For as long as I can remember venture capital has been promoted as the Holy Grail of economic growth by a good number of business people and almost all politicians. It has been mentioned in practically every budget speech in the last several years because of the warm feeling it brings to those who believe that they can indeed become rich by shifting their business risk onto others.
Venture capital is financing that investors provide to start-up companies and small businesses that are believed to have long-term potential. While there are different forms of venture capital financing, the venture capital industry was at its best in the nineties. It is now hardly ever promoted as the solution to every shortage of risk capital that people with exciting new business ideas often encounter.
The first myth that exists, at least locally, is that commercial banks are, or should be, a source of venture capital to promote economic growth. Commercial banks finance their lending either through wholesale borrowing in the money market or through retail deposits. Many depositors and operators in the money market believe in the universal maxim that ‘a banker’s word is his bond’. Put simply, when a banker borrows money either from frail old ladies with a savings account or from another bank that has excess liquidity, he is expected to repay that borrowed money in full and with interest. Commercial banks do not provide venture capital as statistically three out of four start-ups financed with venture capital fail within 10 years.
Junk bonds were never meant to be the haven for investors who have a very low risk tolerance and who could face immense hardships if the company they invest in fails
Another myth is that venture capital is cheap and comes with no strings attached by the investor company. It is no secret that venture capital companies take a big risk when they invest in start-ups. The standard venture capital fund charges an annual administrative fee of two per cent on committed capital over the life of the fund – usually 10 years – plus a percentage of the profits when firms successfully exit through the pre-agreed exit route. Venture capitalists also insist on a share of the equity capital, are represented on the board of directors, and often also want to be consulted on executive decisions. Commercial bank borrowing rarely includes such onerous conditions.
Perhaps one of the most popular myths is that venture capital companies finance speculative property development projects. This is certainly not the case in most countries like the US where the venture capital industry is well developed. Venture capital companies tend to like investing in innovative enterprises that have exciting ideas about developing a new product or service that has big potential growth prospects.
What is really creative – even if arguably very dangerous – is how certain high risk ventures are finding ways of shifting financial risk onto a multitude of investors who may not know much about what this risk may do to their hard earned cash. One of the most recent buzzwords in the financing industries is ‘crowdfunding’ whereby entrepreneurs raise capital from a large number of people. Rewards for financing in this way could be attractive for investors who understand the risk they are taking and demand to be rewarded accordingly.
What is a concern to most people who understand the link between risk and reward is that many companies that are finding it tough and expensive to raise capital for their high risk projects from traditional sources are venturing in the capital markets.
They sell bonds that offer relatively high coupon rates in the context of the present historically low interest rate scenario to thousands of unsophisticated savers. Junk bonds were never meant to be the haven for investors who have a very low risk tolerance and who could face immense hardships if the company they invest in fails.
Yet another myth is that venture capital gives spectacular returns to investors. Venture capitalists ‘bury their dead very quietly. They emphasise the successes but they don’t talk about the failures at all’. If savers were to know that their money was being invested in high risk projects that have a higher rate of failure than other normal business ventures, they would certainly not want their money to be buried with a failed business.
It is an annoying reality that many a Tom, Dick or Harry in public life seems to know how best to manage people’s hard earned savings. They offer free advice on how financiers should take risks with ordinary people’s money to promote economic growth. They know very little about venture capital financing.
johncassarwhite@yahoo.com