The Equity Gap the Reason for the Venture Capital Market

Venture capital arose primarily as a result of the inability of smaller hightech firms to source funds from more traditional sources. Lending to small business has been unprofitable for many banks due to low margins and high losses in the past. Also, banks use traditional measures in their lending decisions that often preclude the newer, smaller, high-risk firm.

A traditional approach to the lending decision by banks is to require security in the form of a house, vehicles and other associated assets that are not directly associated with the business, in the case of sole traders and other unlimited firms. Banks also want tangible assets in the form of equipment buildings and land. They often ignore the valuable intangible assets these firms have in the form of IP, expertise, goodwill and reputation.

On this basis, banks will not lend to many new ventures and therefore a gap is created between what is needed to establish or grow the firm and what is available. This is the basis for the establishment of other forms of equity, including pre-seed, seed and the venture capital market to fill this gap.

A notable exception to the traditional bank approach occurred in the Cambridge region, where one bank manager decided to provide small portions of early seed funding for new high-technology firms spinning out of Cambridge University (Druilhe and Garnsey 2004).

Globally 44 per cent of funding deals are done at discovery phase; 16 per cent at pre-clinical; 10 per cent at phase I and II; 6 per cent at phase III; 5 per cent at registration and 19 per cent after launch (Allant CBIM 2004). Figure 3.4 highlights the typical equity and investment funding through the growth stages of a biotech firm.

The funding can essentially be broken down into several stages, each with distinct characteristics.

a. Informal funding: founders, family, friends and fools b. Pre-seed and seed funding: business angels, pre-seed funds, for example, funds provided by government orpublic-private partnerships c. Venture capital funding d. Private equity investors, mainly forexpansion ormanagement buy-outs

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