Role of Venture Capital in Stimulating the Growth of Innovative Small- and Medium Enterprises: Literature Review

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Introduction

In 2009, after tumultuous times, economic activities increased once again and small and medium enterprises (SME’s) claimed their place as the backbone of the economy (European Commission, 2018). In order to understand how SME’s enabled the economy to climb we must first define SME’s. A SME employs less than 250 persons and have an annual turn no larger than €50 million and/or a balance sheet not exceeding €43 million (European Commission, 2003). Within the term SME fall the micro, small and medium enterprises. Small with a limit of 50 persons and €10 million annual turnover and small with a limit of 10 persons and €2 million annual turnover (European Commission, 2003). In this paper I will be researching the how venture capital can stimulate the growth of innovative small- and medium enterprises (SME’s).

SME’s represent 99% of all businesses in the EU and provide over 66% of the private sector jobs (European Commission, 2019). One could say that the SME’s form the backbone of the entire economy, thus it is of crucial importance that these businesses are able to grow and fulfil their potential (Lee, Sameen & Cowling, 2015). However, many SME’s face troubles in growing. Accessing financial funds can be troublesome, Freel (2007) found that the economy’s most important enterprises, being the innovative firms, often have the hardest time obtaining finance.

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SME’s can experience growth through various roads, one of them is by using funding from venture capital firms to finance their growth. Venture capital is defined as equity financing (Wang, & Zhou, 2014). Investments are made into SME’s in exchange for a portion of the ownership, shares, of the firm. This entails that the SME does not acquire debt and this will decrease the impact on the liquidity of the firm (Wang, & Zhou, 2014). Most countries’ banks can solely provide debt financing, simply because they are not allowed to partake in equity financing, (Marx, 1998). According to Cassar (2004) firms the strive to achieve significant growth are more likely to use bank/debt financing. However, Cressy and Olofsson (1997) found that SME’s using debt financing on average have a lower growth rate. They add that the preferred type of financing depends on the size of the firm. Asset rich companies are more likely to request venture capital since they are more capable of carrying the debt (Cressy, & Olofsson, 1997)

Innovative and technological SME’s seeking to achieve (rapid) growth often lack the resources to finance their own growth, therefore they turn to external sources of financing that are of utter importance for, not exclusively, their growth, but also for the continuous existence of the SME (Beck & Demirguc-Kunt, 2006; Schneider, & Veugelers, 2010). Venture capital can provide the solution. SME’s that obtain venture capital are more likely to experience employee and revenue growth (Davila, Foster & Gupta, 2003). Davila et al. (2003) controlled their own findings by researching if growing SME’s attract venture capitalist or that venture capital leads to SME growth, concluding that venture capital indeed leads more growth. Therefore, this research poses the following research question: Is venture capital effective in stimulating growth in innovative SME’s, evident from Dutch technological SME’s?

This paper will contribute to the academic research by filling the research gap that is the effect on specifically innovative technological SME’s provided with the entrepreneur’s perspective. The research will achieve this by interviewing Dutch entrepreneurs, venture capital consultants and venture capitalists. Research focusses in this field focusses mainly on venture capital contribution to start-up companies, this research however, will focus on the expansion of existing SME’s.

Previous papers by multiple authors discussed that innovative SME’s struggle in obtaining financial funds, since innovation is hard to valuate and thus difficult to secure a loan against (Lee et al., 2015). Moreover, innovative firms offer no guarantee to success, a great number of innovative SME’s fail and make funder reluctant to provide funding (Lee et al., 2015). For this paper I will combine previous research done into growth of innovative technologically SME’s and 12 interviews conducted with entrepreneurs, venture capital advisors and a venture capitalist.

The research hypothesizes that venture capital will be effective in stimulating growth for technologically innovative SME’s. The stimulating effect will have multiple cause for the SME, however it is hypothesized that the growth will be stimulated by all aspects of the venture capitalists, being the new connections and network, the additional funding and the recruitment of new talent.

Literature review

Venture Capital can be best defined by separating the two terms; Venture is defined as “an activity that involves risk or uncertainty” (Cambridge Dictionary, 2019). Capital is defined as “a large amount of money used for producing more wealth or for starting a new business” (Cambridge Dictionary, 2019). Combining these to term explains that venture capitalists partake in activities that involve risk with money in order to capture more wealth. Venture capital carries different definitions in Europe and the United States. In Europe venture capital and private equity are similar terms. Unlike regular passive investors that solely invest money, the active private equity investors invest both money and time. The investors frequently join the board of directors or the advisory board in order to practice control over their investments. It is not rare that the active investors deliver a new CEO and other managers in the company (Jeng, & Wells, 2000). In the United states private equity is an overarching term that can also include leveraged buy-outs, the purchase of a company with borrowed money, uncommon finance methods in Europe and venture capital focusses on start-up firms (Jeng & Wells, 2000). Venture capital exists because of the cooperation of 2 types of partners, the passive and the active partners. The passive partners provide the funds from which the investments are made. These are among others insurance firms, pension funds or highly affluent individuals. Large funds are prohibited by law from being active investors and holding large equity stakes in companies, in the United States (Roe, 1990). The active partners are the venture capitalists, they manage the fund by investing in promising opportunities. Venture capital investments are done in high-potential companies and the venture capitalist will advise or control the company to secure adequate growth rates. The investors receive, in addition to their salary, a proportion of the profits made, which stimulates them to carefully nourish the investments (Samila, & Sorenson, 2011).

The importance of agreements between entrepreneurs and venture capitalist is increasing. These agreements often consist of 4 standard agreement. Firstly, monitoring frequency. Secondly, the frequency of internal process checks, the compensation schemes for the entrepreneurs to increase the motivation. Often the compensations are based on equity to stimulate the focus on growth (Jeng, & Wells, 2000). Thirdly, the activity of the venture capitalists in the board. Lerner (1995) shows that their presence is higher when the need for oversight is larger, however entrepreneurs are very reluctant with requesting venture capitalists in the board (Jeng, & Wells, 2000). Lastly, the presence of securities in the deal. A potential buy-out scheme for both parties in case the one decides to alter its ideas about the cooperation.

Alternatives. When entrepreneurs are seeking capital to fund their business or new branches of the business, they have many funding opportunities available, however not all are suitable due to the inherent entrepreneurial risk attached of entrepreneurship (Hellman, & Puri, 2000). Bank loans are the more traditional option for funding, yet for entrepreneurial funding, loans are given only sporadic. Often the amount of funding that startups need is not aligned with what traditional bank loans can offer. Adverse selection and moral hazard play significant roles moreover, the rules and regulations do not allow banks to invest when the firm’s hard assets are not enough to secure the potential losses (Jeng, & Wells, 2000). Startups often compensate the lack of hard assets with information, however this does not suffice in convincing traditional investors. Furthermore, in some countries, like the United States, banks are not allowed to hold equity, but in countries where bank are allowed to hold equity, Germany and Japan, bank are still not eager to use equity funding (Zider, 1998, Jeng, & Wells, 2000).

Self-funding is the first considered option for most entrepreneurs. This implies raising money from friends and family or from the entrepreneur’s own funds. The risk involved makes most entrepreneurs reluctant from requesting funds from friends and family (Fluck, Hotlz, & Rosen, 1998). Angels are wealthy individuals managing their own fund. Often angels are active in funding startup company, however the opportunity for receiving large sums of money is low (Gompers, 1994). Corporations offer loans as well by investing from their own investment fund in order to diversify their wealth (Hellman, Puri, 2000). The possibility of conflict of interest and increased bureaucracy is what might prevent entrepreneurs from using this type of funding (Block, & Milan, 1993). Venture capital is the only type of funding willing to take relatively high risks and therefore they operate in a special niche of investments, high risk entrepreneurial companies (Sawers, Pretorius, & Oerlemans, 2008).

It is important for entrepreneurs to be reminded that venture capitalists are often not interested in the firm and its capability itself. Their interest comes from the potential value of the firm. Many venture capitalists are not investing for the long-run (Zider, 1998). The aim of Venture Capital money is to facilitate an environment in which rapid growth can be achieved. To capture the rapid growth venture capitalists generally enter the firm when it takes the next step as a company, exploiting innovation. Estimates shows that approximately 80% of the VC investments made are into creating the infrastructure and environment for the exploitation of the innovation (Zider, 1998). The infrastructure and environment exist among others of bringing forth working capital and funds for manufacturing, marketing and sales.

When significant growth has been realized the venture capital firm wishes to re-sell (it’s stakes in) the company in order to translate their investment into profit. The reselling happens either by going public or be reselling to another corporation. Initial public offering (IPO) refers to when a private company starts selling its shares to the public for the first time in order to gain capital for the firm and/or for its shareholders (Ritter, & Welsch, 2002).

Investment stages. Venture Capital can be received in multiple stages of the SME finds itself in, these are called seed, startup and expansion investments. Seed investment entails that SME’s are seeking funds that are willing to help their ‘seed’ grow. The SME still finds itself in the idea stage, the received funds in this stage will be utilized for development and research of the product. In the startup phase, meaning that the firm is ready to produce, however that SME is still experiencing a negative cashflow and thus need funding. Since investments are done in the early phases these type of investments are simply called early stage investments (Jeng, & Wells, 2000). Furthermore, when an SME has grown passed the early stages, funding can be employed to finance further growth. Manufacturing and R&D operations can be expanded. This paper will focus not on early stages investment but on expansions stage investments.

VC management advice. The possibility to create technological advances is ever present, however to commercialize new technological techniques or products is different from developing it. Not all engineers have the required commercial techniques (Stam, Bosma, Van Witteloostuijn, De Jong, Bogaert, Edwards, & Jaspers, 2012). Many people are able to start a business, however not all are able to manage it properly, all project require the right entrepreneurial ability. Another opportunity for venture capital arises, they can offer passive and active advice or provide the SME with a matching manager to oversee and escort the project and to train the right people (Jeng, & Wells, 2000).

Venture capital risk factors. According to Jeng and Wells (2000) venture capitalists judge their investments by using main pillars, labor market rigidity, macroeconomic variables, fund providers and IPO’s. These are the four main determinants on which venture capitalist decide to invest and thus use to measure the rate to which the risk can be covered.

Firstly, labor market rigidities can form hurdles for the growth of an SME. Rigidities are different throughout cultures and reflect the geographic culture in which SME is based. Several factors can affect these hurdles such as working spirit and entrepreneurial acceptance. For example, returning to a previous job is frowned upon in Japan and often not even an option due to the perceived unloyalty of the employee, however in the United States employees are often encouraged to return to their previous employers (Lu, & Beamish, 2006). Labor market rigidities are often used to explain the difference in presence of venture capital in the United States and Europe.

Secondly, macroeconomics can affect the growth of the SME and thus the return on the investment (Lerner, & Tåg, 2013). Fluctuating macroeconomic circumstances influence the activity of start-ups (Acs, & Audretsch, 1994). Positive changes in the macroeconomic environment result in an increase of startup activity, this in turn results in an increase of venture capital activity (Jeng, & Wells, 2000).

Lastly, we will discuss the option of initial public offering. The main risk for venture capitalist is losing money, a realistic option that is frequently used is an “exit”. The exit mechanism provides the venture capitalist with the opportunity of exit the firm after a set amount of time (Hellmann, 2006). The exit only works when the SME has grown significantly so that the venture capitalists reach the required return rates of their investment. The exit strategy provides the entrepreneur with incentives as well for two reasons (Black, & Gilson, 1998). First, the entrepreneurs still own a certain percentage of the firm, with the exit their value can be determined and equity-based compensation will be paid out. Secondly, the entrepreneurs are offered the chance to buy back the control over the firm from the venture capitalists (Jeng, & Wells, 2000). An IPO is not only a way in which investments can be turned into cash, however a study conducted by Venture Economics (1998) shows that within a similar time frame an IPO on average yields a more than 4 times higher return. Moreover, deciding on an IPO is found more attractive by the entrepreneur, since he is able to regain control over the firm (Jeng, & Wells, 2000).

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Role of Venture Capital in Stimulating the Growth of Innovative Small- and Medium Enterprises: Literature Review. (2022, September 27). Edubirdie. Retrieved October 5, 2024, from https://edubirdie.com/examples/role-of-venture-capital-in-stimulating-the-growth-of-innovative-small-and-medium-enterprises-literature-review/
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Role of Venture Capital in Stimulating the Growth of Innovative Small- and Medium Enterprises: Literature Review [Internet]. Edubirdie. 2022 Sept 27 [cited 2024 Oct 5]. Available from: https://edubirdie.com/examples/role-of-venture-capital-in-stimulating-the-growth-of-innovative-small-and-medium-enterprises-literature-review/
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