CHAPTER 1 INTRODUCTION
1.0. INTRODUCTION
This chapter presents the historical background of Venture Capital Funds together with the objectives of this particular particular term paper. Furthermore Furthermore this chapter shows how the study was conducted.
1.1. THE HISTORICAL HISTORICAL BACKGROUND OF VENTURE CAPITAL CAPITAL FUND
The concept of venture capital fund started to come into existence in the 1st half of the 20th century specifically the late 1930’s in the United States of America (USA). During this time it was known as Development capital. During this era there were a few families in USA which had accumulated substantial amounts of wealth and used this wealth to invest in growing companies by providing them with funds to finance these growing businesses. The good examples of these families which have a lot of fame up to date are The Rockefellers, The Vanderbilts and The Whitneys. In 1938, Lawrenc Lawrencee Rockefel Rockefeller ler helped helped to finance finance the creation creation of two compani companies es namely namely,, Eastern Airlines Co and Douglas Aircraft Co. The Rockefeller family had a lot of vast holdings in various companies in USA.
Eric M Warburg, founded his own company known as E.M Warburg & Co in 1938, but he faced the challenge of expanding the company. So he invited investors who invested in the form of leveraged buy outs and venture capital, and the company’s name was ultimately modified to Warburg Pincus Co.
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The origin of the modern private equity or venture capital
Before the Second World War (WWII), venture capital was known as Development capital. These development capitals were originated from the wealth families and individuals. It was not until WWII that venture capital is considered today to be the true private equity. Due to this improvement, Investors started to emerge all over USA which marked the founding of the first two (2) Venture Capital Firms which were, American Research and Development Corporation (ARDC) which was founded by Georges Donot “the Father of Venture Capital” together with Ralph Flanders and Karl Compton who altogether encouraged people with funds to invest in private sector companies which were managed by soldiers who have returned from The Second World War (WWII). The second Venture capital Firm to be formed during this era was J.H Whitney & Co.
ARDC’s significance was that primarily it was the first Institutional Private Equity Investment Firm that raised capital from sources other than wealthy families although it had several notable successes as well. Furthermore ARDC has a reputation of being the first venture capital firm to show success in 1957. This was due to the fact that its’ $70,000 investment in Digital Equipment Corporation (DEC) was valued over $355 million after company’s Initial Public Offer (IPO) in 1968. This investment had a return of 1,200 times its Initial Investment of $70,000 though its expected annual rate of return was 101%.
Venture capital in the 1980s
The public successes of the venture capital industry in the 1970s and early 1980s (e.g., Digital Equipment Corporation, Corporation, Apple Inc.) Inc.) gave rise to a major rise of venture
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capital investment firms. From just a few dozen firms at the start of the decade, there were over 650 firms by the end of the 1980s, each searching for the next major "home run". While the number of firms multiplied, the capital managed by these firms increased by only 11% from $28 billion to $31 billion over the course of the decade.
The growth of the industry was hindered by drastic declining returns that led certain venture firms begin experiencing losses for the first time. In addition to the increased competition among firms, several other factors impacted returns. The market for initial public offerings dropped in the mid-1980s before collapsing after the stock market crash in 1987 and foreign corporations, particularly from Japan and Korea, flooded early stage companies with capital.
In response to the changing conditions, corporations that had sponsored domestic venture investment firms, including General Electric and Paine Webber either sold off or closed these venture capital units. Furthermore, venture capital units within Chemical Bank and Continental Illinois National Bank , and many others, began shifting their focus from funding early stage companies toward investing in more mature companies. Even The founders of Venture Capital Funding, J.H. Whitney & Company and Warburg Pincus began to transition towards leveraged buyouts and growth capital investments.
The
venture
capital
boom
and
the
Internet Bubble (1995
to
2000)
By the end of the 1980s, venture capital returns were relatively low, particularly in comparison with the emerging leveraged buyout methods; this was due to the reasons including the increased competition for hot startups, excess supply of Initial Public Offerings (IPO) and the inexperience of many venture capital fund managers. Growth in the venture capital industry remained limited throughout the 1980s and the first half
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of the 1990s increasing from $3 billion in 1983 to just over $4 billion more than a decade later in 1994 which is relatively low.
After a “wake up call” of venture capital managers, the more successful firms retrenched employees, and turned their focus on improving operations at their portfolio companies rather than continuously making new investments. The results began to turn very attractive, successful and would ultimately generate the venture capital boom of the 1990s. Former Wharton Professor Andrew Metrick referred to these first 15 years of the modern venture capital industry beginning in 1980 as the "pre-boom period" in anticipation of the boom that would begin in 1995 and last through the bursting of the Internet bubble in 2000.
Venture Capital funds in Africa
African continent has been recognized as on of the continents which lack long term funding. It has come into knowledge that most of the African private businesses are traditionally run by short term loans from commercial banks. But since the beginning of the 21st century, private equity or venture capital funding has gained prominence in most African emerging economies like that of Tanzania.
The conducted surveys in 2006 and 2007 in Africa show that the venture funds have raised over 2 billion USD which are invested across different investments in the continent. Economists anticipate that Africa has still a lot of opportunities for investments and that many resources are still untapped.
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1.2. THE OBJECTIVES OF THE TERM PAPER
To evaluate the importance of using Venture Capital Funds in financing the businesses.
To assess the factors limiting the use of Venture Capital funds in Tanzania.
To suggest possible ways to improve Venture Capital Funding in Tanzania.
1.3. THE SCOPE OF THE STUDY This study was conducted at TANCOL Energy Ltd at its headquarters in Dar es salaam. This is among the companies in Tanzania which uses Venture Capital Funds to finance its projects. However the results can be inferred to other companies that operate by using Venture Capital funds in Tanzania.
1.4. THE RATIONALE OF THE STUDY
This study can help to enlighten people in Tanzania about the issue of Venture Capital Financing. Most of the people know about 2 common financing methods used by companies which are borrowing from financial institutions and issuing shares at the Capital market. But most people are not so much aware on nature of Venture Capital funds for instance how to establish a venture Capital Fund Firm.
So by using this study, people with different excellent business ideas in Tanzania but lack funds to finance their businesses can be able to learn how to raise funds from private sources rather than borrowing which involves complications like possession of collaterals. The development of many firms dealing with pharmaceuticals and other important scientific discoveries in The United States of America came as a result of Venture Capital Funds from Private institutions or people.
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1.5. HOW THE STUDY WAS CONDUCTED This study was conducted in a group of eleven (11) people. This group was further sub divided into 2 sub groups of 4 people and 1 sub group comprising of 3 people. Each of theses sub groups was assigned different tasks. The tasks were as follows;
Collection of data: this task involved a subgroup of 3 people who were responsible to collect data from the Tancoal Energy Ltd. The method used to collect data was structured interviews which involved direct contact with the management and inquiring them on different matters regarding the study.
Processing of data: this involved the analysis of data and arranging them in a way that would provide clear results and gave the researcher the ability to provide appropriate recommendations.
Report preparation: this involved the whole process of preparing the report or the Term paper.
1.6. CHAPTER SUMMARY
This chapter has scrutinized the historical background of Venture Capital Funds which started in USA in late 1930’s. Also the chapter has presented the objectives and rationale of this study together with its scope and how it was conducted.
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CHAPTER 2
LITERATURE REVIEW
2.0. INTRODUCTION
This chapter presents two aspects of literature review. The first aspect is about critical literature review where different models about Venture Capital Funds have been critically evaluated. The second part is about empirical literature review where findings of other studies concerning the same subject have been discussed.
2.1. THEORETICAL LITERATURE REVIEW
There is a wealth of literature dealing with the issue of Venture Capital Funds explaining its meaning, how Venture Capital firms are established and many other relevant issues. Campbell & Catherine (2008) defined Venture Capital Fund as a pooled investments vehicle that primarily invests the financial capital of third party investors’ enterprises that are too risky for a standard capital market and bank loans.
Furthermore they explained that Venture Capital Funds create jobs and are good to be used in new companies with limited operations history and that are too small to raise capital in public markets and have not reached a point where they are able to service bank loans or complete debt offering. They explained that the main disadvantage of Venture Capital funds is that the capitalists who have invested their funds in smaller and less mature companies have significant control over company’s decisions in addition to a significant partner of company’s ownership.
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Kirsner Scott (2008) evaluated six stages of financing offered in Venture Capital. The first stage is Seed Money which is a Low level financing needed to prove a new idea which is offered by angel investors. The second stage is Start-up stage which is an early stage that firms need funding for expenses associated with marketing and product development. First-Round is the third stage characterized by early sales and manufacturing funds. The fourth stage is Second-Round stage which involves generating working capital for early stage companies that are selling product, but not yet turning a profit. The fifth stage is Third-Round: Also called “Mezzanine financing” which is expansion money for a newly profitable company. The last stage is Fourth-Round stage which is also known as “bridge financing” and is intended to finance the "going public" process.
Joseph Bartillet (2005) has evaluated different ways by which Venture Capital firms meet with the investors because there are no public exchanges listing their securities. Some of these involve, references from the investors' trusted sources e.g. financial analysts and other business contacts, the other way is through investor conferences, symposia and summits where companies interact directly with investor groups in face-to-face meetings, including a method commonly known as "Speed Venturing", which is a sort of speed-dating for capital, where the investor decides within 10 minutes whether she/he wants a follow-up meeting.
Herve Lebret (2007) has scrutinized the situations when Venture Capital Fund is appropriate. Venture capitalists need high returns from the venture funded company, this makes venture funding an expensive capital source for companies, and most suitable for businesses having large up-front capital requirements which cannot be financed by cheaper alternatives such as debt. That is most commonly the case for
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intangible assets such as software, and other intellectual property, whose value is unproven. This is the reason why venture capital is most common in the fast-growing technology and life sciences or biotechnology fields.
If a company does have the qualities venture capitalists seek including a solid business plan, a good management team, investment and passion from the founders, a good potential to exit the investment before the end of their funding cycle, and target minimum returns in excess of 40% per year, it will find it easier to raise venture capital.
2.2. EMPIRICAL LITERATURE REVIEW
Various researchers in different countries around the world have conducted studies on Venture Capital Funds by evaluating areas like the growth of this financing method in their countries. Also various studies have been conducted about the challenges and limitations facing Venture Capital Funds. This part discusses the findings of the studies conducted in both developed and less developed countries.
Recent studies conducted by The National Venture Capital Association (NVCA) of USA in (2008) found out that Venture Capital fund sector has grown substantially starting from 2006. During the third quarter of 2006, Venture capitalists invested some $6.6 billion in 797 deals in U.S. Also this survey revealed that a majority (69%) of venture capitalists predict that venture investments in the U.S. will level between $20-29 billion in 2007 which will lead to the substantial growth of this sector.
The survey conducted by the Venture Capital Association of Canada (2008) revealed that Canadian technology companies have attracted interest from Venture capitalists from other countries due to generous tax incentives through the Scientific Research
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and Experimental Development (SR&ED) investment tax credit program. The basic incentive available to any Canadian corporation performing R&D is a non-refundable tax credit that is equal to 20% of "qualifying" R&D expenditures (labor, material, R&D contracts, and R&D equipment). An enhanced 35% refundable tax credit of available to certain (i.e. small) Canadian-controlled private corporations (CCPCs). This is because the CCPC rules require a minimum of 50% Canadian ownership in the company performing R&D, foreign investors who would like to benefit from the larger 35% tax credit must accept minority position in the company, which might not be desirable. The SR&ED program does not restrict the export of any technology or intellectual property that may have been developed with the benefit of SR&ED tax incentives.
The survey also revealed that Canada also has a fairly unique form of venture capital generation in its Labour Sponsored Venture Capital Corporations (LSVCC). These funds, also known as Retail Venture Capital or Labour Sponsored Investment Funds (LSIF), are generally sponsored by labor unions and offer tax breaks from government to encourage retail investors to purchase the funds. Generally, these Retail Venture Capital funds only invest in companies where the majority of employees are in Canada. However, innovative structures have been developed to permit LSVCCs to direct in Canadian subsidiaries of corporations incorporated in jurisdictions outside of Canada.
Studies conducted in Europe show that this continent is experiencing a substantial growth in the Venture capital sector. The study conducted by The European Venture Capital Association (2006) revealed that Europe has a large and growing number of active venture firms. The Venture Capital raised in the region in 2005 including buy
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outs exceeded 60billion Euros, of which 12.6billion Euros were specifically for venture investment. The study also discovered that in 2006, the top three countries receiving the most venture capital investments in Europe were the United Kingdom, with 515 minority stakes sold for 1.78billion Euros, France with195 deals worth 875 Million Euros, and Germany with 207 deals worth 428million Euros.
The study explains further that European venture capital investment in the second quarter of 2007 rose by 5% to 1.14 billion Euros from the first quarter. However, due to bigger sized deals in early stage investments, the number of deals was down 20% to 213. In the second quarter of 2007, venture capital investment results were significant in terms of early-round investment, where as much as 600 million Euros (about 42.8% of the total capital) were invested in 126 early round deals which comprised more than half of the total number of deals. Also it was further disclosed that Venture Capital Funds in Italy during 2007 were 4.2 billion Euros.
The study conducted by Josephson Matthew (2008) in South Africa reveals the major challenge that Venture Capital Funds face in this country which is South African laws and regulations. South African laws are a major factor impeding the growth of the Venture capital sector in the country. These laws restrict the foreign exchange flows and movement of intellectual property out of the country. Intellectual property made in South Africa can’t just leave the country or be sold or licensed outside South Africa without South Africa Reserve bank approval. This requires the Venture Capital firm to incur heavy costs to get legal advice in order to avoid doing something illegal.
2.3. CHAPTER SUMMARY
This chapter has critically discussed various literatures concerning Venture Capital Funds in the theoretical literature review aspect. The findings of studies conducted in
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other countries concerning the same subject were also analysed in this chapter. The next chapter of this Term Paper presents the case study analysis.
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CHAPTER 3
CASE STUDY ANALYSIS
3.0. INTRODUCTION
This section is a vital part of the study because it reveals the findings and results of the study. It presents the results that were obtained in the field regarding the questions that were asked relating to the objectives of this study.
3.1. CASE STUDY
THE NAME OF THE COMPANY
This Term Paper used TANCOAL Energy Limited in Tanzania as a case study of a Venture Capital funded company
THE LOCATION OF THE COMPANY
Most of the operations of TANCOAL are conducted in Southern Tanzania but it has its headquarters in Dar es salaam.
THE MAJOR ACTIVITIES OF THE COMPANY
TANCOAL Energy Limited is involved with exploring mining resources related to the energy sector and it is currently holding a number of prospecting concessions which have been granted as applications.
THE MAJOR OBJECTIVE OF THE COMPANY
TANCOAL Energy Limited is aimed at exploiting coal resources at Ngaka and Mhukuru in Ruvuma region, Southern Tanzania. The company focuses on the development of the Ngaka and Mhukuru coal deposits in Mbinga and Songea districts
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as a solution to the problem of power shortages in Tanzania. This is by enhancing the national energy security by decreasing dependence on electricity imported from outside the country.
THE ORIGIN OF TANCOAL ENERGY LIMITED
The company was formed in 2008, The National Development Corporation (NDC) for a long time desired to explore and exploit coal resources in the Southern Tanzania lacked sufficient capital to undertake the activity. So in 2008, NDC invited Pacific Corporation East Africa (PCEA) to invest in the project. So the agreement was entered where PCEA was supposed to provide a proportion of capital needed for the project. This proportion of capital is known as Venture Capital Fund. The other proportion was to be provided by NDC. The $1.2 billion, which was the total combined capital, would be used to develop a coal feedstock, construction of a 400MW coal-fired power station and erecting a long distance, high voltage transmission line.
The agreement required the formation of a new company in 2008 namely TANCOAL Energy Ltd. The principal business of this company is to explore mining resources related to the energy sector and it is currently holding a number of prospecting concessions which have been granted as applications.
Since its incorporation in 2008, TANCOAL Energy Limited has been able to expand its capital by offering shares, whereby majority of its shares are owned by Atomic Resources Limited which is based in Australia. The company has been able to succeed in one year because the drilling programme has provided results for seam correlations, and has confirmed stratigraphic continuity and classification of coal reserves. Also the preliminary resource work shows that Ngaka has about 90-120
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million tonnes of coal reserves which can be mined by a combination of opencast and underground methods. Since its formation, TANCOAL has spent Tshs 1.4 billion ($1.27 million) on studies and fieldwork.
TANCOAL Energy Limited is enthusiastic that it will create opportunities from excess power production that would be exported to other countries in the future. Also power tariffs will be reduced and the outflows and exchange risks of foreign currency required to purchase fuel or to import electricity from outside Tanzania will decrease.
Power from coal is expected to promote rural electrification which will stimulates development of various economic sectors such as mining, agriculture, industry and tourism and would accelerate industrialization and poverty eradication. For the past 50 years, Tanzania has been trying to explore coal in collaboration with multinational mining companies but no significant results have been obtained to date. However, TANCOAL has been able to achieve significant results in just a year of operation.
3.2. PRESENTATION OF THE FINDINGS
During the process of collecting data from TANCOAL Energy Limited, questions were asked in accordance with the study objectives, below are the findings of this study with respect to every objective of the study.
Objective 1: To evaluate the importance of using Venture Capital Funds in financing
the businesses.
The findings from TANCOAL management revealed that Venture Capital Funds are very important compared to borrowing from bank because it allows a company to carry out projects which are very risk. Before formation of TANCOAL, NDC didn’t
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have enough funds to carry out the coal exploration because the project is very risk and the probability of getting loss is very high. They couldn’t obtain funds from the bank because there is no commercial bank that can lend money to a project that has high risk and high probability of losses. This is due to the fact that coal exploration involves heavy costs and there is no guarantee that the coal reserves will be found. So the only way was to invite Venture Capitalists (Pacific Corporation East Africa), who would be able to take the high risk to provide the funds for the project which resulted in the formation of TANCOAL Energy Ltd.
So Venture Capital Funds allow a company to invest in the high risk projects that any other sources of funds i.e. commercial banks loans would not provide funds for due to the maximum risk.
The other importance of using Venture capital Funds is that there is no an obligation to pay back the funds like in borrowings. NDC and PCEA had an agreement to form TANCOAL, so TANCOAL has no an obligation to pay back the funds invested in it, however the investors will be able to get their money back through profits which will be made by TANCOAL i.e. Return on Investment (ROI). If TANCOAL makes losses, then the Venture Capitalists have to be tolerant and let the company continue to operate with the expectation of the profits in the future. They can’t ask for their money back because they were made aware of the risks before investing. But if TANCOAL was funded by loans and the company incurs losses that it can’t service the debt together with interest then it can be in a blink of being liquidated so as to repay the debt which will affect its long term existence.
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Objective 2: To assess the factors limiting the use of Venture Capital funds in
Tanzania.
The findings of this study reveal problems which limit the use of venture capital funds in Tanzania. These are as follows;
Many businesses in Tanzania are family owned; this causes owners to be reluctant to extend ownership to the other people through the provision of venture capital funds. Also family owned businesses don’t like to disclose some aspects of their business which are family secret. This causes them to fail in expanding their businesses through listings or venture capital funds which require full disclosure.
Tanzania is characterized by a huge number of small and medium scale enterprises which rely only on bank loans and informal sources of funding. These businesses don’t give regard to funding methods like shares and venture capital funds.
Costs associated with funding venture capitalists are also a problem. To get a venture capitalist is not an easy task, you have to do research to determine worth individuals who are willing to take risk and invest in your company. It involves advertising your business, preparing good business proposals and transport and accommodation costs to meet with venture capitalists to convince them face to face i.e. a venture capitalist is in Boston, Massachusetts (USA) while the business is in Tanzania.
Bad reputation of Tanzanians in management issues; nowadays the level of corruption has increased together with embezzlement of companies’ funds. Due to information technology most of the people around the globe are aware
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of the current corruption issues occurring in Tanzania. This has a negative impact because most venture capitalists like businesses which can be managed well and offer a high return on investment (ROI). Due to this bad reputation which can be stereotyped, venture capitalists from abroad become reluctant to invest their funds in Tanzanian businesses fearing to get no return.
Many Tanzanians are risk averse, this causes them to become reluctant to invest in riskier businesses but which have high returns i.e. mining and exploration. But TANCOAL took a risk to explore coal and it has achieved much in just a year since its incorporation in 2008.
3.3. CHAPTER SUMMARY
This chapter has presented the findings and results of the study. This was done through the analysis of findings by using the objectives established before.
The next chapter presents the recommendations of the study.
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CHAPTER 4 RECOMMENDATIONS 4.1. INTRODUCTION
This is the last chapter of this study and it presents the recommendations on the issue of Venture capital fund in Tanzania.
4.2. RECOMMENDATIONS
It is vital for the government to control inflation and maintain it in a single digit because some investors don’t like to invest their funds in the economies with increasing rates of inflation. By controlling inflation even the Tanzanian currency will be stable and this can ensure international investors that they will get a high rate of return in Tanzanian shillings with a high purchasing power. For instance there is no a rational investor who would like to invest in Zimbabwe at its current condition of hyper inflation.
The government should also privatise public entities which are not performing well. This is because there are wealth individuals who are willing to provide funds for these entities if they were private because they believe that with proper management they could perform better than they are performing currently under the government ownership.
The capital market and security authority (CMSA) should educate the people that there is a venture capital funding method which is not very common to Tanzanian businesses. The authority should conduct seminars with small business owners urging them that bank loan is not the only way of funding a business, and they should
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enlighten the people on the importance of using venture capital funds.
Nowadays the life standards of Tanzanians have raised, there are private individuals who have bank accounts with up to 8 digits. These people should provide capital to small businesses but which grow fast and have good future prospects. Keeping the money in the bank without rotating it is irrational. So it would be rational to provide these funds as venture capital funds so that others can do business and get a desirable return on investment (ROI). Venture capital sector in USA developed fast because wealth individuals like the Rockefellers were ready to provide funds so that others could invest and give them the part of their return.
Also Life Assurance Funds companies like NSSF, PPF and insurance companies in Tanzania like NIC should engage themselves in providing venture capital funds. These companies collect huge sums of money from its customers since most of the people employed in various sectors in the economy are registered with any of these companies. They should encourage small and growing businesses to expand their businesses by investing their funds and later get their return on investment.
4.3. CONCLUSION
This term paper has scrutinised the type of funding commonly known as venture capital funding, its importance and problems limiting its use in Tanzania. Tanzania as a developing country needs to expand its business sector, any investment involves risk, and the wealthiest people in the world are the ones who undertook very risk projects e.g. mining. So this term paper urges Tanzanian entrepreneurs to consider also the venture capital funding instead of just relying on borrowings from
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commercial banks which are profit oriented and have harsh loan terms e.g. high interest rates. So by encouraging venture capital funding investments across Tanzania will increase which obviously will expand employment to the individuals and will increase government revenue due to income taxes and Value added Tax (VAT).
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REFERENCES
1.
Bartillet, J (2005): Value Added by Venture Capital Firms, San Diego, California (USA).
2.
Campbell and Catherine, 2008: Smarter Ventures: A Survivor's Guide to Venture Capital Through the New Cycle , New York, USA .
3.
Lebret, H (2007): The Money Lords; the great finance capitalists and Venture Source, Munich, Germany
4.
Matthew, J (2008): Introduction to Venture Capital and Private Equity Finance in South Africa” Johannesburg, South Africa.
5.
Scott, K (2008): The Venture Capital Cycle, 2nd ed., MIT press, Leicester, United Kingdom.
6.
The European Venture Capital Association (2006): The growth of Venture Capital Sector in Europe, Paris, France.
7.
The National Venture Capital Association (NVCA) (2008): The Venture Capital trend in USA, USA.
8.
The Venture Capital Association of Canada (2008): Venture Capital development in Canada, Toronto, Ontario (Canada).
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