) is a strong financial injection for early-stage companies that do not

have evidence for persistent profitability yet (Kleberg, 1998). In other words, venture capital

is needed to trigger, maintain and to speed up the small enterprise’s growth and its

3
performance, and therefore to result in improved profitability. That is its primary role: it is

the main contributor in getting rid of the most financial impediments that occur in the

establishing phase of a new business. (Reynolds, 2000). In other words, it is “seed money”

for the small business; it helps smart ideas to rise up. However, on the other hand, venture

capital financing is associated with high levels of risk, which refers to the uncertainty of the

positive returns that may occur even after a number of years or never (Mason and Harrison,

2004; Klofsten et al, 1999). Not only this, but venture capitalist may also embark on a new

business strategy which defers from entrepreneur’s one; the former can even throw the

entrepreneur out of the firm. These aspects are discussed later.

What is sure, once it has been agreed, venture capital flows in the company and

enables its start-up. This is the point when the idea becomes reality. But, not only providing

the capital, venture capital injection brings more benefits for the venture-backed company

than one could think of. Manigart and Sapienza (1999; cited in Manigart et al, 2002) point out

“its roles of pre-investment screening, post-investment monitoring and value-adding” (p.104).

Critically said, venture capitalist becomes active entrepreneur’s mentor, because, from now

on, firm’s destiny turns out to be his concern too. Having this on mind, the result should be

higher future returns for the investor and, of course, enhanced performance for the venture

capital backed company. Consequently, when the role of the venture capital in financing

small businesses is discussed, it can be inferred that it is multiple. Therefore, more attention

to the latter is devoted in the following sections.

Why invest in promising business? – Venture capitalist perspective

It is vast agreed and practically proven that venture capitalists invest only in

promising projects. At the very beginning, investors are deeply sceptical, bad mood reasoning

4
with more answers “no”, rather than “yes” (Mason and Rogers, 1997; cited in Mason and

Harrison, 2004). Furthermore, venture capitalists screen potential investments in regards to

the collecting information about business, its market approach, management team or

entrepreneur (Berger and Udel, 1998; cited in Baeyens and Manigart, 2003), all in order to

reduce the initial information asymmetry and potential problems with entrepreneurs. In other

words, before final contracting, venture capitalist spends much of his time and efforts in

assessing and observing the opportunity, in terms of its market size, strategies, customer

adoption etc. (Kaplan and Strömberg, 2001b). This, in turn, should eliminate the possibility to

access a non-quality project (adverse selection problem) and “... [should] ensure that the

funds will not be diverted to fund an alternative project (moral hazard problem)” (Berger and

Udell, 2002, p.32). In this phase of initial scanning, investor should be convinced that his

money will not simply “evaporate”. Instead of that, it should make future value for him.

Pre-screening phase, accordingly, enables platform for contracting on a sustainable

basis. This means that the investment will surely bear fruit later. Thus, venture capitalists

provide the capital and begin with creating new value, which they can extract benefits for

themselves from. Consequently, the role of the venture capitalist is dual: careful selection of

promising firms or projects and than close observation over time (Kaplan and Strömberg,

2001a; cited in Hellmann and Puri, 2002a). The latter constitutes the next phase of the

process of venture capital financing accompanied with creating new value.

Venture capital – “rich services package” and innovation stimulator

Even though the main role of venture capital is feeding small, innovative and fast

growing firms with fresh capital, many articles (Giudici and Paleari, 2000; Kortum and

Lerner, 2000; Bottazzi and Rin, 2002; Hellmann and Puri, 2002a; Sætre, 2003; Wilson, 2005)

5
suggest that venture capital backed firms receive many other services from venture capitalist

which are as much important for the entrepreneur, as the very capital infused is.

In their article, Giudici and Paleari (2000) argue that as the capital is introduced in the

firm, venture capitalist gains power to dynamically impinge on the management process in

the firm in many different ways. Vast literature recognizes the last as a process of adding new

value to the venture capital backed company. Indeed, the process of pre-investment screening

discussed above, aims to provide stabile platform for investing in a company where the

venture capitalist is convinced that he can add value to (Reynolds, 2000).

The mission of the venture capitalist is to raise the business and not just to get reward,

because as the business is raised, the rewards will come automatically (Pandey et al, 2003).

Instead of that, “riding” together with the entrepreneur is more crucial for being rewarded.

Broadly speaking, raising a business means that venture capitalist provides complete

oversight to the firm, in terms of provided services, help and guidance for the entrepreneur

(Lerner, 1995). Indeed, venture capitalist introduces a package of services in the firm in order

to enhance its performance and its value.

One of the most important services for the venture capital backed firm is the expert

advice that venture capitalist offers to the entrepreneur. Indeed, investor acts as

entrepreneur’s mentor, because, investing in nearby located start-up firms, means that he has

sufficient knowledge for the industry, and therefore he can be involved in designing

strategies, hiring the best executives and enhancing the network of contracts with suppliers

and costumers (Bottazzi and Rin, 2002; Hellmann and Puri, 2002a). According to Jungwirth

and Moog (2004), this specific knowledge establishes basis for advanced assessment of the

project: will it be successful or not and allows it “to be monitored at lower agency costs”

(p.111).

6
 Moreover, value-add process facilitates the venture capitalist as a firm’s promoter and

consultant (Repullo and Suarez, 1998), because of his richness of expertise, competencies,

experience and reputation (Sætre, 2003; Wilson, 2005). In the same line of thinking, Fried

and Hirish (1995) also agree that venture capitalists create value by providing “networks,

moral support, general business knowledge and discipline” (p.106). Kaplan and Strömberg

(2001b) further broaden the areas where the investor could be contributable: “developing a

business plan, assisting with acquisitions, facilitating strategic relationships with other

companies, or designing employee compensation” (p.429). It can be inferred that, once the

investor introduces its money in a business, he must devote much of his time in helping the

business to succeed, structuring internal organization and appropriate human resources

management (Hellmann and Puri, 2002b). In other words, venture capitalist’s help and

adding-value are decanted in professionalization of the firm. Generally, it seems that firm’s

professionalization is the major benefit from the venture capital financing.

The article of Hellmann and Puri (2000; cited in Bottazzi and Rin, 2002) offers good

explanation of the process of professionalization. Besides above mentioned features, they

point out the speed of developing and bringing ambitious product to the market by venture

backed companies. Moreover, this is crucial to achieve market leadership, especially among

innovative firms (Hellmann and Puri, 2002a). “Venture backed companies are, in fact, found

to pursue more radical and ambitious product or process innovations than other companies”

(Hellmann and Puri, 2000, p.236). Furthermore, Kortum and Lerner (1998) found that

venture capital financing strongly impinge on firm’s innovation, patenting processes and the

influx of technological opportunities. Consequently, this is the unique way to extract the

social significance of an innovation (Gans and Stern, 2003). Hence, triggering innovations,

along with the firm’s professionalization, is another valuable feature of the venture capital

funding.

7
 All in all, contribution of the venture capital to the start-up firm is considerable.

Besides many features provided by the venture capitalist discussed above, venture capital has

one more important attribute: providing credibility, it attracts new funding. Baeyens and

Manigart (2003) explain this by the fact that, through screening, observing and value-adding,

venture capitalists reduce the information asymmetries and financial risks, and therefore

adjoin legitimacy to the venture backed company and consequently influence on further

financing. The last is an admirable fundament for further expansion of the firm. This, in turn,

spurs the growth and development of entrepreneurship in the national economy in general –

the initial notion at the very beginning of this paper.

Up to now, one may conclude that venture capital funding is brilliant way of raising

new business and realizing one’s “imagination”. Indeed, the role of venture capital in

financing small early-stage business is noteworthy, but this way of funding new business has

its “dark side” too. This is examined further.

The “dark side” of the venture capital funding

Once the venture capitalist and the entrepreneur have ended up the initial

negotiations, and the former introduced its capital in, joint efforts should lead toward

improved performance and higher expected returns. Both sides develop and contribute

different types of knowledge and skills, “allowing each party to exploit its comparative

advantage” (Cable and Shane, 1997, p.143). Moreover, confidence is crucial in entrepreneur -

venture capitalist relationship and corresponds with a certain level of certainty and trust,

which in turn promotes mutually compatible interests, but not acting opportunistically

(Shepherd and Zacharakis, 2001). Not surprisingly, at one moment, a prisoner’s dilemma

arises: each side tends to behave selfish, although knowing that joint success yields to

8
synergy (Cable and Shane, 1997). Consequently, a conflict of interests comes up. At that

point of time or even earlier, the investor strengthens the monitoring process of the firm.

Now, he does provide not only value-add services, but he actively involves in running the

firm in order to limit or eliminate eventual opportunistic behaviour from the entrepreneur

(Lerner, 1995) and to force him to perform effectively.

As a result, agency problems often occur. “Conflicts arise in such situations because

the entrepreneur may have information unknown to the venture capitalist and may choose to

shirk or overinvest, creating agency costs” (Barry, 1994, p.6). But, Admati and Pfleiderer

(1994) describe venture capitalist as well-informed, so it is high probable that agency

problems will be avoided in such risky investments.

Whether it is, hedging itself is the most common strategy for the venture capitalist.

Stage financing is the most suitable monitoring and control device, acting as a buffer versus

entrepreneur’s opportunistic behaviour, because each time new capital is introduced in the

firm, contracts’ renegotiation arises as a necessity (Giudici and Paleari, 2000). Renegotiation

leads toward reporting what has been done until now, and what is the basis for the further

running of the firm. Instalment financing takes place after every renegotiation, only if certain

milestone (i.e. enhanced profitability, approached additional market share) is achieved; at this

point venture capitalist gathers information and always bears on mind the option to abandon

the company if something went wrong (Gompers, 1995; cited in Bottazzi and Rin, 2002).

These considerations are the most cited reason in the literature, why the optimal contract

between venture capitalist and entrepreneur should not be debt (Bergemann and Hege, 1998;

cited in Bottazzi and Rin, 2002). Instead of debt, convertible securities should be positioned

in the basics of this relation, in order to evoke efficient behaviour from the entrepreneur

(Repulo and Suarez, 1998). Furthermore, “a convertible … contract assigns the venture

capitalist the right to accrue a pre-specified equity fraction when he decides to convert debt

9
into equity after both parties invested” (Lulfesmann, 2000, p.3). And the latter usually occurs

when renegotiating happens and when new great stake of money is infused in the firm.

Conflict of interests often results in another form too. Namely, the treatment of the

firm’s founder (entrepreneur) is also the most controversial issue in venture capital

(Hellmann and Puri, 2002a). Even though there are many possibilities ranging from those

where entrepreneurs claim that venture capitalists are “notorious for removing founders from

the position of CEO and bringing in an outsider” (Hellmann and Puri, 2002a, p.21), to those

where venture capitalist counts the change as contribution to the firm’s professionalization,

literature often points out that CEO replacement takes place after experienced enterprise’s

crisis and when strengthened monitoring is found essential (Lerner, 1995). Hellmann and Puri

(2002b) examined a sample of 170 high-tech firms in Silicon Valley and found that outside

top manager usually replaces the founder if the firm is venture capital financed. Furthermore,

they found that these firms can even faster accommodate to such changes in leadership,

because, primarily, the latter further professionalize the firm.

The above findings are supporting what Barry (1994) acknowledges in his article, that

venture capitalists actively identify and recruit members of the management team in the

venture backed company. In other words, they usually reshape management team. Moreover,

investors tend to hold a board or managerial seat in the firm in which they have invested, in

order to access closer oversight and to reduce agency problems (i.e. possess overall control if

difficulties occur) (Lerner, 1995). At the end, even though many control devices, emphasized

above, are used by the venture capitalists to enhance firm’s performance and minimize the

influence of potentially risk causes, Kaplan and Strömberg (2001b) found that venture

capitalists “do not intend to become too involved in the company” (p.429).

All in all, albeit venture capital has its “bad” side too, it comes up that it is not too

bad: it is only a tool for control and, therefore, for better performing. But, having the bad side

10
in account, however, the venture capital’s role in financing small businesses is not

diminished. Rather than that, potential conflicts between investor and entrepreneur could be

avoided with confident and trustworthy behaviour, where the role of the entrepreneur and that

of the venture capitalist are going in the same direction, in order to extract the maximum

benefits for the firm and for themselves, of course.

Conclusion

Several conclusions could be extracted from the arguments supplied above. Firstly,

deep pre-screening process should be performed before investing in small, start-up business

because of the information asymmetries, which in turn are the main cause for adverse

selection and moral hazard problems. Well performed initial scan ensures good investment.

Seed capital provided than enables the firm’s set off.

But what is more important for the purpose of this paper is the conclusion that “there

is much more than just capital that flows from the investor to the organizations in which they

invest” (Sætre, 2003, p.85). Indeed, fresh capital inflow is accompanied with the process of

value-adding which provides the company with monitoring, skills, expertise, help and,

basically, reputation for attracting further finance. Consequently, the role of the venture

capital in financing small business is tremendous. Even though findings in the last section

show that venture capital funding is related with strengthened control, potential conflict of

interests and founder replacement from the top manager’s seat, venture capital remains

crucial factor for spurring innovations, enhancing growth opportunities, especially for the

small and medium-sized enterprises and therefore, creating new jobs. The latter are enough

reasons for every national economy to take care for the venture capital financing as proven

chance for the realization of smart ideas.

11
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