Bridging The Gap Between Funders And Entrepreneurs Commerce Essay

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A research project submitted to the Gordon Institute of Business Science, University of Pretoria, in partial fulfilment of the requirements for the degree of Master of Business Administration.

ABSTRACT

The abstract should appear on the next page and should be limited to 200 words. The abstract should start with a sentence that describes the major theme of the research. The purpose and methodology of the research and the outcome should then be briefly described.

KEYWORDS

Business angels

Entrepreneur

Funder

Start-up

Venture Capitalist

DECLARATION

I declare that this research project is my own work. It is submitted in partial fulfilment of the requirements for the degree of Master of Business Administration at the Gordon Institute of Business Science, University of Pretoria. It has not been submitted before for any degree or examination in any other University. I further declare that I have obtained the necessary authorisation and consent to carry out this research.

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Frans Sarel Jacobus Els

7 November 2012

ACKNOWLEDGEMENTS

I would like to express my appreciation and gratitude to a number of people who have made this research possible.

I would like to thank my supervisor Judi Sandrock, for her insight, expert advice and guidance.

The staff at the Gordon Institute of Business Science, particularly the library staff, for all their assistance.

A big thank you goes to Yendra Booysen and Sharon van der Westhuizen for all their assistance from start to finish.

This research would not have been possible without the responses and generous amount of time that the interviewees afforded me. A special thanks to Charl Cilliers and Koos van Ettinger for contributing to my research and my MBA degree and allowing me many hours of study leave.

Thanks to my colleagues at the office for keeping things going while I was away for days.

Last but not least I would like to thank Mikhail Adriaanse for standing by my side, although we sometimes only saw each other on Skype.

TABLE OF CONTENTS

ABSTRACT………………………………………………………………………………………...…ii

KEYWORDS……………………………………………………………………………………….….iii

DECLARATION…………………………………………………………………………………….iv

ACKNOWLEDGEMENTS………………………………………………………………………....v

TABLE OF CONTENTS………………...…………………………………………………………vi

LIST OF TABLES………………………………………………………………………………….viii

LIST OF FIGURES………………………………………………………………………………….viii

LIST OF TABLES

LIST OF FIGURES

CHAPTER 1: INTRODUCTION TO RESEARCH PROBLEM

The problem statement

The European Private Equity and Venture Capital Association (EVCA) (2007) claimed that private equity and venture capital is an increasingly important source of finance for potential companies as three quarters of the Europeans consider a lack of financial support as the main reason for it being difficult to start their own business. In 2008, venture capital-backed firms accounted for 11 percent of jobs and 21 percent of GDP (Dos Santos, Patel & D'Souza, 2011).

ENTREPRENEURS - The South African private equity (PE) and venture capital (VC) industry has over R100 billion under management. The supply of VC to the small and medium enterprise (SME) segment is an integral part of a healthy funding economy. Typical the supply of risk capital enables the formation and growth of businesses that would not be able to raise other forms of finance due to the risk profile of such investments. In 2010, SAVCA commissioned a review of all VC funding in the last ten years based on our belief that an adequately large body of empirical evidence has developed in South Africa, making possible a comprehensive and useful analysis of VC activity. (J P Fourie 2010).

The term entrepreneurship in business has advantages and disadvantages.

The advantages of being entrepreneur are people can earn a lot of money from their business. It can happen if their business is very interesting to the customer. And that condition can make the business more famous in society.

Beside it, by becomes an entrepreneur, people can determine their future by themselves.

It is caused that the people who are entrepreneurs should:

Organize

Manage

Calculate the risks of their business by themselves.

So thus an entrepreneurship can lead the people to earn a lot of money and as the stock for the future.

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The important thing is an entrepreneur will take the benefit for him or herself only. On the other hand, an entrepreneurship also gives some disadvanges for the people. For example, the people who are entrepreneurs will not have more time to just relax or refreshing. It is because they have to work for long hours to manage the business.

Entrepreneurs organize and manage the business themselves. Even, if they cannot handle the business, they can fall down and fail. In some cases, that condition was happened to the passive and uncreative people or entrepreneurs. While in the active and creative entrepreneurs, that condition will not happen. (Entrepreneurs Line 2012).

There is absolutely no doubt that enterprise development is the key when it comes to small business development for South African entrepreneurs. Gone are the days when you could simply leave school, study and then get a job. With more and more people in the marketplace, and fewer corporate jobs to go around, a large percentage of school leavers remain unemployed, hoping family members will be able to support them. That is fact of life in the 21th century.

But - and it isn't a very big but either - if you are able to identify opportunities and create and successfully grow your own business, you can make a good living and contribute toward the economy of the country at the same time. You will be able to live comfortably and be a valuable member of society.

Entrepreneurs are essential to economic development everywhere

It has been said that economic development is directly related to the level of entrepreneurial activity in any country. This is because there simply aren't enough regular jobs to go around, and people who would otherwise be unemployed, have to make money to live, not only that entrepreneurial development also adds value to society as a whole.

People improve themselves and create opportunities for other people. They also make products and services available, many of which are more affordable than those by large corporations.

Recent advances in entrepreneurship research indicate that the differences in entrepreneurs and the heterogeneity in their behaviors and actions can be traced back to their founder's identity. For instance, Fauchart and Gruber (2011) have recently utilized social identity theory to illustrate that entrepreneurs can be distinguished in three main types: Darwinians, Communitarians and Missionaries. These types of founders not only diverge in fundamental ways in terms of their self-views and their social motivations in entrepreneurship, but also engage fairly differently in new firm creation.

Influences and characteristics of entrepreneurial behavior

Management skill and strong team building abilities are often perceived as essential leadership attributes for successful entrepreneurs. Robert B. Reich considers leadership, management ability, and team-building as essential qualities of an entrepreneur.

This concept has its origins in the work of Richard Cantillon in his Essai sur la Nature du Commerce en (1755) and Jean-Baptiste Say [5] in his Treatise on Political Economy.

Psychological studies show that the psychological propensities for male and female entrepreneurs are more similar than different. A growing body of work shows that entrepreneurial behavior is dependent on social and economic factors. For example, countries with healthy and diversified labor markets or stronger safety nets show a more favorable ratio of opportunity-driven rather than necessity-driven women entrepreneurs. Empirical studies suggest that men entrepreneurs possess strong negotiating skills and consensus-forming abilities.

Research studies that explore the characteristics and personality traits of, and influences on, the entrepreneur have come to differing conclusions. Most, however, agree on certain consistent entrepreneurial traits and environmental influences. Although certain entrepreneurial traits are required, entrepreneurial behaviours are also dynamic and influenced by environmental factors. Shane and Venkataraman (2000) argue that the entrepreneur is solely concerned with opportunity recognition and exploitation, although the opportunity that is recognised depends on the type of entrepreneur; while Ucbasaran et al. (2001) argue there are many different types contingent upon environmental and personal circumstances.

Jesper Sørensen has argued that some of the most significant influences on an individual's decision to become an entrepreneur are workplace peers and the social composition of the workplace.

In researching the likelihood of becoming an entrepreneur based upon working with former entrepreneurs, Sørensen discovered a correlation between working with former entrepreneurs and how often these individuals become entrepreneurs themselves, compared to those who did not work with entrepreneurs. The social composition of the workplace can influence entrepreneurism in workplace peers by proving a possibility for success, causing a "He can do it, why can't I?" attitude. As Sørensen stated, "When you meet others who have gone out on their own, it doesn't seem that crazy.

Perception of entrepreneurs

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The ability of entrepreneurs to innovate is thought to relate to innate traits such as extroversion and a proclivity for risk-taking. According to Schumpeter, the capabilities of innovating, introducing new technologies, increasing efficiency and productivity, or generating new products or services, are characteristic qualities of entrepreneurs.

Entrepreneurs are catalysts for economic change, and researchers argue that entrepreneurs are highly creative individuals with a tendency to imagine new solutions by finding opportunities for profit or reward.

Largely due to the influence of Schumpeter's heroic conceptions of entrepreneurs, it is widely maintained that entrepreneurs are unusual individuals. In line with this view, there is an emerging research tradition investigating the genetic factors that are perceived to make entrepreneurs so distinctive (Nicolaou and Shane, 2009).

However, there are also critical perspectives that attribute these research attitudes to oversimplified methodological and/or philosophical assumptions (Gartner, 2001). For example, it has been argued that entrepreneurs are not that distinctive, but that it is in essence unrealistic preconceptions about "non-entrepreneurs" that maintain laudatory portraits of "entrepreneurs" (Ramoglou, 2011).

Classification of entrepreneurs - Based on functional characteristics:

Innovative entrepreneur:

Such entrepreneurs introduce new goods or new methods of production or discover new markets or reorganize the enterprise. EX: new product, new ways of product, new markets and reorganise the enterprise.

Imitative or adoptive entrepreneur:

Such entrepreneurs don't innovate or copy technology or technique of others. .

Fabian entrepreneur:

Such entrepreneur display grates situation and scepticism in experimenting with any change in their enterprise. They change only when there is a serious threat to the very existence of the enterprise.

Drone entrepreneurs:

Such entrepreneurs are characterised by a diehard conservatism and may even be prepared to suffer the losses. EX: Acc. To MC Kinsey in 2015, 110-130 million people will be unemployed out of which 90-100 million people will be Fresher.

Prime mover:

This entrepreneur sets in motion a powerful sequence of development expansion and diversification of business.

Manager: Such an entrepreneur doesn't initiate expansion and its content in just staying in business.

Minor innovator: This entrepreneur contributes to economic progress by finding better use for existing resources. EX: minimum wastage maximum production.

Satellite: This entrepreneur assumes a suppliers role and slowly move towards a productive enterprise.

Local trading: Such entrepreneur limits his enterprise to the local market.

Venture capital (VC) is financial capital provided to early-stage, high-potential, high risk, growth startup companies. The venture capital fund makes money by owning equity in the companies it invests in, which usually have a novel technology or business model in high technology industries, such as biotechnology, IT, software, etc. The typical venture capital investment occurs after the seed funding round as growth funding round (also referred to as Series A round) in the interest of generating a return through an eventual realization event, such as an IPO or trade sale of the company. Venture capital is a subset of private equity. Therefore, all venture capital is private equity, but not all private equity is venture capital.[1]

In addition to angel investing and other seed funding options, venture capital is attractive for new companies with limited operating history that are too small to raise capital in the public markets and have not reached the point where they are able to secure a bank loan or complete a debt offering. In exchange for the high risk that venture capitalists assume by investing in smaller and less mature companies, venture capitalists usually get significant control over company decisions, in addition to a significant portion of the company's ownership (and consequently value).

Venture capital is also associated with job creation (accounting for 2% of US GDP),[2] the knowledge economy, and used as a proxy measure of innovation within an economic sector or geography. Every year, there are nearly 2 million businesses created in the USA, and 600-800 get venture capital funding. According to the National Venture Capital Association, 11% of private sector jobs come from venture backed companies and venture backed revenue accounts for 21% of US GDP.[3]

It is also a way in which public and private actors can construct an institution that systematically creates networks for the new firms and industries, so that they can progress. This institution helps in identifying and combining pieces of companies, like finance, technical expertise, know-hows of marketing and business models. Once integrated, these enterprises succeed by becoming nodes in the search networks for designing and building products in their domain.

In 2007, the European Parliament introduced a new budget line entitled "Erasmus for Young Entrepreneurs". The European Commission then started to design the Pilot Project with the aim of supporting mobility periods abroad for recently established and nascent entrepreneurs, with a view to improving their skills and fostering the cross-border transfer of knowledge and experience between entrepreneurs.

Erasmus for Young Entrepreneurs comes under the Small Business Act for Europe which considers this initiative a key contribution "to create an environment within which entrepreneurs and family businesses can thrive and entrepreneurship is rewarded".

Erasmus for Young Entrepreneurs is to a certain extent similar to the well-known Erasmus Programme for students since it is a mobility action which addresses a particular target group.

However, it is also clearly different: whereas the existing Erasmus programme in higher education enhances student-to-university relationships, the new Erasmus for Young Entrepreneurs focuses on business-to-business relationships. The various EU mobility programmes are complementary to each other offering mobility opportunities to different target groups at different moments of life.[3]

Entrepreneurs are playing an increasingly important role in the South African economy and according to the outcomes from The Entrepreneurial Dialogues in 2010, these individuals need to be identified and nurtured (Fal, Sefolo, Williams, Herrington, Goldberg & Klaassen, 2010).

'South Africa needs a vibrant new business ecosystem to generate the kind of job growth necessary to make a dent in the 25% unemployment rate haunting this country. We know SMEs and new businesses are the only sustainable way to create economic growth and employment, yet the environment can be particularly unfriendly to newcomers, burdened with administrative red tape and the lack of access to capital' (Charalambous, 2012, p.1)

However, it is not only newcomers who are faced with challenges. Access to capital was discussed at length in The Entrepreneurial Dialogues by Fal et al. (2010), and the insights clearly show that there is a disconnect between the entrepreneurs and funders with regards to:

Too many entrepreneurs in saturated markets / industries make them less attractive to funders;

The entrepreneurs are most often un-researches and unprepared for the lengthy process of accessing funding;

Entrepreneurs' expectations are not managed. They expect a quick and easy process and tend to become very pessimistic when this does not happen;

In the majority of cases the perception is that capital is the main reason for business success, whereas there are various factors, including the entrepreneur him- or herself which play a role in the business succeeding;

Discrepancies in matching between funding mandates, criteria used and the entrepreneur's eligibility.

Based on these insights, the recommendation was that a more direct approach is needed to address this perception gap and this could be achieved by analysing feedback from entrepreneurial groups on their experiences in trying to access capital (Fal et al., 2010).

Given this context, the aim of this study is to create a comprehensive understanding of the criteria used for evaluating entrepreneurial ventures within South Africa. A comprehensive understanding will be created by exploring the differences and similarities between funders' use of evaluation criteria and entrepreneurs' experiences in the application of these criteria by funders during each growth stage. Therefore, the author intends contributing to the growing body of knowledge on entrepreneurial funding, but most importantly to bridge the perception gap between these two stakeholders.

Scope of the research

This study will be conducted within the boundaries of South Africa, with a specific focus on entrepreneurs and funders. In the context of this study, funders are categorised as venture capital firms and banking institutions which invest in entrepreneurial ventures. The focus will furthermore be on exploring all growth phases.

CHAPTER 2: LITERATURE REVIEW

The Entrepreneur

Sarasvathy (2004) stated that individuals need to be motivated to become and succeed as entrepreneurs, and went further by highlighting that a restriction of choice in a variety of risk capital is needed. Several examples of the challenges that prevent small and medium enterprises from expanding operations in developing countries are listed by Leo (2010). These include a lack of access to financing instruments designed for their needs. Entrepreneurs face budget constraints that limit spending on resources (Allen & Hall, 2009).

Forms of funding

An Entrepreneur's most likely source of outside finance is listed by Van Osnabrugge and Robinson (2000) as being:

Founder, family and friends; also named as SEED FUNDING the initial capital used to start a business. Seed capital often comes from the company founder's personal assets or from friends and family. Seed money is typically used to pay for preliminary operations like market research and product development. Seed funding is not normally associated with VC fund managers, especially not in South Africa.

Seed investments did not feature in any of the years except 2008. Many critics of the South African VC asset class quickly point to the lack of seed investment in South Africa. (SAVCA 2010).

START UP CAPITAL: Funding used for setting up operations (hiring staff, renting office space, equipping the production system, commercialising intellectual property, and other activities.

DEVELOPMENT CAPITAL (MOSTLY PRE-REVENUE DEALS) - Finance used after start-up capital to further launch the business and grow market share in order to become profitable.

GROWTH CAPITAL (POST-REVENUE DEALS) - Equity type investments used to assist established but still high-risk ventures in expanding activity such as launching into foreign markets, creating new product / technology lines, accelerating production and / or acquiring competitors.

Source and extent of funding

Business Angels typically invest their own funds, unlike venture capitalists, who manage the pooled money of others in a professionally-managed fund. Although typically reflecting the investment judgment of an individual, the actual entity that provides the funding may be a trust, business, limited liability company, investment fund, etc. The Harvard report by William R. Kerr, Josh Lerner, and Antoinette Schoar tables evidence that angel-funded startup companies are less likely to fail than companies that rely on other forms of initial financing.

Angel capital fills the gap in start-up financing between "friends and family"-(sometimes humorously given the acronym FFF, which stands for "friends, family and fools") who provide seed funding-and venture capital.

Although it is usually difficult to raise more than a few hundred thousand dollars from friends and family, most traditional venture capital funds are usually not able to consider investments under US$1-2 million.

Thus, angel investment is a common second round of financing for high-growth start-ups, and accounts in total for almost as much money invested annually as all venture capital funds combined, but into more than 60 times as many companies (US$20.1 billion vs. $23.26 billion in the US in 2010, into 61,900 companies vs. 1,012 companies).

Of the US companies that received angel funding in 2007, the average capital raised was about US$450,000[. However, there is no "set amount" for angel investors, and the range can go anywhere from a few thousand, to a few million dollars.

In a large shift from 2009, in 2010 healthcare / medical accounted for the largest share of angel investments, with 30% of total angel investments (vs. 17% in 2009), followed by software (16% vs. 19% in 2007), biotech (15% vs. 8% in 2009), industrial/energy (8% vs. 17% in 2009), retail (5% vs. 8% in 2009) and IT services (5%). Angel financing, while more readily available than venture financing, is still extremely difficult to raise. However some new models are developing that are trying to make this easier. ] Many companies who receive angel funding are required to file a Form D with the Securities and Exchange Commission.

Investment profile

Angel investments bear extremely high risk and are usually subject to dilution from future investment rounds. As such, they require a very high return on investment. Because a large percentage of angel investments are lost completely when early stage companies fail, professional angel investors seek investments that have the potential to return at least 10 or more times their original investment within 5 years, through a defined exit strategy, such as plans for an initial public offering or an acquisition. Current 'best practices' suggest that angels might do better setting their sights even higher, looking for companies that will have at least the potential to provide a 20x-30x return over a five- to seven-year holding period. After taking into account the need to cover failed investments and the multi-year holding time for even the successful ones, however, the actual effective internal rate of return for a typical successful portfolio of angel investments is, in reality, typically as 'low' as 20-30%.

While the investor's need for high rates of return on any given investment can thus make angel financing an expensive source of funds, cheaper sources of capital, such as bank financing, are usually not available for most early-stage ventures, which may be too small or young to qualify for traditional loans.

Profile of investor community

The term "angel" originally comes from Broadway where it was used to describe wealthy individuals who provided money for theatrical productions.

Angel investors are often retired entrepreneurs or executives, who may be interested in angel investing for reasons that go beyond pure monetary return.

These include wanting to keep abreast of current developments in a particular business arena, mentoring another generation of entrepreneurs, and making use of their experience and networks on a less than full-time basis. Thus, in addition to funds, angel investors can often provide valuable management advice and important contacts.

Because there are no public exchanges listing their securities, private companies meet angel investors in several ways, including referrals from the investors' trusted sources and other business contacts; at investor conferences and symposia; and at meetings organized by groups of angels where companies pitch directly to investor in face-to-face meetings.

According to the Center for Venture Research, there were 258,000 active angel investors in the U.S. in 2007.

The past few years, particularly in North America, have seen the emergence of networks of angel groups, through which companies that apply for funding to one group are then brought before other groups to raise additional capital.

Angel investing in the US

Geographically, Silicon Valley dominates the destination of angel funds, receiving 39% of the $7.5B invested in US-based companies throughout Q2 2011, 3-4 times as much as the total amount invested within New England.

Angel investing in the UK

A study by NESTA in 2009 estimated that there were between 4,000 and 6,000 angel investors in the UK with an average investment size of £42,000 per investment. Furthermore, each angel investor on average acquired 8 per cent of the venture in the deal with 10 per cent of investments accounting for more than 20 per cent of the venture.

In terms of returns, 35 percent of investments produced returns of between one and five times of the initial investment, whilst 9 per cent produced returns of multiples of ten times or more. The mean return, however, was 2.2 times investment in 3.6 years and an approximate internal rate of return of 22 per cent gross.

The UK Business Angel market grew in 2009/2010 and, despite recessionary concerns, continues to show signs of growth.

VENTURE CAPITALISTS: VC refers to investments provided to early-stage, innovate, and high growth start-up companies. A commen characteristic of all venture capital investments is that investee companies do not have cash flows to pay interest on debt or dividends on equity. Rather, investmnets are made with a view towards capital gain on exit. The most sought after exit routs are an initial public offering (IPO), where a company list on a stock exchange for the first time, and an acquisition exit (trade sale), where the company is sold in entirety to another company. However, VC's may exit by secondary sales, where the entrepreneur retains his or her share but the VC sells to another company or another investor, buybacks, where the entrepreneur repurchases the VC's interest, and write-offs or liquidations.

The Oxford Handbook of Venture Capital provides a comprehensive picture of all of the issues dealing with the structure, governance, and performance of venture capital. It comprises contributions from 55 authors currently based in 12 different countries (Douglas J. Cumming) 2012).

BANKING INSTITUTIONS: A banking institution (also referred to as a universal or commercial bank) can range from a large financial institution with a highly visible brand name and an international presence to a small organization with a local presence.

A banking institution's financing activities generally involve various types of lending, such as corporate finance, housing, project finance, retail, short-term finance, small-medium enterprises, trade, and others. Alternatively, the focus of a banking institution may be only on specific transactions with clients that meet certain requirements and within certain industry sectors. Banking institutions may also provide financial products with a focus on environmental business opportunities.

A banking institution's exposure to environmental and social risks varies greatly as a function of the clients within its portfolio. Some banking institutions usually have highly visible brands in their markets or globally, and are particularly susceptible to reputational risk. Banking institutions are also driven to improve their environmental and social risk management capacity to reduce credit and liability risks arising from environmental and social issues. A number of banking institutions have publicly committed themselves to sustainable banking, and many have voluntarily adopted the principles established under various sustainability initiatives.

NON -FINANCIAL CORPORATIONS: Definition:

The sector non-financial corporations consists of institutional units whose distributive and financial transactions are distinct from those of their owners and which are market producers, whose principal activity is the production of goods and non-financial services

The sector non-financial corporations also include non-financial quasi-corporations.

The term 'non-financial corporations' denotes all bodies recognised as independent legal entities which are market producers and whose principal activity is the production of goods and non-financial services.

The institutional units covered are the following:

A private and public corporations which are market producers principally engaged in the production of goods and non-financial services;

Co-operatives and partnerships recognised as independent legal entities which are market producers principally engaged in the production of goods and non-financial services;

Public producers which by virtue of special legislation are recognised as independent legal entities and which are market producers principally engaged in the production of goods and non-financial services;

Non-profit institutions or associations serving non-financial corporations, which are recognised as independent legal entities and which are market producers principally engaged in the production of goods and non-financial services een00043.gif;

Holding corporations controlling (see paragraph 2.26.) a group of corporations which are market producers, if the preponderant type of activity of the group of corporations as a whole - measured on the basis of value added - is the production of goods and non-financial services;

Private and public quasi-corporations which are market producers principally engaged in the production of goods and non-financial services.

The term 'non-financial quasi-corporations' denotes all bodies without independent legal status which are market producers principally engaged in the production of goods and non-financial services and meet the conditions qualifying them as quasi-corporations (see paragraph.

The sector non-financial corporations also includes all notional resident units (see paragraph 2.15.) which, by convention, are treated as if they were quasi-corporations.

Control over a corporation is defined as the ability to determine general corporate policy by choosing appropriate directors, if necessary.

A single institutional unit (another corporation, a household or a government unit) secures control over a corporation by owning more than half the voting shares or otherwise controlling more than half the shareholders' voting power. In addition, government secures control over a corporation as a result of special legislation decree or regulation which empowers the government to determine corporate policy or to appoint the directors.

In order to control more than half the shareholders' voting power, an institutional unit needs not own any of the voting shares itself. A corporation C could be a subsidiary of another corporation B in which a third corporation A owns a majority of the voting shares.

Corporation C is said to be subsidiary of corporation B when: either corporation B controls more than half of the shareholders' voting power in corporation C or corporation B is a shareholder in C with the right to appoint or remove a majority of the directors of C.

The sector non-financial corporations is divided into three sub-sectors:

1. Public non-financial corporations

2. National private non-financial corporations

3. Foreign controlled non-financial corporations

IPO AND EQUITY MARKETS:

The term initial public offering (IPO) slipped into everyday speech during the tech bull market of the late 1990s. Back then, it seemed you couldn't go a day without hearing about a dozen new dotcom millionaires in Silicon Valley who were cashing in on their latest IPO. The phenomenon spawned the term siliconaire, which described the dotcom entrepreneurs in their early 20s and 30s who suddenly found themselves living large on the proceeds from their internet companies' IPOs.

An initial public offering, or IPO, is the first sale of stock by a company to the public. A company can raise money by issuing either debt or equity. If the company has never issued equity to the public, it's known as an IPO.

Companies fall into two broad categories: Private and Public.

A privately held company has fewer shareholders and its owners don't have to disclose much information about the company. Anybody can go out and incorporate a company: just put in some money, file the right legal documents and follow the reporting rules of your jurisdiction. Most small businesses are privately held. But large companies can be private too. Did you know that IKEA, Domino's Pizza and Hallmark Cards are all privately held. (Investopedia)

Business angels;

Venture capitalists;

Banking institutions;

Non-financial corporations;

IPOs and equity markets.

ACCESS-ICT (2012) breaks the various sources of finance down into a ladder of finance (Figure 2.1) on their website, indicating that venture capital expects high returns for the risk they take and is targeted at early stage high growth companies.

The organisation for economic co-operation and development (OECD) (2006) argues that the venture capitalist firm may participate at any stage of the process, from seed funding, before production has begun, to expansion. EVCA (2007) agrees with this and goes further - that funders have a particular emphasis on entrepreneurial undertakings rather than on mature businesses.

This raises the question as to whether the criteria used by funders to evaluate companies in different growth stages are similar. ACCESS-ICT (2012) lists the different growth stages:

The seed capital stage, where the entrepreneur has an idea and funders willing to provide funding up to €50 000;

The start-up stage, where the entrepreneur have researched the market and established a working prototype and funders willing to provide funding up to €50 000;

The early stage, where the entrepreneur has completed the product and generated sales and funders willing to provide funding between €50 000 and €1million;

Growth and expansion stage, where the entrepreneur has an established business, generating profits and needs funding to develop new products and explore new markets and funders willing to provide funding from €750 000.

Figure 2.: Ladder of finance

Source: ACCESS-ICT (2012, p. 2)

2.3. Differences between debt and equity

The main differences between debt and equity funding were summarised in a table form by Van Eeden (2004). The table clearly indicates that banking institutions are not involved in the future growth prospects of a business.

Table 2.: Venture Capital versus Debt

Source: Van Eeden (2004, p. 7)

South Africa continued to feel the effects of a sluggish global economy, albeit on a more limited basis as compared with the rest of the world. After the financial crisis at the end of 2008, mergers and acquisitions started picking up again in the early part of 2010 and this trend continued into 2011. In the early part of 2012 fewer large deals were announced, but anecdotally, there are large deals in the pipeline that could result in announced deals when greater market confidence returns.

Most recent M&A activity has been in the small to mid-cap sectors and between unlisted entities. M&A activity has also been more pronounced in cross-border deals in South Africa, inward investment into South Africa and investment from South Africa into other African jurisdictions.

Many of the recent transactions (particularly in the resources sector) have involved Chinese, Indian, Japanese and US parties. There were again relatively few black economic empowerment ('BEE') deals, which for a number of years provided great impetus to the South African M&A market. Mainly due to the higher cost of debt, the private equity market in South Africa is still slow in both the number and value of deals. Deal flow has, however, started to increase in 2011, nevertheless the cost of debt remains prohibitive. It will be interesting to see how the rest of 2012 pans out, but all signs point to favourable activity in the M&A market. (Ezra Davids and Ashleigh Hale)

Funders:

A funder is a person who provides money or financial support for something, a provider of funds as for the support of a charitable or non-profit organization.

A Mid Atlantic fund for technology start-ups and active investors with specializations in cyber security, infrastructure, mobile, and enterprise platforms said the following:

We share openly and enjoy working with people who make things happen! We take an active role in the lives of our portfolio companies. We believe in the collective success of the founders, the management team, and the investors. Pivots happen and we've been a part of many; it's all part of the process. Disruptive and emerging technology coupled with a business model that drives innovation, managed by dedicated founders - that's what we are all about. Our partners and mentors are matched with innovative founders as an essential part of the process at Fortify.vc.

Banking institutions

A banking institution (also referred to as a universal or commercial bank) can range from a large financial institution with a highly visible brand name and an international presence to a small organization with a local presence.

A banking institution's financing activities generally involve various types of lending, such as corporate finance, housing, project finance, retail, short-term finance, small-medium enterprises, trade, and others.

Alternatively, the focus of a banking institution may be only on specific transactions with clients that meet certain requirements and within certain industry sectors. Banking institutions may also provide financial products with a focus on environmental business opportunities.

A banking institution's exposure to environmental and social risks varies greatly as a function of the clients within its portfolio. Some banking institutions usually have highly visible brands in their markets or globally, and are particularly susceptible to reputational risk.

Banking institutions are also driven to improve their environmental and social risk management capacity to reduce credit and liability risks arising from environmental and social issues. A number of banking institutions have publicly committed themselves to sustainable banking, and many have voluntarily adopted the principles established under various sustainability initiatives. (International Finance Corporation)

Debt financing is explained by Barringer and Ireland (2008) as getting a loan or selling corporate bonds and focuses on obtaining loans. Lenders insist on ample collateral to fully protect the loan, which can include the entrepreneur's personal assets to be collateralised as a condition of the loan.

Van Osnabrugge and Robinson (2000) reiterated the finding by Moore (1994) that bank loans are one of the highly sought after options to funding to a start- up firm in the high-tech industry, but that only 7 percent of such firms actually succeeded obtaining funding for their venture. They go further adapting from Roberts (1991) and state that for those mature firms raising a second round of funding, commercial banks become an important source of finance.

Venture Capitalists

Barringer and Ireland (2008) defines venture capital firms as firms who raise money in funds, typical from $75million to $200million to invest in start-ups and growing firms, typically 20 to 30 companies over a 3 to 5 year period, who manage the fund and receive an annual management fee, in addition to 20 to 25% of the profits earned by the fund. ACCESS-ICT (2012) explains that a venture capital firm will make larger investments than business angels (from 3million to 5million euros), which it will raise from institutional and individual investors and use to buy companies with high growth potential. The OECD (2006) explains that venture capitalists find individuals with strong management background and diversify their investments, thereafter they screen potential deals, raise funds and then structure financing and monitor performance.

Some investors prefer a "hands-on" approach as they wish to operate very closely with the entrepreneur and his team, compared to a "hands-off" approach if the entrepreneur's team is more experienced and the investor would prefer to be less involved in the day to day operations of the business and will only engage in the event of a crisis (EVCA, 2007).

EVCA (2007) also discusses that some investors would prefer to be present as board members, which allows the company the benefit from the experience of a more active board member, who will also take part in the important committees.

Advantages and disadvantages of using Venture Capital

A company's reasons for deciding to publicly list on the stock exchange often include the ability to get access to the capital markets for financial expansion and acquisitions. They usually have invested many years of plowing back profits and guaranteeing borrowings and rather than sell out, they wish to remain with the company and be part of its future growth.

Even if your business is suited to floatation, it may not be the right choice for you. There are a number of key advantages and disadvantages to weigh up:-

Advantages:

You get access to new capital to develop the business

A float makes it easier for you and other investors to realize your investment

You can offer employees extra incentives by granting share options

Being a public company can provide customers and suppliers with added reassurance

Your company may gain a higher public profile, which can be good for business

Having your own traded shares gives you greater potential for acquiring other businesses, because you can offer shares as well as cash

Personal guarantees of directors are not usually required for borrowings

Disadvantages:

Your business may become vulnerable to market fluctuations, which are outside your control.

If market conditions change during the floatation process you may have to abandon the float.

The costs of floatation can be substantial and there are also ongoing costs such as higher professional fees.

You will have to consider shareholders' interests when running the company - which may differ from your own objectives.

You may have to give up some management control of the business and ultimately there's a risk that the company could be taken over.

Public companies have to comply with a wide range of additional regulatory requirements and meet accepted standards of corporate governance

Managers could be distracted from running the business by the demands of the floatation process, and by dealing with investors afterwards

It generally takes 6 months to publicly list a company on the stock exchange although the time period can range from 3 months to 2 years. You will need a range of professional advisors to assist with the legal, financial, accounting and valuation aspects of publicly listing plus prospectus preparation, underwriting of shares and assistance with IPO Plans. (Len Mcdowall 2007)

Zacharakis and Meyer (2000) refer to Gupta and Supienza (1992), who suggested that venture capital firms add value by bringing investors and entrepreneurs together, making superior investment decisions and providing non-financial assistance which enhances survival. The venture capitalist offers financial, managerial and marketing support to the venture until it materializes (Al-Suwailem, 1998).

2.4.4. Different types of "deals"

Gladstone and Gladstone (2004) tables six groupings of deals (Table 2.2) from "Big Winners" where about 90% or 100% return on investment is received to "Wipeout" deals, where investors lose all of their investment if it cannot be avoided.

Table 2.: Types of deals

Category

Return on

Investment (%)

Probability of

making projection

(%)

Weighted average (Return on Investment probability) (%)

Big Winner

100

10

10

Winner

30

50

15

Sideways

10

20

2

Workout

0

10

0

Loser

(50)

5

(2.5)

Wipeout

(100)

5

(5)

Source: Gladstone and Gladstone (2004, p.185)

Criteria for selecting investments

1. Management

Management, in other words the team. This is the single most important part of the investment criteria that investors use to grade their potential investments. In teams, Next Ventures, looks into both the depth / quality of the team, but also into how diversified they are. Teams need to have various skill sets. There needs to be a clear business focus, but also a very deep understanding of the industry the company works in.

Naturally, other aspects of entrepreneurs are also graded and looked at; how well are the people in the team prepared to work in the face of high risk and uncertainty, how well are they organized to pursue the opportunity, how dynamic is the team if they need to change course and so on. One of the ways entrepreneurs can look at this is that when investors look into early stage companies, there is seldom anything else to support the investment decision than a strong and a qualified team. (By Antti Vilpponen, November 24, 2010)

2. Viable Product or Service  

It is essential that any product or service be feasible and executable, we target companies that can demonstrate that risk will be minimized while ensuring that the proof of concept is reasonably sound. This includes the potential for rapid customer or business acceptance and a targeted customer base. Each plan must also consider the appropriate product or service pricing threshold and deliver a clear customer needs assessment. (Westmountain.com 2011)

3. Market potential

Another very clear and obvious criterion for investors. Since VCs look into high potential areas where they could exit their investments at a higher valuation - the demand for the company's services need to be supported by a strong market.

There are a few things regarding the market investors look at on top of the obvious size of it. These issues are for example the growth and/or internal dynamics of the market, the level of competition, access to the market, what distribution mechanics work in the market and what at what stage is the market - timing is essential. (By Antti Vilpponen, November 24, 2010)

4. The Finances

Finally, the last criteria are the financial status of the company. There are four smaller points to look at and they are the use of the funds, financing terms, financial risk and the potential of a 10x return on investment.

The use of funds is important, because investors want to see how you'll be using the funds to grow your business. If you're paying debt away, it's probably not a good idea for an investor to be investing in your company. Financing terms are important and vary from investor to investor. These will be covered in more detail in the term sheet and are seldom one of the key points in the negotiations. (By Antti Vilpponen, November 24, 2010)

Financial risk means what kinds of risks are involved with the current investment. These can be for example, if the company needs further financing to complete the R&D of its products, will there be a risk that market conditions will change and the company will need more funding, etc. Finally, the question on where all venture capitalists make their money - will the exit potential of the investment be many fold?

Investment Criteria

Management

Investors should look into factors affecting management decision and policy making, such as

Management ethics

Corporate governance compliance

BEE Accreditation

Conflict of interest

Product

Prices of products

Competitors

Market share- unique products

Market

JSE

Reputable supplier

Customers

Industry sector

Finance

Ratio- profit margin and current ratio

Earnings per share

Dividends

Reference

www.google.com

blogs.law.harvard.edu/.../how-conflicts-of-interest-thwart-institutiona... www.iim.co.im/

The Finance Authority of Maine (FAME) (2003) lists the investment principles guided by most firms as being:

Be highly selective

Seek companies with innovative products

Back outstanding management teams

Invest in companies with a clear and realistic exit strategy

Add value and play a significant role in the management of the company

Make sure that companies have access to enough cash

Build a diverse investment portfolio

Investing in teams and markets is highlighted by Engel (2011), who further stress that one should eliminate pain, and focus on customer development and not product development. He further states the importance to dedicate resources in stages, and ended his list stating that 'entrepreneurs and venture capitalists are always selling, but the company is never for sale.'

For venture capitalists, the entrepreneur and thereafter the initial impressions of the venture's feasibility remain the most important decision factor, while the management team and financials can become critical later on in the investment, (Van Osnabrugge & Robinson, 2000).

Hudson and Evans (2005) did an analysis of eight different studies conducted between 1974 and 1993. They found that in six investment criteria, 50% or more of the eight studies agreed. These criteria were: Management skills and experience; the venture team; product attributes; market size; market growth and expected return on investment

An additional criterion was suggested as being important, namely competitive conditions, market share and business strategy, which approximates Porter's model of the five forces of competition (Hudson & Evans, 2005).

Table 2.: Evaluation criteria from: A review into venture capitalists' decision making

Source: Hudson and Evans (2005, p. 8)

Rakhman and Evans (2005) went further and managed to send a questionnaire to 450 potential respondents in 2002 of which some were venture capitalists, some investees and others entrepreneurs. They found that venture capitalists deem the financial aspects and personality and experience of entrepreneurs as most important and were less concerned with the availability of raw material, marketing skills, fair trading and legal actions.

Entrepreneurs, on the other hand, rated the ability to manage risks, the product being well accepted and the ability to attract customers as very important, while the audited financial report and the relationship with venture capitalists as only important to entrepreneurs. To the investee honesty, openness and approachability, the product being well accepted, to attract customers and the venture capitalist to actively develop trust and relationship with investees are important. Tax benefits were rated the lowest. (Rakhman and Evans, 2005). This was consistent with Tyebjee and Bruno (1984), who argued that venture capitalists are not looking for tax shelters.

The main investment criteria identified in studies from 1970 to 2004 as reviewed by Khanin, Baum, Mahto and Heller (2008) is listed as follows:

Top management team competency, skills, expertise, characteristics

Market and market growth

Uniqueness of product

Various risks

Projected returns from investment to justify a venture's funding

Exit choices

Quality of the deal

Venture strategy

Analysis of customers' perspective

Competitive threat in an industry sector

It is clear from the various research extracts that the following attributes are common and most frequently listed. These are management, product, financial and market, and were evaluated by Van Deventer and Mlambo (2009).

In Table 2.4, Van Deventer and Mlambo (2009) list their findings regarding the criteria rated as important by participating venture capitalists, with the entrepreneur being honest and having integrity, good market acceptance for the product or service is expected and the venture will provide a high internal rate of return (IRR) topping the list.

Table 2.: Criteria rated as important by participating Venture Capitalists

Source: Van Deventer and Mlambo (2009, p. 39)

The criteria as outlined by Van Deventer and Mhlambo (2009) will be used in this study as these four categories - product, management, market and financial - were identified and verified through extensive desk research by several authors.

The evaluation criteria in detail

Management

The trustworthiness of the entrepreneur is rated as the most important criteria by Van Osnabrugge and Robinson (2000), followed by the entrepreneurs expertise and then his enthusiasm.

Gladstone and Gladstone (2004) list the characteristics which investors are looking for in an entrepreneur. These are:

working long hours to compensate for the lack of employees;

the ability to evaluate risk and analyse complex situations;

the ability to persuade banking institutions to make loans;

carry an enormous amount of detail around with them;

personality that is compatible with the venture capitalist;

Extra items Gladstone and Gladstone (2004) list as important to look for in an entrepreneur's experience are market knowledge, a track record, leadership and reputation.

It is important to entrepreneurs and investees to show self-confidence. All groups rated experience as important, followed by willingness to hire staff to cover weaknesses in management as desirable and stated that attributes of importance are: honesty, openness and approachability, entrepreneur's experience and risk management capabilities (Rakhman and Evans, 2005).

Van Deventer and Mlambo (2009) found the criteria rated important by venture capitalists as being the entrepreneur's honesty and integrity, his desire for success, his management skills and being hard working and flexible.

Product

It is important for an entrepreneur to have a good understanding of the products a company sells, its competitors as well as the seasonality which is common in most industries. The potential impact to a company's cash flow should be discussed with the marketing department as well as developments around the companies' products. These issues are crucial when evaluating the product potential, (Gladstone and Gladstone, 2004).

Rakhman and Evans (2005) list seven items for consideration under the product category: availability of raw materials, demonstrated market acceptance, length of time in the market, functioning prototype. They found differences in ratings across various groups with the items: is proprietary, can otherwise be protected, availability of raw materials and demonstrated market acceptance.

Venture capitalists rated products are in an early stage of life cycle and the venture has production capabilities in place, as not important, (Van Deventer & Mlambo, 2009).

Financial

A venture capitalist needs to analyse the financial people before continuing to analyse the financial information, (Gladstone and Gladstone, 2004). They continue to discuss various ratio analysis which should be done by a venture capitalist, such as to calculate the sales per sales person as well as the selling expenses as a percentage of sales.

A venture capitalist can get a good understanding of a business by analysing the annual report of a new venture as well as the reports management uses on a day-to-day basis (Gladstone and Gladstone, 2004).

The venture capitalists that Van Deventer and Mlambo (2009) assessed, rated a high internal rate of return as the highest criteria, followed by high valuation projections and thereafter by the fact that there are significant potential for earnings growth. The lowest rated was the item that the venture has low overall capital requirements, followed by the requirement for low marketing and production costs.

Market

Gladstone and Gladstone (2004) stress that a venture capitalist should try to determine whether a company is market-driven, as marketing-driven companies are usually high-growth companies. They continue to advise that it is important to understand the motivation behind the sales force and then determine if the motivation is sufficient to sell the product. Market growth, market information and marketing strategies are some of the factors that the marketing department should understand and be able to supply when requested.

The lowest rating given by venture capitalists in the market category was that the venture will create a new market and will operate in a non-competitive industry. This reflects that these two criteria were not as important as the need for the product and the potential for growth (Rakhman & Evans, 2005).

When receiving an investment request from a new venture, McKaskill (2009) highlights that it should talk about market segmentation, customer buying patterns and pricing models. He highlights that the following should demonstrate a growing market with global potential that will be attractive to a major corporation in the long-term.

The literature review indicates that there are various criteria used by funders and that entrepreneurs experience or interpret the importance of the criteria differently compared to funders. Clearly there is no standard criteria used by funders and this creates challenges for entrepreneurs. Exacerbating the challenge is that there is no clear understanding or standard practice regarding at which stage of growth funders make investments.

According to Fal et al. (2010) there is a disconnect between the entrepreneurs and funders with regards to:

Too many entrepreneurs in saturated markets / industries make them less attractive to funders;

The entrepreneurs are most often un-researches and unprepared for the lengthy process of accessing funding;

Entrepreneurs' expectations are not managed. They expect a quick and easy process and tend to become very pessimistic when this does not happen;

In the majority of cases the perception is that capital is the main reason for business success, whereas there are various factors, including the entrepreneur him- or herself which play a role in the business succeeding;

Discrepancies in matching between funding mandates, criteria used and the entrepreneur's eligibility.

These authors thus recommend that further research is needed to understand and bridge this gap in perceptions.

CHAPTER 3: RESEARCH QUESTIONS

Research Objectives

In order to address the aim of this study, the research objectives are to:

Identify the differences and similarities between funders' use of criteria in the different growth stages;

Identify the differences and similarities between entrepreneurs' experience of criteria in the different growth stages;

Identify the differences and similarities between funders' use of and entrepreneurs' experience of criteria in general;

Identify the differences and similarities between funders' use of and entrepreneurs' experience of criteria in the different growth stages.

Research Hypotheses

The following research questions will be answered:

Investigate Funders' use of criteria between the growth stages;

H01: There are no differences in how Funders use criteria between the growth stages.

HA1: There are differences in how Funders use criteria between the growth stages.

Investigate Entrepreneurs experience of criteria used between the growth stages;

H02: There are no differences in how Entrepreneurs experience the use of criteria by funders between the growth stages.

HA2: There are differences in how Entrepreneurs experience the use of criteria by funders between the growth stages.

Investigate Funders' use of and Entrepreneurs' experience of criteria between the growth stages;

H03: There are no differences in how Funders' use and Entrepreneurs' exp