Venture Capital In Technology Ventures

A "disruptor" is someone who creates a product, service, or way of doing things that initially displaces and then replaces the market leader. These are entrepreneurs with creativity and a love of innovation. Even if they are not industry experts, they just realize that something is needed to meet a market need.

The problem is that when a person decides to start a disruptive business, they face all kinds of challenges that test their character and determination. He then learns that entrepreneurship is an attitude toward life-based on the predisposition to turn ideas into reality and adopt a proactive behavior in the face of the challenges that arise every day to find solutions and achieve new goals.

From the project's birth until it becomes a sustainable business, the entrepreneur will encounter problems he did not expect and situations that will disappoint him, but he will also encounter successes. The task seems more difficult for the technology-based entrepreneur, whose great challenge is to put supply in contact with demand. Many times it is a question of non-configured markets in which it is necessary to explain very well what is the benefit of his product or services. But perhaps the most difficult part for the technology-based entrepreneur is the start-up financing.

"Due to the high rate of change in technological development, the proliferation of innovative products (including new versions of existing products, as well as the availability of new products) and market demand, most technology-based companies face difficulties in obtaining sources of financing, because high-tech industry products have a very short life span and a high-risk rate."

Nevertheless, technology-based entrepreneurship has great potential, especially in emerging markets: As governments and individuals embrace technological innovations, opportunities arise, and those with the necessary expertise (in technology, entrepreneurship, or investment) can export their knowledge to help solve global problems.

An example of this is what is happening with technology start-ups in Africa, where they are undermining payment problems by leveraging Internet and mobile penetration. While around 40 percent of payments are made via mobile devices in the developed world, the rate shoots up to 60 percent in certain emerging markets such as Kenya and the Philippines.

Perhaps this is why, in recent years, technological entrepreneurship has attracted the interest of researchers and policymakers who recognize its positive effect on economic development. Drawing on a rich research tradition several authors define technology entrepreneurship as the interface of two well-established but related fields: entrepreneurship and technological innovation (Beckman, Gary. North Carolina State University).

Options available to a technology-based entrepreneur

But for any startup, funding events are strategic and require a lot of discipline, effort, and foresight. (See Kawasaki's book The Art of the Start.) So what are the options available to a technology-based entrepreneur? You can turn to traditional venture capital, angel investors, incubators, bank loans, personal funds, and even bootstrapping (using only existing resources, such as savings and personal equipment and facilities).

In the United States, for example, there are more than 3,000 entrepreneurship programs; among them are those at universities, startup accelerators such as Y Combinator and MassChallenge, regional economic development initiatives such as Jumpstart Ohio, and local Small Business Development Centers (SCORE) to support local business owners. These programs provide essential assistance in business planning, operations, and business management. Accelerator programs also help validate the idea through proof-of-concept strategies, outreach to potential customers for feedback and internships, and securing meetings with potential investors or corporate partners. Outside the U.S., there are more than 1,000 startup accelerators that help launch high-growth companies.

But it all depends on the type of company, the product, and the level of startup or development. While venture capital may be appropriate to bolster some companies, other models can help fund a technology-based startup, such as revenue and profit financing or strategic grants.

Revenue and profit financing models

Revenue and profit financing models are an option that could well be supported by state and local governments looking to grow their technology ecosystem. These are debt-like structures that support entrepreneurs whose businesses are largely funded by paying customers and take equity only when needed.

This model has grown in importance in recent years by some entrepreneurs rejecting the growth expectations, dilution, and constant fundraising cycles that come with raising venture capital. This model generally seeks steady, recurring revenues, healthy gross margins, and stable cash flows.

An example of the same is employed by the Calm Company Fund (formerly Earnest Capital) focused on supporting entrepreneurs through equity and advisory, which operates through a profit-sharing arrangement acting as a substitute for an equity-like structure, where an investor provides upfront capital and receives a percentage of the entrepreneurs' profits (essential profits), up to a cap. Another example is revenue-based financing, such as that offered by Lighter Capital, the largest provider of debt capital to startups, which provides entrepreneurs with growth capital in the form of a loan in exchange for a percentage of monthly revenues up to a repayment cap, paid out flexibly based on the company's performance.

Unlike an early-stage venture capital fund model, which relies on a minority of portfolio companies that generate most of the fund's returns through an exit event, revenue and profit-sharing models rely on a larger number of portfolio companies that provide moderate returns without exit pressure, thus aligning the incentives of entrepreneurs with those of investors to build profitable, durable, and steadily growing companies without the pressure of growth at all costs and high risk of failure.

Government involvement

Some believe that, to leverage revenue and profit financing mechanisms, governments should consider providing equivalent financial support to emerging funds using these approaches. Traditionally, this type of government involvement has been used to attract venture capital to places that hope to grow technology ecosystems.

One example of this model, which many believe governments should adopt, is Israel: in 1993, Israel launched the $100 million Yozma initiative to develop its fledgling venture capital industry. Through this initiative, the government provided up to 40% of the capital raised by outside investors to develop funds and invest in Israeli start-ups with funds led by private and international investors. The success of many Yozma funds attracted new fund managers and, by the late 1990s, much of the government's initial participation was acquired by private investors as the technology and investment ecosystem became self-sustaining.

Traditionally, this type of government involvement has been used in the venture capital space to grow technology ecosystems.

Direct grants are another option. These, provided by governments, can be a key early funding mechanism to support companies operating in sectors crucial to national or regional interests. They supplement venture capital for companies operating in sectors such as advanced manufacturing, which have difficulty raising venture capital due to high initial expenditure requirements.

One of the grant programs is, for example, the Small Business Innovation Research (SBIR) Program, which encourages companies to participate in federal research and development efforts critical to the U.S. government. This program operates in three phases: In the first, technical merit, feasibility, and commercial potential are established; in the second, research and development efforts are supported based on the program results of the first phase; and, finally, the phase of continuity to the commercialization goals of the previous phases is entered.

Continued federal support for these programs, as well as the expansion of grant programs to critical industries that drive regional economies, can provide the initial funding needed to demonstrate the technical soundness and commercial demand necessary to attract venture capital.

Continued federal support for these programs, as well as expanded grant programs to critical industries that drive regional economies, can provide the initial funding needed to demonstrate the technical soundness and commercial demand necessary to attract venture capital.

What about the venture capital option?

Venture capital is a form of investment suitable for early-stage innovative companies with strong growth potential. Generally, although not always the case, venture capital funds tend to invest in technology ventures with an innovative and attractive concept or technology, which have revolutionary potential and can be qualified as a "disruptor", as this guarantees a better return on investment.

Venture capital investments are traditionally made in exchange for a minority stake in the venture, due to the perceived higher risk of investing in early-stage companies.

Difference between venture capital and venture capital funds

At this point, it is important to distinguish the difference between venture capital and venture capital companies. Venture capital is a way of financing startups that do not have a track record that allows confidence in their results or the assurance that a profit will be received for the money lent to nascent projects. The venture capital fund (VC) is a specialty or subtype of the limited liability company, designed for temporary investment in companies, excluding those of a financial, real estate, or listed nature.

Unlike venture capital investments, VCs are willing to invest in companies that are not yet making a profit and typically hold their investments for a period of five to seven years before seeking an exit. Since their "reward" can easily be lost by one or more poor investments, before investing, the VC will thoroughly examine the potential risks of the investment and assess what the key ingredients are for the company's success, including the management team; they will want to know whether the management is up to the task, the size of the market opportunity and whether the concept of technology on which the investment is focused has what it takes to ensure a return on their investment.

Ultimately, due to the nature of the early-stage business, a venture capital fund will seek to reduce the risks associated with its investment to the greatest extent possible.

As far as the entrepreneur is concerned, they should provide the VC with guarantees for the investment, wait to have ultimate control of the company, and accept the investor's eventual intervention in the operation of the business since the "Series A investment" documents (the first venture capital investment made in a company) will normally impose strict restrictions on the management of the company. You will also need to have a well-thought-out, realistic, and achievable business plan.

Although venture capital has been championed as a popular funding mechanism for innovative technology companies for decades and provided more than $164 billion to startups in 2020, it funds less than 1% of startups in the United States.

Venture capital investment will depend on the sector

This means that venture capital is not for every type of venture. The venture capitalist adopts a high-risk, high-reward investment model of backing companies early in their life cycle considering their potential to grow and scale quickly in giant markets. They, therefore, look for companies that are asset-poor but capital-efficient and focused on growth over profitability.

Companies that can achieve steady or uneven growth, but are not like a rocket ship, are often not well suited to receive venture capital as they may have long sales cycles or sell into markets with a large revenue potential-not $100 billion-but may require significant capital expenditures or regulatory approvals before scaling.

Venture capital investment will depend on the sector in which the venture participates. For example, in the United States in 2020, the Internet and software sectors consumed more than 47% of national venture capital investment, while the industrial sector hovered around 4% and agriculture and energy/utilities did not exceed 1% each. Thus, sectors such as agriculture, public administration, and manufacturing see limited venture capital-driven innovation due to the incompatibility of the financing model with the sales cycles, market potential, and growth trajectories of these sectors. Even some technology companies operating in sectors more attractive to venture capital may not be able to access funding. If they do not exhibit the rapid growth trajectory sought by venture capitalists, leaving many sustainable growth technology companies with limited funding options.

Not all money has the same intrinsic value

Regardless of choosing the funding source that fits the specific needs of a project's moment in time, it is important to keep in mind that not all money has the same intrinsic value. For example, venture capital managed by professionals not only provides money, but also strategic advice and a network of contacts.

Similarly, it is necessary to be clear about concepts such as multi-stage financing, valuation criteria, risk mitigation, and employee stock pools. It is also important to consider the structure and terms of the transaction, corporate governance and control, and the role of liquidity events for stakeholders, such as IPOs (Initial Public Offerings) and merger and acquisition transactions. One can also consider, depending on the stage of development the venture is in, the Initial Public Offering (IPO), which in essence is a financing event (albeit with special features) and certainly not the final destination of a startup. Good references are "Raising Venture Capital for the Serious Entrepreneur" by Dermot Berkery and "The Entrepreneurs Guide to Business Law" by Constance Bagley and Craig Dauchy.

"The maturity of science and technology-based ventures depends on the degree of progress in the generation of the new product. Likewise, its investment plan depends on it, since profit expectations are associated with the level of technical knowledge achieved, which means that the technological advantage may also represent a commercial first."

Venture capital remains an important tool for supporting a subset of highly innovative, fast-growing companies. Its model is tailored to the financing needs and objectives of fast-growing software companies, and not necessarily to "hard tech" companies with large capital expenditures, or to sustainable growth companies in need of patient capital.

For policymakers looking to revitalize innovation in critical industries or support a broader swath of sustainable growth technology companies founded by a diverse set of entrepreneurs, it is important to take stock of what types of companies their funding programs encourage and consider cultivating private and public sources that meet their objectives.

There is an opportunity to facilitate financial support for funds and grants that would support a broader range of technology companies, through federal funding or from home-grown regional sources. By looking beyond venture capital and supporting the various avenues of growth for technology companies that best fit the goals of entrepreneurs, investors, and the community, governments can play an important role in fostering innovation that achieves broad-based prosperity.

Ethics of technological entrepreneurship

Finally, a factor that has been little considered and is thought-provoking: what are the ethics of technological entrepreneurship?

Entrepreneurship is not just about personal financial gain. It is about making a life-long plan that has a positive impact on society. Having character is important and there is no problem if you fail because you can start over, but unethical behavior is not valid. True wealth requires the creation of lasting value, which requires integrity and ethics.

Entrepreneurship and business are not contact sports subject to their own rules; they are an integral part of life and project the values of each participant. A culture of reliability and professional trust begins with the initial behaviors of the entrepreneurial team. Good readings in this regard are: "The Monk and the Riddle," by Randy Komisar (Harvard Business School Press), and "The Smartest Guys in the Room" by Bethany Mclean.