20: Entrepreneurial Finance and Venture CapitalGreg Udell, Indiana
University
‘Firms that access
venture capital finance
typically have loads of
intangible assets on
their balance sheets and
very little in the way of
tangible assets.’
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SMART VIDEOSource: Cengage Learningusually plan to convert to public ownership, either through an initial public offering (IPO) of ordinary
shares or by selling out to a larger company. Once they become publicly traded, EGCs are much more
likely to raise external financing through a further equity offering than are older, larger companies.
Second, the most valuable assets of many of these companies are often patents and other (intangible)
intellectual property rights. Because these rights are difficult to finance externally, they pose a huge
challenge to the professionals who must obtain adequate funding on attractive terms. Amazon
demonstrates this point very well. The company has total assets of around US $55 billion, but it boasts
a stock market capitalisation of around US $285 billion. Third, many EGCs seek to commercialise
highly promising, but untested, technologies. This inevitably means that both the risk of failure and the
potential payoff from success are dizzyingly high. Fourth, EGCs must attract, motivate, compensate
and retain highly skilled technical and entrepreneurial talent – but do so in a way that minimises cash
outflow, because EGCs are often severely cash constrained. Not surprisingly, they partially compensate
employees with share-option grants.
The distinctive features of entrepreneurial finance are that: (1) EGCs rely heavily on equity financing;
and (2) financial contracting between them and their financiers is fraught with information problems.
As we learned in Chapter 13, growth opportunities cannot easily be financed with borrowed money, so
they must be funded with equity capital. Whereas most technology- and knowledge-based companies
struggle to finance growth opportunities with equity, mature companies can obtain the bulk of the equity
funding they need each year by reinvesting profits. EGCs grow very rapidly. They must rely on external
equity financing to fund investments, which vastly exceed the amount of internal funding the companies
can generate. Finally, because most EGCs are privately held, they lack access to public share markets
and rely instead on private-equity financing. Private equity generally means either capital investments by
current owners or funding by professional venture capitalists or private investors, rather than through
public equity markets, as is typically the case for listed companies. Thus, the private equity asset class is
an example of an unlisted asset class. The term is also used to refer to buyout funds, organisations that
manage companies acquired through leveraged buyouts.
In Australia, the term ‘private equity’ is often used to refer to this entire asset class, which ranges from
very early or seed-stage investments to typical venture capital investments, and more broadly to include
later-stage investments such as managed or leveraged buyouts, and even some infrastructure investments.
Alternatively, it is also used in Australia to refer to later-stage (non-venture capital) investments. Thus,
‘venture capital’ in Australia is either a subset of private equity, or refers to a different set of investments
from private equity investments. The Australian Private Equity and Venture Capital Association Limited
(AVCAL) defines a venture capital company as a company ‘that makes equity investments for the launch,
early development or expansion of a business, typically in an innovative/high tech product or service.
Venture capital covers seed, early stage, later stage VC and balanced VC funds. It does not include
buyout investing. AVCAL defines private equity (PE) as a term that ‘covers growth/expansion, generalist,
buyout/later stage, turnaround, secondary and mezzanine funds’.^1
In contrast, in the US, the terms ‘venture capital’ and ‘private equity’ are often used interchangeably,
and are assumed to mean the same thing.
The vast majority of companies, even those that subsequently emerge as EGCs, begin life on a
modest scale, often with little or no external equity financing other than that provided by the founder’s
friends and family. Only after entrepreneurs exhaust these sources of personal equity can they expect
1 Sourced from the 2012 Yearbook Australian Private Equity and Venture Capital Activity Report, November 2012, Australian Private Equity and
Venture Capital Association Limited (AVCAL) in partnership with Ernst & Young, p. 28.
private equity
Financing provided either
through capital investments
by current owners or through
funding by professional
venture capitalists or private
investors, rather than through
public equity markets, as is
typically the case for listed
companies. Thus, the private
equity asset class is an
example of an unlisted asset
class