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

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

The other major cost is the price of capital. When analyzing the source of funds, the CDC's approach (with CV's exception) of using funds from their general asset base makes comparisons difficult. However, there is clearly a variety of sources of capital. Both the private venture funds raise their assets from foundations and one has raised money from a business, and another, from individuals. One fund has loans and equity investments, the other has only equity participation. The S/SBICs have been backed by the stock of Shorebank, but their assets have come from foundations and the Small Business Administration. The CDCs' main source of assets is their retained earnings. They also receive funding through low-cost federal loans, foundations and miscellaneous local (and usually housing-related) sources. One CDC received about $900,000 in grants from various sources to start its equity program. For all players government programs, other than the Federal Farm Lending, housing-related funding, and SBA, play negligible role in doing financing (although for actually doing deals, sometimes local state benefits like seed tax credit are available).

For two of the study group organizations, retained earnings make up the majority of their assets and provide capital without external obligation. Loans used to capitalize any of them usually cost one percent but sometimes, are as high as five percent. Their investors (as opposed to lenders) expect a long-term return of five percent or more. All this means that the funds have a significantly below market cost of capital, and therefore have much more flexibility in their operations than do traditional venture capital firms. Taking the five percent figure as a ceiling, some would have average cost of capital as low as a fraction of a percent, with the average less than two percent. The Investors' Circle reports that many deals it circulates could be done with modestly below-market expected rate of return.

Revenues. There are also two major sources of revenue for the study population: interest income and gains from the sale of investments. Interest income, coming from management of liquidity and debt financing (some organizations provide both debt and equity), depends upon the interest rates and the percentage of the fund not invested in equity. Most of the study group had a specific amount targeted for equity and near-equity investments, and averaged less than 50 percent placed in long-term equity or debt investments. This makes short-term money management an important issue. For the private venture funds, debt financing was negligible; for the S/SBICs it is very modest; but for CDCs it is significant.

[TABULAR DATA FOR TABLE 5 OMITTED]

Determining returns on equity investments is particularly problematical; indeed, since the average investment horizon is five to seven years, it is simply too early to make any conclusive comment with regards to the venture funds. To exit from investments, many equity investments become debt, and thus return calculation becomes further complicated. Some of the study group have no current estimated value of investments. With an average investment of 5.8 years, it is still too early to speak of clear-cut results. However, it can be said that out of the total 49 investments made by six core study group members, 10 (20 percent) have been written off or had a recorded loss. This picture compares with traditional venture capitalists who one study found write off completely 15 percent of their investments, lose money on 25 percent, up to double their money on 30 percent, make up to 500 percent on the original investment in 20 percent, and make over 500 percent in 10 percent. The latter group generates more than half of the total returns to the funds. (Wilson, 1985)