Venture capital: The facts and the fiction

During the global Internet and technology boom of the late 1990s, many technology start-ups had the luxury of being able to choose which venture capitalist`s money to accept. Now, after the dot-com crash, capital is still available, but venture capital funds are more circumspect about where they invest it.

It is now more difficult for entrepreneurs to access the funds they need to start their dream companies. Funds are looking to make a return on their investment within a given period, a sea change from the dot-com years, when everyone spoke only about market share and revenue.

While capital is not being handed out to everyone with a business plan, venture capitalists say that, given the right criteria, entrepreneurs still stand a good chance of accessing it.

A joint global venture capital survey by VentureOne and Ernst & Young found that after a brief plateau in the fourth quarter of last year, venture capital investment fell to $5.1 billion raised in the first quarter of this year, 26% lower than the previous quarter. It says minor increases in communications, electronics and medical information systems could not offset steep declines in biopharmaceuticals, software, semiconductors, and particularly consumer and business services.

It says that, with a large Internet services component, the consumer and business services segment is now seeing the flipside of the Internet spending curve. This sector, which ballooned to more than $8 billion in the first quarter of 2000, has shrunk to $434.9 million in the first quarter of this year, in line with early 1998 levels.

The perception among South African entrepreneurs is that there is little or no money available for local start-ups. Many say they have approached several venture capitalists only to be told that the funds are not willing to invest the small amounts they need, or will invest only once the new business is profitable. "If I was making a profit I wouldn`t need the capital," one laments. But the venture capitalists say this is a wrong impression and does not present the full picture.

A recent survey of the local private equity market by the Southern African Venture Capital & Private Equity Association (Savca) and KPMG shows that SA`s private equity industry now has funds under management of R25.3 billion, including undrawn commitments of R8.4 billion, a 2% increase from 31 December 2000, when funds under management totalled R34.7 billion, including undrawn commitments of R7.4 billion.

The Savca/KPMG report says that while a number of factors contributed to the disappointing growth, a key issue has been the significant decrease in the level of new commitments raised by the independent private equity fund managers. (The survey distinguishes between captive funds - where private equity firms manage assets only off their own balance sheet or that of their parent company - and independent funds, which raise commitments from third-party investors and are usually closed ended.) This, it adds, is partly due to the availability of undrawn commitments, but also reflects the tough fund-raising environment. It says half of the funds raised in SA last year were for funds with a focus on earlier-stage investments. Funds raised from government agencies amounted to about 60% of total funds raised during the year. While more than a third of funds raised from government or aid agencies were sourced offshore, most of the remaining government funds were committed by the Industrial Development Corporation (IDC), a marked change from previous years when insurance companies and pension funds contributed most of the third-party funds. The report says the overhang of prior years` uncommitted funds raised from these sources, together with the smaller value of investments last year, may have resulted in limited new funds from those institutions. The depressed market conditions also reduced exit opportunities and therefore the amount of funds returned to investors.

Horizon Equity Partners MD Richard Flett says while the Savca/KPMG report shows that the total value of third-party funds raised last year (amounting to R1.1 billion) was lower than in previous years (R1.7 billion in 2000 and R3.2 billion in 1999), the percentage available for earlier-stage venture capital funds increased. Half of the funds raised last year were for venture capital funds (the other half for buyout-focused funds), compared with 41% in 2000 and only 3.1% in 1999. "So although funds raised are coming down, the percentage raised for early-stage venture capital funds has actually increased, and that money will have to be disbursed within the next few years," Flett says.

While there may still be a large amount of venture capital available, most fund managers agree the criteria for accessing it have been tightened up in the wake of the dot-com crash, and many prefer to invest development or later-stage capital. Earlier this year Vantage Venture Partners announced the first closing, at R200 million, of a R300 million venture capital fund targeting the information and communications technology industry.

One of Vantage`s founders, Chris Lister-James, says the total amount of venture capital available in SA has increased since the dot-com era, but that may be partly as a result of the length of the decision-making process. "People wanted to invest at the time of the boom," he says. "It took time to take the decision and to set up a fund, which might only be established now." However, he adds that now is also a better time for venture capitalists to invest. "There are probably more quality deals now, although there are fewer deals. A lot of the rubbish that approached us at the time of the boom, we don`t see anymore."

Flett says that compared with the rest of the world, SA never raised mountains of cash during the Internet boom, and the degree to which South African venture capitalists got burned is also much less than in the US, and so they are less reluctant than in the US to invest. "Post boom, more capital has been raised for IT in SA, but cash is not being held back here like in the US where VCs got burned. If you have a good project you can get capital. The message I would give is a positive one. Compared to overseas, the South African IT entrepreneur is relatively well placed," he says.

Compared to overseas, the South African IT entrepreneur is relatively well placed.

Richard Flett, MD, Horizon Equity Partners

Treacle Venture Partners says there is still a lot of demand for venture capital from people with early-stage ideas hoping to raise money. Partner Rudolf Pretorius says: "Our fund is both venture capital and private equity in the technology and telecoms market, and we have five investments of which two are really venture capital in the sense that they`ve had very little sales - they are very early-stage operations - and the other three investments are more of a private equity nature." He says while 80% of the firm`s deal flow is venture capital, it will make up about 10% once its fund is more fully invested. But that should not give the impression that there are no good ideas or good technology.

"The simple reason is that there`s a fair amount of technology skills in the SA market for the size of our market. There`s a lot of stuff going on at the universities and bright people who`ve got ideas. The difficulty comes with our market generally being too small to successfully commercialise something and so you need to have an international angle in order to make a business case with the technology. And that is very difficult coming from SA. Israel has got this massive Jewish community in the States and it`s easier, I think, because there`s a bigger contact base on that side and a lot of capital, whereas coming from SA people just don`t have the same links to actually internationalise their technologies cost-effectively. Secondly, there is obviously scepticism that anything can come out of SA. I think incorrectly so, but there is. Even in the local market, your larger corporates are very sceptical about buying IT from SA operations. So it`s actually quite a mountain to climb, and as a result of that we only back absolutely outstanding ventures as opposed to backing anything that looks very good and hoping that three out of 10 will come off because it`s just not going to be economically feasible for us to build a business that way."

The difficulty comes with our market generally being too small to successfully commercialise something and so you need to have an international angle in order to make a business case with the technology.

Rudolf Pretorius, partner, Treacle Venture Partners

Mark Shuttleworth`s recently launched Here Be Dragons (HBD) focuses on early-stage companies, and recently announced four investments in start-ups. Although spokesman Andrew High says most venture capital companies will not invest if an entrepreneur needs small sums such as R10 million, other private equity firms disagree. Flett says the idea that there is little or no venture capital for early-stage companies is a myth. "There are loads of capital available, from multiple sources, and most of the firms involved are quite happy to consider investments below R10 million. The myth that there is no seed or early stage capital for IT entrepreneurs has been in the financial fabric of this country for so long no one knows where it originated, but it`s accepted as fact because it`s repeated so often.

"Two or three years ago we saw the creation of a number of pure technology funds, but there were some funds prior to that with investments for IT start-ups as part of their whole portfolio. None of them focus purely on start-ups, except perhaps HBD." However, he adds that the rejection rate is much higher on seed projects because they are fundamentally riskier, and entrepreneurs have not done enough to reduce those risks. Lister-James says although there is still seed and early-stage funding available, the emphasis has moved to deals where the business is already established and is seeking funding for expansion, with many funds focusing on later-stage companies.

The IT and Internet boom was characterised by an emphasis on generating revenue and market share rather than earnings, and many funds invested capital on that basis. But times have changed. "There were a tremendous percentage of people looking for money in the dot-bomb era, people who never actually intended to build a business," says Treacle`s Pretorius. "They were trying to raise capital and then get a free option on something working or maybe passing it onto somebody else at a higher price and getting lucky, a quick buck sort of mentality. There`s still a bit of that around, but far less. There`s far more reality in the marketplace."

Says Lister-James: "Funds have become a lot more rigorous and diligent in the analysis process. During the boom many deals were done without responsible and thorough analysis, but there is more responsibility now."

Vantage principal Mutle Mogase says that while the ICT environment had hurt venture capital funds that invested at the height of the Nasdaq boom, expectations are now more sensible. "We have found the expectations of local ICT players seeking funding are far more realistic than they were during the Nasdaq and IPO boom. Instead of paying multiples of projected turnover, valuations are based on defined and achievable business models. Furthermore, the ICT sector in SA that has survived the downturn is strong, innovative and in many instances poised for internationalisation," he says.

During the boom many deals were done without responsible and thorough analysis, but there is more responsibility now.

Chris Lister-James, partner, Vantage Venture Partners

Pretorius says: "We still find guys coming to us saying, 'We`ve developed this very sexy piece of technology and we`ve installed it at such and such a client and it`s a reference site now, and now we`re going to go for R40 million fund-raising.` But what for? You don`t need the capital. And that`s sort of a way they exit. They`re not building real businesses. It`s still a way to make money - is to raise some. And it irritates me, because the way you make money in the real economy is by building a business with the minimum capital and getting a maximum return for your shareholders."

His message to would-be entrepreneurs seeking capital may be a difficult one for them to digest: "It`s incredibly tough. You conceptualise something, raise a bit of capital and get it to the point where it`s a product you can take to market. When you get to that point after maybe two or three or sometimes four years of very hard work and test marketing and having your initial reference sites up for whatever you want to do, and going through that very, very difficult period ... now you`ve got to commercialise, you`ve actually got to raise more capital to take it to market. About 20% of the job has been done at that point, and the entrepreneurs always think that`s about 80% of the job.

"It actually also requires a different skills set at that point in time which many entrepreneurs find it very difficult to adjust to because suddenly you`ve got to create a sales culture in your organisation, and you`ve essentially come from a developmental, technical [background] in many cases, and it`s a very, very difficult transformation to go through and only the exceptional entrepreneurs can actually make it."

Lister-James says there are ingenious software and smart people in SA. "But there is also the need for rounded and seasoned management. We won`t look at a project where there is just one good developer who expects to develop, market, do the accounts and everything else. There is a need for management who understand just how difficult it is to market software. We also favour companies with international potential and we look for an unfair advantage to market overseas, such as a distribution partnership. It is exceptionally difficult to market software overseas. If companies simply wish and hope their product will succeed, we don`t look at them."

The message from the venture capital industry is that while there is still a large pool of capital available, investors want to make money from it. As a result, they are more cautious about where they invest it. The onus is on the entrepreneur to present a convincing case that he or she can generate a better return than another investment. Only then is the struggle for funding won.