The mechanics of venture capitalism

By Ogembo Kaching’a in Pretoria

The financial markets are bruised and battered. The global economy is limping. Venture capitalists are the warriors of global economy regeneration. One way to get out of the economic mess is through venture capitalism — investing in cutting-edge technological innovations and new scientific discoveries or inventions, especially given the historical role of innovation and entrepreneurship as the lifeblood of the global economy growth.

Another way is through public investments and bailouts. The competitive advantage of venture capitalism is that it invents the future through creation of new industries and markets, products and services.

The most elite global financiers of technology business are venture capitalists. These are daredevil investors who typically give reasonable amounts of money to untried technological entrepreneurs to form companies in microelectronics, genetic engineering, tissue engineering, green technologies or others to develop new products and services.

Venture capitalism is big in the USA compared to other countries. American venture capitalists tell tales of their big scores: the $1.5 million (Sh117 million) stake in Apple computers by Venrock Associates that grew to $100 million(7.8 billion) or the $25 million (Sh2 billion) investment in 1974 by Court Securities Corp in Federal Express, the airfreight company, that is currently valued at $ 1.2 billion (93.6 billion).

Venture capitalists have become critical players in the global industrialisation process because they invest in cutting-edge technologies that will eventually define the future of the global economy — creating new products and services for future markets.

Venture capitalists have the courage to invest in unknown and untested business enterprises. Call it leaps of faith. Venture capital is the force behind transformational changes in innovative industries, while conventional funding instruments drive incremental changes.

Normally, venture capital firms take a block of stock in exchange for seed or start-up money. The venture capitalist may own between 15 and 60 per cent of the company’s outstanding shares, which then often jump in value when the new company goes public.

not for the fainthearted

It is not always a success story. Sometimes the venture fails, and venture money disappears. The venture capitalists seek out start-ups at the forefront of new industry, which the banks are reluctant to fund.

The odds may be long, but returns can be high. The generic rule in venture investment can be stated as follows: One large winner takes care of a lot of mediocre situations and even of an occasional failure. Venture capitalism is not a game for faint-hearted investors.

For the last 40 years, developed countries have focused their venture capital investments on high-tech industries. The aim was to open new industrial frontiers and markets. Success stories of those investments include innovations in industries such as computers, genetics and nanotechnology.

Some emerging economies like South Africa have developed a groundbreaking approach to venture capital investments by directing their limited resources (financial and intellectual) to social and economic investments such as health care and education.

The projects are driven by public and private partnership. The aim is to use intellectual property to generate revenue and social change.

For example, Cuba is one of the developing countries using their limited venture capital to invest in biotechnology for the development of vaccines for primary health care projects.

At the heart of venture capitalism resides comprehensive market analysis and business savvy to sort out possible winners from losers.

In the final analysis, venture investments boil down to educated business instinct. Most venture decisions depend on the management team, products or services of the start-up company.

major determinants

Because venture capital activities are at the cutting-edge frontiers of new industries, there is a high reliance on the team’s knowledge, experience and track record in the business sector.

Intellectual property and human capital are major determinants of any venture’s success. Venture capitalists prefer investing in people with technological innovation track records and excellent business ideas. Apart from bankrolling new businesses, they spend between two and six years providing judicious management assistance to the company.

The current boom in venture capitalism is driven by technological innovations and technological entrepreneurship. Venture capital has stimulated the process of making business sense of scientific inventions and discoveries.

Globally, nowhere is the venture capital pace faster than in Santa Clara County, California, where genetic-engineering firms are springing up alongside already successful semi-conductor manufacturers. The area once known as Silicon Valley has become the meeting point of high-tech business evangelists and venture capitalists.

One of the leading winners residing in the Valley is Genetech, which went public last year. The initial $200,000 (Sh15.6 million) put into the firm has swelled into stock worth $40 million (Sh3 billion).

New products, new jobs

Although the initial risk and reward of venture capital belong mostly to the small select club of moneymen, the eventual winner will be the entire global economy.

The secrecy surrounding venture capital is slowly fading away, ultimately improving the efficiency of the funding processes as well as the relations between financiers and technological entrepreneurs.

The innovative companies that venture capitalists fund and foster will manufacture new products, provide jobs and increase productivity in the 21st century.

Fundamentally, what we have to do is restructure capitalism. There is a need to get rid of the conservative capitalism that entrenches participants in the market while stifling innovation, by raising the barriers to entry for innovative ideas. We must have new rules that bias the playing field toward innovation capitalism, promoting investment in new ideas.

The writer is a Biomedical Engineering Scientist, Consulting Entrepreneur and Professor of Technological Entrepreneurship at the Graduate School of Technology Management, University of Pretoria, South Africa.