Emerging social-economic institutions in the venture capital industry: an appraisal

American Journal of Economics and Sociology, The,  July, 1995  by Steven J. Waddell

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I

Introduction

Perhaps no industry is closer to the heart of capitalism than the venture capital industry. Without it, new enterprises cannot be formed. With it, growth rates that are indispensable to the capitalist paradigm are possible. Therefore, both the ways investment decisions are made, and social systems are connected to the venture capitalist, are important for the performance of the economy. While the traditional neoclassical view of self-interest and financial profit goals dominate this industry perhaps more than any other, there is increasing activity and experimentation with ways to bring social factors into consideration.

In the investment field over the past thirty years, a phenomenon called "social" investing has taken root. It is based in a theory that a single-minded focus upon financial outcomes overlooks negative social performance that eventually will impact financial performance. Most publicly offered "social investment" funds first assess companies in terms of their financial performance (i.e. return on investment on ROI), then review them for specific social issues. Numerous studies and indices support the contention that well-run social investment funds' financial performance is competitive with traditional funds. (Bruyn, Severyn, 1987; Lowry, Ritchie, 1991; Lydenberg, Steven and Domini, Amy, 1992)

These social investment funds that invest in existing companies through the stock market are being supplemented with similarly motivated venture capital investment vehicles that put money into companies which are at very early stages of development and not listed on a stock exchange. Venture capital, an essential ingredient in business formation and expansion, is difficult to obtain. Most lenders impose collateral and servicing requirements that are often impossible for new and expanding businesses. Venture capitalists supply money without such requirements, but become part owners of a new enterprise. This equity investment is usually long-term, for seven to 10 years. As owners, venture capitalists have a greater role in the actual operations than a debt-holder. Although stockholders are the least secure of any investors, they also have a chance for very high returns as the value of a new company expands.

Venture capitalists in the social investment tradition are sometimes referred to as "social purpose" equity investors. However, a more correct term would be "socially-guided" equity investors since both financial and social objectives are important. These investors believe that by creating jobs in new business, returns should be thought of as including factors such as reduced welfare costs, lower crime rates and greater self-esteem. Some of these investors also see themselves as making particularly valuable contributions to society by developing particular types of enterprises such as environmentally sensitive ones or ones which are employee- or minority-owned. This paper aims to investigate how these socially guided venture capitalist organizations formed, how they operate and how they perform socially and financially.

II

Methodology

This research was conducted for the Boston-based ICA Group, a non-profit consulting organization specializing in employee-ownership.(1) The organization includes a small loan fund which takes debt positions, and in the spring of 1993 was considering whether it should also establish a venture capital fund to take equity positions. With the financial support of The Mort Foundation, the author was engaged to investigate the current activity of socially-guided equity venture capitalists.

To be considered "socially-guided" an organization's investment strategy had to include two criteria. First, the investment organization had to focus upon investments under $500,000. Equity investments of this small size are notoriously difficult to find but are arguably of growing importance for an economy where small enterprise is providing an increasing share of the nation's jobs.(2) Family and friends have been the traditional source of investment at this level. Investment firms often argue that this is an uneconomic sub market, and that the costs to screen and service this size deal are similar to those entailed with much larger investments which also have the potential of large returns. Some argue that the inaction in this area by traditional venture capitalists results from fund managers' lack of familiarity with small business and their psychological desire for a few big wins, rather than many smaller ones.

The second defining criterion for inclusion in this study was that social goals were part of the matters an organization considered in making its investment decisions. This much harder to define criterion arises out of a concern over the impact of investments beyond that of their financial possibilities and relates to goals such as local ownership, employment creation and environmental protection.

The study was restricted to organizations in the private sector which also have to attain financial goals. Through innumerable telephone calls, companies were sought out that had substantial records. Organizations were looked for which had at least five equity positions, did not receive any organization specific special legislative privileges, combined both social and financial returns as goals, and had an equity portfolio dominated by investments of between twenty-five and five hundred thousand dollars.