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1、The Role of Venture Capital in Financing Small BusinessesMarjan PetreskiAbstract：Venture capital is an important alternative for companies that have difficulties accessing more traditional financing sources and it is a strong financial injection for earlystage companies that do not have evidence for
2、 persistent profitability yet. Firstly, deep prescreening process should be performed before investing in small, start-up business because of the information asymmetries, which in turn are the main cause for adverse selection and moral hazard problems. Well performed initial scan ensures good invest
3、ment. Seed capital provided than enables the firms set off. But what is more important is the conclusion that there is much more than just capital that flows from the investors to the organizations in which they invest. Indeed, fresh capital inflow is accompanied with the process of value-adding whi
4、ch provides the company with monitoring, skills, expertise, help and, basically, reputation for attracting further finance. Consequently, the role of the venture capital in financing small business is tremendous. The paper sheds light on these issues.Keywords： Venture Capital, Small Business, Entrep
5、reneurship, Financing1. IntroductionFinancing opportunities for small businesses have grown in the last few decades. On the other hand, entrepreneurships are crucial for the development of every national economy. Therefore, financing a small business is an issue which continuously captures academic
6、interests.Great part of the literature acknowledges that entrepreneurship is the fundament of the economic growth and productivity performance (OECD, 2004) and, as such, it triggers creating innovative small firms, which in turn add huge “blocks” in building the national competitiveness (Pandey et a
7、l, 2003). But, on the other hand, because of the high start-up risk and informational inconsistency, small firms are often highly vulnerable (Berger and Udell, 2002) and face with a harsh financing issues due to the investors refusal to “feed” the earlystage business (Gans and Stern, 2003). In other
8、 words, “the problem is that once you have bled your friends and family dry of cash, sold the cat and remortgaged the house, where do you go in order to get the wad of cash needed to progress your get-rich idea further?” (Reynolds, 2000, p.52).This is the point where the role of venture capital beco
9、mes important in financing small businesses. Moreover, economists agree that venture capital “provides a boost of adrenaline” (OBrien, 2001, p.9) for small start-up, innovative and dynamic firms, especially in the high-tech industry (Bottazzi and Rin, 2002). Therefore, it is said that venture capita
10、l fuels the growth and development of entrepreneurships. This paper aims to evaluate the contribution of venture capital for such entities and critically evaluate its role in financing small businesses.This is achieved by emphasizing the basic role of the venture capital in financing small business
11、in section one. Than, venture capital is viewed as a box of services which are also important as the very capital provided is. Moreover, this is acknowledged as a main contributor toward the firms professionalization. Finally, in the last part, certain space is devoted to the less attractive side of
12、 the venture capital.2 Why small start-up firms (must) choose venture capital financing? Venture capital primary roleEven though the process of brainstorming could be really productive and endless, entrepreneurs must often think about the financial side of their idea. Indeed, one could have brillian
13、t idea for starting up a smart business, but launching that idea needs fuel this makes him troubles. Therefore, such “poor” entrepreneurs must rely on external financing in order to start their business (Lulfesmann, 2000). Indeed, young, especially innovative and fast growing businesses find it very
14、 difficult the access to traditional ways of financing (Gompers and Lerner, 1999; cited in Giudici and Paleari, 2000). The latter is due to the fact that these start-up firms are too small to be fed by public debt and equity markets, than, because of their infancy, they can not collateralise eventua
15、lly offered bank loans (Repullo and Suarez, 1998) and they are associated with a “significant levels of business uncertainty” (Giudici and Paleari, 2000, p.154), arising from the persistent information asymmetries and high risk associated with the opportunity to cease. But, this does not mean that t
16、he majority of innovative ideas must go away. A brilliant chance arises for such cases venture capital.“Venture capital is thought to be an important alternative for companies that have difficulties accessing more traditional financing sources” (Manigart et al, 2002, p.103-104) and it (venture capit
17、al) is a strong financial injection for early-stage companies that do not have evidence for persistent profitability yet (Kleberg, 1998). In other words, venture capital is needed to trigger, maintain and to speed up the small enterprises growth and its performance, and therefore to result in improv
18、ed profitability. That is its primary role: it is the main contributor in getting rid of the most financial impediments that occur in the establishing phase of a new business. (Reynolds, 2000). In other words, it is “seed money” for the small business; it helps smart ideas to rise up. However, on th
19、e other hand, venture capital financing is associated with high levels of risk, which refers to the uncertainty of the positive returns that may occur even after a number of years or never (Mason and Harrison, 2004; Klofsten et al, 1999). Not only this, but venture capitalist may also embark on a ne
20、w business strategy which defers from entrepreneurs one; the former can even throw the entrepreneur out of the firm. These aspects are discussed later. What is sure, once it has been agreed, venture capital flows in the company and enables its start-up. This is the point when the idea becomes realit
21、y. But, not only providing the capital, venture capital injection brings more benefits for the venture-backed company than one could think of. Manigart and Sapienza (1999; cited in Manigart et al, 2002) point out “its roles of pre-investment screening, post-investment monitoring and value-adding” (p
22、.104). Critically said, venture capitalist becomes active entrepreneurs mentor, because, from now on, firms destiny turns out to be his concern too. Having this on mind, the result should be higher future returns for the investor and, of course, enhanced performance for the venture capital backed co
23、mpany. Consequently, when the role of the venture capital in financing small businesses is discussed, it can be inferred that it is multiple. Therefore, more attention to the latter is devoted in the following sections.3 Why invest in promising business? Venture capitalist perspectiveIt is vast agre
24、ed and practically proven that venture capitalists invest only in promising projects. At the very beginning, investors are deeply sceptical, bad mood reasoning with more answers “no”, rather than “yes” (Mason and Rogers, 1997; cited in Mason and Harrison, 2004). Furthermore, venture capitalists scre
25、en potential investments in regards to the collecting information about business, its market approach, management team or entrepreneur (Berger and Udel, 1998; cited in Baeyens and Manigart, 2003), all in order to reduce the initial information asymmetry and potential problems with entrepreneurs. In
26、other words, before final contracting, venture capitalist spends much of his time and efforts in assessing and observing the opportunity, in terms of its market size, strategies, customer adoption etc. (Kaplan and Strmberg, 2001b). This, in turn, should eliminate the possibility to access a non-qual
27、ity project (adverse selection problem) and “. should ensure that the funds will not be diverted to fund an alternative project (moral hazard problem)” (Berger and Udell, 2002, p.32). In this phase of initial scanning, investor should be convinced that his money will not simply “evaporate”. Instead
28、of that, it should make future value for him. Pre-screening phase, accordingly, enables platform for contracting on a sustainable basis. This means that the investment will surely bear fruit later. Thus, venture capitalists provide the capital and begin with creating new value, which they can extrac
29、t benefits for themselves from. Consequently, the role of the venture capitalist is dual: careful selection of promising firms or projects and than close observation over time (Kaplan and Strmberg, 2001a; cited in Hellmann and Puri, 2002a). The latter constitutes the next phase of the process of ven
30、ture capital financing accompanied with creating new value. 4 Venture capital “rich services package” and innovation stimulatorEven though the main role of venture capital is feeding small, innovative and fast growing firms with fresh capital, many articles (Giudici and Paleari, 2000; Kortum and Ler
31、ner, 2000; Bottazzi and Rin, 2002; Hellmann and Puri, 2002a; Stre, 2003; Wilson, 2005) suggest that venture capital backed firms receive many other services from venture capitalist which are as much important for the entrepreneur, as the very capital infused is.In their article, Giudici and Paleari
32、(2000) argue that as the capital is introduced in the firm, venture capitalist gains power to dynamically impinge on the management process in the firm in many different ways. Vast literature recognizes the last as a process of adding new value to the venture capital backed company. Indeed, the proc
33、ess of pre-investment screening discussed above, aims to provide stabile platform for investing in a company where the venture capitalist is convinced that he can add value to (Reynolds, 2000).The mission of the venture capitalist is to raise the business and not just to get reward, because as the b
34、usiness is raised, the rewards will come automatically (Pandey et al, 2003). Instead of that, “riding” together with the entrepreneur is more crucial for being rewarded. Broadly speaking, raising a business means that venture capitalist provides complete oversight to the firm, in terms of provided s
35、ervices, help and guidance for the entrepreneur (Lerner, 1995). Indeed, venture capitalist introduces a package of services in the firm in order to enhance its performance and its value.One of the most important services for the venture capital backed firm is the expertadvice that venture capitalist
36、 offers to the entrepreneur. Indeed, investor acts asentrepreneurs mentor, because, investing in nearby located start-up firms, means that he has sufficient knowledge for the industry, and therefore he can be involved in designing strategies, hiring the best executives and enhancing the network of c
37、ontracts with suppliers and costumers (Bottazzi and Rin, 2002; Hellmann and Puri, 2002a). According to Jungwirth and Moog (2004), this specific knowledge establishes basis for advanced assessment of the project: will it be successful or not and allows it “to be monitored at lower agency costs”(p.111
38、). Moreover, value-add process facilitates the venture capitalist as a firms promoter and consultant (Repullo and Suarez, 1998), because of his richness of expertise, competencies, experience and reputation (Stre, 2003; Wilson, 2005). In the same line of thinking, Fried and Hirish (1995) also agree
39、that venture capitalists create value by providing “networks, moral support, general business knowledge and discipline” (p.106). Kaplan and Strmberg (2001b) further broaden the areas where the investor could be contributable: “developing a business plan, assisting with acquisitions, facilitating str
40、ategic relationships with other companies, or designing employee compensation” (p.429). It can be inferred that, once the investor introduces its money in a business, he must devote much of his time in helping the business to succeed, structuring internal organization and appropriate human resources
41、 management (Hellmann and Puri, 2002b). In other words, venture capitalists help and adding-value are decanted in professionalization of the firm. Generally, it seems that firms professionalization is the major benefit from the venture capital financing. The article of Hellmann and Puri (2000; cited
42、 in Bottazzi and Rin, 2002) offers good explanation of the process of professionalization. Besides above mentioned features, they point out the speed of developing and bringing ambitious product to the market by venture backed companies. Moreover, this is crucial to achieve market leadership, especi
43、ally among innovative firms (Hellmann and Puri, 2002a). “Venture backed companies are, in fact, found to pursue more radical and ambitious product or process innovations than other companies” (Hellmann and Puri, 2000, p.236). Furthermore, Kortum and Lerner (1998) found that venture capital financing
44、 strongly impinge on firms innovation, patenting processes and the influx of technological opportunities. Consequently, this is the unique way to extract the social significance of an innovation (Gans and Stern, 2003). Hence, triggering innovations,along with the firms professionalization, is anothe
45、r valuable feature of the venture capital funding.All in all, contribution of the venture capital to the start-up firm is considerable. Besides many features provided by the venture capitalist discussed above, venture capital has one more important attribute: providing credibility, it attracts new f
46、unding. Baeyens and Manigart (2003) explain this by the fact that, through screening, observing and value-adding, venture capitalists reduce the information asymmetries and financial risks, and therefore adjoin legitimacy to the venture backed company and consequently influence on further financing.
47、 The last is an admirable fundament for further expansion of the firm. This, in turn, spurs the growth and development of entrepreneurship in the national economy in general the initial notion at the very beginning of this paper.Up to now, one may conclude that venture capital funding is brilliant w
48、ay of raising new business and realizing ones “imagination”. Indeed, the role of venture capital in financing small early-stage business is noteworthy, but this way of funding new business has its “dark side” too. This is examined further.4 The “dark side” of the venture capital funding Once the ven
49、ture capitalist and the entrepreneur have ended up the initial negotiations, and the former introduced its capital in, joint efforts should lead toward improved performance and higher expected returns. Both sides develop and contribute different types of knowledge and skills, “allowing each party to exploit its comparative advantage” (Cable and Shane, 1997, p.143). Moreover, confidence is crucial in entrepreneur - venture capitalist relationship and corresponds with a certain level o