Features of the informal venture capital market
The economic value of the informal capital market is not limited to the total amount of financing. Its positive impact on the development of small innovative businesses and on economic development as a whole is expressed in the following.
1. Informal capital, to a greater extent than venture funds, finances small businesses in the early stages of their development.
2. Having extensive experience in evaluating investment projects, business angels make a decision to invest or refuse within a much shorter period of time compared to venture funds.
This makes the process of financing small innovative businesses as a whole much more dynamic. Another advantage of the informal sector is that this form of financing is more flexible and can simultaneously include investments in equity, credit resources, or some combination of both.
3. Business angels, more than venture capitalists, support funded firms by providing them with comprehensive services in management development, marketing strategy, networking, business planning, etc., which, in particular, makes it easier to receive further these firms of financing from other sources, first of all - venture capital funds.
4. In most cases, business angels invest within their geographic region, which is understandable given the need for day-to-day involvement in the affairs of the firms that have received investments. This contributes to a more even distribution of wealth within the regions, the use of financial resources for the development of small businesses in these regions and, thus, more dynamic regional development.
The life cycle of small firms includes the following stages.
1. Seed ("company for sowing") - at this stage there is only a project or business idea. At this stage, it is necessary to obtain "seed capital" (seed finance) to conduct additional research and create pilot samples before entering the market. Thus, this is the stage of the incubation period.
2. Start-up ("starting" stage of development of the company) - at this stage, the company is just starting to work on the market and does not have a long market history.
3. Early stage, infant/young firm (early stage of company development) - at this stage, the company already has finished products and gradually begins to increase sales.
4. Expansion ("expansion") - the company already has a significant volume of sales, and it requires additional investments to expand production and sales, conduct additional marketing research, increase fixed assets and working capital.
The difficulty of obtaining financing is one of the limiting factors in the development of small firms. This problem is especially acute in the case of small high-tech firms, since they, introducing new technological products to the market, operate in an environment of high uncertainty, complexity and rapid pace of change. In addition, these firms typically have predominantly intangible assets and are unable to provide adequate collateral. All this makes them unattractive for banks in terms of providing investments. The importance of the above factors increases as we move from the seed stage to the expansion stage. But it is precisely in the early stages of development that a powerful financial push is especially important for these firms to gain a competitive advantage and, possibly, market leadership.
Most of the investments of large funds are in the expansion stage of companies. Seed and start-up investments generally account for about 30% of investments, the remaining 70% - for investments in the expansion stage. But if we talk about the structure of investments of business angels, then we get a completely different picture. About 80% of business angel investments are in start-up and young companies, and the remaining 20% are in established firms.
In the past few years, the role of business angels in financing small firms in the early stages of development has begun to increase significantly. This is due to the large influx of financial resources into venture funds. Formal sector venture capitalists, who as a result have to invest much larger amounts of capital, are forced to impose higher requirements on applicants for investment and increase the minimum investment amount.
Now the average investment of venture funds is $4.3 million. Typically, venture capital funds aim to invest at least $2 million in start-up firms. But for many "start-up" firms and firms at the "seed" stage, investments in such a volume are not needed: they simply will not be able to master them. Therefore, business angels, with their average investment of $50-100 thousand, are often the only solution to the financing problem for such firms.
As for the main sectors in which business angels invest their funds, among them are retail and wholesale trade, services, industrial
production, finance and insurance. Young high-tech companies receive a significant amount of investment in the informal capital market.
One of the main differences between formal venture capitalists and business angels is that the former manage other people's money, while the latter invest their own funds. In the process of investing, informal investors rely mainly on their own judgment and are more willing to make small investments in the early stages of a project. As a rule, informal investors require fewer formal documents and make decisions more quickly, which simplifies the process of obtaining investments for a small firm. After providing an investment to a small firm, business angels provide it with comprehensive support, in fact, becoming members of its management team and exercising hands-on management.
If an angel-funded firm gets off the ground and starts to grow successfully, then it has a high chance of getting larger investments in institutional venture funds in the future. This happens not only due to the fact that its characteristics and potential begin to meet the requirements of these funds, but also due to the fact that business angels themselves often maintain partnerships with venture funds and simplify the process of interaction between entrepreneurs and funds through their contacts. Therefore, it is quite fair to say that the informal and institutional sectors of the capital market play a complementary role.
By one definition, the classic venture capitalist is focused on long-term investments in high-tech projects in the early stages, which are accompanied by active participation in the implementation of funded projects and in the development of entrepreneurial skills of the staff of small firms. In contrast, the merchant venture capitalist is focused on larger investments in projects at later stages of implementation. Know-how in financial management, commercial transaction design and pricing are the most important skills inherent in this type of venture capital. There is a lot in common between the activities of venture capitalists and business angels, especially in terms of hands-on management. Indeed, both those and others in the implementation of venture capital investments are guided by the same principles. But given the trend towards larger venture capital funds mentioned above, it is business angels who are starting to fit more into the “classic” form of venture capitalist, while institutional funds are starting to gravitate towards a larger amount of venture capital.
To count on business angel investment, small firms must be prepared for the emergence of a large shareholder and for a significant loss of autonomy in managing the firm.
In doing so, they must be able to:
competently negotiate with a potential investor so that the participation of a business angel in the affairs of the company becomes a source of new opportunities and growth and does not lead to a loss of control over the company by its founders;
have a good business plan;
be aware of what skills they will need to grow;
be able to organize financial accounting;
study the market well.
By receiving business angel investments, firms receive the following benefits:
access to the capital necessary for growth;
the presence of a new competent team member interested in the development of the company;
hands-on learning of skills and experience as the firm grows;
objective point of view on business and market situation;