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The
US Venture Capital Sector
Venture capital in the US
can be divided into 'professional' and 'angel'
finance. 'Professional' venture capital is typically
provided through venture capital funds, while
'angel' venture capital is more usually invested
direct by one or a small number of private individuals.
Generally,
venture capital investors can be said to invest
alongside management in young, rapidly growing
companies that have the potential to develop into
significant economic contributors. Venture capital
is an important source of equity for start-up
companies.
Venture
capitalists generally invest in equity, and actively
participate in the strategic development of their
target companies. Nornally they have a long-term
perspective.
Recently,
some investors have been referring to venture
investing and buyout investing as "private equity
investing." This term can be confusing because
some in the investment industry use the term "private
equity" to refer only to buyout fund investing.
Institutional investors commonly allocate 2% to
3% of their institutional portfolio for investment
in alternative assets such as private equity or
venture capital. Increasingly, the two terms overlap.
Professionally
managed venture capital firms in the US are generally
private partnerships or closely-held corporations
funded by private and public pension funds, endowment
funds, foundations, corporations, wealthy individuals,
foreign investors, or venture capitalists themselves.
Professional
venture capitalists mitigate the risk of venture
investing by developing a portfolio of young companies
in a single venture fund. Many times they will
co-invest with other professional venture capital
firms. In addition, many venture partnerships
manage multiple funds simultaneously.
The
phrase 'Angel Investor' originally referred to
investors in Broadway plays, but by now the term
encompasses a wide spectrum of individual investors
in business and cultural activities.
It
is estimated that angel investors in the US invest
three to five times more money than venture capitalists
and fund thirty to forty times more ventures,
making them the primary source of outside capital
for entrepreneurs. Generally an angel investor
has a net worth of $1 million or more or a salary
of $200,000 or more for the past two years. An
Angel investor must be prepared to get involved
with the business and should have his or her own
management experience. Angel investors may either
be wealthy people with management expertise or
retired business men and women who seek the opportunity
for first-hand business development.
Typically,
angel investors choose small companies that are
too speculative for bank loans and too young for
venture capital. Often they are in the high-tech,
health services, retailing and personal services
industries, but are not limited to those industries.
Start-up businesses may need financing to begin
operations, develop a product or bring that product
to market. Angels also prefer to invest in industries
that they are personally familiar with.
Angel
investors are at the opposite end of the spectrum
from companies using shelters driven mainly or
wholly for tax reasons, in that they may actually
hope to make money out of their investment, and
also see it as a positive involvement in business
terms. Nonetheless, 'angels' need to minimise
their tax bills as much as anyone else, and venture
capital is at the end of the day a tax-efficient
investment.
In
the US, the National Venture Capital Association
(NVCA) is a trade association that represents
the venture capital industry. Its membership of
more than 400 consists of venture capital firms
and organizations who manage pools of risk equity
capital designated to be invested in young, emerging
companies.
According
to the MoneyTree Survey by PricewaterhouseCoopers,
Thomson Venture Economics and the National Venture
Capital Association, venture capitalists invested
$4.6 billion in 674 companies in the first quarter
of 2005, which is below Q4 2004 of $5.4 billion,
but matched Q3 2004 of $4.6 billion. Over the
past two years, quarterly investing has floated
between $4.4 billion and $5.9 billion.
First-time fundings inched up near a two-year
high of $1.2 billion in 197 companies on the strength
of relatively more mature companies receiving
their first round of venture capital. And, Life
Sciences investing abated for the first time in
two years.
Mark Heesen, president of the National Venture
Capital Association, said: “Venture investment
was indeed down this quarter, but it still fell
within the $4-6 billion range that we consider
to be at a rational, investable, performance-driven
equilibrium. We would like to see the industry
stay within this ‘RIPE zone’ for the
remainder of the year, as a $20-$23 billion annual
investment level is a logical place to be considering
market conditions.
Two
reports released in early May, 2006, suggested
that venture capital investment in the United
States had got off to a flying start in 2006,
led by a resurgence of investment in the information
technology (IT) segment and the media and entertainment
sector.
According
to the MoneyTree Report by PricewaterhouseCoopers
and the National Venture Capital Association,
which is based on data provided by Thomson Financial,
US venture capitalists invested US$5.6 billion
in 761 deals in the first quarter of 2006 representing
a 12% increase over the same period in 2005.
“As
far as investment equilibrium, it doesn’t get
much more stable than this," noted Mark Heesen,
president of the National Venture Capital Association.
"In
the last 16 quarters, venture capitalists have
consistently placed US$4 – US$6 billion into a
diverse set of emerging growth companies with
no single sector experiencing major surges or
major draughts. We are experiencing the regular
ebb and flow of venture investing and we are truly
at our healthiest and most sound investment point
since the mid 1990’s," he added.
The
PwC/NVCA MoneyTree Report goes on to state that
the media and entertainment sector reached a four-year
high, rising 80% over the prior quarter to US$396
million from 57 deals. Several large deals accounted
for a significant portion of this increase. Additionally,
companies focused on delivering content via the
internet accounted for approximately half of the
total dollars invested and number of deals.
Software
investments rose 12% in Q1 to US$1.2 billion in
197 deals and remained the largest single industry
category with 22% of total dollars and 26% of
all deals.
Internet-specific
companies captured US$861 million going into 145
deals, a 10% increase in investment dollars over
Q4 2005. Internet-specific investing has grown
slowly over the last several quarters with Q1
accounting for 15% of total investments, compared
to 14% in the prior quarter.
However,
the telecommunications industry category, which
experienced a notable increase in Q4 2005, fell
in Q1 by 17% to US$601 million, with a decrease
in wireless investments accounting for the majority
of the decline, the PwC/NVCA MoneyTree Report
revealed.
Investments
in biotechnology also declined, falling 24% from
Q4 2005 to US$808 million, but the report stated
that this was consistent with historical patterns
of lower first quarter investing in the sector.
Meanwhile,
the Quarterly Venture Capital Report released
by Dow Jones VentureOne and Ernst & Young LLP
suggested that overall deal count increased 6%
from the first quarter of 2005 to reach a five-year
high. Investment in the information technology
(IT) segment led the way, posting 327 deals with
$3.36 billion invested. This was nine more deals
than a year ago and 13% more capital - the most
capital directed toward the IT segment in a single
quarter since the second quarter of 2004.
“The
results of this quarter's study suggest that investors
are placing fewer but bigger bets on exciting,
innovative companies," noted Joseph Muscat, Americas
Director of the Ernst & Young Venture Capital
Advisory Group.
"This
reflects a desire by investors to accelerate the
business models of these companies and a recognition
of the increased capital needs of private companies
up to an eventual exit transaction, whether an
acquisition or an initial public offering," he
added.
The
median size of a round of financing in the first
quarter of 2006 was $7.5 million, up from $6.8
million a year ago. It was the highest median
round size since the fourth quarter of 2000. By
industry, both health-care and IT median round
sizes were $7.5 million, while the median round
size for a products and services deal was $6.4
million.
The
largest deal of the first quarter was an information
technology company: the $150 million second round
for communications company Amp’d Mobile of Los
Angeles, Calif., a mobile entertainment services
provider.
Also
noteworthy for the IT segment was the fact that
$727.7 million was directed toward seed- and first-round
deals in the quarter. That is the most capital
investment in early-stage IT companies since the
fourth quarter of 2001. About 32% of all the IT
deals in the first quarter were early-stage rounds,
about the same percentage as a year ago.
“Overall,
the first quarter numbers point to a positive
start for the U.S. venture market in 2006," observed
Steve Harmston, director of global research at
VentureOne.
"The
renewed IT activity is a sign that investors are
recognizing the significant potential of new information
technology innovations and are supporting them
once again,” he added.
“But
investors also remain committed to existing portfolio
companies as the predominance of the capital investing
shows," Mr Harmston concluded.
While
the archetypical venture capital investor looks
for baby Microsofts, there is in fact a wide range
of different types of vc investor. Venture capitalists
can be generalists, investing in various industry
sectors, or various geographic locations, or various
stages of a company's life; alternatively, they
may be specialists in one or two industry sectors,
or may seek to invest in only a localized geographic
area.
Not
all venture capitalists invest in "start-ups."
While venture firms will invest in companies that
are in their initial start-up modes, venture capitalists
will also invest in companies at various stages
of the business life cycle. A venture capitalist
may invest before there is a real product or company
organized (so called "seed investing"), or may
provide capital to start up a company in its first
or second stages of development, known as "early
stage investing." Also, the venture capitalist
may provide needed financing to help a company
grow beyond a critical mass to become more successful
("expansion stage financing").
Some
funds focus on providing financing to help the
company grow to a critical mass to attract public
financing through a stock offering or to attract
a merger or acquisition with another company.
At the other end of the spectrum from start-ups,
some venture funds specialize in the acquisition,
turnaround or recapitalization of public and private
companies that represent favorable investment
opportunities.
While
high technology investment makes up most of the
venture investing in the U.S., and the venture
industry gets a lot of attention for its high
technology investments, venture capitalists also
invest in companies such as construction, industrial
products, business services, etc. There are several
firms that have specialized in retail company
investment and others that have a focus in investing
only in "socially responsible" start-up endeavors.
Venture
capitalists will help companies grow, but they
eventually seek to exit the investment. Most venture
capital investments mature in three to seven years,
but an early stage investment may take seven to
ten years to mature, while a later stage investment
many only take a few years. The life cycle of
the investment must match the liquidity profile
and investment goals of the investing limited
partnership.
From
a tax perspective, the timing of investment and
of disposal or exit is obviously a key aspect,
and one which is not necessarily under the control
of the investor. If investments are being made
through a venture capital fund, timing is specifically
not under the control of the investor, although
in a classical closed-end fund there's nothing
to discuss, because the rules were laid down at
the beginning. The vagaries of the market are
one reason for preferring direct, individual investment,
although an investment in any given company is
probably even more volatile than the market as
a whole.
In
June 2007, former United States Treasury Secretary
suggested that fund managers receiving pay through
performance fees are not paying their fair share
of tax, adding fuel to the debate as to whether
curbs should be placed the escalating sums earned
by the top fund managers.
Sitting
as a panelist at a tax reform conference organised
by the Hamilton Project, part of the Brookings
Institution, Robert E. Rubin, a Treasury Secretary
during the Clinton administration, was asked whether
it would be more appropriate for fund managers
earning profits from managing others' money, known
as carried interest, to pay income tax at rates
of up to 35%, instead of capital gains tax, which
can be taxed at 15%.
“It
seems to me what is happening is people are performing
a service, managing peoples’ money in a
private equity form, and fees for that service
would ordinarily be thought of as ordinary income,”
Rubin said. He went on to state that the issue
should be examined “with great seriousness”
by the Congressional tax committees.
Currently,
the standard basic fee structure for managers
of hedge and private equity funds is 20% of gains
made by the fund, plus a 2% management fee. This
has helped to fuel some massive pay increases
for the heads of the most successful funds. According
to Alpha magazine, the average pay of the 25 top
performing fund managers was $570 million last
year. The highest paid of these fund managers
was James Simons, chairman of Renaissance Technologies,
who earned $1.7 billion.
Senate
Finance Committee Chairman Max Baucus (D - Mon)
has expressed concern that hedge fund and private
equity fund managers are manipulating the US tax
code to reduce their tax bills.
Senate
Finance Committee staff are currently examining
this area of taxation after a closed-door hearing
heard from a number of experts on the subject,
including University of Colorado law professor
Victor Fleischer, who has written a study of the
tax implications of hedge-fund managers' pay,
and Internal Revenue Service officials.
"The
different rate between capital gains and ordinary
income puts a lot of strain on the code,"
Baucus explained.
Later
that month, the industry's main lobby group suggested
that new legislative proposals that would tax
as corporations all publicly traded partnerships
that directly or indirectly derive income from
investment adviser or asset management services
would leave the majority of US venture capital
firms unaffected.
Responding
to the introduction of a bill that aims to tax
such funds at 35% instead of 15%, Mark Heesen,
president of the National Venture Capital Association
(NVCA), said in a statement that "almost
no" venture capital firms would be affected
by the proposals since they are aimed at funds
which are publicly traded.
"The
Bill proposed by Senators Baucus (D-MT) and Grassley
(R-IA) is directed at publicly-traded partnerships,"
Heesen stated. "As almost no venture capital
firms are publicly held, this proposed legislation
does not impact our business."
Heesen
added that the NVCA has met with staff members
of the Senate Finance Committee, Joint Tax, and
the House of Representatives Ways and Means Committee
over the past several months to explain how the
venture capital model is "taxed correctly".
"We
remain hopeful that lawmakers will continue to
demonstrate an understanding that the existing
venture capital tax structure is appropriate and
critical to economic growth in the US," Heesen
stated.
The
National Venture Capital Association (NVCA) represents
approximately 480 venture capital and private
equity firms. According to a 2006 Global Insight
study, venture-backed companies accounted for
10.4 million jobs and $2.3 trillion in revenue
in the United States in 2006.
Baucus and ranking committee Republican Chuck
Grassley explained that they had introduced the
bill because, in the words of Grassley, some firms
are "pretending to be something they’re
not to avoid most, if not all, corporate taxes".
"It’s
unfair to allow a publicly traded company to act
like a corporation but not pay corporate tax,
contrary to the intent of the tax code,"
he said upon the bill's introduction, adding:
"If left unaddressed, the tax concerns presented
by the public offerings of investment managers,
like private equity and hedge fund management
firms, could fundamentally erode the corporate
tax base."
Similar
sentiments are being echoed across the Atlantic
in the United Kingdom, where incoming Prime Minister
Gordon Brown is under increasing pressure from
unions and the left of the ruling Labour Party
to change tax rules allowing private equity firms
to treat income as capital gains, and qualify
for a special tax regime that can reduce tax on
carried interest to 10%.
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