Small and Medium-sized Enterprise Financing in Canada — Part IV: Profile of Risk Capital Financing

1. Risk Capital Financing — An Overview

Risk capital is only one of many financing instruments available to Canadian SMEs. As discussed earlier in Part II, most SME debts are secured by business assets — short-term debt by accounts receivable and inventories, and long-term debt by fixed assets, such as land, buildings, machinery or equipment. SMEs also commonly use lease financing and quasi-equity debt. These involve flexible repayment terms over a relatively long period and royalty participation in the success of the business. Risk capital, on the other hand, is totally unsecured.

Which firms typically seek risk capital financing?

High-growth and KBI firms usually develop an idea, concept or product that requires an incubation period before generating revenues and profits. These firms face unique challenges in securing access to timely and appropriate financing, since they lack sufficient tangible assets to secure bank loans or other types of formal financing. Risk capital is often a more appropriate financing instrument for high-growth-potential and start-up SMEs, particularly in knowledge-based industries. It can originate from a number of sources, including: the entrepreneur's own investment, investment by family and friends (love money), informal private investment by wealthy individuals (angel investors), venture capital investment and investment through initial public offerings on stock exchanges.

The main characteristics of firms that are financed by risk capital are: High-growth orientation involving rapid potential and actual growth in terms of sales and market share, based on competitive advantage and dominant market position International orientation requiring strong potential for penetration of foreign markets and rapid growth in exports and/or foreign business operations High rates-of-return on equity arising from rapid sales growth and wide profit margins (or a high potential to achieve these targets). Generally, venture capitalists invest in firms that provide annual rates of return in the 35-to-40-percent range over a three-to-seven-year period (or at least returns proportional to the perceived risk) High R&D spending for product development and the creation of unique products, with the potential for a variety of applications that are required to maintain rapid sales growth and high profit margins in domestic and foreign markets; Strong management teams with a combination of technical, financial and marketing skills, ideally with experience raising and exiting risk capital investments Ownership structures providing for approximately one third ownership holdings by each of the initial informal investors or venture capitalists (up to a maximum of 50 percent), follow-on venture capitalists and founders

Venture capital is an important source of financing for a small number of technology-based start-up firms. In 2002, the majority of venture capital investments (84 percent) were concentrated in two technology-intensive sectors — information and communications technologies (65 percent) and life sciences (19 percent) — while traditional sectors attracted 11 percent of VC investments. However, low technology companies⁹² in traditional sectors with a unique idea or product and high market potential may also attract risk capital investment.

The spectrum of risk capital financing
Most businesses use a variety of financial tools throughout their life cycle. Business creation and company growth usually require several stages of financing, involving both debt and risk capital. In fact, what is appropriate at one stage of development may not be appropriate at another stage. For example, although SMEs commonly use traditional debt, this type of financing is often not appropriate or accessible for fast-growth and start-up KBI firms, for at least two reasons:

• These firms are knowledge-based and technology-driven, so their assets may be intangible and financial institutions are usually unable to realize any value in the event of a default
• Their products may take time before generating revenues and profits, so firms may be unable to service the debt during this preprofit period

As shown in Figure 47, during the seed and start-up stages, technology-driven high-growth SMEs are often almost entirely dependent on risk capital from owners' personal resources and informal investors (family, friends, private individuals or business angels) to finance their initial operations, such as research and product development. In the seed stage, equity financing is initially obtained either from the entrepreneur or from family and friends. Subsequently, financing may be supplemented by seed capital investment from informal private investors and, in a few cases, (e.g. high-growth-potential firms), by seed financing funds and venture capitalists. For high-growth-potential start-ups, informal investors and/or early-stage venture capital investors are the main source of external financing. In the expansion stage, SMEs generally require increasing amounts of equity to maintain R&D and product commercialization while expanding marketing and sales activities.

As companies continue to expand, they often require growing amounts of equity investment — amounts normally only available through IPOs on stock exchanges. Not only do IPOs supply growth capital, they also provide exit avenues for venture capitalists and other early-stage investors. Timely exits allow investors to recoup their original investments, realize their gains and reinvest their capital.

Risk capital encompasses a broad spectrum of financing options for companies at various stages of development. For investors, these options are highly interdependent, since market conditions that affect one type of risk capital often affect others. These market conditions determine the likelihood of a profitable exit from an investment, which in turn has a direct bearing on the availability of risk capital for other investments. From the investee company's perspective, market conditions determine whether they can access risk capital. For example, the availability of venture capital often depends on conditions in the IPO market. When venture capitalists see high prices and active markets for new firms on stock exchanges, they are more willing to invest in early-stage firms. A healthy IPO market goes hand-in-hand with a robust venture capital sector.⁹³ Without the ability to liquidate their positions in companies by taking them public, venture capitalists cannot, realize their profits and reinvest in other high-growth-potential firms. However, as will be discussed later in Section 4, IPOs are not always an appropriate financing option for SMEs.

The following sections examine three closely related sources of SME financing — informal investors, venture capital and initial public offerings — and assess the level of activity and impact of each type of financing on SMEs' development.

Figure 47
Types and Amounts of Risk Capital Financing by Stage of Development — Technology-Driven Businesses

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92. Paul Gompers, A Note on the Venture Capital Industry, Harvard Business School, July 2000.

93. Josh Lerner, Venture Capital, Technological Innovation, and Growth, 2001, Harvard Business School.