An alley to escape ‘capital’ punishment

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Small & Medium Enterprises (SMEs), though they account for more than 40% of domestic production, 50% of exports and 45% of industrial employment, have a weak capital base. The limited resources at their disposal make them susceptible to external and internal business shocks.

A key obstacle in SMEs development is their non-access to timely and adequate finance. Here, venture capital (VC) funding could be of help.

In fact, VC becomes an alternative way for financing SMEs when banks cannot intervene, and stringent collateral requirements cannot be met. It is also the only source of alternative finance when firms have outgrown their start-up phase, but have not yet reached full development. Private-equity financing for SMEs is still an underdeveloped market.

VC is a type of private equity capital typically provided to immature, high-potential, growth companies in the interest of generating a return through an eventual realisation event such as an IPO or trade sale of the company.

VC investments are generally made in cash in exchange for shares in the invested company. The financing typically comes from institutional investors and high net-worth individuals, but pooled together by dedicated investment firms.

During the 1960s and 1970s, VC firms focused primarily on starting and expanding companies. More often than not, these companies were exploiting breakthroughs in electronic, medical or data processing technology. This made VC almost synonymous with technology finance.

The investors are typically selective about where to invest in; as a rule of thumb, a fund may invest in one in 400 opportunities presented to it. Funds are mostly interested in ventures with exceptionally high growth potential, because of their ability to render high returns.

As investments are ‘illiquid’ and require three-to-seven years to harvest, venture capitalists carry out detailed due diligence prior to investment.

VCs also are expected to nurture the companies in which they invest, in order to increase the likelihood of reaching an IPO stage with attractive valuations. VCs are typically active at four stages in a firm’s development: idea generation; start-up; ramp-up; and exit.

The need for high returns makes venture funding an expensive capital source for companies, and most suitable for businesses having large up-front capital requirements which cannot be financed by cheaper alternatives such as debt.

That is most commonly the case for intangible assets such as software, and other intellectual property, whose value is unproven.

In turn, this explains why VC is most prevalent in the fast-growing SMEs.