Financing+2

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===Venture capital financing and other investment alternatives for technology companies: Risk Capital in Developing and Middle-income Countries===

Module 1 Issues and questions
Frequent issues raised when discussing investment capital in developing countries and emerging markets include:

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 * 1) Developing countries need to set the right balance between investing in (i) technology commercialization and investing in (ii) technology absorption, together with investment in building the capacity to support technology translation and development.
 * 1) Developing countries should understand that capital for investment does not exist in isolation. It is critically important to have an “ecosystem” including, but not limited to, such features as: provision of advisory services, a supportive IP regime, access to markets, an effective governance structure, exits for investments and the rule of law.
 * 1) Many developing countries use the term “venture capital” for the concept of an investment vehicle, frequently wholly or partly publicly funded, designed to support technology-based or “innovative” businesses. In most cases the intended model is not a traditional venture capital fund as found in developed nations, and use of the term “venture capital” may cause confusion.
 * 1) Furthermore, traditional venture capital is not appropriate for most developing countries which lack, or have an underdeveloped, infrastructure necessary for venture funding such as a strong flow of investable opportunities, stock markets and a large business sector for public listing or trade sales, and an entrepreneurial culture where risk and failure is acceptable.
 * 1) Several factors have caused a recent interest in alternative financing mechanisms for developing countries, including difficulties in scaling-down the traditional venture capital limited partnership structure, and increasing developing country government interest in using public funds to invest in new businesses and new product generation.

In this discussion technology commercialization refers to the development and commercialization of indigenous technologies for local use and transfer to other developing and developed countries – for example from universities and public research institutes or small and medium sized businesses - and/or development and commercialization of new products or services from imported and adapted technologies. Technology absorption refers to the absorption and adaptation of new to the country and/or new to the firm technology and know-how developed outside the country and imported and adapted for local use – for example for upgrading a firm’s capabilities.

Investment in both technology commercialization and technology absorption can be effective methods for creating new firms or growing existing ones leading to economic development and job creation. In this report we shall use the generic term “investment capital” (also known as “risk capital”) to describe these kinds of investments.

We will not discuss why technology companies need investment but, we will assume there is a demonstrable need for government intervention in the investment marketplace. We will attempt to provide some practical ideas for ways in which developing/middle-income countries can establish investment vehicles suitable for their own ecosystems.

Not all companies will need investment. Some will be able to “bootstrap” – that is manage to generate early sales of products so that paying customers can provide the development funds needed. It is important to emphasize that the whole question of investment capital can only be considered in the context of an individual country’s total support ecosystem (policies, culture [xx], business climate, availability of skills, etc). For example a country should:


 * Assess the legal framework and national innovation capacity for technology absorption and adaptation and commercialization and recommend policy changes to facilitate this spin-in/spin out process.
 * Build the institutions to facilitate this spin-in/spin-out process.
 * Train local staff to handle these highly technical, specialized tasks.

Thus, the main challenges for a developing country or region is to:


 * Create a sufficient deal flow of quality opportunities for investment.
 * Develop an ecosystem to support deal flow and investments.
 * Invest limited amounts of capital in a “smart” fashion, especially to attract private sector participation.
 * Access resources needed to scale up successful investments.

Key financing needs in the inclusive innovation technology transfer and commercialization, and entrepreneurial development value chain should be identified and addressed. Early stage financing remain difficult issues even in developed markets. Investment capital is moving to later stages, that is avoiding technology risk, in developed markets and even in some developing markets such as India. The basics of the classic investment capital model, that twins financing with technology and management advice, need to be replicated in emerging markets. However, alternate finance systems are emerging – often taking advantage of web 2.0 technologies - as today’s venture capital model is being questioned as inadequate, restricted, or even broken. New, especially early-stage, financing vehicles are appearing. Crowdsourcing [xx] of early stage investment and monetizing patent portfolios are among a growing number of open innovation based methodologies. Not all of these new initiatives will be proven viable and some may be simply fads, but they should be evaluated.

Israel Yozma fund http://www.yozma.com/home/

Questions to ask
We should begin by asking where do we want to end up? What problems are to be solved or needs to be met? Only then can we turn to the issues or whether or not the provision and use of investment capital could help accomplish the expected outcomes. Businesses and country governments often believe that what they need most is investment capital when in fact this may not be the immediate critical need. Also, before investment capital can be deployed effectively and efficiently it may be necessary to make improvements in a country’s IP regime and improve the support ecosystem. But, it is also necessary to be realistic about what improvements can be made in the short-term. Waiting until there is ideal legislation is in place, or a fully functioning support system, will mean delaying action indefinitely. The state of such systems is built into the risk assessment of investment in a country.

In more detail:

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 * What is the reason for investing in technology projects or technology companies? Is it to earn a financial return on the investment, to create economic development or social good, or other reasons? The purpose of an investment or investment strategy should be decided and made clear to all involved at the start of the process.
 * If an investment fund or other investment vehicle is to be developed then the question is: how much money will be dedicated to the fund or other vehicle and under what conditions or constraints? The question of the amount of funds available is critically connected to the question of what is the purpose and investment strategy of the fund? Some public investment funds have sizeable amounts of money but have not succeeded due to a poorly conceived or implemented investment strategy. Others with limited amounts have no been able to support businesses to become self sustaining.

Module 2 Investment Models: General considerations
We will use the term, “investing in a technology” to cover what is typically the broader investment not only in an invention or a technology, but also an investment in the management team for example. The critical importance of the management team is indicated in the often quoted comment that it is better to invest in a mediocre technology with an excellent management team than a superior technology with a poor management team.

Models for technology and innovation investment fall generally into these categories:

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 * 1) Grants may be wholly publicly funded or require matching private sector funds in some public-to-private ratio. No repayment is usually required for grants, but optional partial repayment based for example on success of the business which has been supported has been attempted.
 * 1) Loans may range from micro-finance to large scale loans, sometimes with specially adjusted interest rates and with public and/or private sector components.
 * 1) Technology firms may have difficulties in providing loan collateral as most of their assets will be intellectual rather than real property. Another form of a loan is a bond issue by a national or regional government, although this is rare in the technology space.
 * 1) Equity investments are typical of venture and seed capital funds as well as for angel investors. A share of the ownership of the company is taken in expectation of the share increasing in value because of the investment made and assistance provided by the fund management or other advisory service providers. Return on investment is expected when the investment fund cashes out through a sale to a strategic or a financial investor, merger, public offering, or other exit.
 * 1) Guarantees are an under-used facility, but for example a government could guarantee the principle of a loan or the amount of an initial investment thus reducing the risk for private sector investors in high risk situations. Governments could provide guarantees to bonds issued by investment banks.
 * 1) Public-private partnerships involve co-financing by the public and private sector partners. Such partnerships are typically used for infrastructure development and large scale engineering projects, but may have underutilized potential in the technology space.

Investment criteria
Any investment fund or individual investor will seek projects offering potential for attractive growth and earnings. Key criteria may include: > > > > > >
 * 1) A strong and committed core management team with a demonstrated performance track record, commitment, enthusiasm and energy.
 * 1) Sales of products or services locally or in other markets.
 * 1) Potential for scaled-up of the business.
 * 1) Potential for sustainable high growth for the business.
 * 1) Ability to sustainable long-term competitive advantage.
 * 1) A viable business model followed by a viable business plan delivering an attractive return on investment.
 * 1) A strategy for a clear investment exit within a reasonable time period.

Public, private or public-private partnership funds will have different criteria as the basis for investment decisions. This will depend on (as noted on page xx) whether the objective is to earn a financial return on the investment, to create economic development or social good, or other reasons.

Stages of Investment
Before considering criteria and vehicles for different types of investment it will be helpful to review typical equity investment stages. These do not have clearly defined boundaries, and variations will be introduced later in this Note, but may be generally defined as:

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 * 1) Angel Investment: An angel investor is someone who provides backing to very early-stage businesses or business concepts. Angel investors may group together to form angel investment pools.
 * 1) Seed Fund Investment: A pool of money used to back companies which are too small to attract venture firms.
 * 1) Venture Capital Fund Investment: Venture capital funds pool and manage money from institutional investors seeking private equity stakes in small and medium-size enterprises with strong growth potential. Venture capital funds usually invest at several stages of a businesses development, including:


 * //Start-up//**: Funding for businesses at the early stage of product or service development.


 * //First-Round//**: Funding for businesses which have initial sales.


 * //Second-Round//**: Working capital for early stage companies that are selling product, but not yet turning a profit.


 * //Third-Round//**: Expansion funds for a profitable company (also called mezzanine financing).


 * //Fourth-Round//**: Financing for exit preparation such as an initial public offering (IPO) or sale, also called bridge financing.

Module 3 Investment models: Examples
This section will describe several investment vehicle models within the general categories presented above.

The Portfolio versus the Agent model.
There is a current debate in the technology transfer community over which approach is better for commercializing technology from universities and research institutes; the “portfolio” model which supports many opportunities hoping a few will be big hits, or the “agent” model which picks a few opportunities and provides intensive support for each.

The “portfolio” or “accumulation” model. In the USA, the Bayh-Dole ActAnchor] of 1980 which encouraged universities to commercialize the results of research has, in many cases, led to technology transfer/commercialization offices accumulating a large portfolio of technologies in the hope that there will be a few big hits in the portfolio. Budget constraints mean that in-depth attention and support cannot be given to each case. What matters is whether the portfolio performs well overall.

The “agent” model. Another approach is to provide focused and intensive support to a small number of promising technologies, work with the development teams, provide management services, and introduce intermediaries for marketing or finance for example. This is the opposite of the portfolio approach because clearly a much smaller number of cases can be handled. The problem of course is how should this small number of cases be selected and others no longer supported?

Both approaches need to consider issues such as: how close is the research to markets, the cost of IP protection, the cost of agent services, and how dedicated is the research organization to commercializing technologies?

Partnership Models
The principle of the partnership model is that any developing country team which is commercializing a new technology, adapting (sometimes referred to as “translating”) an existing technology for new uses, or developing a solution to a need, will typically lack the capacity to produce a fully marketable product or service. A partner is needed, or perhaps more than one partner, which has the necessary skills which the development team needs. These partners may be located in the team’s country or may be elsewhere in the world. For example, if the product or service is aimed at markets outside the country then the partner may be in a targeted country. In addition to market access, partners may provide services such as product development, product design, and testing to meet standards. Having a partner in a stable developed country may also be a conduit for investment; investors may feel more comfortable knowing their investment, and investment returns, will flow through such a partner. Another advantage of the partnership model is that it can reduce overhead costs and at the same time increase flexibility.

There are several possible variations on the partnership model. For example: the Distributed Partnering Mode [xx] which has been proposed by the Kauffman Foundation and developed for US needs, but could relevant to developing countries. This model emphasizes the importance of advancing innovative technologies and products rather than building individual companies around new technologies. This model has four independent entities that work collectively to advance innovation, each with its own rational investment risks and rewards.


 * Discovery**: A research institute that focuses on new discoveries.
 * Definition**: A company that invests in defining the initial product(s) from the research-based discoveries in a given field of expertise.
 * Development**: A company with responsibility for funding and advancing product development.
 * Delivery**: A company with a significant marketing and distribution channel.

The new feature of this model is that it focuses on these independent groups to collectively contribute to advancing products from research discovery to commercialization. According to the Kauffman Foundation, “The model focuses on advancing products as opposed to companies. We need thousands of new products, not thousands of new companies.”

Another variation is to have a single partner entity, inside or outside the developing country, responsible for defining products, identifying market needs (or the possibility of creating a new market), advancing product development, and marketing. Typically, a contract research organization (CRO) carries out these functions for its industrial clients and would be best suited for this role.

Both these variations propose a more efficient use of infrastructure and product development expertise provided by professional service providers (PSP). Potential investors in the product definition company would include angels, large corporations, venture capital funds, foundations, etc., and investor focus would be on their field of interest and the expertise of the operating team. Instead of investing in infrastructure, as was the norm for the venture capital start-up company model, the translational experiments to reach “proof of relevancy” would be contracted to PSPs to perform the key development activities. In this model the PSPs would become a significant force for providing expertise in a given area. Developing country governments can be investors alongside the private sector and take a share of the profits.

Front-end Model
Over time, the venture capital model has been increasingly challenging to maintain. It has proven difficult to fund start-up companies and achieve a sustainable and acceptable return on investment based solely on an early stage discovery. The highest investment risk occurs at the early stages of technology development. Sometimes called a “first loss” fund, one model is to set up either a non-profit company or government/public sector fund designed to finance very early stage needs and squeeze out some of the risk to attract later stage investors. Such entities must have a light weight infrastructure and efficient management.

Venture Capital
The basic elements of a venture capital fund are described here.

Private equity capital is capital invested in private companies; that is, companies not listed on a stock exchange. Venture capital [xx] is a form of private equity typically provided for early-stage as well as more mature companies with substantial market potential. Returns on venture capital investment are from a trade sale (sale to another company) or an initial public offering (IPO) on a stock exchange. Venture capital firms typically raise their funds from institutional investors and high net worth individuals who become limited partners in the venture capital fund. Venture capital funds will not only provide money, usually in tranches, but will nature and mentor their investee firms. Venture capital funds are very selective in making investments. A fund may review many hundreds of business plans before investing in one opportunity. By their nature venture capital investments are high risk and investments may fail. On average, about one in ten venture capital investments will provide a substantial return on investment, others may fail or provide insufficient returns to justify the investment (sometimes known as “the living dead”).

Venture capital firms are typically structured as limited partnerships (“limited” because they limit the liability of the limited partners) the general partners of which serve as the managers of the firm and as investment advisors for the venture capital funds raised. Investors in venture capital funds are limited partners and therefore passive investors. These limited partnerships are closed-end funds, i.e. they have a limited lifetime, typically around 10 years. This means that the fund must exit their investments in say 5 to 7 years, and this need will be a factor in selecting opportunities in which to invest. One effect of the financial crisis has been a shortage of profitable exits for investments which has meant that venture capital funds have had to hold and support their investments for longer than usual. This can be a problem for a limited life fund.

Venture capital fund management teams (general partners in the limited liability partnership fund structure) receive a combination of management fees and carried interest (sometimes called the "2 and 20" arrangement). Management fees consist of an annual payment of typically up to 2% of the committed capital under management. Carried interest is a share (typically 20 - 30%) of the fund’s profits as a performance incentive. The remaining 80% of the profits are paid to the fund's investors. Management compensation in the form of a percentage of the fund’s capital means that there is a lower limit on the amount of capital necessary to adequately support qualified management teams. Thus, this venture fund model cannot function if only small amounts of capital are available (e.g. seed funds therefore have to consider other management structures and compensation systems).

Venture Capital: Corporate structure
A few venture capital funds are structured as corporations, having no fixed lifetime, rather than limited liability partnerships. The IP Group plc, UK, (www.ipgroupplc.com/ipo has developed a business model based on long-term partnerships with universities to provide funding for university spin-off firms. Although all partnerships are tailored to the requirement of the university partner, IP Group offers the following benefits to its partners:


 * Significant support for its partners' IP commercialization activities and, in particular, expertise in the identification of novel intellectual property with commercial potential
 * Seed capital finance for portfolio companies
 * Ongoing strategic and financial support for portfolio companies to maximize their chances of success

The IP Group’s extensive expertise in the area of commercializing intellectual property combined with its inside knowledge of both industry and finance have enabled the group to create a formidable track record of consistently delivering excellent results for shareholders and partners. The IP Group was created as a private investment but later was listed on the UK Alternative Investment Market (AIM). Several of its investee firms have also had IPOs on AIM as their exits from the IP group’s equity stakes, returning capital to the IP Group for recycling among new investments.

Angel Investment
Angels investors are typically individuals who invest their own funds, although angel investors may band together to form investment clubs. There is also some evidence that angel-funded startup companies are less likely to fail than companies that rely on other forms of initial financing, probably because angel investors provide more hands-on help.

Angel capital provides very early stage financing to supplement what the business creator can provide from his or her own resources. Angel investors will typically want to see that the business creator or inventor of a new product has their own money invested to provide a level of confidence and commitment. Angel investment is a common second round of financing for high-growth start-ups, and accounts in total for almost as much money invested annually as all venture capital funds combined, but into more than ten times as many companies ($26 billion vs. $30.69 billion in the US in 2007, into 57,000 companies vs. 3,918 companies).

Angel capital is typically, in developed countries, in the tens to hundreds of thousands of dollars – well below the level at which a venture capital company has any interest. The Angel investor will usually invest their money into a business working in an area of technology in which they have experience. Thus, in addition to money the investor may provide valuable experience.

Venture Capital Trust model
Some developed countries, as a way to provide tax relief to investors, have established Venture Capital Trusts. In the UK for example, the Venture Capital Trust (VCT) is a closed-end investment scheme listed on the London Stock Exchange and designed to provide capital for small expanding companies and capital gains for investors. A VCT is a form of publicly traded private equity which invests in private (unlisted) companies. Investors benefit from tax relief in the form of exemption from income tax on dividends on ordinary shares in VCTs, and exemption from capital gains tax on disposal of shares in VCTs. VCTs may invest up to 1 million pounds in a qualifying company but each individual investment cannot make up more than 15% of VCT assets. The gross assets of the company into which the VCT invests must not exceed 8 million pounds following the investment. This model is of course only relevant to investors who are paying income tax at a level where some legal shelter is beneficial, and is thus not appropriate for all countries, but is another form of public investment.

Angel Investment Networks
Angel investors may want to invest in deals which do not require large amounts of later stage funding. A later stage investment of tens or hundreds of millions of dollars will overwhelm an Angel investment of say $25,000 to $100,000. For example, a clean tech investment may have much higher funding needs and a longer exit horizon than a software deal; making the latter more attractive to an angel investor.

The Oxford Investment Opportunity Network, UK (OION, http://www.oion.co.uk) is an investment network that focuses on innovative technology companies with high growth potential. OION aims to match entrepreneurs seeking business development funds with groups of business angels and other investors, and secures investment rounds of between 200,000 and 2 million pounds for between 10 and 15 companies each year.

OION links investors with companies seeking funds through investment meetings and by direct introduction between companies and investors. For companies seeking investment, OION provides active investors who can add value to growing businesses. In the five years from 2001-2002 through to 2005-2006, 92 deals were closed raising 19.1million pounds. On average, one in three of the companies using OION receive funding from members; an extraordinary high proportion when compared to venture stage financing probability.

OION carefully selects businesses for presentation to investors according to key criteria including:


 * High growth potential
 * Intellectual property rights ownership
 * Proof of principle
 * Access to a growing market
 * Entrepreneurial flair

Before the investment meeting, companies have an opportunity to test their business proposals before an Investment Readiness Panel of investors, which will typically include an angel investor, an institutional investor, plus professionals from OION's sponsors. They have specialist experience in dealing with early stage technology businesses and provide practical advice to improve the presentations.

Companies present their business proposals to investors at OION's monthly investment meetings. They also include networking opportunities, enabling the parties to meet on an informal basis. Meeting Programs are sent to investors in advance of each meeting.

Social Investment Funds Social investment funds invest “patient capital” (investments that provide social and environmental returns in addition to financial returns). Social investments fund will typically invest in opportunities:


 * With the potential for significant social impact.
 * Which make a product or deliver a service that addresses a critical need at the BoP.
 * Which have a business model that shows potential for financial sustainability within five to seven years.
 * Which have an objective of reaching large numbers of end users within a five year period.

Module 3 Implementation of investment capital systems: Lessons Learned
Some are saying that the Western venture capital model is “broken” and that new structures and procedures are needed. There are also ongoing discussions in the technology transfer community about changes to traditional thinking and how accomplish more with fewer resources.

Developing and middle-income countries have an opportunity to create new approaches to the provision of investment capital to address the needs of the innovation economy in their countries. Policy makers need to craft policies which reflect their own history and current conditions. These policies may be very different from developed countries which may be seen as models worthy of replication. For example, some European nations have been concerned that unfair competition from public investment initiatives might well induce some private funds with stricter financial criteria to leave the European venture capital industry. Most developing countries will simply not have any significant number of such private funds. Government funds must have the opposite effect of attracting the private investment sector.

A cautionary lesson from developing countries is that investment decisions can be distorted by political influence. Government officials typically lack the experience to evaluate and manage investment opportunities. Consequently, developed countries have moved towards systems in which the state invests as a partner in a fund managed by a private sector fund manager – although this does not guarantee immunity from management inefficiencies and rent seeking.

A practical problem for many developing countries in negotiating financing agreements to either acquire a technology or out-license IP is that someone has to "put money on the table" meaning make a commitment to get started. Someone has to take the first step and agree to provide initial funding which could be matched later by others. Sometimes this can be in the form of a grant for early stage development. But, if these grants take too long to be approved (as is often the case) the deal may be lost. In other business transactions, such as real estate purchase, this takes the form of “earnest money” – a small amount to demonstrate good faith. The ability to provide such small sums quickly at a very early stage should be built in to other forms of early stage technology development or technology translation funding.

Note that usually angel and seed funding rely on the availability of later stage capital to be able to get a return on their investment through their equity being bought out. Of special interest to developing countries is that some investment models specifically attempt to address the “investment gap” which is also referred to as the “valley of death” which occurs when private and public funding is either unavailable in the first place or runs out, and where the company’s net cash flow does not close the funding gap.

Many businesses – frequently ones based on research discoveries - continue to reside in the valley of death because they lack the necessary financial support and skilled management teams to progress into the “proof of relevancy” phase. To address this gap, foundations and advocacy groups have stepped in to try to provide funding. However, these investments are generally insufficient to carry these startups to follow-on venture capital funding.

Creating investment funds of sufficient size can bea problem for developing countries. Because a fund may run out of capital prior to the end of its life, larger venture capital firms usually have several overlapping funds at the same time; this lets the larger firm keep specialists in all stages of the development of investee businesses almost constantly engaged. Smaller venture capital funds tend to thrive or fail with their initial industry contacts; by the time the fund cashes out, an entirely-new generation of technologies and people may be ascending, whom the general partners may not know well, and so it is prudent to reassess and shift industries or personnel rather than attempt to simply invest more in the industry or people the partners already know.