Small Business Investment Companies

Following the Funds of the Venture Capital Cycle

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Venture capital comes from a variety of sources, including institutional public and private pension funds, endowments, foundations, insurance companies, banks or individuals. A venture capital firm is a pool of capital, typically organized as a limited partnership that invests in companies expected to yield a high rate of return within five to seven years. The venture capital firm serves as the general partner and the investors are the limited partner(s).

Venture capitalists may be generalist investors, which means they invest in a variety of industry sectors, geographic locations or stages of a company's life. Or, they may be specialist investors and invest only in specific industry sectors or geographical locations.

According to the National Venture Capital Association, the amount of capital invested by venture capital funds rose to more than $16 billion in 1998, a 12-percent increase over 1997. California continued to receive the most disbursements--almost $6.5 billion. Massachusetts followed with more than $1.8 billion while Texas, New York and Colorado rounded out the top five for 1998.

Not all venture capitalists invest in start-up businesses. In fact, many will invest in companies at various stages of the business life cycle:

• Seedinvesting occurs before a real product or the company is organized.
• Early Stageinvesting happens when a company is in its first or second stages of development. These companies have expended their initial capital in development and market testing and require funds to begin full-scale operations and sales.
• Expansion Stageinvesting, as the term implies, helps a company grow to become more successful. These companies are producing and shipping and have growing inventories and accounts receivable.
• Later Stageinvesting occurs in companies that are break-even or profitable and are experiencing increased sales volume to the point that additional funds are needed for plant expansion, full-scale marketing programs and working capital.
• MBO/Acquisitioninvesting occurs when managers have the opportunity to purchase an independent company or a division or product line of their employer, thus creating a new, independent business. Another situation that might occur is when a family business is experiencing growth and needs an ownership change to other family members and management.

The most common type of venture capital firm is the private independent firm, which has no affiliations with any other financial institution. Venture firms also may be affiliates or subsidiaries of a commercial bank, investment bank or insurance company. Others may organize through local, state or federal government investment programs that assist start-up companies. One common vehicle is the Small Business Investment Company program that is administered by the Small Business Administration. (See side bar for additional information.)

Corporate venturing programs are another form of venture capital. This investment vehicle, usually called "direct investing," seeks to invest in portfolio companies that have similar strategies as the parent company and will produce synergy or cost savings. These programs are designed to assist in meeting specific strategic objectives. Generally, the parent company's capital is used for investing.

In addition to organized venture capital funds, individuals also may be venture capitalists. Commonly referred to as "angels," these people mentor a company and provide needed capital and expertise to help them develop. Many angel investors are wealthy people with management expertise or retired businessmen and women who seek the opportunity for first-hand business development.