Chapter 9
Venture capital
Background
9.1
Venture capital is the very early stage external equity funding that
businesses, particularly in innovative industries, may need to start up. The Committee
received far more submissions about lending to small business than about the
provision of venture capital. A brief discussion of venture capital is included
in this final chapter.
9.2
New innovative firms, sometimes called ‘gazelles’, require some form of
equity because until they finish commercialising their product and start making
profits they are not in a position to repay debt (and often have little in the
way of hard assets to offer as collateral). It is probably only a minority of
new firms that are funded by formal venture capital. Most entrepreneurs
initially rely on their own savings, or money provided by family and friends
(also known as ‘love capital’), employees (‘servant capital’) or individual
private investors (‘angel capital’) or by borrowing from a bank using property
as collateral.
9.3
The Reserve Bank note:
Compared with large companies, small businesses tend to make
greater use of debt funding and less use of equity funding; the latter is
generally limited to the personal capital of the owners.[1]
9.4
Venture capitalists tend to be more closely involved in the company’s
operations than a typical shareholder, sometimes acting as a mentor to the
company’s management or holding a seat on the board. Sometimes the provision of
further capital is promised subject to meeting performance benchmarks. Venture
capital fund managers typically specialise in certain industries, such as
biotechnology or information technology. Some now large and well-known
companies, such as Apple, Google, Intel, Microsoft and Starbucks, started life
with support from venture capital. Australian companies to have benefited from
venture capital include Cochlear (makers of the bionic ear) and ResMed (medical
technology).
9.5
As there is inherently more risk in subscribing venture capital than in
making a secured loan, the increase in risk and risk aversion that occurs in
recessions tends to lead to larger reductions in the provision of capital than
in loans.
9.6
The House Economics Committee looked at the medium-term adequacy of
venture capital. A review of ABS data suggested to them that:
...if there is any problem in the venture capital market, it is
not a lack of money coming in but either the poor quality of many of the
companies seeking funding or excessive conservatism of the venture capital fund
managers.[2]
9.7
At least implicitly, Australian governments have apparently regarded the
market as under-providing venture capital, as there have been a number of
programmes to encourage it. Treasury comment:
The Government also supports access to financing for
innovation by investing in Australia’s venture capital market through the
Innovation Investment Fund, which was allocated $224.7 million over 5 years in
the 2006-07 Budget. In August 2009, a further $64 million was invested through
the Innovation Investment Follow on Fund (IIFF) to support venture capital
during the downturn. The IIFF is a temporary response to address the lack of
capital available during the global financial crisis. The IIFF will enable
previously supported companies to continue to develop and to commercialise
research.[3]
9.8
The Reserve Bank noted:
... there is a venture capital market. It is not as large here
as it is in other countries.[4]
9.9
As well as capital, many new ventures need loans and some submitters
claim this has also become harder to attract:
...there has been a significant reduction in the availability
of start up loans from banks and other financial institutions.[5]
9.10
Industry has noted the problem of securing venture capital for small
business:
...a barrier for the new business starting up with an
experimental idea is a financing problem because it is like the chicken and the
egg, you have to prove yourself before you can attract finance and you have to
have the finance to prove yourself. That is an area where we think ideally the
market would provide more funds.[6]
9.11
Asked about the role of government, the Australian Industry Group
replied:
We think that there is a case for government involvement in
those areas where information failures occur, if you like, so that the market
is not working as efficiently as it might. The feedback we received at the time
the Commercial Ready program was axed was that this was having an influence on
the interests of venture capitalists in providing funds to emerging businesses,
that that source of liquidity into that area of the market was withdrawn and
that the flow-on of that was less venture capital was available to small
businesses. That was an area where government intervention was facilitating
lending in that area, but that was withdrawn a couple of budgets ago.[7]
Superannuation funds and venture capital
9.12
A potential source of venture capital is superannuation funds, but they
appear not to have a large involvement. The House Economics Committee's report
commented:
The reason for the limited involvement of superannuation
funds in venture capital is not clear. It may just be that the returns offered
by venture capital are inadequate, or it may be that superannuation fund
managers are being unduly ‘conservative’ in their investment practices.[8]
9.13
Their regulator's view is that:
APRA recognises that investment in venture capital can form a
legitimate part of a diversified portfolio. As with all investments, any
venture capital investment has to be consistent with the investment objectives
and strategy of the fund. The trustee needs to, inter alia:
- make an appropriate assessment of the expected risk and returns
of venture capital investment, with specific regard to the risk profile of such
investments;
- undertake due diligence and ongoing monitoring of venture capital
investments;
- consider the liquidity profile of venture capital investments,
especially due to the requirement to meet future commitments; and
- understand there is greater dispersion of returns from venture
capital funds; as such, the trustee needs to make a stronger assessment of
manager skills.[9]
Equity-loan hybrids
9.14
Another possible type of finance is a kind of equity-loan hybrid where
repayments on the loan are income-contingent, and so the lender shares more of
the risk. The best-known example of such income-contingent loans is the
'HECS' scheme for students. Unlike a normal loan where the lender shares in any
bad fortune by not being fully repaid, it would be possible for a lender to
also share the benefit of a better than expected performance by being repaid
more quickly or even getting a 'bonus' interest rate.
Senator Alan Eggleston
Chair
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