AN INQUIRY INTO THE VENTURE CAPITALISTS’ INVESTMENT CRITERIA FOR SMES IN DEVELOPING COUNTRIES: A SOUTH AFRICAN STUDY

By

Frederick Ahwireng –Obeng * PhD And Jane Mwebi +

University of the Witwatersrand (Wits) Business School 2 St David’s Place Parktown 2193 Johannesburg South Africa (Key Words (Venture Capital Criteria; SMEs; Developing Countries; South Africa)

*Professor Emeritus +PhD Candidate

Paper presented to the 57th ICSB Conference at Wellington, New Zealand 10-13 June 2012 1

SUMMARY

Venture capital is most suited for SMEs in developing countries. It provides growth capital, alongside managerial and technical skills, and networks for the entrepreneur. Yet, most SMEs fail to qualify for financing, predominantly because venture capitalists hardly consider fully the poor and underdeveloped institutional conditions of developing countries and apply criteria intended for developed countries. Consequently, SMEs in developing countries perform poorly. This study identified three major obstacles to SMEs lack of investment attractiveness – high risk, high transaction costs and lack of investment readiness – as well as 14 critical success factors. Using factor analysis and regression techniques on a combined sample of 62 SMEs and 31 venture/equity capital firms in South Africa, the study has established that : (i) the three obstacles account largely for the high rejection of SMEs (ii) collectively and undoubtedly, the 14 critical success factors significantly mitigate these obstacles. It offers alternative investment criteria and assessment perspective.

INTRODUCTION

Small and medium enterprises (SMEs) in South Africa are yet to contribute fully to the economy by generating employment particularly and contributing to economic development and social stability. Undoubtedly, their growth and expansion do not hinge on financial support alone; nevertheless access to finance is central to their ability to develop and play their pivotal role. To the extent that venture capital provides both growth and capital as well as managerial and marketing advisory functions, it is one of the most appropriate tools for early-stage SMEs (Eid 2006; Gregoriore, Kool and Kraeu SSE, 2007; Tykkvov, 2007). However, most venture capitalists fail to discriminate between developed and developing economies in their assessment of SMEs for investment readiness. They apply to the two economies, investment criteria tailored for developed economies where institutions are welldeveloped, in sharp contrast to developing countries which suffer predominantly from the absence of strong formal institutions.

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Quite expectedly, a high percentage of potentially viable SMEs in developing countries fail to qualify for venture capital funding because they are found to be very risky, extremely costly to assess, and unattractive, that is, not ready for investment. This situation where these obstacles constrain venture capital funding represents a wide and growing SME equity financing gap (HM Treasury and SBS, 2003).

The overriding importance of SMEs in developing economies suggests that the lack of empirical evidence on the probable relationship between the application of the conventional venture capital investment criteria to a developing country, and the existence of the SME equity financing gap is a significant omission from the venture capital literature. Even though the literature describes a range of strategic measures, intended to overcome these obstacles, it fails to demonstrate how these measures referred to as “SME equity capital success factors” mitigate the obstacles.

Given that the conventional venture capital investment criteria are inappropriately applied to developing economies only to find several potentially viable SMEs to be relatively risky, costly and not ready for investment, it is probable that some relationships exist among these criteria and the SME equity financing gap. Given also the limited favourable outcomes of applying the SME equity capital success factors to developing countries, it is hypothesized that there is an

optimum

combination of these factors which when applied to evaluate SMEs located in the South African context will render a greater proportion of the investment ready and qualify for venture capital funding.

This study uses factor analytical and linear regression techniques to identify the most critical success factors and determine how and the extent to which they reduce the barriers to SME equity financing. Fourteen success factors are recommended to replace the conventional criteria.

The 14 critical success factors which were identified initially as mitigators of the three obstacles are:

SME Investment Readiness - proactive deal generation, that is, proactive involvement of private venture or equity capital investors in the SME sector; 3

collaboration with non-profit-entrepreneurial organisations in providing non financial support services such as business and management training; training entrepreneurs and the venture management team on the venture capital investment process; networking with entrepreneurs personal contacts, other businesses, government and other local investors; and hands-on monitoring farming. SME Risk Reduction – forming strategic partnership and alliances; leveraging strengths of existing institutions; using experienced fund managers; and exit strategic planning at the beginning of investment. SME Transaction Cost Reduction – use of investment clusters (geographical/regional/industry clusters); use of non-financial evaluation methods, that is, assessing SME project viability using local operational experience; outsourcing local skills, that is, using knowledgeable local experts in SME equity finance. The study is based on a number of hypotheses which set out the relationships amongst investment readiness, risk reduction, transaction cost reduction and perceived SME financing gap in South Africa.

The rigour of these evaluations adds to the significance of this study in three ways. First, in a country where the official employment rate is close to 25% (Statistics South Africa 2011), it will inform South African policy makers of the form and extent of institutional reform required to stimulate SME development. Second, for venture capitalists who are looking for appropriate criteria for evaluating SMEs in developing countries, the study will provide a scientific basis of criteria design.

Third,

entrepreneurs in developing countries who are seeking venture capital funding will be better informed of the rationale for the criteria they are required to meet.

Section 2 outlines various aspects of the theoretical basis of the study while Section 3 describes the methodology. The study data and interpretation are presented in Section 4, while Section 5 concludes with recommendations and implications for theory and practice. 4

2.

LITERATURE REVIEW

2.1 Theoretical Foundations of Venture Capital Research Within the principal-agency framework, the tendency for adverse selection occurs throughout the investment process and ultimately influences the criteria venture capitalists use to accept or reject investment proposals. The theory of contracts frequently suggests how to structure venture capital deals as much as corporate governance and moral hazard considerations reflect the monitoring preferences of venture capitalists. Finally, institutional theory is particularly relevant to developing economies where formal institutions are either unavailable or underdeveloped and therefore fail to accommodate conventional venture capital investment criteria.

Agency Theory Agency Theory explains the relationship between one who delegates (the principal) to another who performs the task (Agent). Thus, the agent acts on behalf of the principal. Stability of the relationship is usually threatened by the existence of divergent goals between the parties and hidden information before or after contracting the agent.

For example, when in a developing country the agent has private information that preconditions the incentive to act opportunistically corporate governance becomes

difficult

because

independent

legal

institutions

are

lacking

(Dharwadkar, George and Brandes, 2000). An adverse selection problem that may put a severe strain on the market arises when previous information about the quality of investment is asymmetrically distributed. Similarly, information about the behaviour of the entrepreneur that is unevenly distributed between the parties raises the risk of moral hazard (Sood, 2003).

Adverse Selection 5

Entrepreneurs are usually reluctant to disclose information to outsiders to promote their self-interest and for fear of compromising their firms’ competitive edge (Cardis, Kirschner, Richelson, and Richardson 2001). Additionally, SMEs have other characteristics that exacerbate the information problem. First, SMEs are usually not required to comply with stringent information reporting. Second, their relatively younger age does not enable them to provide adequate past record of performance. As a result, the quality of information is usually poor and fund managers and venture capitalists have to identify other sources of information or devise new information systems, all of which are expensive (ECI, 2003; Abereijo and Fayomi 2005).

Theory of Contracts Venture capitalists act as agents of their limited partner investors and as principals to the entrepreneurs of their portfolio firms (Eisenhardt ,1989). Contracts specify the rights of the parties, the performance criteria on which the agent is evaluated and the payoff functions the agent faces (Farma and Jensen, 1983). Typically, the contract is outcome-based in order to influence behaviour indirectly by aligning the interests of the agent and the principal thereby minimizing the risk involved in venture capital investments (Eisenhardt, 1983).

Venture capitalists tackle agency risks by utilizing stringent contractual provisions that normally include the restrictions: no further fundraising without prior approval; limited board representation; appointment of auditors and key employees are subject to prior approval; imposition of anti-dilution clauses to ensure additional shares are not sold to new investors without the consent of the initial investor(s); stage investment of funds subject to achieving specified milestones (Durani and Boocock, 2006).

Corporate Governance Corporate governance is the sum of the mechanisms by which owners of a firm exercise control over management to protect their interests (John and Senbet, 1998). This is of primary concern for investors because they want to control the functioning of the company to protect their investments (Gompers, 1995). But many developing countries lack adequate investor protection because corporate 6

governance principles are not fully developed and practised.

Generally,

common law practising countries offer better investor protection than countries where common law is not practised (La Porta, Lopez-de-Silanes, Shleiter and Vishing, 1998).

Since venture capitalists prefer a governance structure that increases investor control, financial constructs between themselves and entrepreneurs detail the division and allocation of control rights including: cash flow rights, board rights, voting rights, liquidation rights, and other control rights (Kaplan and Stromberg, 2003).

Furthermore, financial information is necessary to bridge the

information asymmetry gap between venture capitalists and entrepreneurs. The role of non-executive directors is to monitor the provision of and accuracy of financial information in order to reduce the incidence of fraud. Thus, a fullydeveloped and properly implemented corporate governance system reduces the information asymmetry problem.

Moral Hazard Moral hazard is a hidden action motivated by self-interest.

It arises from

information asymmetry and is prevalent in early stage investments in sectors where assets are largely intangible and the firm faces a number of growth options (Amit 1988) Other origins of moral hazards are situations where: agents have different attitudes towards market risks and thereby pursue different actions; the agent has private information about the projected future performance of a project (Barako, Hancock and Izan, 2006).

In these

circumstances more detailed and more frequently reported accounting information is required.

Institutional Theory North (1990:3) defines institution as “the rules of the game in a society … the humanly devised constraints that shape human interaction”. According to the World Bank (2003:37) institutions “coordinate human behaviour and are essential for sustainable and equitable development. Thus, institutional theory explains the impact of contextual systems on human behaviour and economic 7

performance (North, 1990; Hos Kisson, Eden, Chung and Wright, 2000). In this way, it facilitates better understanding of organisational performance in developing economies as they face increasing bureaucratic and information processing costs because of undeveloped institutions such as weak legal systems, inefficient financial markets and unstable political structures (Peng and Heath, 1996).

It is therefore, the role of strong institutions to reduce information and transaction costs and facilitate human and organisational interactions including the agency role so critical for the venture capital investment process.

2.2

The Venture Capital Investment Process The venture capital market involves three parties – the investors, the venture capital firm and portfolio company. The venture capital firms raise capital from investors and invest in portfolio companies. To address the problem of lack of capital and managerial skills, venture capitalists offer both equity capital and managerial support (Tykvova, 2007).

The venture capital investment process comprises a number of distinct stages ranging from five to nine. Developing countries attract the highest number because of their underdeveloped intuitions (Kilonowski, 2007).

Table 3.1

summarises the venture capital decision making process stages; namely deal origination. Screening, evaluation, structuring, monitoring and exit. Venture capitalists consider for each stage specific factors that reduce cost and risk. The various stages and accompanying factors are discussed below.

2.2.1 Deal Generation The main and most reliable source of deal flow for venture capitalists is personalized networks of bankers, lawyers, brokers, consultants, entrepreneurs and other venture capital funds (Tyebjee and Brune, 1984; Klonowski, 2007). Lack of established network of referrals hinder deal flows in developing countries but the real problem is that sources of deal opportunities are efficient. 8

Therefore, proactive solicitation methods are necessary to generate deals (Bliss 1999; Patricof 2005).

2.2.2 Initial Screening Detailed business plans are necessary to support prospective projects seeking venture capital. The screening process is essentially a review of the business plan against a set of investment criteria. This is a cursory screening stage that considers such general factors as geographic location industry and stage of financing. The majority of projects in developing countries are rejected at this stage for missing important information, poor presentation of the business plan, and poorly presented financial statements and projects. The rationale for rejecting poor quality business plans is that they add to the problem of asymmetric information and increase due diligence costs.

2.2.3 Deal Evaluation/Due Diligence Deals which pass through the initial screening stage are scrutinized in detail in a process involving the gathering of information from inside and outside sources, a series of meetings with management, interviews with suppliers, customers, other investors and industry experts, and review of financial statements (Tyebjee and Bruno, 1984). It is customary for venture capitalists to assess subjectively the risks of investments against its expected returns on the basis of a set of multidimensional

criteria

that

include:

market

attractiveness;

product

differentiation’ the entrepreneur; the venture management team; and financial considerations.

These set of criteria as further explained in the following

paragraphs:

Market Attractiveness Market attractiveness refers to a range of market characteristics including: familiarity with the market; limited competition; size of the market; long term growth rate; capability of the market, and profitability. Information is usually gathered from market surveys, consumer clinics and test market experiments (Douglas and Shepherd, 2002). 9

These characteristics designed for markets in developed countries are similar to those that venture capitalists require of markets in developing countries (Gupla, Chavalier and Dulta, 2003) indicating that they have not modified their investment criteria for developing countries.

Product or Service Factors Venture capitalists prefer products or services that are unique and can deter competition through patents to attract high profit margins. Such products must be mass-produced at a unit cost that allows sufficient profit at the projected price level. Pronmose and Murray (2006) observe that venture capitalist put extra effort to ensure that any proprietary technology has adequate intellectual property protection to sustain the venture’s competitive advantage.

These

criteria are similar to those applied to developing countries (Chotigeal 1997).

The Entrepreneur Venture capitalists consider identical personality and experience characteristics of the entrepreneur in both developed and developing economies. They prefer entrepreneurs who have a thorough familiarity with the target market or industry, demonstrated leadership capability and a track record relevant to the venture including the ability to evaluate and handle risks (Zutshi 1999). Additionally, integrity, openness and the reputation of the entrepreneurs as known by fund managers networks contribute to the venture capitalist’s degree of confidence in the entrepreneur. This is important because venture capitalists perceive that the choice of a good entrepreneur minimises the problem of moral hazard (Paybe, Moor and Bett, 2009).

The Venture Management Team Venture capitalists look for strong managerial capabilities such as appropriate management acumen, prior experience in the same or related industries and markets, prior start-up experience and strong commitment to the growth and launch of new venture. (Proimos and Murray, 2006). Furthermore, the top management team is collectively expected to possess experience and 10

qualifications across the range of business and technology areas required for the particular new venture. Finance, marketing and general management skills are critical areas of expertise.

(Mishra, 2004).

The need for balance, high

motivation compliment personal integrity, hard work and flexibility, all of which are also emphasized as the management team’s attributes for developing countries (Ibid).

Financial Considerations According to Mason (2005), the purpose of performing financial analysis is to ascertain the value of the business and to assess whether the investment is likely to generate the required rate of return. Factors such as high rate of return, high investment liquidity and profitable exit are considered critical (Pintado 2007). For developing countries a high expected return of over 25%, the ventures ability to be made liquid and the opportunities for exit are important considerations (Gupta et al 2003; Mishra 2004; Deventer and Mlambo, 2009). Because SMEs do not have adequate financial information, expected rate of return calculations are unreliable and lower than the venture capitalists’ requirement for not rejecting a project. Consequently, the rejection rate is high, contributing further to expanding the SME equity financing gap.

2.2.4 Valuation Valuation is the process of placing monetary value on an investment opportunity.

The degree of uncertainty of achieving future expectations

influences the discount rate applied in evaluating projects for investment. The rate of return demanded by an investor depends on the projects’ characteristics and the type of financing instrument used.

Finance theory recommends the use of the Capital Asset Pricing Model (CAPM) when estimating the cost of equity in valuing companies. But, because of the new venture’s short operating history and limited accounting information, this financial valuation model faces considerable shortcomings, including the following: liquidity risks persists; it fails to capture unsystematic risks; the required rate of return depends on the stage of the project; the use of stage

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financing may affect the cost of outside equity; and the distribution of voting rights does not correspond to the distribution of cash flow rights.

Although finance theory has attempted to modify the CAPM for use in venture capital projects ambiguity and confusion over how the theory is best applied has led to practitioners using a wide range of completely different approaches some of which conflict with or compliment each other notwithstanding the added problem of limited access to information, input (Durani and Boocook, 2006). Therefore, the valuation of venture capital projects in developing countries is even more complex due to a lack of standardized methods for determining discount rates and the limited SME accounting information. These obstacles demand in practice, alternative, largely subjective approaches to accessing the financing potential of SME projects, most of which are excluded for reasons that cannot be technically and consistently justified.

2.2.5 Deal Structuring This is the stage for the venture capitalist and the entrepreneur to negotiate the terms and conditions of the investment following the decision to invest. The object of deal structuring is to reconcile varying needs and concerns of the two parties in respect to the venture capital deal (Sagari and Guidotti, 1992). The contract terms specify among other things, control rights, the division of any returns, the mix of financial instruments to use and the circumstances in which debt can be converted into equity. When negotiating an investment deal, the venture capitalists’ aim is to control corporate decisions, minimize potential costs and risks and guarantee sufficient downstream protection and a favourable position for additional investment ore exit (Mason, 2005b).

It is customary for venture capitalists to use risk reduction and control mechanisms in structuring deals. These mechanisms include: choice of financial instrument; stage capital infusion; syndication; separation of ownership and control rights; and portfolio diversification.

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Choice of Financial Instrument The type of financial instrument used in venture capital operation is designed to respond to expected agency problems (Cunnings, 2005) and depends on the type of firm financed, the venture capitalists’ philosophy and concerns as well as the legal and business regulations of the country. Eventually, the venture capitalist ensures that issues such as liquidity, protection and control of the investment are explicitly and adequately addressed in the construct.

Furthermore, the type of financial instrument used in financial constructing depends on the legal regime, contract enforcement efficiency and other institutional features of the working environment of the country. Levier and Sehoar (2004,2005) have concluded that high contract enforcement in common law countries foster an investment climate in which private investors tend to use convertible preferred stocks with covenants. On the other hand, in low contract enforcement civil law countries private equity groups tend to use common stock and debt and rely on equity and board control.

Venture capitalists favour convertible securities dominated by preferred stocks for various reasons. First, they reflectively resolve governance problems and facilitate the separation of control and cash flow rights enabling the venture capitalist to monitor the firm without undermining management incentives (Gibson and Schizer, 2003). Second, they minimise excessive entrepreneurial risk taking that occurs when straight debt is used. Third, they reward the entrepreneur for good performance of the enterprise and discipline for poor performance.

Fourth, the use of convertible securities facilitates efficient

investment without making either parties – the entrepreneur and venture capitalists – residual claim out on the margin (Schmidt, 2003).

Finally,

combining convertible preferred securities and staged capital infusion, mitigates information asymmetry and agency problems in venture capital operations (Cornell and Yosha, 2003).

Staged Capital Infusion Staged capital infusion is a control mechanism that enables venture capitalists to subdivide their investment into various stages of the venture’s life. It reduces 13

risks, controls moral hazard and allows the venture capitalist to gather information and monitor progress while maintaining the option to abandon the project at any time (Wang and Zhou, 2004; Gompers, 1995).

Syndication Syndication occurs when two or more venture capitalists participate together in an investment opportunity.

It provides valuable second opinion that could

sharpen and fine-tune selection decisions, mitigate adverse selection, and reduce idiosyncratic and financial risks. Furthermore, it involves pooling resources to improve capabilities to add value and to establish social status (Lockett and Wright 2001; Hochberg 2007).

Separation of Ownership and Control Rights Separation of ownership and control is yet another reliable control mechanism although venture capitalists tend to use contracting to allocate control rights distinctively from ownership rights. To avoid the dilemma of taking a large share that also gives the opportunity to expropriate investors, venture capitalists assume control rights over the enterprise through contract covenants such as majority seats on the board, majority requirement for major decisions, mandatory redemption, prohibition of asset sales, restriction on control transfer, restrictions on expenditure and on new securities (Zeng 2004; Durrani and Boocock 2006).

Additionally, venture capitalists often require protection

against future financing rounds that may have lower valuation than the current valuation. This is achieved through the inclusion of anti-dilution protection clause in the financing contracts (Kaplan and Stromberg, 2003).

Portfolio Diversification Portfolio diversification takes two forms: including many different investments in a portfolio of ventures in different sector or geographical locations, and putting together a portfolio of ventures in different stages of development. These risk reduction strategies provide protection against agency risks and permits the venture capitalists to focus on market risks for which they have the skill to manage (Fiet, 1995).

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2.2.6 Post Investment Monitoring Following the initial investment venture capitalists adopt several alternative means of monitoring the venture.

They monitor by telephone and email

converting video conferences or on-site visits (Zider, 1998).

Another monitoring approach is to appoint non-executive directors to protect the reputation of the company, monitor the activities of the company on behalf of investors, ensure regular high quality information on performance (Phan and Yoshikawa, 2006).

Quite often, venture capitalists use their networks and expertise to recruit key individuals to the firm, work with suppliers and customers.

The intensity of monitoring required is much greater for developing countries because of deficiencies in accounting systems, higher agency risks, and higher moral hazards. Consequently, monitoring costs are higher.

2.2.7 Exit from Investment The venture capitalists’ ultimate aim is to secure profitable exit from their investments and not maximum dividend income. Therefore, a healthy venture capital industry must have a range of exit mechanisms to choose from, three of which are initial public offering, trade sale and private placement (Maons 2005b).

Other options, according to Coyle (2000), are repurchase and

involuntary exit.

In an initial public offering, the shares of the venture capitalist and potentially other shareholders are sold on the stock market and usually produce the highest returns. However, public markets are cyclical and cannot be relied upon to produce the most profitable exit. Ventures can also be sold to another company in a trade sale (Mason 2005b); KPMB and SAVCA, 2009). Another option is private placement involving the purchase of the venture capitalist’s share by another investor. The other two options are ideal for a company in distress. A repurchase is ideal for family-owned businesses which are in financial difficulty

15

but do not want to lose ownership to other companies. Involuntary exit occurs when a company fails and goes into receivership or liquidation (Coyle, 2000).

Despite the attractiveness of initial public offerings, they are a rare option in most developing countries because the capital markets are underdeveloped; they have low volumes of private equity transactions and low liquidity

The venture capital investment process is diagrammatically shown in fig 2.1.

2.3

The Venture Capital Investment Criteria Applied to Developed and Developing Countries

2.3.1 The Venture Capital Investment Criteria Applied to Developed Countries Most of the empirical studies on the venture capital investment criteria were conducted in the United States (US), and have influenced similar studies in Canada and Europe.

The United States (US) One of the earliest studies on the venture capital investment criteria was conducted by Tybjee and Bruno (1984) who interviewed 46 venture capital firms and used factor analysis to determine the factors considered to be the most important decision criteria. Five factors were mentioned in the following order of importance: market attractiveness; product differentiation; managerial capabilities of the entrepreneur and the team; environmental threats; and cashout potential.

Another study by MacMillan (1985), collected data from 102 venture capitalist, using the same data collection and analytical technique as Tyegjee and Bruno (1984) and found that the entrepreneur’s personality and experience were considered to be of overwhelming importance. A follow up study by MacMillan et al (1987) for the best predictors of performance emphasized the importance of the entrepreneurial team over product/ service and market characters as well as financial considerations. Other studies in the US (Robinson 1987; Hirsch and 16

Jankowicz, 1990; Hall and Hofer and Fried and Hirsch, 1994) confirmed the relative importance of the five factors to be: personality and experience of the entrepreneur and the management team; product or service characteristics, market/industry characteristics and financial consideration, namely financial track records and expected returns.

Canada Boyle and Reber (1992) surveyed 23 members of the Association of Canadian Venture Capital Companies using descriptive statistics to analyse the responses and confirmed all five factors to be a replication of the US results.

Europe Muzyka Birley and Lelelux ( 1996) surveyed 73 venture capitalists from the UK, Ireland, Germany, Austria, Switzerland, Italy, France, Belgium, Netherland, Spain, Portugal and Nordic countries and identified seven factors, the first five being consistent with those from earlier studies, the two others being the deal and fund characteristics.

Thus empirical studies from the US, Canada and Europe confirm that the five common factors applied by venture capitalists to evaluate new venture in developed countries to be: the characteristics of the entrepreneurs and those of the management team; product/service characteristics; marketing/industry characteristics and financial considerations.

2.3.2 The Venture Capital Investment Criteria is Developing Countries Several studies of the venture capital investment criteria in developing countries including those of Chotigeal (1979), Zutshi (1999), Mishra (2004), and Wong (2009), have tested the relevance and applicability of those criteria used in developed countries.

Other studies such as Kakati (2003) replicated the

methodology of MacMillan et al (1987) and added two other criteria, namely research-based capability and competitive strategy of the venture. Furthermore in a more recent study of South Africa, Deventer and Mlambo (2009) while using the criteria applied in the developed countries gave respondents the option to add other criteria of their own. These studies show the most important 17

criteria to be those relating to the entrepreneur, the management team and financial consideration.

Product/service and market/industry considerations

were found neither important nor essential. Remarkably noteworthy however, is the fact that none of the important criteria is met by most SME in developing countries as long as obstacles in their working environment persist. Alternatively, the criteria must be modified to suit the developing country conditions. Six of such case studies are outlined below and summarised in

Taiwan, Sri Lanka and Thailand Chotigent et al (1997) tested 30 criteria covering the five core areas on 29 venture capital firms in Taiwan, 15 in Sri-Lanka and 7 in Thailand, and found that respondents from all three countries ranked financial considerations and the management team’s characteristics as the top categories of criteria.

Singapore Zutshi et al (1999) used a mail survey methodology to study the investment evaluation criteria of 58 venture capitalists in Singapore using the five core criteria and an additional criterion – country risk, and found that Singapore venture capitalists use investment criteria similar to those of US, Canada and Europe.

India and South Asian Countries Kekati (2003) studied 43 venture capitalists financing high-tech industries in India and South East Asian Countries. The studies used 38 criteria in six categories pertaining to product, market and entrepreneurs characteristics, resource-based capability, competitive strategy, financial considerations and performance measures. As with other studies, characteristics of the entrepreneur were considered the most critical.

India Mishara (2004) surveyed members of the Indian Venture Capital Association and tested 42 criteria in six areas covering all criteria categories, and found results that mirrored the criteria developed by MacMillan et al (1985) and

18

Tybyee and Bruno (1994), the entrepreneur’s personality and experience being the most important.

South Africa Deventer and Mlambo (2009) applied the Likert-Scale technique in a survey of16 South African venture capital firms regarding the screening and investment criteria that they use in selecting firms for financing. The results show that South African venture capitalists consider overwhelmingly management related factors in evaluating new projects.

Hong Kong Wong (2009) surveyed 100 Hong Kong venture capitalists to find out which investment criteria identified in previous studies were useful predictors of venture performance. The study ranked characteristics of the venture team as the top criterion. Table 4.9 summarizes the developing country case studies. The table confirms that the same set of criteria used for evaluating ventures in developed countries are those applied to development countries without any modifications to reflect the peculiarities in the working environments of developing countries.

2.4

Limitations of the Conventional Venture Capital Investment Criteria in the Working Environments of Developing Countries It is, perhaps not surprising that the same model of investment criteria is used in the two distinctively different working environments of the developed and developing countries because most of the venture fund investors originate from developed markets. It is also not surprising that limitations of applying the conventional criteria in a developing country are remarkable, and could be contributing significantly to the growing venture capital equity financing gap. This section details those limitations.

Institutional Context The cost of doing business is relatively high in developing countries not only because of infrastructural bottlenecks but also because the legal and financial systems are underdeveloped property rights are ambiguous and regulatory 19

systems are not transparent (Chiva, 2002; Patricot …. 2005; Siddigi, 2008; Ramamurti, 2000) The weak institutional environment contributes to piracy and other intellectual property violations, in addition to a lack of contract enforcement (Deloitte, 2008).

Without reliable institutions, entrepreneurial

effectiveness is weakened (Zahara 2000) and the likelihood of agency problems increases. Dharwadkar 2000) The accounting environment is poor and corporate governance is weak. (World Bank 2004, 2005, 2006; Deloitte, 2006) thereby affecting the availability of quality information for diligence during project evaluation.

Consequently, investors are unable to assess the true

creditworthiness of potential SME proposals.

Furthermore, investor protection legislation is largely lacking, which means that potential investors might not obtain adequate and reliable information on the markets and on the financial health of companies they intend to invest in. Worst of all is the inefficient and slow settlement systems owing to underdeveloped institutions (Eid, 2005; Deloitte, 2008).

Deal Flow Developing countries lack quality deals that fit venture capital firms’ investment preferences. This is because sources of opportunities for deals are lacking or limited causing long lead times to develop projects (Eid 2005; Patricof et al 2005; Deloitte, 2007). Another drawback is that the technology and research environment is limited (Cetidamar, 2003); channels of communication between research and industry are weak, (Wu, 2007; Nabeshima and Yusuf, 2007; and Chen and Kenny, 2007); time is lost in the bureaucracy of starting up a business (World Bank, 2005) and regulation does not always promote entrepreneurial activities (World Bank, 2005).

As a result of all this, available deals are

inadequate and SMEs are of particularly small size which required venture capitalists to combine many deals, all of which increases transaction costs.

The lack of dialogue between venture capitalists and University Research Centres creates a knowledge gap and problems involving business ideas as long as venture capitalists focus on economic returns while academic researchers focus on academic results. 20

Entrepreneurs and Managerial Skills Entrepreneurial skills and ideas are relatively scarce in developing countries. Adding to this, is a shortage of skilled workers, experienced local investors and a talented entrepreneurial team (Kinniainen and Keuschnigg, 2004; Deloitte, 2008). This weak management capacity and a lack of expertise in venture finance because of the newness of the venture capital business in developing countries, creates a formidable barrier to commercial ideas or starting up new firms.

Venture capitalists look for management with competence, motivation, reputation and creativity. However, venture capitalists in developing countries experience difficulties in screening the capabilities of management because most lack the experience of having operated in a market environment and available information is subjective (Tan, Zhang and Zia, 2008).

Most entrepreneurs have little or no understanding of venture capital finance, and this may have suppressed the demand for venture capital. (Eid, 2006). Moreover, entrepreneurs are reluctant to give up large equity stakes from their family businesses to outside investors for fear of loss of control and management freedom. As a result, they dislike sharing power and suspect that leaking information to outside partners or experts (Cardis 2001).

Product/Services High demand for a product or service is required to generate high profits, however, it is difficult to measure demand in a developing country due to a lack of reliable information (Lockett, Wright, Saprenzaand Pruthi, 2002). Additionally, products and services in developing countries are packaged in small quantities due to limited income of customers. (Prahalad, 2005; Mahajan and Benga, 2006). As a result, profit margins per item are low, giving the false impression of a lack of mass market opportunity.

It is difficult in developing countries, to guarantee patent-right protection because of the underdeveloped legal systems and ambiguous property rights. 21

Consequently, it is neither easy prevents piracy and other intellectual property violations through the legal process nor advisable to rely on the weak institutions to enforce contracts, except through relationships and reputation (Fafchamps, 2004).

High Return Potential Investors use the expected rate of return on a project to determine profitability which is one of the criteria on which they base their investment decision. In developing countries however, investors apply inflated discount rates to account for perceived high risks arising from the uncertain financial economic and institutional environment (Sabal, 2004; Estrada, 2007). But, the perceived risk is diversifiable (Brumer 1998) and finance theory recommends that it is adjusted for, in the cash flows (James and Kololier, 2000; Pereiro, 2000). There is however, no widely acceptable method to determine the size of the risk premium nor is there a standard model to estimate the required rate of returns on equity in developing countries (Estrada, 2007). Ultimately practitioners apply a simple subjective model that generates the cost of equity consistent with their perception of risk (Ibid).

In regard to the calculation of fair value, there is no proper guidance on what assumptions to make and how to calculate estimates. (Heathcote and Human, 2008). As a result, the determined expected rate of return is often low compared with investor’s expectation on which basis many potentially viable projects are rejected.

SMEs in developing countries characterize cash flows that approximate a JCurve, because of the relatively long period of negative cash flow expected at the beginning and a rapid in cash flows expected later in the life of the firm. (Ribeiro, 2007a).

This unattractive cash flow position coupled with the

uncertainty of success add to the likelihood of rejecting many SME project proposals.

Exit Options

22

In view of the underdeveloped state of capital markets in developing countries venture capitalists are unable to exit with the expected rewards and are either forced to stay longer or sell their shares at a high discount (Cumming, Flemming and Schweinbacher, 2005).

Table (4.10) summarizes shortcomings of the convention venture capital investment criteria applied to developing countries.

Venture capitalists generally focus on the same set of criteria in both developed and developing countries.

Theses criteria, namely, the entrepreneur, the

entrepreneurial team, product/service, market and financial considerations tend to ignore the following barriers to investment in developing countries: entrepreneurial skills are scarce; managerial skills are in short supply; property rights are ambiguous; distribution channels are poor; availability of SME accounting information is limited; methods of determining discount rates are not standardized; stock markets are small and illiquid; it is difficult to measure effective market demand; and it is difficult to achieve a rewarding exit. These obstacles which the conventional venture capital criteria are unable to mitigate or eliminate may be classified into three categories of factors which: render SMEs not ready for investment; increase SME risk profile; and increase transaction costs. Any modifications to the conventional criteria must be able to undo these obstacles individually and collectively.

2.5

SME Equity Capital Success Factors in Developing Countries Limitations to the conventional investment criteria require venture capitalists to find new ways of reducing the high risks and high transaction costs and rendering SMEs ready for investment. Wright (2002) compared the perception of local venture firms in India with US operating venture capital firms and found that these firms that adapted were successful. According to Khana, Palepu and Sinha (2005), success means working around the institutional void and inefficiencies to develop appropriate strategies that facilitate doing business in developing countries. This section identifies 17 such strategies and explains how they may reduce or eliminate the obstacles.

23

2.5.1Invetment in Clusters SME industry sectors are highly fragmented with small players operating at less than optimal scale. Geographical and regional clusters facilitate consolidation of small scale deals and enable economically equity funding. Ideas evolve quickly and move faster in clusters (Bowender and Mani, 2002; Ahlstrom and Yeh, 2004). The advantages of concentration are not only economies of scale that reduce transaction costs but also proximity to other firms increases the potential for high deal flow and the probability of selecting high returns company’s. In Brazil and Argentina (Ribeiro and Carvalho, 2008) as well as Philippines (Scheela and Isidoro, 2008) these advantages of clustering have addressed the problems of limited investment opportunities for SMEs.

2.5.2 Non Financial Evaluation Methods Considering the limitations of the methodologies for determining discount rates in developing countries and the lack of financial information for valuation purposes some venture capitalists do not consider financial aspects at the screening stage. In Latin America, for example, the venture capitalist assesses the risks/return potential of projects applying their own criterion, such as “if the right entrepreneur, right strategy and right product are chosen and the right capability is developed, what return will follow?” (Kakati, 2003:450)

Others use financial projections to estimate the break-even point and not as an investment criterion (Silva, 2004). Others like Alvarez and Jenkins (2007) advise going beyond the numbers and due diligence and employ a hands-on approach. This requires hiring skilled fund managers who understand how to probe beneath the surface to identify previously unseen opportunities.

In Argentina, venture capitalists do not adjust the discount rate because they choose the rates consistent with the assumption that global markets are integrated (Bruner 2002).

2.5.3 Outsourcing Core Skills 24

Venture capitalists in developing countries, do outsource core skills to address the skills shortage problem.

Due diligence is outsourced to professional

research-based consulting firms or even expatriates who have proved to undertake the task thoroughly systematically efficiently. The outsourcing option reduces operational costs.

2.5.4 Government Incentives Government incentives such as the elimination of capital gains tax offset the high taxation cost associated with SMEs. According to Deloitte and SAVCA (2008) venture capital and tax incentives increase equity investors’ interest in early stage business and seed capital. This has been demonstrated also in the UK, Singapore and Taiwan (Lui and Chen, 2006; Bruton, Ahlstrom and Singh, 2002).

2.5.5 Exit Strategy Planning The limited option available in developing countries for an exit strategy gives it a special place in the venture capital investment process, and it is important to make the chosen strategy explicit at the onset. Besides the domestic initial public offering method which is unavailable to most developing countries because of underdeveloped domestic stock markets, one preferred option is to use foreign stock markets.

For example Celtel a regional mobile phone

company operating in Sub-Saharan Africa exited through initial public offerings in the London Stock Exchange following a buyout by a mobile phone company in Kuwait (Adongo and Stork 2006). It is therefore advisable to establish strategic partnerships and alliances to acquire the investee company when the venture capitalist is ready to exit. Other exit routes such as convertible loans and equity backed by

private options, strategic investors, trade sales,

refinancing, share buyback and reissue takeover, repurchase and voluntary exit are practised but viable exit options are those which offset the costs of investing in SME projects and reward the venture capital investor with a high profit return.

2.5.6 Proactive Deal Generation

25

To the extent that fund managers can create deals that fit their skill profile and industry knowledge they are able to create their own opportunities by beginning start-ups of their own and getting into joint-ventures with banks. This is already happening in Africa (AVCA, 2006).

They supplement this with active marketing of venture capital services through direct mailing, newsletters, seminars or workshops (Adongo and Stork, 2006), publicity and promotion of success stories as well as road shows (Reitan and Sorheim, 2000; Bertoni, Colombo, Crowe and Pria, 2007). Deals created by fund managers are likely to meet the requirements of venture capital firms and qualify for funding.

2.5.7 Business Incubators Business incubators have provided a source of deals for venture capital firms in developing countries. They have increased the survival rates of innovative startup companies, and have nurtured and developed entrepreneurs and fostered creativity and innovation (Ndabeni, 2008; Adongo and stork 2006; OECD 2006). Besides, they tend to bring products and services to the market in a much shorter time (Adongo, 2006).

Brazil, China and Israel have successful

incubators for start-ups which are a source of deals for the venture capital firms (Searamuzzi, 2002). They attract fund investors with the adoption of superior selection, assessment and monitoring practices (Carvalho, Ribeiro and Furtado, 2006).

2.5.8 Cross institutional Dialogue Universities and research organisations have provided innovative business ideas leading to the creation of new firms.

Therefore partnering with research

organisations spins out innovative technologies and companies which are a source of deals for venture capital firms.

26

In Israel, venture capitalists source deal flows from the Army controlled Israeli Institute of Technology (Malva 2006); and Taiwan’s product innovation success has been credited to its developed academic community and its network of research (Badino, Hu and Hung, 2006).

Venture capitalists can also strengthen cross institutional networks and promote dialogue with industry and syndicate partners such as accountants, lawyers, financial consultants and the banking community.

Strengthening cross

institutional networks can boost the number of deals in a low deal environment (Adongo and Stork 2006; Allen, 2009).

2.5.9 Collaboration with Non Profit Entrepreneurial Organisations Non profit entrepreneurial organisations combine deep local knowledge with operational, technical and marketing expertise to provide non-financial support services to SMEs.

These services include labour management training,

extension, consultancy and counselling, marketing and information services; technology development and diffusion, and mechanisms to improve business linkages through sub-contracting, franchising and business clusters (Hallberg, 2006).

Thus non-financial support services prepare entrepreneurs and the

management team with the skills required by venture capitalists when evaluating potential projects for investment. Singh (2005) advise that venture capitalists collaborate with non-profit entrepreneurial organisations to access this source of potential deal flows.

2.5.10 Training Entrepreneurs and Venture Management Venture capitalists have an important role to play in bridging the human skills deficiency gap to prepare SMEs for investment. They need to train and coach the entrepreneur and the management team to understand the venture capital investment process, explain and encourage constructive relationship with investors, and conduct awareness programmes on the risks and benefits of a venture capital financing (Singh 2005; Adongo and Stork, 2006; SAVCA and Venture Solutions, 2010). All this will contribute to reducing due diligence cost and the information gap and the risk profile leading to increase in quality deals (Aernout, 2005). 27

2.5.11 Strategic Partnership and Alliances Strategic partnerships and alliances provide a channel for identifying deals and exit opportunities for venture capital investors.

Partnerships with large

corporations are useful in determining the demand for products of the company (Mavla 2006).

In Israel, venture capitalists have foreign strategic partners in the US and Asia to support internationalization of their portfolio companies.

In Brazil, private

equity and venture capital managers spend considerable time networking with potential assurers. In all these efforts, the venture capitalist is assured of success and reduction in the risk of loss.

2.5.12 Networks Networks provide essential information for various due diligence evaluations and minimising agency problems in developing countries where institutions are deficient.

Three

such

networks

mechanisms

are:

networking

with

entrepreneur’s personal contacts; networking with other business and governments; and networking with local investors.

Networking with Entrepreneurs Personal Contacts Venture capitalists in China and Hong Kong, Singapore and Taiwan focus their due diligence on the entrepreneurs’ background and their contacts, and build relationship networks with relatives and educators of the entrepreneurs to determine the credit worthiness of the entrepreneur and enforce contracts (Bruton and Ahlstrom, 2003, 2004; Chu and Hirich, 2001) This investment strategy minimizes adverse selection of investment projects.

Networking with other Business and Government In developing countries, networking with civil society organisations, local governments, individuals and non-governmental organisations is important because relationship building with key influential figures in public and private sectors increase deal flow and success of the venture capital investment. In Vietnam, venture capitalists work with government officials to get necessary 28

approval for an investee company or to improve economic policies that affect their firms. (Scheela and Dinh, 2004).

Networking with Local Investment Partners Co-investment with local partners reduces individual risk. Local partners can also reduce information asymmetry and adverse selection since they know the market better and have the experience to navigate it (Adongo and Stort, 2006). In Africa, private equity players keep a network on the ground to keep them in touch with opportunities and threats (Allen, 2009).

2.5.13 Leveraging Strengths of Existing Institutions Venture structuring relies on existing laws and regulations, but the deficiency of institutions have forced venture capitalists in developing countries to find alternative methods. In Brazil where the legal system is inefficient because of the long and costly process of going to court, the lack of case law and judges’ limited knowledge of financial contracting, arbitration is frequently used as a dispute resolution method. (Ribeiro, 2007).

In Eastern Europe, some venture capitalists use diversification and offshore legal jurisdictions as a basis for venture capital investing. (Grikschct, 2006). In many developments the use of various control positions mitigates risks

2.5.14 Experienced Fund Managers Venture capital fund managers identify and evaluate propositions, structure and negotiate deals, manage and divest the portfolio of equity holding. To succeed in developing countries, they need a diverse set of skills including strategic planning, financial engineering, investment analysis, operations management, market research and sales. These specialized skills are required to evaluate the risks and rewards of a business plan, access growth potential and help entrepreneurs to succeed.

To succeed fund managers must have in-depth knowledge of local conditions and a network of contracts, all of which reduce the risk of adverse selection. Studies in Latin-America, the Caribbean (Gunning, 2003) and Poland (Bliss, 29

1999) confirm that the most experienced fund managers generally record the best performance.

2.5.15 Corporate Governance Practices Good corporate governance practices with strong financial controls help companies to transition from informally-run businesses to professionallymanaged organisations. It is advisable for the venture capitalists to insist on transparency

in

management,

accounting

and

operational

information

formulation. They must be physically close to the companies, and educate the entrepreneur and the venture team on the benefits of good governance which include, higher company valuations, lower cost of capital, increased investor confidence, greater access to external funding and increased exit premium. (Griksscheit, 2006; Adongo and Stork, 2006).

Good corporate governance

reduce information asymmetry and the risk of moral hazard. (Adongo and Stork, 2006).

2.5.16 Portfolio Diversification Diversifying portfolios among ventures in different industries and geographic areas reduces unsystematic firm-specific risks. Business concepts that enjoy patent, copyright or trade secret protection or enjoy unique geographic or market niche advantages are highly valued by venture capitalists because they reduce the risk of competition (Ruhnka and Young 1991). In developing countries, good ventures include those which address local demand for education, fast foods, fashion, cell phones and beauty products or address infrastructure deficiencies in generators, water purification systems especially those which apply new technologies (Mahajan and Banga, 2006).

Portfolio diversification reduces also, the discount rate applied when evaluating return potential on investments, and consequently improve the acceptance rate of SME projects.

2.5.17 Hands-on Monitoring A hands-on approach that has people on the ground with local connections and understanding of the market and culture adds considerable value to the venture. 30

Close monitoring enables appropriate recruitment of management, and sourcing of support services. All this enhances information flow, strengthens corporate governance to minimize adverse selection and moral hazards and reduces the risk of failure while enhancing the chances of SME success. (Cape, Cave and Ecdes, 2004; AVCA, 2006; Zong, 2005).

Fig 2.2 is a diagrammatic representation of the link between the 17 success factors and three sets of obstacles.

2.6

A Conceptual Model of SME Equity Financing Gap Reduction Review of the literature so far, suggests that there is a relationship between the perceived SME equity financing gap (dependent variable) and SME risk reduction (independent variable), SME cost reduction (independent variable) as well as SME transaction cost reduction (independent variable) Fig (6.1) represents the hypothesized inter-relationships.

2.6.1 Influence of SME Investment Readiness on SME Equity Financing Gap SME investment readiness means that the business has a sound investment proposal and that the entrepreneur and the management team have the appropriate skills and competency. The role of the pre-investment factors in preparing SMEs for investment readiness are outlined as follows:

(i)

Proactive Deal Generation refers to a situation where venture capitalists or their fund managers identify investment opportunities and are handson in preparing the business proposal; facilitating the investment financing process, guiding the entrepreneur and management team through the process, leading and growing the company.

(ii)

Business Incubators nurture and develop entrepreneurs and cultivate their creativity and innovation.

They provide hands-on business and

management assistance that improve entrepreneur’s business skills and ideas, all of which contribute to making companies investable and thus reducing the financing gap.

31

(iii) Collaboration with Non-Profit Entrepreneurial Organizations involves the organisations preparing SMEs for investment by providing a wide range of non-financial support services including business and management training including preparation and presentation of proposals.

These competencies reduce risks and costs arising from

information asymmetry.

(iv) Cross institutional dialogue such as SMEs affiliating with universities and research organisations expose SMEs to new technologies, innovation and quality business ideas which are attractive to venture capitalists.

(v)

Training Entrepreneurs and Venture Management Team on the venture managerial process, and bringing them into contact with venture capitalist addresses the human skills shortage problem, reduces due diligence costs and the information gap, risks of adverse selection and moral hazard.

The combination of these five strategic factors not only enable SMEs to prepare quality business proposals and articulate the ventures potential to the financier, the SMEs also understand the venture capital process and requirements and attain the skills needed for venture capital finance. To the extent that SMEs reduce both risks and costs significantly, they are investment ready.

Hypothesis 1 (H1) There is a positive relationship between SME investment readiness and reduction in the perceived SME financing gap

Insofar as investment readiness implies reductions in due diligence and monitoring costs, it is hypothesized that:

Hypothesis 1a

32

There is a positive relationship between SME investment readiness and reduction in SME transaction cost.

Furthermore, since SMEs that are investment ready are less risky because financial and business information is readily available and the entrepreneur and the management team have the relevant business skills and knowledge to run the venture, it is hypothesised that:

Hypothesis 1b There is a positive relationship between SME investment readiness and SME risk reduction

2.6.2 Influence of SME Transactional Costs Reduction on the SME Equity Financing Gap SME transaction costs are the total costs that the venture capitalist incurs during the investment validation process as well as the likely costs of running the business.

They include the assessment cost of the entrepreneur and the

management team, product/service and industry attractiveness and the cost of additional due diligence work due to poor financial and business records. The SME transaction costs are higher not only because of the small size of SME but also because of the poor institutional system. Thus, the cost of hiring fund managers to provide hands-on support can be substantial.

The five SME

transaction costs reduction factors are outlined below:

(i)

Investment Clusters refer to geographical, regional or industry concentration of SMEs with the advantages of economies of scale in monitoring and skill organisation. This enables lowering operational costs and economical equity funding to an otherwise highly fragmented group of SMEs.

(ii)

Using Non-Financial Evaluation Methods involves basing the investment decision not on financial analysis but on a hands-on local 33

knowledge and experience. This is necessary for two reasons. First, there are no standardized methods of determining discount rates. Besides,

Besides, SME accounting information is limited. This approach saves due diligence costs.

(iii) Outsourcing Core Skills refers to the use of core skills of local people not working directly for the venture capital firms. These people know the local information system and are able to obtain relevant information with relative ease. This approach reduces due diligence and operational costs.

(iv) Using Government Incentives such as tax in the form of up-front tax reduction, a tax write-off on losses, tax-free dividends and capital gains tax referral improves the post-tax returns of investors and encourages them to invest more in SME.

Tax incentives can be used also to

subsidize operational costs to improve the performance of investee companies.

(v)

Exit Strategy Planning such as having a strategic partner to take over or purchase equity at the end of the investment term increases the likelihood of a profitable exit. This in turn offsets the costs of investing in SME and maximises the returns of the venture capital fund.

All five factors reduce SME transaction costs making SME projects more attractive for potential investments. It can therefore be hypothesized that:

Hypothesis 2 (H2) There is a positive relationship between reduction of SME transaction costsand reduction of the perceived SME equity financing gap.

2.6.3 Influence of SME Risk Reduction on SME Equity Financing Gap Risk is defined, in this study, as “potential loss that may arise from a particular investment decision” (Parhankangas and Hillstrom, 2007:185). SME risks is 34

often perceived to be high because of information asymmetry, difficulty of assessing the management skills and track records of entrepreneurs and the knowledge that local entrepreneurs are unfamiliar with the venture capital investment process and practices (ECI, 2006) Since the conventional venture capital risk reduction strategies are not adequate for improving the reward-torisk ratio of SME investments in developing countries, the following six strategies are designed to reduce significantly the SME investment risk.

(i)

Strategic Partnerships and Alliances provide due diligence information for the screening and evaluation of potential projects and improve exit opportunities to reduce uncertainty.

Links with large corporations

provide information for assessing the demand for their products.

(ii)

Three network forums are frequently used, and include: entrepreneurs’ personal networks to assess his/her creditworthiness in order to reduce moral hazard risk and minimize adverse selection of projects; networking with other businesses are a source of reliable referrals to reduce the risk of adverse selection; and networking with local authorities assist venture capitalists to understand local regulatory regimes to reduce the risk of moral hazard.

(iii) Using the strengths of existing institutions reduce the risk of moral hazards by: applying arbitration clauses to resolve conflicts; creating private governance systems in the form of long term relationships; and applying control rights and various financing investments.

(iv) Experienced fund managers can reduce the risk of adverse selection and other agency problems by using their specialized skills to identify, evaluate, and negotiate deals and manage portfolios successfully.

(v)

Good governance practices lead to better management control and other benefits such as greater access to external funding, increased investor confidence, higher company valuation, lower cost of capital and increased exit premium. The increased transparency and trust which 35

they bring about addresses the problem of information asymmetry and reduces the risk of moral hazard.

(vi) Portfolio diversification across industries, industry sectors, and geographical areas reduce the risk portfolio disasters leading to reduction in the discount rates applied to evaluate the return potential of SME projects.

(vii) Hands-on monitoring minimises operating risks, reduces the risk of moral hazard and information asymmetry and eventually the risk of failure. All this, is made possible by the venture capitalist’s access to networks, direct contact with the entrepreneur and the management team and direct observation and action.

Given that these factors will mitigate SME risks and make SME projects attractive to venture capitalists, it can be hypothesized that:

Hypothesis 3 (H3) There is a positive relationship between reduction of SME risks and the reduction of the perceived SME equity finance gap.

Since the reduction of SME risks is expected to reduce SME transaction costs, particularly due diligence and monitoring costs, it can be hypothesized also that:

Hypothesis 3a There is a positive relationship between SME risk and SME transaction costs.

3.

RESEARCH DESIGN AND METHODOLOGY

This section discusses the research population and sample the data collection instruments and the statistical techniques used to test the hypotheses.

3.1

The Population Sample

36

Since this study is about SME equity capital, the population comprised of two sub-sets – private venture/equity capital investors, and SMEs that were looking for or have benefited from venture capital investment.

The directory of the South African Venture Capital and Private Equity Association (SAVCA) provided the email contacts of its 81 fully registered members. Seven were excluded because they did not deal with SMEs. Out of the remaining 74 members, 31 completed the survey questionnaire online, giving a response rate of 42 percent.

The South African SME toolkit directory, which is the only publicly available source of registered SMEs in South Africa. Out of the 502 registered SMEs, 85 indicated that they had looked for or obtained venture capital investment funding, but only 62 completed the whole questionnaire, giving a response rate of 73 percent.

To achieve the high response rates the researcher contacted all the companies in the two sub samples, explained the questionnaire in detail and requested them to respond online. Data collection took three months between March and June 2011.

3.1.1 Demographic Information on Samples

Table 3.1 shows that only six percent of venture equity capital companies invest in rural areas only. The rest invest predominantly in urban locations. About 74% are male with a similar percentage being white. The mode age range is3140 years old. All fund managers have at least a Bachelors Degree.

According to Table 3.2, 71% of SMEs surveyed operate in urban locations while about six per cent are located in rural setting with the rest (23%) working in either rural or urban areas. About 69% are males, 49% are white with a mode age range of 31-40 years. About 42% of SME operators have a certificate or diploma while 45% have an Honours or Masters degree.

37

3.2

The Questionnaire Review of the literature guided the design of a structured survey questionnaire reflecting the success factors influencing the SME equity financing gap. The two sub-samples – the venture capital firms, and the SMEs had separate questionnaires which were pre-tested with five investors and two industry experts to fine-tune for specificity and relevance.

The two questionnaires were set up at the survey monkey website and provided a means of collecting data consistently without bias by setting up responses that were anonymous and collected data at an aggregate level. The questions were worded as statements and respondents had to indicate their degree of agreement or disagreement on a five point Lickert Scale.

The questionnaire for the venture/equity capital sample sought information about the nature of the company, choice of economic sector, choice of development stage of business for investment and reasons for rejecting SME proposals.

For the SME sample, business information solicited included

location of economic sector, stage of development and obstacles to equity funding.

Statements on obstacles to SME equity capital and demographic

information were similar in the two questionnaires.

3.2.1 Operationalization of Variables The variables in the proposed model – Independent Variables are – SME investment readiness; SME risk reduction; and SME transaction cost reduction.

SME Investment readiness has five factors: Proactive deal generation; business incubators; cross-institutional dialogue; collaboration with non profit entrepreneurial organisations; training entrepreneurs and the venture team;

38

SME transaction cost reduction has five factors: investment in clusters; using non-financial evaluation methods; outsourcing core skills; using government incentives; and exit strategy planning.

SME risk reduction has seven factors: strategic partnerships and alliances; networks; leveraging the strengths of existing institutions; using experienced fund

managers;

adopting

good

governance

practices;

portfolio

diversification; and hands-on monitoring.

The Mediating Variables Mediation is a hypothesized casual chain in which one variable affects a second variable that, in turn, affects a third variable. (Bryman and Cramer, 1990). In the model indicated, the independent variables, SME risk reduction and SME transaction cost reduction are mediating variables for SME investment readiness. Similarly, SME transaction cost is a mediating variable for SME risk reduction.

Control Variables The demographic categories of race, gender and geographical location (rural and urban) were the control variables. The study did not use industry dummies since respondents either invested or operated in more than one industry. Besides, the number of respondents per industry was significantly below the minimum sample (30) acceptable for regression analysis.

Dependent Variable SME equity financing gap can be measured as the difference between what SMEs seek and what they actually receive (OECD, 2006b). However, as data is not readily available in South Africa, this study rather focused on the “perceived SME equity financing gap”. This variable was measured on the basis of the extent to which respondents agreed or disagreed on the five-point Lickert Scale ranking. With the statement that reduction or elimination of obstacles to equity finance that 39

is, SME lack of investment readiness, high SME transaction cost and high SME risk will encourage equity investors to invest more in SME projects.

3.3

Reliability of Research Instrument Reliability of the survey investments, or the consistency with which they measure concepts for the results to be replicated by other researchers (Leedy and Ormond, 2001) was confirmed by the Cronback alpha, which was calculated for each variable in the model using SPSS19 software. These measures ranged from 0.560 to 0.804 which was between moderate and high reliability (reliability co-efficiencies below 0.5 is low and above .075 is high). These results are therefore acceptable given the explanatory nature of the study.

3.4

Validity This study has ensured a high degree of accuracy or the extent to which research instrument measured what they were required to measure. It ensured internal validity not only by identifying all variables through review of the literature, but also by means of a pilot study and discussions with industry experts and members of the South African Venture Capital Association (SAVCA). The external validity of the research or the “extent to which the results apply to the situation beyond itself” (Leedy and Ormond, 2001:105) was achieved by drawing responses from registered members of SAVCA and SMEs registered in the South African SME Toolkit directly. Therefore, the samples adequately represent South African venture capital firms and SMEs benefiting from or seeking venture finance.

Convergent and discriminate validity were established to ensure construct validity by evaluating the item-to-total correlation. All the question loadings for the three independent variables in the theoretical model had an item-to-total correlation score of above 0.3 which is considered reliable. (Hinton 2004). Discriminate validity was accounted for by means of factor analysis. Kaiser’s rule of values greater than one guided the determination of the number of factors in a data set. Items that loaded on more than one factor were excluded if the 40

loading on a factor was less than 0.4. The final sets of factors were as follows; five for the SME risk reduction variable; three for the SME transaction cost variable; and six for the SME investment readiness variable.

3.5

Methods of Data Analysis Simple linear regression and multiple regression analysis were applied to assess the hypothesized relationships in the theoretical model.

Likert-type scale is technically ordinal scales but the data were treated as continuous to enable the use of linear regression. Zumbo and Zimmerman (1993) agree that this treatment is allowed as long as five or more categories in the Likert scale are used. The average composite scores on the factors that constituted the three independent variables were used for the regression analysis. For example, the average scores of the five factors formed the SME risk reduction (variable), the average scores of three factors formed the SME appraisal cost variable and the average score of the six factors formed the SME investment readiness variable.

3.5.1 Simple Regression Analysis Simple regression analysis was applied separately to the SME survey data, the venture capital investor’s survey data, and the combined data. For each data category the analysis was performed to involve: independent variables, mediating intervening variables, and control variables.

Independent Variables Simple regression was performed on the SME risk reduction variable, and the SME investment readiness variable to measure the capacity of each variable to contribute individually to the reduction of the perceived SME equity financing gap. These were hypothesis 1, 2 and 3.

Mediating/Intervening Variables In this case the three hypotheses tested were 1a, 1b and 3a.

Control Variables 41

Simple regression was finally performed while controlling for the three control variables: race, gender and geographical location. The data used in this case was the combined sample data because the sample sizes were too small for regression analysis.

3.5.2 Multiple Regression Analysis A standard multiple regression was applied to measure the highest possible correlation among the three variables. The correlation matrix was checked for multi-colinearity but the results of the Pearson Correlation Coefficient was less than 0.4 (less than the 0.8 indicator of multi-colinearity).

In the absence of multi-collinearity multiple regressions was conducted separately for the venture capital investors, sample the SMEs sample and the combined sample.

When controlling for gender, race and geographical location, the combined sample was used as individual samples were too small for regression purposes.

Backward and stepwise regression stages were applied on the data to establish which of the three independent variables contributes most to SME equity financing gap reduction.

4.

ANALYSIS AND INTERPRETATION OF DATA

This section reports on the empirical analysis in two parts – results and interpretations of the factor analysis and the regression analysis.

This is

preceded by descriptive statistics of the sample population.

4.1

Descriptive Statistics Nearly 84% of the venture/equity capital sample were independents and captive financial services which controlled over 80% of funds under management in South Africa in 2010 (KPMG and SAVCA, 2011)., and over 80% invest in the expansion and development stage. Regarding the economic sector which they

42

represented 65% were in the finance and business services sector, with the rest and operating in the manufacturing sector.

Regarding the SMEs, 47% were in the expansion and development stage, 39% in the start up and early stage of development, with the rest at seed capital stage. None was at the bridge financing stage.

About 39% operated in the

finance and business sector, followed by 20% in transport, storage and communications, the rest representing a wide range of sectors. Most of the SMEs classified their businesses in multiple sectors.

4.2

Principal Component Factor Analysis The first step in the principal component analysis was to determine whether the data matrix had sufficient correlation to justify application of factor analysis. Three tests were performed, namely: the Kaiser-Meyer Okin (KMO) test for measuring sampling adequacy requiring a KMO result higher than 0.05 or higher and the Bartlett test indicating whether there are relationships to investigate and require a P-value of less than 0.05; and the determinant (R matrix) test requiring a measure greater than 0.000001 for inclusion. (Hinton et al, 2004).

The results of the three tests suggested that the survey data for the combined sample was suitable for factor analysis without need for adjustment. However, six success factors were deleted from the private venture/equity capital sample and two from the SME sample. This was determined through an interactive process where factors were dropped and added until a suitable combination of factors was reached.

To determine how significantly a factor loading contributed to a factor component Hinton et al (2004) recommended a p-value of 0.3 or greater. This cut off point, was however, raised to 0.4 because the disaggregated data sets were small.

For the combined sample and SME sample respectively, 14 out of the 17 factors loaded significantly to the three variables, SME investment readiness, 43

SME risk reduction and SME transaction cost reduction.

Regarding the

venture/equity capital sample only 11 factors significantly loaded the three variables.

Results of Cronbach alpha tests computed for each of the three variables to determine internal consistency and reliability showed values between 0.560 and 804 which are greater than the acceptable range of 05 and 0.75. (Hinton et al, 2004).

4.3

Interpretation of Factor Analysis Results The factor analysis confirmed those factors which make relevant and significant contributions to the three variables – SME readiness, SME risk reduction and SME transaction cost reduction respectively.

This section

discusses implications of these results on the combined sample.

SME Investment Readiness The final list of success factors contribute to SME investment readiness are: proactive deal generation; collaboration with non-profit organisations, training entrepreneurs and the management team, networks; good governance practices and hands-on monitoring. They collectively mitigate the lack of entrepreneurial skills and ideas, shortage of skilled and talented management teams, limited availability of SME financial information, unreliable legal systems to enforce contracts, and lack of quality deals.

Individual, proactive deal generation permits the venture capitalist to identify entrepreneurs and projects that fit their skills and sector preferences and fulfil the requirement for information on product/service and market attractiveness. Collaboration with non-profit organisations provide entrepreneurs with managerial, financial, marketing and

technical skills while training

entrepreneurs enables them to understand the venture process enough to develop convincing business plans.

Furthermore, hands on monitoring

supports entrepreneur and the management team with advice, better governance and efficiency practices, and connection to new markets.

It minimises 44

information asymmetry concerns about profits and return on investment. Networks particularly reduce agency and information risks by ensuring enforcement of contracts, navigating around institutional voids and deficiencies and market acceptance of products or services. Finally, corporate governance practices ensure that adequate financial and performance reports are available. It further reduces monitoring costs and increase investor confidence about the venture liquidity and the opportunity exit.

SME Risk Reduction The selected risk reduction factors are: strategic partnership and alliances; leveraging the strengths of existing institutions; using experienced fund managers; exit strategy planning and business incubators.

These factors

mitigate a wide range of financial and non-financial risks which reduce the attractiveness of SMEs in developing countries for venture capital funding.

The involvement of experienced fund managers does not only directly address financial concerns of venture capitalists and the lack of experience of the entrepreneurs and their managers; they are able to identify the competitive advantage of the firm and translate into significant growth earnings. They are able to exploit strategic partnerships and alliances to guarantee profitable exit options and draw on the strengths of existing institutions to enforce contracts and protect property rights. Above all placing the SMEs in business incubators provide the opportunity to nurture develop and cultivate creativity and innovation among the entrepreneurs to overcome the tendency to replicate other projects and present quality deals.

SME Transaction Costs Reduction The three factors contributing to SME transaction costs are: investment in clusters, non-financial evaluation methods and outsourcing of core skills.

45

They address the “financial consideration” aspect of the conventional investment criteria by reducing management, operational, transactional and coordination cost to boost return on investment.

Individually, the reduced costs of deals through the economies of scale obtained by clustering SMEs complement cost reduction achieved by outsourcing core skills.

When fund managers lack local knowledge and

outsource to well-informed local people they reduce transaction cost to increase profits. Finally using non-financial evaluation methods to determine the size of risk or return on investment reduce research and dividend costs.

In conclusion the 14 factors in the three variables collectively and individually mitigate the following obstacles to SME venture capital funding in developing countries: weak institutional environment; low quality deal flow; poorly prepared business proposals; lack of entrepreneurial ideas and managerial skills; violation of property rights; lack of product and market attractiveness; shortcomings in financial valuation methods; lack of knowledge about venture capital; inadequate financial information about SMEs and limited exit options.

This technique for appraising SMEs for venture capital funding differs from the conventional criteria in two distinct ways. First, it simplifies the conventional five-component isolated criteria to three-point overlapping criteria reduces the multiple obstacles into three – lack of investment readiness, high transaction costs and high risks.

Furthermore, the new technique adopts a different

perspective to appraisal. Rather than assessing the current condition of SMEs, this technique adopts a normative perspective to examine critically the extent of the ventures attractiveness given courses of action to reduce the three critical constraints. The linkage between the three success variables and the obstacles to financing identified form application of the conventional criteria is show in Table 8.15.

4.5

Regression Analysis This section uses the results of the factor analysis to test if indeed, and to what extent the three independent variables individually and collectively reduce the 46

perceived SME equity financing gap. The first part is the descriptive statistics of the composite scores of SME investment readiness, risk reduction and cost reduction obtained by means of the Likert technique. The research hypothesis is then tested using sample regression and multiple regression analysis.

4.5.1 Descriptive Statistics The composite scores of the SME equity success factors were computed and used as independent variables in the regression analysis. The summed scores were calculated as average scores across items contained in that variable. For example in Table (9.1) the SME investment readiness mean score of 4.2.4 is the average of the original scores on the following success factors: government incentives;

proactive

deal

generation;

collaboration

with

non-profit

entrepreneurial organisations; training entrepreneurs and venture management; networks and hands-on monitoring. Thus summated scale include only the initial factors that load highly on the variable. The results of the composite scores for the SME sample the venture/equity capital sample and the combined sample are show in Tables 9.1, 92. And 9.3 respectively. SME investment readiness is the highest mean score in the sample (4.24 as well as the combined sample (4.23) while in the venture/equity capital sample SME transaction cost reduction is the highest mean (4.19).

4.5.2 Simple Regression Analysis The first analysis was to regress the perceived SME equity gap individually on the three independent variables in three separate simple regression analysis for each of the three samples. The results show that more of the relationships in the venture/equity capital and SME samples as well as the combined sample were significant.

Intervening Variables The relationships among the three independent variables were tested using the combined sample to eliminate the effects of a small sample size. According to the theoretical model, SME readiness is the predictor variable and the other two are outcome variables. Similarly, the relationship between SME risk reduction

47

and SME transaction costs was tested with the former as the predictor and the latter as the outcome variable.

The results show statistically significant positive relationships, thus supporting the hypothesis 1a, 1b, and3.

Multiple Regression The multiple regression for the three explanatory variables in the combined sample was significant and explained 66% (R²) of the variance in the dependent variable at 95% confidence level. Based on the beta values, SME risk reduction contributes more to the explanation of the perceived SME equity financing gap compared to SME investment readiness and transaction and cost reduction.

CONCLUSIONS, RECOMMENDATIONS AND DIRECTIONS FOR FUTURE RESEARCH

This study has confirmed that there is a statistically significant positive relationship between the growing SME equity financing gap in developing countries and the three major obstacles to SME venture capital funding, that is, high risk, high transaction cost and lack of investment readiness. In other words, these obstacles individually and collectively account for the high rate of rejection of SME ventures in developing countries by venture capitalists. However, when the 14 critical success factors identified in this study are disaggregated into three multiple-factor variables tailored to mitigate those obstacles, they are indeed able to do so individually and collectively with significant positive results.

The significance of this finding is two-fold. First, the conventional five-point approach to new venture assessment involving separately evaluating the entrepreneur, the venture management team, product/service attractiveness, market attractiveness and financial considerations, has to give way to the threepoint holistic approach suggested in this study. In this approach, the focus is 48

on identifying the optimum combination of factors from the three variables – risk reduction, cost reduction, and enhancing investment readiness – which collectively improve a venture’s attractiveness. Second, the new approach suggests a more strategic conjectural and optimistic perspective of an SME venture in regard to what actions are possible to identify.

Its potential

attractiveness, given its relative strengths and opportunities, weaknesses and threats. This contrast the conventional criteria’s normative perspective of a new venture that pays greater attention to what must constitute investment readiness.

South African financial institutions in general and venture/equity capitalists in particular, have, so far, failed to change their approach to perspective of SME financing in response to the growing expectation of SMEs to play a more central role in employment growth and 3economic progress. Changing their mindset requires a more proactive role by venture capital investors in building the capacity of entrepreneurs and recognizing the value of existing local institutions by collaborating with non-traditional partners such as non-profit entrepreneurial organisations to prepare SMEs for investment and coinventing solutions. (London and Hart, 2004).

Government will be contributing to SMEs attractiveness by improving the legal, institutional and regulatory framework conditions. For example, the South African Company Act does not require SMEs to produce audited accounts, a factor which increases transaction cost of venture assessment. Furthermore, South Africa has a stock market – the ALTX for SMEs but it lacks the facility for

??? (IPO), which creates uncertain prospects for future

exit for investors. Therefore, creating an exact conduit will add a lot more ot SME attractiveness. Finally, the factor analysis showed insignificant loading for the “crossinstitutional dialogue” SME equity success factor, implying the need to promote a closer collaboration among entrepreneurs, research centres, venture capitalists and government. 49

Direction for Future Research Since the scope of this study is limited to and empirical analysis, it is necessary to explore the applicability of the new criteria among South African venture capitalists to expand the boundaries of critical success factors and refine the coordinated actions required to enhance its effectiveness. Additionally, a study to provide data for measuring the SME equity financing gap, in order to replace the perceived SME equity financing gap used in this study, will add a great deal to the significance of this study.

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