As mentioned earlier, all the funds provided to the “principal owner” and most of the “other equity” in Table 1 are insider financing. These funds are crucial in the “seed financing” and “start-up” phases, where information problems are most serious. Insider financing is often an essential requirement for injections of foreign finance to avoid moral hazard and adverse selection issues. In later growth phases, represented by the “middle-aged” and “old” categories in Panel C of Table 1, retained earnings are usually a significant source of financing. They are an essential source of strength to ensure external financing flows.
Venture capital and angel finance which account for 3.59 percent and 1.85 percent of total finance, respectively – constitute relatively tiny portions of small-business finance. However, this understates the importance of the private equity market, which comprises these two types for certain kinds of firms. Venture capitalists and angels make investments with a high degree of discretion and focus on small businesses with significant opportunities for upside. 13 So, most kids and teens would not be good candidates for angel financing, and the vast majority would not be eligible for venture capital.
The value of external private equity may best be measured not by the size of equity but rather by the firms’ final performance. According to the financial growth cycle model, The biggest winners are typically those that go public in the form of an initial public offering. 14 In the 1980s, about 15% of IPOs were funded by venture capital, far from the percentage of companies that received venture capital. Since 1990, this percentage has nearly doubled to 30 percent ( Fenn et al., 1997). Furthermore, discussions with business leaders indicate that most companies that receive venture capital have previously received angel financing. The next issue is the structure of angel and venture capital investment markets.
3.1. The market for angel finance
Angel finance is different from the other external finance forms in that it does not have an intermediary. Instead, it is an unregulated market for direct financing in which people invest directly into small-sized companies through an equity contract. It is usually common stock. The theory of modern financial intermediation implies that financial intermediaries can exist due to economies of scale in the production of information. They eliminate redundant information production by allowing small investors to pool their money through an intermediary. They also eliminate the costs of delegation associated with financial intermediation. Since angels, as a result of SEC regulations, are wealthy individuals, the amount of money they wish to invest into a tiny company will usually be in line with the amount the business requires. A single angle can be sufficient. Therefore, redundancy of information production is acceptable to consider. Angels generally provide funding ranging from $50,000 to $1,000,000, less than the typical venture capitalist ( Wetzel Jr., 1994).
However, angels do not continuously operate on their own. Angels may be part of an investment group that is small in size that coordinates their investment activities ( Prowse, 1998). Sometimes, this happens together with a “gatekeeper,” such as an accountant or lawyer, who helps bring the flow of deals into the organization and assists in creating the contract. The angel market tends to be localized, and proximity to investors is a factor in solving information-related issues.
There is some disagreement about the extent to which angels are active investors. Barry (1994)described angels as investors who do not “(take) on the consulting role of venture capitalists.” However, Wetzel Jr. (1994)reported that “angel deals typically involve a close group of co-investors led by a successful entrepreneur who is familiar with the venture’s technology, products, and markets.” Wetzel also noted that the advice and guidance angels provide entrepreneurs is often crucial. Many believe that angels will accept a psychic reward in exchange for monetary rewards and establish friendships with the entrepreneurs they invest in time. Angels typically invest in several rounds at various stages of their companies as they invest in progress through the initial stages of financial expansion. The extent to which angels are active investors and the degree to which their psychic return partially offsets the financial return remain unexplored questions. It is a safe bet that angels are less controlled in their investment decisions and have less financial knowledge than venture capitalists.
Although the angel market could best be described as informal, there have been attempts to formalize the market. These efforts could be prompted by the belief that the costs of information and search have been significant barriers to market effectiveness. One of the goals was to create private angel networks through which entrepreneurs can seek equity investment from angel investors who are part of the networks. The network is usually run by a non-profit organization (such as the university). It is sometimes called”the “switch.” Entrepreneurs solicit private equity by showing basic information about their company and their financial requirements through term sheets available on the network. Angel investors who have been “qualified” by the switch can then look through these terms sheets to identify businesses that are of interest to them. The entrepreneur then contacts the angels to discuss investment opportunities. Recently, the SBA has joined a variety of Angel Capital Networks to create a system called ACE-Net. The system allows angels to look up term sheets of entrepreneurs across the US ( Acs & Tarpley, 1998; Lerner, 1998a).
The merits of angel networks, and ACE-Net specifically, is an unsolved problem. The networks are generally subventioned and based on the notion that an element of market failure exists in the Angel Market. However, the current informally-based nature of the angel market could be the ideal solution to the ad-hoc information problems associated with beginning-stage financing for new ventures. Gatekeepers’ role could be crucial in reducing contracting costs based on information. An accountant, for instance, could have an investor and an entrepreneur as clients. When connected, accountants have reputational risk and therefore provide a portion of the benefits associated with traditional intermediation. It is unclear if an official market for angel financing is a viable alternative or supplement to the existing informal market for angels. 15
3.2. Market for venture capital
In contrast to the angel market, this market for venture capital is a middleman. 16 Venture capitalists fulfill the essential roles of financial intermediaries, acquiring funds from an array of investors and then redeploying those funds by investing in obscure issuers. Besides screening contracts, screening, and monitoring, they also decide on the timing and manner of exit from investments ( Tyebjee & Bruno, 1984; Gorman and Sahlman and Sahlman, 1989). In these duties, Venture capitalists are the most active investor, usually involved in strategic planning and, occasionally, in operational decision-making.
The relation between venture capital funds and portfolio investments can be seen in an increasing body of research aided by the creation of a new database ( Fenn & Liang, 1998). This research investigates the origination process and due diligence, how the venture capital firm has agreements with businesses it invests in, and how the institutional characteristics of the market impact the investment. At the time of origination, the venture capitalists face a complicated issue of adverse selection that is associated with providing external financing to opaque companies and thus spend a substantial amount of time looking at potential issuers (Amit et al., 1990; Fried & Hisrich, 1994; Fenn et and. 1997). Syndication can help resolve the adverse selection issue ( Lerner, 1994a).
A problem with agency arises in relationships between entrepreneurs and venture capitalists. In this situation, the entrepreneurs may need to exert more effort, display a preference for expense behavior, or need more knowledge or skills to make the right decision-making decisions regarding production. The issue could be exacerbated because information generally about the worth of the venture is only sometimes accurate and is revealed over time ( Cooper & Carleton, 1979; Bergemann and Hege Bergemann Hege, 1998). The variety of contractual features characteristic of venture capital investment could be explained as solutions for the agency issue. This includes the staging of venture capital investment to ensure optimal utilization of production options, as well as efficient stopping (Sahlman, 1988; Sahlman & Sahlman, 1990; Chan and. 1990; Admati and Pfleidererer in 1994, Admati and Pfleidererer Gompers 1995 Bergemann and Hege, 1998),17 control and the selection of a debt or equity instrument (Gompers, 1993; Marx, 1993; Cornelli & Yosha, 1997; Trester, 1998) and entrepreneur compensation (Sahlman Sahlman, 1990) as well as restrictive covenants (Chan et al., 1990 ), restrictive covenants (Chan et al.; Gompers & Lerner, 1996) as well as board representation (Lerner, 1995) as well as the distribution to shareholders voting rights (Fenn and. 1997). Additionally, venture capitalists spend a lot of time and effort monitoring their portfolio companies ( Gorman & Sahlman, 1989) as well as they usually focus on particular areas where they have developed expertise ( Ruhnka & Young, 1991; Gupta and Sapienza Gupta and Sapienza, 1993; Norton & Tenenbaum, 1993).
The majority of investment in ventures within the US flows through limited partnerships, with the majority part of the rest being provided by financial institutions’ subsidiaries. In partnerships, the general partners typically consist of the senior management from venture capital management companies, while the partners with limited rights are usually institutional investors. 18 The most significant categories of institutional investors include private pension funds (26 percent) and corporate pension funds (22 percent), commercial banks, Life insurance firms (18 percent), and also foundations and endowments (12 percent) ( Fenn et al., 1997; Fenn et al., 1997, Fenn et. 1997). The limited partners generally contribute the majority of the funds and are paid more than 80% of the profits from the partnership. General partners get 20 percent of the profits plus a fee for handling the fund. 19
The limited partnership structure is designed to deal with issues of asymmetric information and also to align the motivations of the general partners and those who are limited. This is done mainly due to the finite-life character of the partnership contract, which requires the general partners to raise funds annually to continue operating, as well as the linkage of their general partner’s pay to the performance that the association has. Other aspects include covenants that limit the management of a venture capitalist’s fund, the requirement for mandatory distribution, and other restrictions on any activities connected with dealing with self ( Sahlman, 1990; Gompers & Lerner, 1996).
Venture capital funds typically are a 10-year life span, generally with the possibility of extending it for two years. The most well-established venture capital management firms manage multiple funds simultaneously, each at different points in their lives. In the initial years that the funds are in operation, top managers look for and review new deals and negotiate agreements with the companies they select. In the later years, the venture capitalists are responsible for the investment portfolio of their fund’s portfolio. This involves an active role in administrating all of their portfolio firms. This includes providing consultancy services and solving significant operational issues, including serving as a director on boards of directors. Searching for and bringing on managers, sometimes replacing poor performers, and assisting the company in forming strategic alliances. Gorman and Sahlman (1989)found that these actions were connected to venture capitalists spending over 100 hours visiting their portfolio companies on an average of 19 times a year.