Angels and Other Venture Capitalists

April 01, 1999
By  Kim Peters

For decades, venture capitalists have nurtured the growth of America's high technology and entrepreneurial communities, resulting in significant job creation, economic growth and international competitiveness. Companies famous for receiving venture capital early in their development include Apple, Federal Express and Microsoft. Venture capital is money raised to invest in companies that have the potential to develop into significant economic contributors. The expectation is that the high-risk, long-term investments will yield higher rewards. Far from being passive financiers, venture capitalists foster growth in companies through their involvement in the management, strategic marketing and planning of their investee companies. They are entrepreneurs first and financiers second.

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.

Investing at any Stage

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

  • Seed investing occurs before a real product or the company is organized.
  • Early Stage investing 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 Stage investing, 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 Stage investing 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/Acquisition investing 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 below 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.

Venture Capital Investments (by industry) % $ Invested (in millions)
Computer Software & Services 33.9 5,428.5
Communication 17.3 2,763.5
Medical/Health Related 13.9 2,221.2
Other Products & Services 10.1 1,622.5
Biotechnology 6.8 1,085.5
Semiconductors/Other Electronics 5.2 834.9
Computer Hardware 4.5 727.3
Industrial/Energy 1.9 311.3

SOURCE: National Venture Capital Association

Small Business Investment Companies

The Small Business Investment Company (SBIC) program fills the gap between the availability of venture capital and the needs of small businesses that are either starting or growing. Licensed and regulated by the Small Business Administration (SBA), SBICs are privately owned and managed investment firms that make capital available to small businesses through investments or loans. They use their own funds plus funds obtained at favorable rates with SBA guaranties and/or by selling their preferred stock to the SBA.

According to Joe Foglia, SBA district director for Arkansas, "SBA licensed 31 new SBICs in 1998 and helped to provide equity capitalto nearly 3,500 small businesses. In addition, SBA soon will introduce a New Market Venture Capital program to support $100 million in equity investments and $30 million in technical support for firms located in low-to-moderate income areas."

SBICs are for-profit firms whose incentive is to share in the success of a small business. In addition to equity capital and long-term loans, SBICs provide debt-equity investments and management assistance. The SBIC program provides funding to all types of manufacturing and service industries. Some investment companies specialize in certain fields, while others seek out small businesses with new products or services because of the strong growth potential. Most, however, consider a wide variety of investment opportunities.

According to the Community Reinvestment Act (CRA) regulation, a bank's investments in support of organizations promoting economic development by financing small businesses receive favorable consideration as a CRA-qualified investment. Such organizations include SBICs and specialized SBICs.

For information on the following upcoming SBIC workshops, call 1-800-734-9496:

  • Kansas City, April 6
  • New York, April 12
  • Atlanta, May 6
  • Dallas, May 17
  • San Francisco, June 2

Bridges is a regular review of regional community and economic development issues. Views expressed are not necessarily those of the St. Louis Fed or Federal Reserve System.

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