Tackling the innovation focus continuum; implications for change in venture capitalists' investment models

Tackling the innovation focus

continuum; implications for change in

venture capitalists' investment models

JOHAN LENNEFALK

DAVID TÖRNQUIST

Hantering av kontinuumet för

innovationsfokus; implikationer för

förändring i riskkapitalisters

investeringsmodeller

av

Johan Lennefalk

David Törnquist

Examensarbete INDEK 2012:49

KTH Industriell teknik och management

Tackling the innovation focus continuum;

implications for change in venture capitalists'

investment models

Johan Lennefalk

David Törnquist

Master of Science Thesis INDEK 2012:49

KTH Industrial Engineering and Management

Examensarbete INDEK 2012:49

Hantering av kontinuumet för innovationsfokus;

implikationer för förändring i riskkapitalisters

investeringsmodeller

Johan Lennefalk

David Törnquist

2012-06-13

Terrence Brown

David Sonnek

Sammanfattning

Innovation har länge ansetts vara den kritiska drivkraften bakom ekonomisk tillväxt och

värdeskapande. Emellertid, för att uppnå en innovativ status, krävs kommersialisering

av en uppfinning genom att tillföra kapital och strategi. Kapital existerar i flera olika

former, dock fokuserar denna uppsats på området riskkapital, och hur denna typ av

finansiell backning kan analyseras och hanteras. Häri presenteras kontinuumet för

företagskaraktäristik, där innovation inom affärsmodeller och teknik representerar de två

ändpunkterna. Syftet var att undersöka om det fanns signifikanta skillnader mellan

riskkapitalisters investeringsmodeller, när ett företag rör sig längs det ovan nämnda

kontinuumet.

Semi-strukturerade intervjuer användes och tolkades oberoende av författarna, genom

att använda kodord, för att förbättra objektiviteten. Uppsatsen berör främst företag inom

industrin för informationsteknologi, där analys har gjorts på fyra av de största aktörerna

inom marknaden för riskkapital i Norden.

Ett Nordiskt fokus, kombinerat med en hastigt utvecklande industri, resulterade i att

signifikanta skillnader, i riskkapitalisters investeringsmodeller, identifierades; vilket gav

implikationer för både teori och praktik. Dessa skillnader identifierades att härstamma

från de initialt anammade riskprofilerna, som sedan påverkade alla andra områden inom

investeringsmodellen.

Nyckelord

Riskkapital, Venture Capital, Investeringsmodeller, Teknologisk Innovation,

Tackling the innovation focus continuum;

implications for change in venture capitalists'

investment models

Johan Lennefalk

David Törnquist

2012-06-13

Terrence Brown

David Sonnek

Commissioner Contact person

Abstract

Innovation has been considered the critical driver behind economic growth and value

creation for a long time. However, in order to achieve an innovative status, the

commercializing of an invention is required by injecting capital and strategy. While

capital comes in many forms, this thesis focuses on the field of venture capital and how

this type of financial backing can be analyzed and managed. Herein, the company

characteristics continuum is presented, where business model innovation and

technological innovation represent the two extremities. The purpose was then to

investigate if there are significant differences in the venture capitalists' investment

models as one moves along the aforementioned continuum.

Semi-structured interviews were used and interpreted independently by the authors,

with respect to coding units, in order to enhance objectivity. The thesis mainly targeted

the information technology industry, where analysis was conducted on four of the

largest actors on the Nordic venture capital market.

The Nordic focus, combined with the rapidly moving industry, resulted in that significant

differences, in the venture capitalists' investment models, were identified; giving

implications both for theory and practice. These differences were identified as stemming

from the initially adopted risk profiles, which then affected all other areas of the

investment models.

Key-words

Venture Capital, Investment Models, Technological Innovation, Business Model

Innovation, Commercialization, Company Innovation Characteristics, Innovation Focus,

Screening Process, Risk and Portfolio, Investment Stages, Capital Contribution,

Preface

After a finished Master’s thesis at KTH Royal Institute of Technology, we would like to thank the people that made this thesis possible. First of all, our sincere thanks go to David Sonnek at SEB Venture Capital, who, apart from being the one that initially sparked the interest for venture capital three years ago, has guided us through the entire process. This includes everything from inspirational meetings, that helped us understand the industry, to helping us approach the other actors within the field.

We would also like to thank Terrence Brown, for the academic guidance and feedback regarding the thesis, as well as the interview respondents Conor, Crean-dum, Northzone, and SEB Venture Capital; for letting us in and supplying us with insights vital to our findings.

Stockholm, May 2012

Preface vii Contents viii List of Figures x List of Tables xi 1 Introduction 1 1.1 Problem formulation . . . 2 1.2 Perspective . . . 4 1.3 Delimitations . . . 4 1.4 Disposition . . . 5 2 Frame of reference 7 2.1 Definitions of innovation . . . 7

2.2 Definition of venture capitalist . . . 8

2.3 The evolution of venture capital . . . 9

2.4 The investment characteristics of venture capital . . . 10

2.4.1 The institutional nature of venture capitalism . . . 11

2.4.2 Asymmetric information . . . 13

2.4.3 Performance of venture capital . . . 15

2.4.4 Macro-effects on external stakeholders . . . 16

2.4.5 Supply and demand of venture capital . . . 18

2.5 Investment models . . . 19

2.5.1 The screening process . . . 20

2.5.2 Risk profiles . . . 22

2.5.3 Investment stages in venture capital . . . 25

CONTENTS ix

3.1 Methodology . . . 38

3.2 Sample selection . . . 38

3.3 Data collection . . . 38

3.3.1 Interview areas aimed at the venture capital firms . . . 39

3.4 Data analysis . . . 40 3.4.1 Reliability . . . 41 3.4.2 Validity . . . 41 3.4.3 Generalizability . . . 42 4 Results 43 4.1 Company profiles . . . 43 4.2 Investment models . . . 44

4.2.1 The screening process . . . 44

4.2.2 Risk and portfolio . . . 51

4.2.3 Preferred investment stage . . . 57

4.2.4 Capital contribution . . . 59

4.2.5 Strategic contribution . . . 62

4.2.6 Exit strategies . . . 65

5 Analysis 69 5.1 Screening process . . . 69

5.2 Risk and portfolio . . . 70

5.3 Preferred investment stage . . . 72

5.4 Capital contribution . . . 73 5.5 Strategical contribution . . . 74 5.6 Exit strategies . . . 75 6 Conclusion 77 7 Discussion 81 7.1 Limitations . . . 81 7.2 Critique of method . . . 81 7.3 Further research . . . 82 7.4 Implications . . . 83 7.4.1 Entrepreneurial . . . 83 7.4.2 Venture capital . . . 84 7.4.3 Research . . . 84 Bibliography 87 Interviews 93

1.1 The trade-off between the different characteristics . . . 3 1.2 The company innovation characteristics (CIC) continuum . . . 3 2.1 The institutional nature of venture capital as described by Zider (1998) 13 2.2 The valley of death (Wessner, 2005) . . . 14 2.3 The entrepreneurial gap (Kluge et al., 2000) . . . 17 2.4 The venture capital investment process and the possible outcomes (Zacharakis

and Meyer, 2000) . . . 20 2.5 The venture capital investigation process as described by Zacharakis and

Meyer (2000) . . . 21 2.6 An actuarial model used to aid in the screening process as described by

Zacharakis and Meyer (2000) . . . 22 2.7 The risks affecting venture capital as described by Fiet (1995) . . . 23 2.8 Company development phases as described by Christofidis and Debande

(2001); Mackewicz & Partner (1998) . . . 29 6.1 Main differences with regard to the adopted risk profile summarized . . 79

List of Tables

2.1 Venture characteristics identified by Ruhnka and Young (1987) among the stages. . . 26 2.2 Major goals/benchmarks identified by Ruhnka and Young (1987) among

the stages. . . 27 2.3 Major risks identified by Ruhnka and Young (1987) among the stages. I

= Internal and E = External. . . 28 5.1 The return on investment multiples in relation to the investment stage 72 5.2 Investment stage focus . . . 72

Chapter 1

Introduction

For a long time, innovation has been considered the critical driver behind economic growth and value creation (Schwienbacher, 2008). However, innovation involves substantially more than simply a technical invention. In order for an invention to be truly innovative, there are several inputs that need to be considered.

Apart from a strategy and the idea or invention itself, there needs to be financing involved as well. While financing comes in many forms, this thesis focuses on the field of venture capital (often called VC) and how this type of financial backing can be analyzed and managed. As a financial and strategical facilitator, venture capital clearly plays a big part in the modern society, especially within the field of information technology.

One might believe that money is the main hurdle that prevents success, and that stronger financial backing implies better capabilities. However, historical case studies have often proved that a major money focus will make the innovation pro-cesses similar to gambling (Hargadon, 2005). This is an area where venture capital historically has added value, to make sure that there is a balance between capital and strategical contribution.

Therefore, the question of how to manage this type of funding is critical. There-fore, this thesis aims to map the complex environment within the venture capital field. Several factors exist as to why the landscape is complex; e.g. the institutional nature, the involvement of different industries, the asymmetric relation among the agents, and the macro-effects. However, the main focus will be on how the invest-ment models vary, with regard to the type of innovation, within the information technology industry.

The interest for the area of venture capital has always been present due to the entrepreneurial spirit within the Nordic information technology industry. Herein, the interaction between information technology and venture capital has helped to facilitate start-ups such as Spotify, Skype and the like.

1.1 Problem formulation

Much has changed since the dawn of venture capitalism, especially when the in-dustry of information technology is considered. The evolution of this inin-dustry has created an infrastructure that has enabled innovation to emerge both cheaply and quickly. Generally, the venture capital industry has become more complex, as men-tioned earlier; hence, the investment models need to be adjusted appropriately.

The challenge with venture capital firstly concerns the process of selecting prospects worth investing in, and secondly to de facto facilitate the investments in order to achieve returns in the future. These are problems that venture capital firms have to deal with on a daily basis. Thus, relevant investment models are beneficiary. With regard to venture capital, it is desirable to find a balance between the capital and strategic input. Excess spending will never compensate for the lack of adequate strategic and managerial input and vice versa. The strategic factor is therefore considered to be part of the investment model, due to the nature of the venture capital investment vehicle, where the investor enters into a partnership. Thereby, the venture capital firms also invest human resources apart from simply capital.

One might believe that the most straight-forward approach to become a success-ful and innovative organization is to invest vasts amounts of money in top-of-line scientists and engineers, isolate them from the rest of the organization, give them a discretionary amount of time and money, and wait for the results (Hargadon, 2005). However, this approach is problematic due to the lack of a relevant understanding of business models to support the processes. Strategic and managerial implications need to be considered as well in order to succeed. Thus, to find a beneficiary balance between capital and strategic input is of great importance.

1.1. PROBLEM FORMULATION 3 Company _Innov atio_{n C} har_act eris_tic s C on tin uu_m

Business Model Innovation

Te ch no lo gi ca l I nn ov at io n

Figure 1.1. The trade-off between the different characteristics

If the area of information technology is considered; it is hypothesized that there exist two types of extremities regarding the companies. Firstly, there are those which are focused towards fundamental technology development and are often highly research dependent. This means that they enable other areas of business to prosper as a result of their contribution. Secondly, there are those companies which depend on the existing technology to support their business model. Thus, the latter are enabled by technology.

Furthermore, it is also hypothesized that these two extremities can be seen as endpoints on the company innovation characteristics continuum; see figure 1.2. The positioning of a company on the continuum depends on the innovation focus of the company. If a firm mainly focuses on business model innovation, it is preferably positioned close to the right. However, if the company in question is more focused towards technological innovation, it should be positioned to the left. Since few companies are likely to be focused exclusively towards one type of innovation, a continuum is used. Technological innovation Business model innovation  Enables technology

 Creates infrastructure  Enabled by technology Utilizes infrastructure

Figure 1.2. The company innovation characteristics (CIC) continuum

As argued by Slack and Lewis (2008), and initially stated by Skinner (1969), there is a trade-off at the efficient frontier; it is not possible to “have everything”, due to the nature of being “technically constrained.” Therefore, “we must sacrifice one to get the other.” The company innovation characteristics (CIC) continuum could be interpreted as moving along the efficient frontier, where trade-offs are made when moving towards the extremities.

The pre-hypothesized continuum can therefore be seen as a simplification of the two-dimensional trade-off space, seen in figure 1.1, which has been created by establishing face-validity with practitioners. However, the purpose is not to

investigate the existence of the aforementioned continuum, but to conduct research regarding the two innovation foci. This hypothesis could be seen as a pre-hypothesis

that will be used as if it were true. Hence, rejecting HP0 and accepting HP1.

HP0: The venture capital landscape cannot be represented by a continuum; where

the extremities are technological innovation and business model innovation.

HP1: The venture capital landscape can be represented by a continuum; where the

extremities are technological innovation and business model innovation. Based on the company characteristics continuum, as can be seen in figure 1.2, the purpose of this thesis is to investigate the following hypothesizes:

H₀: There are no significant differences in the venture capitalists’ investment

mod-els as one moves along CIC continuum.

H1: There are significant differences in the venture capitalists’ investment models

as one moves along the CIC continuum.

If significant differences can be identified along the CIC continuum, it would be possible to rationalize investments to a further extent.

1.2 Perspective

This thesis mainly takes the perspective of the venture capitalist, where companies along the CIC continuum represent the domain of investments; it will mainly include companies within the information technology industry. Thus, it omits other popular areas of venture capital, such as bio-tech, med-tech, and clean-tech. Since the focus is on the venture capitalists’ investment models, taking this perspective is relevant. Neither the fund investors, typically pension funds, nor the entrepreneurs have a major influence on the shaping of these investment models.

1.3 Delimitations

1.4. DISPOSITION 5

the study. As mentioned earlier, information technology will be the focal industry, where the analysis will be performed on the Nordic venture capital market. Since the industry scope is narrow, the resulting generalizability may be impaired by the study. However, venture capital has historically been very well represented both within the information technology industry and in the Nordic region. According to Antonczyk and Salzmann (2012), Sweden, Norway, and Finland are among the top five countries in the world when it comes to venture capital availability. Fur-thermore, Denmark is found at the 9th _{position. The results were extracted from}

the World Economics Forum’s Global Competitiveness Report 2008–2009 and re-flect how easy it is for entrepreneurs with innovative, but risky, projects to find venture capital. These results emphasize the high representation, and the actuality, of venture capital in the Nordic region. Thus, it should still be possible to draw conclusions reflecting the venture capital situation within this region.

Moreover, the study will only include the venture capitalists’ current portfolios and funds, excluding historical data. Timewise it would be beneficiary to analyze portfolios from an entire market cycle, including one period of slowdown and one period of growth. This way, factors such as the influence from the current economic trajectory could be accounted for, and also other macro-economic factors. However, since a fund usually lasts for more than five years, the chosen content will reflect varying economic situations either way. Moreover, combined with the fact that several portfolios and funds will be analyzed, with different initiation dates, this will also contribute to minimizing the specific influence from systematic risk and inaccuracy regarding the phenomenon being studied.

1.4 Disposition

In order to ease the reader’s process, of understanding the vast material that herein is presented, a thorough approach has been taken. Firstly, the theoretical framework sets the stage by explaining relevant concepts that are critical, in order for the reader to understand the data that has been collected. The results are then presented separately for each company, in order to give a straight-forward view of the data, and to highlight what separates them. The analysis section then aggregates these results, in order to create a synthesized view of the situation by connecting it to the initial problem formulation and research questions. Lastly, the conclusion summarizes the findings and relates them to the hypotheses. By adopting this structure the purpose is to make sure that the process, of converting individual interview results into a coherent picture of the situation, is fully explained and can be followed and understood.

wrapped up by presenting the research questions and then motivating how they contribute to the field of research.

• Method: Describes how the research is conducted. The section mainly presents how the interviews are made and interpreted. Also, the choice of sample is described.

• Results: The empirical results are presented by putting each factor in the investment model in relation to each respondent. The factors that constitute the investment model relates to the observed pattern in the frame of reference section.

• Analysis: The empirical results are synthesized for each respondent with regard to the research questions and hypotheses.

• Conclusion: Briefly summarizes the report, with regard to the research ques-tions and hypotheses.

Chapter 2

Frame of reference

The frame of reference intends to create an initial mapping of the complex ven-ture capital environment. It starts out by introducing definitions and descriptions regarding innovation and venture capital. This is followed by identification of the venture capital characteristics, as an innovation facilitator for commercializing in-ventions. Lastly, a deeper analysis of the investment models’ constitution is pre-sented.

Section 2.5 is explicitly connected to the main topic of this thesis. However, it is critical to realize the importance of the implicit areas leading up to 2.5, and the complexity of these; to fully understand the inner workings of the venture capital landscape, within the complex environment.

The last section, research question, is placed at the end in order to clearly illustrate what is missing in precedent research; thus, highlighting the importance of this study.

2.1 Definitions of innovation

“The only constant is change, continuing change, inevitable change, that is the dominant factor in society today. No sensible decision can be made any longer without taking into account not only the world as it

is, but the world as it will be.”

Isaac Asimov As Isaac Asimov stated, innovation is inevitable and has undoubtedly been part of our evolution. One of the first to define innovation was Schumpeter (1934). He defined an economic innovation as the introduction of a new good or new method of

production, opening of a new market, the conquest of a new source of supply, or the

carrying out of a new organization. According to Schumpeter (1934), innovation often involves combinations of existing resources.

If more modern definitions of innovation are considered, they deal with – as briefly mentioned in the introduction, the process of commercializing ideas and

scientific inventions and thereby introducing them to the real world. The purpose of this is to capture the value from the innovation and let the creators, e.g. the firm behind it, reap the the benefits. According to Trott (2008), innovation is the combination of a theoretical concept, a technical invention and a commercial

exploitation.

“Innovation is the process of turning ideas into reality and capturing value from them.”

Tidd and Bessant (2009) It is important to differentiate between an invention and an innovation. An in-vention could precede an innovation by years and represents the actual scientific findings.

“Invention is the first occurrence of an idea for a new product or process, while innovation is the first attempt to carry it out into

practice.”

Jan Fagerberg (2005) As discussed by Trott (2008), an innovation does not neccesarily have to be a product. The typology of innovation involves several possibilities, and can either be a product, process, organizational, management, production, commercial marketing, or a service innovation. If the innovation typology is related to the CIC continuum, proposed in this thesis, all these types can be fitted.

2.2 Definition of venture capitalist

It is important to define the venture capitalist concept before proceeding. While there exist several definitions, one by Gupta and Sapienza (1992); Perez (1986) and Pratt (1987) is as follows:

“Those organizations whose predominant mission is to finance the founding or early growth of new companies that do not yet have access

to the public securities market or to institutional lenders.”

Another definition by the European Private Equity and Venture Capital Association (EVCA) presented by Christofidis and Debande (2001), defines venture capital as:

2.3. THE EVOLUTION OF VENTURE CAPITAL 9

Private equity is in turn defined as equity capital to enterprises not quoted on a

stock market. These definitions are important to distinguish between since figures for private equity frequently are quoted, without explicitly separating them from those of venture capital. If one is to consider the investments in venture capital exclusively, the EU is far behind the figures found in the US (Christofidis and Debande, 2001).

Furthermore, Gupta and Sapienza (1992) suggest that venture capitalists add value by:

• bringing investors and entrepreneurs together in an efficient manner; • making superior investment decisions than limited partners would make; • providing non-financial assistance which in turn enhances survival.

While these suggestions not will fit all venture capitalists, they give a hint of their purpose. The ultimate measurement of success then, ceteris paribus, would be how well a venture capital firm manages to make the investment decision and how ef-fective the post-investment advice is. Roure and Keeley (1990) even claim that a firm’s success can be predicted from the content within its business plan. Hence, to improve the investment decision means to improve the venture capitalist’s perfor-mance (Zacharakis and Meyer, 2000).

2.3 The evolution of venture capital

Ehrenfeld (1990) has summarized an article with the wisdom of Georges Doriot, commonly known as the father of venture capital, and who founded the first publicly traded venture capital company; American Research and Development Corporation. Ehrenfeld (1990) argued that knowledge alone can be almost useless; without a catalyst or a fulcrum, it will not be possible to leverage from it. This is where venture capital comes in handy and, according to Ehrenfeld (1990), the U.S. is largely built upon it.

Cornelius (2005) states that the first usage of the term “venture capital” was in a discussion between J.H. Whitney and Benno Schmidt in 1946. Having inherited US$ 179 million, a fund was developed with the purpose of supplying capital to those who had difficulty obtaining it by traditional means.

However, the situation of today is quite different from back in the 1940s. It is argued that the dawn of venture firms came along during the 1960s, in the wake of the defense industry as above mentioned. This was the time when the era of the semiconductor industry essentially was funded by venture capital, in Silicon Valley, California.

reason as to how the U.S. economy has managed to grow faster than other industri-alized economies for decades. This has resulted in that more than 20 % of the U.S. gross domestic product is generated by companies once funded by venture capital. Examples of successful start-ups include companies such as Microsoft, Google, Dell, Facebook, Apple and the like. In total, the venture capital industry invested $28 billion in start-ups in 2008 (Wall Street Journal, 2009; Schwienbacher, 2008).

2.4 The investment characteristics of venture capital

Today, most of the entrepreneurs and management teams that form new companies come from corporations or universities (Zider, 1998). The reason is that nearly all basic research money, and therefore invention, comes from corporate or government funding. However, these institutions are not good at turning them into new busi-nesses. Therefore, the entrepreneurs feel that the advantages of staying within the academic world, or at their former company, are limited when it comes to com-mercializing their ideas. This is where venture capital enters the picture, because venture capital has no such limitations.

Venture money plays an important role since it funds the next stage in the innovation life cycle period; the stage in a company’s life where the innovation is commercialized. As a consequence, venture money is not long-term money. The concept is based on investing in a company’s balance sheet and infrastructure until it reaches the size and credibility of being sold. The selling can be done either directly to a corporation or by letting the public-equity markets step in and provide liquidity, through an initial public offering (IPO). Hence, the role of the venture capitalist is to buy a stake of the company, nurture it for a few years, and then exit with the help of an investment banker (Zider, 1998).

However, “to buy a stake of the company”, typically means that, in a typical start-up deal, the venture capitalists invest $3 million, over two-three years, in exchange for a 40 % preferred-equity ownership position. Furthermore, in return for this financing, the expected return over the next five years is 10 times the

investment. Therefore, combined with the preferred position, this is a very high

cost of capital corresponding to a 58 % annual compound interest rate. However, this is required in order for the venture capitalists to deliver average fund returns above 20 % to their venture capital fund investors (Zider, 1998).

It is indeed possible to question the high cost of capital; however, the alternatives given are not exactly great. Furthermore, many entrepreneurs understand the risks of starting their own businesses. Therefore, they do not want to put their own, or their family and friends’ money at risk. Unfortunately, some also “recognize that they do not possess all the talent and skills required to grow and run a successful business” (Zider, 1998).

2.4. THE INVESTMENT CHARACTERISTICS OF VENTURE CAPITAL 11

since laws are limiting the interest rates offered by banks. Moreover, banks usually require hard assets in order to secure the debt. However, in the information-based economy of today, few lean start-ups have any hard assets (Zider, 1998; Christofidis and Debande, 2001).

To be able to succeed, the venture capitalists focus on the middle part of the classic industry S-curve. This enables them to avoid both the early stages, with uncertain technologies and unknown market conditions, and the later stages with slow growth rates, market maturity and consolidations. Therefore, venture capital-ists invest in industries with growth potential since this is where the S-curves are to be found (Zider, 1998).

Thus, “regardless of the talent or charisma of individual entrepreneurs, they rarely receive backing from venture capital if their businesses are in low-growth market segments.” Moreover, many imagine the venture capitalists as experienced advisors for the companies they fund. However, this clashes with their schedules since they can manage up to ten companies simultaneously. This is a result from their financial incentives of being a partner in the venture capital firm. Therefore, the more money they manage, the less time they have to nurture and advise en-trepreneurs. This has resulted in “virtual CEOs” being added in order to help out with counseling of the firms, replacing the traditional role that venture capitalists used to have back in the day (Zider, 1998).

This type of counseling for entrepreneurs, in the seed stage, can involve the development of an innovative idea, a prototype, writing a business plan or launching the company. In other words, it is not only capital that the entrepreneur needs in order to evolve; expertise and a large amount of time is also required. This is sometimes referred to as the three Ts of venturing: Time, Talent and Treasure (Amit et al., 1990).

2.4.1 The institutional nature of venture capitalism

of industries. This new trend marked by MBAs doing relatively conservative invest-ments, compared to the classic venture capital, focused more on conserving wealth, than to overcome the pitfalls faced by the investee companies in their growth.

Even so, Sørensen (1987) concludes that experienced investors are more likely to sort out inherently better companies from the market, which succeed in going public. Thus, experienced investors add more value to the investee companies than inexperienced investors do (Sørensen, 1987).

According to Zider (1998), the four main players within the venture capital industry, as can be seen in figure 2.1, are:

• Entrepreneurs

Entrepreneurs need funding for their firms, and crave venture capital compa-nies that want to invest in their ventures.

• Investors who want high returns

These investors include pension funds, insurance companies, family offices, sovereign wealth funds and endowment funds (Taylor Wessing, 2009). Typi-cally, the venture capital fund being invested in represents a small percentage of the institutional investors’ total funds, placed in the high-risk end of a spectrum divided into different funds. In exchange for these high risk profile investments, they expect a return of between 25 % and 35 % per year during the lifetime of the venture capital fund (Zider, 1998).

• Investment bankers

The investment bankers’ task is to sell companies. Hence, they need a supply of companies to sell.

• Venture capitalists

2.4. THE INVESTMENT CHARACTERISTICS OF VENTURE CAPITAL 13

Entrepreneurs Venture capitalists Investment bankers

Corporations and

government Private investors

Public markets and corporations Ideas

$ $

IPOs

$ $ $ $ Stock

Figure 2.1. The institutional nature of venture capital as described by Zider (1998)

2.4.2 Asymmetric information

Federally funded research creates new ideas Capital to develop ideas to innovation Product development and innovation No capital

Figure 2.2. The valley of death (Wessner, 2005)

Amit et al. (1999) present a theoretical framework that views asymmetric infor-mation as the central feature of venture-capital investment. There exist two types of asymmetric information: hidden information that will lead to the selection of low-quality items (also known as adverse selection) and hidden action where one party prior to a transaction makes an action not observed by the other party (also known as the moral hazard).

“Moral hazard and adverse selection create market failures in entrepreneurial financing, which might lead many worthwhile projects

to be unfunded or underfunded.”

(Amit et al., 1999) Depending on how skilled the venture capitalists are, the risk of asymmetric in-formation can be reduced. In general, they often dig deep into the risks of the companies they invest in. Thus, the very existence of venture capital firms can partially be attributed to the fact that they are superior to unspecialized investors (Amit et al., 1999).

According to Amit et al. (1999), venture capitalists are better at avoiding asym-metric information than other investors. In general, this advantage is easier to exploit in later-stage firms than in start-ups.

2.4. THE INVESTMENT CHARACTERISTICS OF VENTURE CAPITAL 15

2.4.3 Performance of venture capital

Benson and Ziedonis (2009) investigate 34 corporate investors and 242 acquired technology startups from the acquirer’s perspective. The authors find that the per-formance of the acquisitions heavily relies on the internal knowledge base of the acquirer. This can be related to the fact that when venture capital investments increase, relative to the total R&D expenditure of the firm, the performance even-tually decreases. This emphasizes that venture capital investments rely on more than simply capital, and as such can act as a mechanism for strategic renewal im-plementation.

Benson and Ziedonis (2009) also find that firms consistently engaged in venture financing receive larger returns than firms engaged in occasional investments.

Caselli et al. (2009) examined 37 venture capital backed firms that went public on the Italian Stock Exchange between 1995 and 2004. These 37 firms were paired, by a statistical matching procedure, with 37 non-venture backed IPOs during the same period. The purpose was to highlight how venture capital affects the firms.

According to Caselli et al. (2009), the degree of innovation among firms is im-portant during the selection phase for the venture capital firms. However, when the investment is made, the firm being invested in does not promote further inno-vation but rather chooses to focus on improving economic and managerial aspects. This was demonstrated by comparing the amount of patents among the venture and non-venture backed firms before and after receiving funding. Before funding, the venture backed firms registered more patents than its non-venture backed twin, while dropping below after receiving funding. This is also a factor in the selection phase among the venture capital firms, since the firms with the highest growth potential are the ones that get selected; the number of patents is only one out of several measurements. Furthermore, R&D and past development were other factors considered vital.

On the other hand, sales show that venture capital backed firms experience a 5.5 % increase over the non-venture backed firms. According to Caselli et al. (2009), this is a result of the venture capitalists trying to maximize the value of the future IPO. The venture capitalist therefore focused mainly on marketing and sales rather than on R&D or technical and patentable innovation. However, these results only reflect situations where IPOs were the exit strategy.

“Our analysis of venture capital backed firms suggests that we can expect higher failure rates among these firms than in the population of

new firms.”

capitalists to assess the ability among the entrepreneurs. The most promising en-trepreneurs also tend to neglect offers from the venture capitalists due to the current institutional structure of the venture capital industry (Amit et al., 1990).

Allen and Hevert (2007) carried out a performance investigation of corporate venture capital programs in the information technology industry. The investiga-tion contained 90 U.S. informainvestiga-tion technology firms during 1990-2002. Allen and Hevert (2007) found that the timing of initiation within the venture capital cycle, the program scale, the annual investments, the write-down and the harvest behav-ior were associated with differences in returns. If the initiation timing within the venture capital cycle is considered, Allen and Hevert (2007) argue that, a late initi-ation can destroy direct value on the program. The venture capital cycle is derived from trends in annual investments and returns, also know as boom-and-bust cycles (Gompers, 2002). The cycle considered in this investigation is 1990-2002.

The program scale, measured by the cumulative investments, showed that small programs generated attractive returns. Small programs included cumulative invest-ments under $95 million. However, small programs may suffer from lacking internal credibility. Allen and Hevert (2007) suggest that $100–500 million of cumulative investments over several years are likely to be required in order to deliver economi-cally significant direct returns and generate a smaller set of in-the-money strategic options.

2.4.4 Macro-effects on external stakeholders

From the macro-economic perspective, Wasmer and Weil (2000) find a significant positive impact from venture capital; both on short-term and long-term employ-ment. This positive impact from venture capital was shown as early as during the World War II, when government contracting resulted in successful innovative in-dustrial ventures that previously had been considered too risky to finance (Reiner, 1991).

According to Trott (2008), the US currently spends 2.6 % of GDP on R&D, and is growing rapidly. Japan is even ahead of this number with a spending of 2.9 % of its national wealth. Europe is far behind at only 1.9 %, with the EU pledging to increase Europe’s state and private R&D spending. Furthermore, a study by the European Commission finds that businesses’ R&D expenditures in the US are 73 % higher than that in EU, while growing by almost three times between the years 1995 to 1999 (Trott, 2008). However, some argue that something else is needed, since it is hard to make companies spend more money on R&D, when the economy is weak and the stock market conditions are uncertain. Also, Gompers

et al. (2008) argue that venture capital investments are increased when the public

market becomes more favorable. The reaction is especially significant among the venture capitalists with the most industry experience. Gompers et al. (2008) state that this is consistent with the venture capitalists’ rational responses to attractive investment opportunities, signaled by public market shifts.

2.4. THE INVESTMENT CHARACTERISTICS OF VENTURE CAPITAL 17

large venture capital industry. Historically, the venture capital funding has been vital to the growth of the US economy. However, in the EU it only accounts for 0.004 % of GDP. Hence, the need for venture capital is clear and the Commission therefore recommends governments to set up schemes to attract venture capital for start-ups (Trott, 2008).

There are also differences between countries in the EU, where the venture cap-ital development is higher in countries with an equity market culture, such as the UK and the Netherlands. Hence, France, Germany, Belgium and Sweden have a less developed venture capital culture, but are rapidly catching-up. As recently presented by Antonczyk and Salzmann (2012), the situation has now changed po-sitioning Nordic countries, such as Sweden, among the top markets. Moreover, there is a “potentially strong correlation between the development of venture capital and investments by pension funds and other institutional funds in venture capital” (Christofidis and Debande, 2001).

In the heart of venture capital, Silicon Valley, 73 % of all companies that have annual sales of more than $50 million were established after 1985; see figure 2.3. Contrastingly, in the German tech-cities Munich and Stuttgart, only 17 and 20 % reach this league. These types of companies are the most likely to grow at above-average rates. Moreover, unlike most established companies, tech companies are also the most likely to raise employment levels (Kluge et al., 2000).

Kortum and Lerner (1998) state, in a massive examination of over twenty in-dustries over three decades in the U.S., that venture capital accounts for about 15 % of industrial innovations. Furthermore, the amount of venture capital activity in any industry significantly increases the rate of patenting. Also, Kortum and Lerner (1998) argue that the R&D funded by venture capital is constantly more productive than that funded inter-organizationally by corporations in the U.S.

27 31 42

69 75 76 80 83

73 69 58

31 25 24 20 17

567 908 139 1954 390 1095 354 382

Percent of companies with annual sales exceeding $50 million. Source: Dun & Bradstreet

Companies founded before 1985 Silicon Valley Boston Austin London Düsseldorf Paris Stuttgart Munich

Figure 2.3. The entrepreneurial gap (Kluge et al., 2000)

of start-ups, regional development and specific industries. Hence, it has become the fourth-largest information technology center in the world, after Silicon Valley, Boston and London. This was achieved through early-stage targeted investments by the state government. This led to the attraction of a cluster of companies within the information technology industry. Similarly, within the aerospace technology, a department was set up in order to transfer knowledge from institutes into poten-tial start-ups, and connecting these as suppliers of technology to established local businesses (Kluge et al., 2000). Conclusively, this shows that a clear strategy is needed in order to achieve innovation in a broader sense. There are several ways to get there, but they all need a clear path, such as the focus on venture capi-tal as a very capable, and historically successful, way. This, in combination with high-tech research clusters, such as in Germany, seems like a potential long-term strategy. Unfortunately, there is a trend towards a growing size of both venture capital funds and individual investee deals, which typically discriminates against smaller investments in technology start-ups. There is also a trend among US firms to exit through an IPO, contrary to the EU region where “trade sales“ are more common (Christofidis and Debande, 2001).

2.4.5 Supply and demand of venture capital

Christofidis and Debande (2001) have identified several factors that affect the

de-mand side of venture capital, and hence affect its expansion.

• Fiscal

Reductions in capital gains tax and the general attitude towards stock options affect the underlying incentives for venture capitalists when starting new firms. • Regulatory

Labor market flexibility which enables employers and employees to quickly

adapt to changes and company law which eases the creation of start-ups. • Infrastructure

Regional science and technology parks, research institutions in combination with incubators in order to encourage the commercial applications and the interaction between venture capitalists, entrepreneurs and researchers. • Exits

Sufficient stock market liquidity, with listing and reporting criteria integrated throughout the Europe region via institutions; which encourages venture cap-italists to exit through the IPO route.

• Investee management

2.5. INVESTMENT MODELS 19

Furthermore, the investee’s management team must be able to prove technical excellence.

Likewise, there are factors suggested by Christofidis and Debande (2001) that affect the supply side of venture capital and hence drive the development.

• Fiscal

Tax reliefs for private investors and business angels ease the funding of venture capital funds.

• Regulatory

Less restrictions put on pension funds, to invest in venture capital, and ini-tiatives to diversify the supply of venture capital; e.g. from state-sponsored funds. Also, reinforcements done to the protection of intellectual property, which both encourage investments in intangible assets and enable such to secure investments by constituting collateral.

• Exits

There is a strong correlation between the public and private equity markets. Therefore, a stock market fall reduces the possibilities of successful IPOs and the subsequent recycling of capital back into new venture capital funds. More-over, the reduction of liquidity leads to a shortage of credit which makes it harder for firms to finance their growth stages, and thus more bankruptcies. • Cultural

Promoting the creation of angel investor networks to create venture capital funds by experienced entrepreneurs in order to invest in start-ups. Evidence suggests that serial entrepreneurs, that themselves have benefited from venture capital investments, are the best qualified fund managers.

• Venture Capital Fund Management

The thorough due diligence process requires managers to have a deep and technology specific knowledge, in order to avoid simply mimicking the market trend (in order to avoid effects such as the dotcom-bubble). The venture cap-italists need to adapt their investment models to the specific growth pattern, industry, and the need of capital of the investee firm. Furthermore, they need to have a sense of the exit route, and the path needed to achieve it; e.g. by building a platform that can be utilized in order to gain critical mass and then accelerate towards an exit.

2.5 Investment models

The following section thoroughly investigates the investment models used by venture capitalists. The section is divided into six main areas, namely the screening process,

2.5.1 The screening process

According to Gupta and Sapienza (1992); Perez (1986) and Pratt (1987), successful ventures provide a high return, while “living dead” (Ruhnka et al., 1992) and failed ventures result in a loss of all or part of the investment. The process of investing and the possible outcomes are presented in figure 2.4 as described by Zacharakis and Meyer (2000). VC Succesful venture Failed or ”living  dead” Invest

Don’t  invest No loss

No return Good return

No return

Figure 2.4. The venture capital investment process and the possible outcomes

(Zacharakis and Meyer, 2000)

According to Kunkel and Hofer (1991); Sandberg (1986) and Timmons (1994), the survival rate of venture capital-backed firms is much higher than those of other sources. Therefore, the venture capital decision process has been investigated thor-oughly within literature. However, venture capital-backed firms still fail at 20 %. In addition, another 20 % of the firms within the portfolio do not provide any return to the venture capitalists at all. Thus, there is room for improvement within the investment process (Zacharakis and Meyer, 2000). However, this contradicts earlier research by Amit et al. (1990), which stated that the success rate among venture capital backed firms is not higher than for conventionally funded firms.

A common approach to the three staged investment process begins with screen-ing, as can be seen in figure 2.5. Here, the venture capitalists screen vast amounts of proposals in order to assess their viability. On average, only 8-12 minutes are spent when assessing a business plan (Sandberg, 1986). Within this time frame, attributes such as key success factor stability, lead time, competitive rivalry,

edu-cational capability, industry-related competence and the interaction of timing are

2.5. INVESTMENT MODELS 21

negotiate the terms of the investment.

Since the due diligence is extensive and the negotiation may take time, it is important to minimize the effort spent on the initial screening process. Yet, it is important to be careful in order to not eliminate potential opportunities prema-turely.

Screening Due diligence Negotiate terms of

the investment

Figure 2.5. The venture capital investigation process as described by Zacharakis

and Meyer (2000)

One solution to this problem could be to use actuarial decision aides, which are models that decompose a decision into components, to assist in the screening pro-cess; as described by Zacharakis and Meyer (2000) that can be seen in figure 2.6. These components could be cues that recombined can predict the outcome. More specifically, an “actuarial (statistical) models refer to the use of any formal quanti-tative techniques or formulas, such as regression analysis, for ... [deciding] clinical tasks” (Elstein and Bordage, 1988). Hence a model of this kind, within the scope of a venture capital investment, could take into consideration the entrepreneur(s), the product and the market etc. Models such as these are already in use within many fields; e.g. at banks, within lending, and psychology. Another popular area of usage is within insurance in order to evaluate a potential customer. The models have been found to be very reliable and “often outperform the very experts that they are meant to mimic” (Zacharakis and Meyer, 2000).

In the example, given by Zacharakis and Meyer (2000), in figure 2.6 the fac-tors entrepreneur/team, product/service, market and financial are decomposed into quantitative measures that are used in order to predict an expected outcome, which is later compared with the actual outcome.

mod-els could be used by low level employees during the screening process to free senior associates’ time. Actual outcome Entrepreneur/Team Product/Service Market Financial Expected outcome Judgement Criterion variable Information cues

Figure 2.6. An actuarial model used to aid in the screening process as described by

Zacharakis and Meyer (2000)

An important conclusion drawn by Zacharakis and Meyer (2000) is that vast in-formation hinders the decision process for venture capitalists, while most people paradoxally claim to prefer more information at hand. As the information factors increased from five to eight, the accuracy of the venture capitalists predictions de-creased from 39.5 % down to 30.9 %. Therefore, a model to aid in screening process eases the task of processing the data, in a consistent way, which minimizes bias.

2.5.2 Risk profiles

2.5. INVESTMENT MODELS 23

The author proposes a model on risk avoidance based on three constructs:

in-vestor type, market risk and agency risk, as seen in figure 2.7. Inin-vestor type is

coded as a dichotomously variable representing either a venture capitalist or a busi-ness angel. The market and agency risks were measured indirectly using several sub-factors as described below:

Market risk is constituted of the following factors: • Many current competitors

• Many potential new competitors

• Competitive products/services that are ready substitutes • Weak customer demand for product/service

Agency risk is constituted of the following factors:

• Entrepreneurs and venture capitalists having different cash flow objectives • Entrepreneurs and venture capitalists having different profit objectives • Manipulation of profitability

• Short-term self-interest seeking by the entrepreneur • Contractual ambiguities

Market risk Agency risk

Venture captal investor type

MR1 MR2 ... MRn AR1 AR2 ... ARn

Business angel/ venture capital firm

Chang (2004) investigated how alliances could decrease risk among investments in Internet startups. Chang (2004) specifically analyzed the importance of venture capital financing and strategic alliances when acquiring resources necessary for the growth of Internet startups. The IPO was used as an early stage performance mea-surement of the Internet startups, and for controlling the IPO market environment. Environmental factors that may influence the incidence of IPO are firstly the general IPO market itself; both entrepreneurs and venture capital firms are more willing to go public in a rising market. Secondly, the population density is defined by how many firms there exist in a specific market nice at a given point in time. High pop-ulation density will imply an increased competition. Chang (2004) considered both these factors and argued that the time to make an IPO was positively influenced by:

• The better the reputation of the participating venture capital firms, and strategic alliance partners, were.

• The more money a startup raised.

• The larger the size of a startup’s network of strategic alliances.

Firstly, Chang (2004) states that reputation among the funding venture capital firms and the partners in the strategic alliances are of great importance for the IPO. Chang (2004) shows that venture capitalists with a success rate of 30 %, instead of the average 10 %, generate an IPO rate that is 2.12 times higher than the average. A similar effect could be seen with regard to the strategic alliance reputation. By partnering with prominent partners, the startup benefits from the reputation of these and builds a stronger external perception of itself. Thereby, gaining ability to access additional resources that can contribute to growth (Baum

et al., 2000; Baum and Oliver, 1991; Gulati, 1998; Miner et al., 1990).

Secondly, the results stated by Chang (2004) suggest that the amount of money raised was significantly positively correlated with the likelihood of going public, and more money would speed up the potential IPO.

Lastly, strategic alliances can provide both legitimacy and needed resources for a start-up. Moreover, the larger the network is, the faster it can go public (Chang, 2004).

Also, Aldrich and Fiol (1994); Deeds et al. (1997a,b); Zimmerman and Zeitz (2002) state the importance of gaining legitimacy and thereby overcoming the li-ability of newness. The results presented by Chang (2004) suggest that one ad-ditional partner in the strategic alliance network would increase the likelihood of going public by 1.17. The purpose of partnering with prominent firms could be e.g. to access social, technical, and commercial resources that normally require years to accumulate (Chang, 2004).

2.5. INVESTMENT MODELS 25

and alliances (providing legitimacy) on average will go public more quickly than a startup that lacks them.

Another approach to reduce risk is by using milestones, as mentioned by Clayton

et al. (1999), which will be described in section 2.5.4.

2.5.3 Investment stages in venture capital

Ruhnka and Young (1987) did studies with the purpose of validating venture capital developmental stages. Researchers have for a long time predicted that the process of new ventures could be chronologically predicted by an evolvement through various functional and strategic developmental stages. Ruhnka and Young (1987) analyzed the perceptions of the CEO or managing partner of 73 U.S. venture capital firms, which possessed comprehensive experience with longitudinal venture development, in order to validate the hypotheses of developmental stages. Ruhnka and Young (1987) investigated whether venture capital firms differentiated stages in the devel-opment process. Ruhnka and Young (1987) categorized the venture stages among four different factors: name of the stage, distinguishing characteristics of ventures in that stage, key developmental goals or benchmarks typically accomplished in that stage, and the major risks involved.

The venture capital developmental model presented by Ruhnka and Young (1987) consists of five distinct sequential stages, here briefly summarized:

• Seed: Idea or concept only

• Start-up: Business plan and market analysis completed • Second round/stage: Market receptive, some orders/sales • Third round/stage: Significant sales and orders

• Exit: Break-even or profitable

Ruhnka and Young (1987) found strong consensus on distinguishing characteristics of ventures in early stages of development, key developmental goals or benchmarks in various stages, and major developmental risks associated with each stage. Consensus on developmental characteristics diminished somewhat in later stages.

In the tables 2.1, 2.2, and 2.3 results from the study by Ruhnka and Young (1987) can be seen in-depth. In each category the answers are ordered from top to bottom according to the response rate.

The study made by Ruhnka and Young (1987) omitted influence factors such as organizational structure, management styles, and control systems for develop-ment. These factors are arguably of major importance for the growth, survival, and financial success of new ventures.

2.5. INVESTMENT MODELS 27 Seed Start-up Second Third Exit/bridge Major Goals/Benchmarks Produce working prototype

32,4% Complete beta testing/get product ready to market 28,8% Achieve market penetration and sales goals 40,8% Achieve sales, growth, market share targets 34,6%

Establish profitability for

IPO, LBO, or merger 56,1% Market assessment 25,2% Make initial sales, verify demand 23,5% Reach break-even or profitability 18,5%

Begin window-dressing for

IPO, buyout, or merger 23,4% Increase market share 14,0%

Assemble management team,

and

structure company

20,1%

Establish manufacturing feasibility

20,9%

Increase production capacity/reduce unit

cost 13,8% Achieve cash flow break-even, profitability 20,6% Turnaround or salvage the company 10,5%

Develop detailed business

plan

18,0%

Build management organization

17,0%

Build

sales

force/ distribution system

12,3%

Increase manufacturing capacity

7,5%

Diversify products

10,5%

Initial production and

marketing

4,3%

Develop marketing

plan

7,8%

Replace management/ execute “get-well” plans

4,6%

Turnaround company/ reposition product

2.5. INVESTMENT MODELS 29

greatly, in accordance with their risk profiles and the firms’ capital needs, across the continuum of actors (Mackewicz & Partner, 1998; Christofidis and Debande, 2001).

Venture capital Business angels Immediate family and friends

Savings

Banks quasy equity Venture capital Business angels Subsidies

Grants

Banks subordinated and mezzaine loans Venture capital

Subsidies Grants

Capital markets high yield bonds Stock markets

Banks Private equity Venture capital

Seed Start-up Second-/Third stage Bridge

Fu n d in g n e e d s High Low R is k p ro fil e Low High Type of financing

Early stage Expansion & growth Later stage

Figure 2.8. Company development phases as described by Christofidis and Debande

(2001); Mackewicz & Partner (1998)

During the studies, made by Gompers (1998), high returns were identified by the venture capital industry, due to the surging market for venture-backed initial public offerings. Also a more beneficial tax reduction on capital gains was introduced. Combined, these two factors led to a dramatic increase in the venture capital com-mitments (Gompers, 1998). The growth in demand for venture capital services resulted in changes in the terms and conditions. According to Gompers (1998), both increases in the profits, retained by venture capitalists, and partnership agree-ments, which eased in restrictiveness, could be seen. Implications from a growth in demand for venture capital services are, according to Gompers (1998), substantially larger fund raising by the venture capitalists and an increasing pressure to find in-vestments. In turn, this leads to venture capitalists including later stage investments within their scope in order to expand the range of potential investments.

2.5.4 Capital contribution

Costs and benefits

ini-tiation costs and both direct and indirect holistic implementation costs in order to create awareness (Bunduchi et al., 2011).

A similar change, with regard to benefits, is noticeable when switching from direct benefits to indirect benefits. Here, direct benefits account for transaction, production and savings costs while indirect benefits relate more to internal efficiency and relations among the supply chain members. (Bunduchi et al., 2011)

Pitfalls from too big investments

“Project teams with too much money may keep going in the wrong direction for too long.”

(Anthony et al., 2006) Anthony et al. (2006) highlight the importance of the size of the investments. With scarce resources, novel approaches may emerge that otherwise not would have been discovered. Also, companies that think they are following an “invest a little, learn a lot” approach might actually fall into one of the three classic traps: (Anthony et

al., 2006)

• Unwilling to kill projects that have fatal flaws • Commitment of too much capital too soon

• Fail to adopt the strategies even in the face of information that suggests the approach is wrong

The best way to avoid these mistakes, according to Anthony et al. (2006), is to be thorough and cautious with the investments, which means rapidly answering to the progress and experiments.

“The problem wasn’t just turning [the experiments] on, sometimes it was turning them off.”

(Anthony et al., 2006)

Strategical approaches with capital

2.5. INVESTMENT MODELS 31

However, lavishing capital does not naturally imply success. Clayton et al. (1999) emphasize that scarce resources is likely to be a success factor when devel-oping new businesses. In the venture capital way of funding, a large focus is on lowering the risk by portioning limited amounts of capital throughout the process. One major risk with over-financing is that the new enterprises might try to de-velop an entire platform of products, infrastructure, and hire staff needlessly before they have a single successful product on the market. In this way, market initiation is often postponed, which results in a late market validation. Clayton et al. (1999) present an example where General Electric, a company with a traditional corporate mindset, tries to venture a factory-of-the-future. Instead of focusing initially on de-veloping a successful product, the company spends $ 35 million on a headquarters building and fills it with employees.

The venture capital way would instead be to create a single niche winner to act as a start of a platform. An example of this is how Amazon.com’s story of success started with a focus in the niche of online book sales, thenceforth attacking related markets. Thus, a limited amount of capital forces the organization into a coherent focus on a principal product.

Another complication that too much capital can incur, is a focus on in-house development. This would imply that the organization may lose the opportunity of utilizing superior solutions on the market. Also, the organization will expose itself to all the risk.

A typical milestone-based approach to funding ventures is, according to Clayton

et al. (1999), a good heuristic for how venture capitalists should invest when the

venture is initiated. Such milestones could be: • Validation from the market and technology • Proof of economic viability

• Explosive revenue growth • Sustained earning growth

The level of capital at each milestone increases as the new business succeeds and the risk decreases. The exact amount of time between each milestone varies across industries. Prior to market and technology validation, there are phases of idea and team development, which not incur any investments. It is important not to allow for funding prior to achieving the milestones, since the need for additional funding at this stage could be a sign of the business not performing well. Even so, depending on the risk profile of the venture capitalist, additional funding might be tempting to give in order to not lose the investments made so far, instead of acting rationally and

cutting one’s losses and killing off the project. Furthermore, according to Clayton et al. (1999) it is important to involve the right kind of people and partners in the

2.5.5 Strategic contribution

Bottazzi et al. (2008) argue for the importance of human capital in venture cap-ital and investor activism. According to Bottazzi et al. (2008), independent ven-ture capital firms are more active than captive firms, such as bank-, corporate-, or government-owned. Bottazzi et al. (2008) state that investor activism is positively related to the success of portfolio companies and that prior business experience is an important predictor of an active investment style among the venture capitalists. The financing gap of potential businesses has typically been filled early-stage by venture capitalists in developed economies, such as United Kingdom, Canada, and the United States (Wright and Robbie, 1998). However, when emerging markets are considered, a fundamental and comprehensive institutional transformation of-ten characterizes the maturing economy (Ahlstrom and Bruton, 2006). Ahlstrom and Bruton (2006) address how the differing environment, in emerging East-Asian economies, and how informal institutions and networks, can tackle the problem with weak formal institutions and what the implications are for venture capital.

Both in emerging and developed economies efficiency and accessibility to in-vestors are vital. However, in emerging markets, Ahlstrom and Bruton (2006) argue that venture capitalists need to have a higher focus on employing personal networks in order to carry out needed activities; namely to select, monitor, add value, and someday exit. The importance of personal connections and relationships with en-trepreneurs, government officials, and customers are likely to be more important in emerging markets. Furthermore, Ahlstrom and Bruton (2006) highlight divergence in the emerging market venture capital practice in several specific areas:

• Less formal institutions can sometimes substitute the weak or lacking of formal institutions.

• Informal ties to entrepreneurs and their families act as a tool for monitoring, and allied actors such as customers and the government are linked by personal connections.

• Informal cultural-cognitive factors often create the requirement for existing relationships, in order for firms to achieve funding.

2.5. INVESTMENT MODELS 33

“If you find good people, they can always change the product. Nearly every mistake I have made has been picking the wrong people, not the

wrong idea... Most entrepreneurs have no problem coming up with a good strategy, but they usually need all the help they can get in developing and implementing the tactics that will make them successful

in the long run.”

Arthur Rock The diversity factor is also important since it highlights that people involved prefer-ably should have experience from creating something new. To employ the everyday senior manager who is great at handling evolved corporations, or people with similar backgrounds to investors, is not always the way to go.

“The last half century has seen the emergence of a new model of business innovation featuring the convergence of entrepreneurs, rapid

technological change, and venture capital.”

(Engel, 2011) Engel (2011) highlights the importance of strategy as an input to innovation and presents a model covering the ten key venture strategies, in order to create value and commercialize innovations quickly.

• Invest In Teams: With a top performing team, missteps could be recognized and handled early. Ventures often involve the top 1 percent performers. • Invest In Markets: Large and, most importantly, growing markets should be

the focus.

• Eliminate Pain: Concentrate on real pains and a possible solution to these rather than just enhancements.

• Focus On Customer Development, Not Product Development: Ongoing tomer interaction should complement the product development with the cus-tomer development seen as an interrelated process.

• Dedicate Resources in Stages: Partition the investments and increase them as the risk decreases when the market is more defined.

• Fail Fast: Kill the risky projects before investing too much capital.

• Speed is Everything: In order to precede competitors, time is the real enemy for a start-up.