Venture capital investment evaluation in emerging markets
The growth in the level of venture capital investment in the emerging small economies of Taiwan, Sri Lanka, and Thailand has been nothing short of astounding. This paper describes the development of venture capital in these countries and analyzes the criteria requested for a venture capital firm (VCF) to invest in a venture. To carry out this empirical study, a questionnaire was devised asking VCFs in the three countries to rate the important criteria when investing in a venture; the surveys were conducted in all venture capital firms over the period 1994-1995. The criteria cover diverse areas such as the entrepreneur’s capability, the product, finance items, environmental conditions, and the market situation. Analysis of the data at both the category and individual levels of criteria revealed that importance differed according to the country where a VCF was investing: VCFs in Taiwan focus more on expected financial returns as well as potential market growth and size, whereas VCFs in Sri Lanka emphasize financial indicators and management team characteristics; in Thailand, the VCFs consider the quality of the venture management team as the most critical evaluation criteria. Potential areas for further research on VCFs in emerging markets are proposed.
Venture capital is a popular method of financing high technology and high-risk enterprises in developed countries like the United States, the United Kingdom, and Japan. And recently, a number of developing countries have established venture capital firms in the private and/or public sectors to finance technology-related and new small- and medium-sized enterprises (for a comprehensive definition of the term venture capital, see Endnote). In the emerging markets of Asia, venture capital activity has been growing at an impressive rate, especially since the late 1980s. During the five-year span of 1988-1993 the Asian venture capital pool increased from US$9.9 to $26.2 billion, an annual growth rate of 21.5%, while cumulative investment increased from $4.5 to $11.6 billion or 26.7% annually [AVCJ, 1994].
Taiwan and Thailand are fast growing economies, and growth of Sri Lanka is also on the rise. All three have emerging markets where venture capital activity is now well entrenched. Although a good amount of empirical work exists on the venture capital investment process in the US and in other developed countries, no analysis has been conducted on these three countries. The purpose of this paper is to empirically study the venture capital investment firms’ evaluation criteria in Taiwan, Sri Lanka, and Thailand. The paper is organized as follows: Venture capital profiles for Taiwan, Sri Lanka and Thailand are provided in the second section; Section 3 summarizes relevant studies on venture capital; the research methodology and the survey data are described in Section 4; Section 5 reports the findings of this study; and finally Section 6 contains the conclusions and the implications of the study, as well as areas for further research.
VENTURE CAPITAL PROFILES: TAIWAN, SRI LANKA, AND THAILAND Taiwan. Venture capital in Taiwan was introduced by the government in 1984 in order to enhance the technological contents of products and processes to attain global competitiveness. The government gave direct support through comprehensive tax incentives and financial assistance programs, as well as through the help of foreign technologies and expertise. A VCF in Taiwan can also establish a domestic fund to directly invest in technology projects in Taiwan and abroad, or invest in other VCFs for indirect investments in technology projects. VCFs are expected to meet the financing requirement of high tech small- and medium-sized firms. Today, many industries in Taiwan have been transformed from imitations to innovations.
The venture capital funds in Taiwan are either managed by the VCFs directly or through a management company. A company may have an in-house team who provide all the services required to select, monitor and assist investee companies. Alternatively, the investors may contribute their capital to establish a “fund.” The fund is managed by a management company which provides all the services associated with selection, monitoring and assistance of investee companies, and gets compensated through a management fee, usually 1.5% – 3% of the fund’s paid-in capital and a proportion of the net capital gains.
The Taiwanese values of the venture capital pool and the numbers of funds for the period 1984-94 are shown in Table 1. The pool of venture capital has steadily increased over the years, significant amounts being invested in 1990-91. After a slowdown in 1992, venture fund-raising activity picked up again in 1993-94 with a total of 29 authorized VCFs in 1994.
The twenty-seven VCFs invested NT$10,796 million by the end of 1993 in 385 domestic and foreign technological companies related to computer, telecommunication, and electronics. The investment activities of VCFs in Taiwan can be described by investment scope (industry focus) in Table 2. With regard to the geographical diversification of investment, 337 are domestic investee companies, and 76 operate in foreign countries.
Sri Lanka. No regulatory framework existed for venture capital in Sri Lanka until 1989 with the passage of the Inland Revenue Act which formed a venture capital association consisting of seven members to promote the venture capital industry. VCFs invested a cumulative amount of Rs 606 million by the end of 1993, half in 1993 itself. From 1988 to 1993, the venture capital pool increased from Rs 245 to Rs 971 million (AVCJ, 1995). On the basis of the information provided by the seven venture capital firms who participated in the study, in 1995 cumulative investment and capital under management are estimated at Rs 964 billion (for 127 projects) and Rs 1.252 billion respectively.
VCFs in Sri Lanka often focus on exportoriented manufacturing companies. According to the president of the Venture Capital Association of Sri Lanka, “The current most attractive opportunities lie in the export oriented low technology assembly and manufacturing industry primarily because of the duty free raw material imports combined with Sri Lanka’s low labor costs” (AVCJ, 1994). Cumulative disbursements exhibit investment in a wide range of industries as given in Table 2. About 90 percent of the investment has gone towards startup (64.3%) and expansion (24.6%) financing.
Under the Inland Revenue Act, the government provides attractive financial incentives (such as a ten-year tax holiday), and the venture capital company shareholders receive tax write-offs subject to a maximum of one-third of the assessable income for the first three years of an investment’s life.
The act also sets guidelines for government approval of venture capital companies. Some requirements in the guidelines are minimum capital required, a professional management team, financial instruments to be used in investment, etc. Furthermore, the investee companies should be in the specified services, manufacturing or exporting goods to promote a new product, process or market. The act emphasizes investment through equity participation or instruments having features that would make them convertible to equity and not by loan funding.
Thailand The first formal venture capital firm, Business Venture Promotion Company, Ltd. (BVP), was started in 1987 by a group of banks and financial institutions, with a total investment fund of Bt. (Baht) 160 million. To take advantage of the fast growth in the relatively deregulated economic environment of Thailand, a number of VCFs has been established by domestic and foreign institutions. According to The Asian Venture Capital Journal (1994/95), there were ten VCFs in Thailand at the end of 1993. Investing Bt. 550 million in 1993, the cumulative investment of these firms increased to Bt. 1.791 billion, and they had Bt. 2.5 billion of total capital under management at the end of 1993. Table 2 shows the disbursement of cumulative investments made by Thai VCFs. About two-thirds of the funds go for expansionstage financing (60 %), followed by mezzanine financing (21.3 %). Start-up firms get about 14.4 % of the disbursements. A very small part of the venture capital funds is committed to seed capital (1.7 %) and turn-around financing (1.5 %).
According to AVCJ (1994/95), the main source of funds for VCFs in Thailand are corporations (45.3%), followed by banks (22.6%) and insurance corporations (22.6%). The contribution of capital by individuals and pension funds is quite insignificant. It is important to note that most of the venture capital has originated outside Thailand; the contribution of domestic venture capital is only 17%.
VCFs in Thailand receive no special tax incentives. However, domestic and foreign investments promoted by the Board of Investment (BOI) enjoy a number of tax incentives. Thailand has a low ordinary income tax rate of 30% which is applicable to capital gains also; thus the investment environment is generally favorable for the growth of venture capital.
A number of empirical studies exists on the investment evaluation criteria used by venture capitalists in the US and other developed countries. The study of Tyebjee and Bruno (1984) is most notable. They investigated the factors which influence the investment evaluation of the VCFs in the USA. Their analysis was carried out on the basis of 41 VCFs’ ratings of 90 deals. These deals had been initially screened in accordance with their expected return and risk and 23 criteria, using a four-point scale from 1(low) to 4 (very high). The VCFs’ assessment of the probability of the failure of a venture was used as a measure of the venture’s perceived risk. The authors found that the factors clustered into five categories: market attractiveness, product differentiation, managerial capabilities, environmental threat resistance, and cash out potential.
Through a survey of 30 American VCFs, Goslin and Barge (1986) found that an investment request accompanied by entrepreneurial talents and a quality management team has a better chance of being accepted.
Macmillan et al. (1985), followed upon the study of Tyebjee and Bruno (1984), interviewed 14 venture capitalists, they identified 27 criteria (six groups) for evaluating venture capital investment. The form of a questionnaire were sent out to 150 VCFs in the USA. Their analysis revealed that the entrepreneur’s personality and experience was most often rated as essential.
Ray (1991) and Ray and Turpin (1993) analyzed the investment evaluation criteria employed by VCFs in Singapore and Japan, using the methodology of Macmillan et al. (1985). The Singapore sample included five venture capitalists and Japan sample eighteen. In both, the entrepreneur’s personality and experience were found to be the most important aspects of evaluation; and financial considerations the least important, in the venture investment evaluation. Similar results have been obtained by Pandey (1995) for venture capitalists in India. Rah, Jung, and Lee (1994) examined the relative significance of the investment evaluation criteria of the Korean venture capitalists. The top six factors identified are: managerial capability, market attractiveness, superiority of product and technology, financing ability, availability of raw materials and production capability. The focus on financing ability may be attributed to (a) conservatism on the part of the Korean venture capitalists and (b) their lack of technical background to fully evaluate the product and technology content of the ventures.
One common feature with regard to the investment evaluation criteria of VCFs in the USA, Japan, Singapore, and India, as revealed in various studies, is their high level of attention on the entrepreneur’s personality and experience [Guan and Cheong (1989); Ray and Turpin (1993); and Pandey (1995)]. However, in terms of specific traits, the practices differ from those of the USA, Singapore, and Japan. For example, amongst the five criteria most frequently rated as essential in the USA, Singapore and Japan, the entrepreneur’s characteristics include sustained intense efforts, familiarity with target market, and ability to evaluate and handle risk well. None of these appears in the top five criteria in India. On the other hand integrity, urge to grow, commercial orientation, long-term vision and well thought-out strategy to remain ahead of competition do appear. In the case of Korea, market attractiveness is the most important evaluation criterion, but at the performance level managerial capability is considered most important.
RESEARCH METHODOLOGY AND DATA
Since most firms seeking venture capital as well as those in this study are new (no historical operating data), thus they cannot be subjected to a standard credit or loan analysis. Therefore, the methodology similar to that used by Macmillan et al. (1985) was considered suitable for this study. A questionnaire with items rated on a 4-point scale for investment evaluation was modified to contain some factors found in the study on India (Pandey, 1995) and those found relevant by Tyebjee and Bruno (1984) and others. A rating of 1 represented the least important criterion, where 4 denoted the most important. The questionnaire method of investigation was supplemented by personal discussion with senior executives of VCFs.
Questionnaires were sent to all twenty-nine venture capital firms in Taiwan, seven in Sri Lanka, and fifteen in Thailand over the period 1994-1995. The survey was done first in Taiwan with a simple questionnaire of 20 criteria, grouped into five categories. Shortly after, the questionnaires was enriched adding more criteria regarding the characteristics of entrepreneur for Sri Lanka and Thailand (total of 30 criteria), specially regard to the characteristics of entrepreneurs. Twenty responses came in from Taiwan (69%), seven from Sri Lanka (100%), and eight from Thailand (53%).
EMPIRICAL RESULTS AND ANALYSIS
The results of the survey as well as of the interviews from VCFs in the three countries are reported comparatively in the following two parts.
Relative Significance of Evaluation Categories. Table 3 shows the relative significance of the five categories of attributes in evaluating investment decisions by VCFs in each country; the percentage of essential criteria in each category indicates the level of significance within that category. For the venture capitalists in Taiwan and Sri Lanka, the two top-ranked categories are financial considerations and characteristics of the management team, and the least important is characteristics of products.
For Thailand, the essential criteria are ordered as characteristics of the management team, characteristics of the entrepreneur, and financial considerations; and characteristics of products and market are at the bottom. Overall, the findings from Taiwan and Sri Lanka differ slightly from the practices of VCFs in the US, Singapore, Japan, and India where the most important focus is on the characteristics of entrepreneurs (Pandey, 1995). In contrast, the findings in the case of Thailand are similar to those of the four countries.
Specific Evaluation Criteria. Table 4 reports all evaluation criteria for all three countries. In each country, all criteria were ranked in order of importance; each criteria is ranked by the size of its mean and standard deviation (for criteria with the same mean, a criterion with smaller standard deviation is ranked higher). In Taiwan, the five most substantial evaluation criteria, which reflect the most important attributes of a potentially successful venture, are: expected return on investment (3.9), management team’s technical skills (3.8), demonstrated market acceptance of product (3.7), high market growth (3.7), and venture to be easily liquid (3.7). Thus, the VCFs in Taiwan, unlike in the US, are significantly concerned about the return on investment, while management skills are a also very important criterion. VCFs in Taiwan usually invest at a later-stage and want to get a quick return. This attitude also differs from the venture capitalists in some developed Asian countries like Japan and Singapore, where much more focus is placed on the attributes of the entrepreneur than on the return on investment. Overall, the Taiwanese results, despite some similarities, reveal main differences from the studies of Wells (1974), Tyebjee and Bruno (1984), and Macmillan et al. (1985).
Sri Lanka, the seven criteria rated most essential by the Sri Lankan respondents are: integrity (4.0), expected return on investment (3.7), opportunity for exit (3.7), management team’s technical skills (3.6), liquidate investment (3.5), capable of sustained intense effort (3.3), and high growth rate (3.3). Sri Lankan VCFs consider proposals backed by an entrepreneur with integrity and one capable of sustained intense effort supported by a technically competent management team offering an attractive rate in a growing market with an opportunity to exit and liquidate the investment.
In Thailand, the seven specific factors most frequently rated essential by Thai VCFs are: well thought-out strategy to remain ahead of competition (3.9), integrity (3.8), entrepreneurs familiarity with target market (3.8), managerial team’s managerial skills (3.8), balanced team (3.7), long-term vision (3.6), and demonstrated market acceptance of the product (3.5). Apparently, VCFs in Thailand are willing to consider a proposed venture initiated by an entrepreneur with a well thought-out strategy and integrity who has considerable familiarity with the target market and a long-term vision. In addition, the entrepreneur should be supported by a balanced management team with relevant managerial, financial and marketing skills, and should offer a product with demonstrated market acceptance. Financial criteria do not appear in the top seven.
Overall, there is a similarity between the perceptions and practices of Thai venture capitalists and those of the same people in the US, Singapore, Japan, India, Taiwan, and Sri Lanka, i.e., the entrepreneur’s characteristics are among the top five criteria (Pandey, 1995). Although financial return is in the top five criteria in the US, Singapore, Taiwan, and Sri Lanka, they are not for VCFs in Japan, India, and Thailand where a balanced venture team and managerial skills are critical, in addition to the quality of entrepreneurs.
CONCLUSIONS AND IMPLICATIONS
The study was aimed at contributing to understanding the criteria of venture capital investors in Taiwan, Sri Lanka and Thailand. The results of the questionnaire survey revealed that when the evaluation criteria are grouped into five categories and when those categories are ranked for relative significance in each country, the first and second most important in both Taiwan and Sri Lanka were financial consideration and characteristics of the management team, whereas for Thailand they were characteristics of the management team and characteristics of the entrepreneur with financial considerations ranking third.
As far the individual evaluation criteria are concerned, for the VCFs in Taiwan the five most important evaluation criteria are: return on investment, market need for product, technical skills of the venture team, growth potential of market, and easy liquidity of investment. VCFs in Sri Lanka put considerable emphasis on financial considerations and venture management team. The Thai venture capitalists consider the quality of entrepreneur and the characteristics of management team as the most critical evaluation criteria.
To extend this study, the underlying reasons why the respective evaluation criteria were considered important in each country should be analyzed in detail. Furthermore, the relationship between the investment evaluation criteria used by the venture capitalists and the subsequent performance of the accepted ventures should be established. The work of Rah, Jung, and Lee (1994) provides some evidence in Korea; however, it needs validation on a larger sample from more developing and developed countries. Another area of research is the comparative performance of the venture capitalists providing early-stage financing to start-ups or high technology enterprises and those emphasizing later-stage financing (specific suggestions in Barry (1994) and Fried and Hisrich (1994)).
Yet further research may be carried out to investigate the requirements and perceptions of the investee companies with regard to the venture capitalists’ involvement in their ventures and the value-added services provided by them. Among important questions are: to what extent do the entrepreneurs depend on venture capital for financing their operations? What are alternative sources of financing for them? How do they see the venture capital assistance? And what are their perceptions of the VCFs’ involvement in their activities and of the quality of managerial support provided?
The notion of venture capital is provided here first as a background before exploring the venture capital profiles in the three countries. Numerous studies have attempted to define the term venture capital [Guan and Cheong, 1989; Dixon, 1990; Sagari and Guidotti, 1991; and Pandey, 1995]. In essence, it may be defined as: investment in the form of equity, quasi-equity, and sometimes debt–normal or conditional*– made in a new or untried technology or a highrisk enterprise proposed by a technically or professionally qualified entrepreneur, where the venture capitalist
expects the enterprise to have a very high growth rate,
provides management and business skills to the enterprise,
expects medium- to long-term gains, and
does not expect any collateral to cover the capital provided.
(* In the case of a capital loan, for instance, interest and principal are payable only when the enterprise starts generating sales.)
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Indiana State University
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