Risk Appraisal and Venture Capital in High Technology New Ventures

Gavin C. Reid, Julia A. Smith

• Publisher: Routledge
• Year: 2007
• ISBN:
  9781134190362
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Negocios en general

This book is a 'crossover' treatment of quantitative and qualitative risk analysis within the setting of new high technology ventures in the UK. Reid and Smith have based their research on extensive fieldwork in patent-intensive, high-technology firms. This has included face-to-face interviews with leading investors, and is illustrated by two chapt

Part I
Conceptual framework

1
Background

Introduction

The aim of this book is to analyse methods of risk appraisal in new high-technology ventures (compare Reid and Smith, 2001; Norman, 2004). The objectives of the research upon which this book reports were threefold. First, to advance best practice in supporting high-technology ventures (compare Hsu and Kenny, 2005). Second, to suggest new methodologies, drawing on accounting, finance and economics, for risk handling (compare Cumming et al., 2005). Third, to increase awareness of the utility of accounting, finance and economics methods in a combined sense, for improving our understanding and management of uncertainty. Such methods are explored from both the venture capitalist’s (investor’s) and the entrepreneur’s (investee’s) perspective.

A principal tool of this book is the notion of a risk class. Three classes of risk are considered: agency risk, arising from incomplete alignment of the interests of investor and investee (Hyytinen and Toivanen, 2003); innovation risk, arising from the use of an entirely new technology (Lerner. 2002; Moore and Wüsten-hagen, 2004; Cumming et al., 2005); and business risk, arising from unpredictable competitor and customer reactions (Goodman, 2003; Frigo and Sweeny, 2005). The research project on which this book reports sought to enquire into attitudes to risk and skills at risk management, in the relationship between high-technology firms and their venture capital backers. The basic idea, building on earlier work by the authors and various co-workers (Reid, 1996; Reid et al., 1997), and related developments (e.g. Fiet, 1995a, 1995b), is as follows. It is that as the venture capital industry matures, so should the techniques which high-technology firms and their venture capital backers use for risk management (compare Dauterive and Fok (2004) in a Chinese context; Liu and Chen (2006) in a Taiwanese context; Robnik (2006) in a Slovenian context; Smolarski et al. (2005) in an Indian context; and Salehizadeh (2005) for a general emerging economies context).

Finally, the book explores the usefulness of financial reporting, risk reporting and disclosure in the context of high-technology firms (Hand, 2005). This lays the basis for an analysis of how investors’ attitudes to risk affect the level of funding they are willing to provide to entrepreneurs who have started (and run) high-technology firms (compare Cumming, 2006).

If total risk is split up into innovation risk, business risk and agency risk, we note that the main category of risk which the venture capitalist seems to have sought to attenuate is agency risk. They have done this by improved management accounting systems, post-investment, and by pre-commitment to the installation of such systems, pre-investment. However, success in this area has been incomplete, and attention to business and innovation risk has been severely limited. Lack of overall success in risk handling has, as a consequence, been a major cause of failure to provide adequate levels of outside finance for hightechnology ventures, compared to appropriate yardstick comparisons in the USA. This book reports on research which aims to investigate the spectrum of methods used for managing innovation, business and agency risks in investors and investees. It thereby seeks routes to better practice in risk handling.

The investigation was fieldwork based (Glaser and Strauss, 1967; Sekaran, 1992, Ch. 4). It drew on our extensive experience in the application of this methodology, both in the venture-capital area (Reid, 1998), and in the investigation of information (e.g. management accounting) system implementation and development (Mitchell et al., 2000). In coping with the high-technology dimension of the study, our previous experience in the intellectual property area, especially as applied to patent-intensive regimes, was also drawn upon. This extended to detailed knowledge of patenting protocols, including the generation of patent ‘families’ (Reid et al., 1994, 1996; Reid and Roberts, 1996).

In this book, we provide a detailed account of our recent and current research into risk appraisal in UK based high-technology ventures. A comparative US component has also been incorporated into our work, as reflected in fieldwork and two case studies (see Case I and Case J of Chapter 8). As our work is fieldwork based (compare Fried and Hisrich, 1995), it is sharply focused on the reality, and efficacy, of contemporary methods of risk assessment. Over a period of a year we engaged in face-to-face interviews (Oppenheim, 2000) with venture capital investors, and with entrepreneurs in whose firms venture capital had been committed (compare Sapienza, 1989). Our sample consisted of twenty leading UK investors who had engaged in the support of high-technology ventures, and ten entrepreneurs (investees), who were involved in bringing to market some of the most exciting high-technology products being developed in the world today (e.g. encrypting and enciphering, quantum cascade lasers, animal robotics, light emitting polymers, thermal imaging). The meetings with venture capital investors and entrepreneurs were conducted using a administered questionnaire schedule (Sekaran, 1992, Ch. 7) (see Appendix 2). This schedule was constructed in a slightly different variant for the investor and investee case, but each used a standardised approach to the following eight-point agenda: risk premia, investment time horizon, sensitivity analysis, expected values, predicted cash flows, financial modelling, decision making, and qualitative risk appraisal. A specimen interview schedule (which contains this eight-point agenda) is contained in Appendix 2. Further sample data were obtained by a postal questionnaire, as reflected in the analysis of Chapters 9 and 10, which is based on the instrumentation detailed in Appendix 4.

This chapter proceeds as follows. First, we deal briefly with general problems of risk appraisal in high-technology ventures. Second, a background sketch of the UK venture capital context is provided. Third, the policy context is briefly considered. Fourth, the research plan behind the work on which we report is laid out. Finally, the structure of the book is outlined.

Risk appraisal in high-technology ventures

Considered as a business proposition, the high-technology venture can be perplexing. It can seem unstructured, distant from exit, highly risky, and difficult to control. In its development company form, the high-technology venture from an investor perspective, can sometimes seem too like a research project, which is largely justified by its pursuit of scientific enquiry, without any plausible justification on commercial grounds. The problem of cost overrun on projects is endemic (Perez-Castrillo and Riedinger, 1999). It is as though the investor feels he or she is being invited by the entrepreneur to bear all the downside risk, without any clear indication of the prospective rewards, except that it might, with a small probability, be ‘large’. Without doubt, such an investment involvement embodies considerable risk of the sort familiar from other areas of enterprise.

One kind of risk that immediately comes to mind is ‘business risk’. This is caused by the complex, competitive environment in which high-technology firms function (compare Goodman, 2003; Frigo and Sweeney, 2005). In a sense, firms are ‘racing’ to be first to get an entitlement to the intellectual property (IP) embodied in a new technology (Brouwer and Kleinknecht, 1999). There are so-called ‘action-reaction’ effects at work. Thus firms will redouble effort, if they are very close to rivals,; but will quickly give up, if they seem outstripped in the race. Reading how other firms will behave in such situations, and crafting one’s strategy appropriately, are all aspects of a form of competition in which firms are in significant interaction (namely, oligopoly). In this industrial setting, conjectures have to be made by firms about rivals’ conjectures. There is no safe guide as to how this should be done, as the proliferation of varied and different solutions from game theory suggests (Dixit and Skeath, 1999).

Another important category of risk is agency risk. This arises, in general, from an incomplete alignment of incentives between economic agents (compare Hyytinen and Toivanen, 2003). In our case, the economic agents involved are: (a) the venture capital investor; and (b) the entrepreneur of a high-technology firm. Briefly, investors are risk specialists, who know a little about technology, and a lot about monitoring and control. They are willing to back their judgements with large injections of equity finance. Typically, entrepreneurs are immersed in technological developments, and are risk averse and starved of cash. They would prefer a less risky life and more financial backing (compare Repullo and Suarez, 2004). They also need advice and guidance on commercial imperatives. In theory, a kind of ‘contract’ should be struck, in which the entrepreneur gives the investor access to potentially valuable intellectual property (i.e. ‘property’ based on new ideas), and the management skill to create it. In exchange for this, the investor bears some of the risk, and provides an infusion of equity finance (Reid, 1998). In practice, it may be hard for the investor to evaluate the entrepreneur’s claim to be able to produce valuable intellectual property; and the mere fact of backing an entrepreneur tends to diminish his incentive to continue to be creative in this respect, unless activity is tightly monitored.

Finally, and most importantly, there are ‘innovation risks’ (compare Lerner, 2002; Moore and Wüstenhagen, 2004; Cumming et al., 2005). Even the entrepreneur (and certainly the investor) is uncertain about what a development programme might produce. The final form an innovation takes and, just as important, both the point in time at which it is proved, and the potential market place value it might have, are subject to high degrees of uncertainty.

Arguably, ‘business risk’ and ‘agency risk’ are in some measure amenable to standard methods of risk analysis. For example, the agency approach has been successful in the insurance industry, and elements of this approach can be carried over into the investor-investee context. However, ‘innovation risk’ is harder to handle in this way. Essentially, the ‘frequency limit principle’, widely used in standard risk analysis, cannot be applied to this category of risk. In this approach, one considers the frequency with which a known event occurs in a large number of trials, conducted under essentially unchanged conditions. However, the conditions necessary for the standard estimation of the probability of an event as a ‘frequency limit’ (implying the number of trials becomes indefinitely large) are never satisfied with innovative events. They are essentially a ‘one-off’. By their very nature, innovations have not happened before. There is no continuous record of evidence on which one can base estimates of their probability of occurring. This is especially true of radical innovation (see Rice et al., 2000). Therefore one cannot estimate the relevant risk on an actuarial basis, as one needs to, for example, in using Value at Risk (VaR) methods of risk assessment (Jorion, 2000).

The assigning of risk in such cases has to be subjective (Moesel and Fiet, 2001; Moesel et al., 2001). This need not occur in a vacuum. For example, there may be technologies which are related to the innovation being attempted which provide useful yardstick comparisons, concerning matters like development costs, and time to discovery. Technology foresight specialists may use a variety of methods (e.g. the polling of opinion of top technologists in a specialist area) to estimate the chances of an innovation occurring. However, the assigning of a numerical probability to an innovative event is perhaps too stringent a requirement. For many purposes, it may be satisfactory to think in terms of ‘risk classes’ rather than in terms of point estimates of probability. Simple classifications of risk like ‘high’, ‘medium’ and ‘low’ may be adequate, if not perfect, substitutes for statistical estimates of probability.

It has been suggested that UK investors have tended to overlook good potential prospects in new high-technology firms. For example, Murray and Lott (1995) have maintained that high-technology firms are not comfortably accommodated within existing frames of reference for risk assessment by investors. Therefore, they tend to be excessively cautious in their risk appraisal, and set risk-adjusted hurdle internal rates of return (IRRs) that are excessive (see Mani-gart et al., 2002). It would not be unusual to see hurdle IRRs of 45 per cent being set, and rates as high as 90 per cent (or more) are not unknown (Murray, 1995). One interpretation of this evidence is that UK investors invoke different, and usually more stringent, investment criteria, than do their US counterparts. This interpretation finds favour, in the light of the evidence that venture capital investors in the UK allocated (proportionately) about one third of the funding to new high-technology firms that US investors did (Lockett et al., 2002).

The UK venture capital market

Our research was largely conducted in the UK venture capital industry. Though often perceived as a relatively new activity, it had earlier roots in colonial merchant adventuring. It then mutated into merchant banking, and, finally was given formal institutional expression in the post-Second World War Industrial and Commercial Finance Corporation (ICFC). The latter was subsequently revamped and modernised into ‘Investors In Industry’ (3i) when the UK venture capital industry emerged in the 1980s. It remains the biggest ‘player’ in the UK industry today and is, indeed, the largest single allocator of venture capital funding in the world (Coopey and Clarke, 1995). As befits European practice, we adopt a broad definition of ‘venture capital’ (see Venture Capital Report (VCR) Guide, 2000, p. 80). The narrower US definition would refer to the outside equity funding of the seed-corn, inception, early growth and expansion stages of the entrepreneurial firm’s life cycle.

Here, our definition is closer to what is broadly referred to as ‘private equity’. It includes the equity financing of management buy-out (MBO) and management buy-in ...

Table of contents

• Routledge studies in global competition
• Contents
• Figures
• Tables
• Preface
• Acknowledgements
• Abbreviations
• Part I Conceptual framework
• Part II Sampling and evidence
• Part III Statistical analysis
• Part IV Case study analysis
• Part V Reporting and investment
• Part VI Concluding material
• Appendices
• Notes
• References
• Index