Who or what comprises the private equity capital marketplace?

Private equity markets tend to form a natural continuum or capital "food chain." Typically, businesses begin with financing from founders, family, and friends, thence moving on to "angel" sources followed by more formal venture capital and banking sources.

Demand for pre-IPO capital in 1997 was estimated by Forrester Research and the SBA at approximately $60 billion, while only $33 billion was actually invested by venture capitalists and angel investors in 32,700 companies and another $10 billion invested by friends, families, and founders. The formal venture capital market is composed of professionally managed venture firms with principals devoted full time to investing. In the United States at the end of 1998, there were approximately 2,200 professionally managed venture firms. These firms generally fall into two categories: those that use private money and are generally unregulated and those that are licensed and regulated by the Federal government and receive some form of subsidy from the Federal Government. At the end of 1998, there were approximately 1,900 private, unregulated venture capital with approximately $70 billion under management (an all time high up from $3 billion in 1980) and 318 Small Business Investment Corporations (SBICs) with $8.1 billion under management. While an average non-regulated venture capital investment is close to $7 million, SBIC average investments are at slightly more than $1 million with a median of $700,000. SBICs thus provide the smaller amounts of venture capital critical to the equity financing of small emerging businesses.

In 1979, less than $100 million of new formal venture capital money was invested in the United States. By 1996, this number had increased over 100 times with $11 billion in new formal venture capital investment being made. This amount increased to $14 billion in 1997 and to a record $19 billion in 1998. In 1998, SBICs contributed 16 percent of the total new formal venture capital investments in the United States accounting for 3,456 investments totaling $3.2 billion. This was up from 1997 when the SBIC industry made a record 2,700 investments totaling $2.37 billion (which in turn was up from $1.2 billion invested in 2,137 firms in 1995).

The small business banking and commercial loan market is substantially larger than the private equity market. United States banks at the end of 1997 held $791 billion in commercial and industrial loans in their portfolios. Significantly, over 50 percent of these loans were to small and emerging enterprises, making small business banking and commercial loan sources the leading source in financing entrepreneurial ventures.

What do these various private equity capital sources mean to the entrepreneur?

Despite the surge of formal capital sources, such as venture capital companies and SBA loans, a major problem of small business is finding investors to provide equity capital. Similarly, the potential investor in a small business or purchaser of a small business often has a problem finding the appropriate small business to invest in. This is true even for formal venture capital companies that may look at a thousand deals to invest in five. While there are large numbers of both small businesses and investors, the systems for providing information on specific small business opportunities and on potential equity capital sources have been very inadequate. The Forrester Report postulates that these inefficiencies will be met by the Internet through cheap and easy distribution of complex information, easy movement of money, and achievement of a critical mass of investors and investments with growth of the Internet.

Why do small businesses need a system like EDIE-Online?

Because of their general lack of creditworthiness compared to large firms, small firms usually rely more on private equity capital and short-term debt, and less on external-debt capital and long-term debt than larger firms. As a consequence of their need to heavily utilize equity financing, the difficulty of finding and raising equity financing, and the cost of that financing, small growing businesses generally are in a constant search for capital. Once they are started, small businesses usually go through several predictable stages of development as they grow, with each stage having its own sources of equity financing. These sources, by stage, include financing by friends and family in the initial startup phases; financing by wealthy, sophisticated individual investors ("angels") as they grow beyond the initial startup, but are still in the development stage; financing by professional venture capitalists after they begin to achieve revenues; and the initial public offering (or alternatively the strategic sale to a larger entity). During the first few years, before significant revenues are generated, about two-thirds of the average venture capital-backed company’s total equity is supplied by venture financing. The average U.S. venture-backed company raises about $16 million of venture capital during its first 5 years of operation.

How does the Internet help financial services providers?

The Internet reduces or completely eliminates the need for a high-cost, bricks and mortar branch system and provides a direct-sell capability reducing the need for an expensive, commissioned sales force. Adoption of an Internet strategy allows them to operate with significantly lower cost structures. Simultaneously, the Internet provides a channel to more effectively target and deliver content-rich information about financial services to potential customers. However, the full growth of Internet commerce would only reach its full development potential when Internet access was simple and ubiquitous, bandwidth expanded to the level where fast, two-way Internet communication was widely available, and the average customers security concerns adequately addressed. Today, these obstacles are rapidly being solved with resulting dramatic growth in Internet-based financial services.

What about mergers and acquisitions?

The business M&A market is huge. There were over 800,000 privately held small businesses with annual sales between $1 million and $50 million in 1992 and an estimated 40,000 of them change hands yearly, a number that is over 10 times the number of publicly reported M&As handled by investment banks at the peak of the M&A boom in the mid-1980s. A substantially larger number of businesses with a value below $1 million are sold annually. Though no formal estimate is available, it can be safely estimated that this number is in the hundreds of thousands. Further, these numbers do not include the secondary transfer of stock or partial ownership interests in a small business that do not involve the injection of fresh capital in the business.

Can I go overseas for capital?

Certainly, and many United States businesses have. The European Venture Capital Association in 1997 estimated that 500 European venture capital firms had made cumulative investments of about $30 billion in 20,000 companies since the 1980s. However, more than half of Europe’s $11.5 billion in venture financing went to buyouts as opposed to start-up or venture financing. According to Jeffrey Nuechterlein writing for the Council on Foreign Relations in 1998, "While European and Asian venture capitalists have an increasing amount of capital under management, much of this capital is dedicated to buyouts of established companies, as opposed to start-up and expansion financing." Of $5.5 billion invested by Asian venture capitalists in 1996, about 70 percent went to later-stage financing. The U.S. lead in developing technologies and new businesses is at least partly explained by this overseas risk aversion. Taxes, regulation, investor risk aversion, ready access to securities exchanges, insufficient exit mechanisms, and related factors aside, there is a need for a comprehensive deal flow mechanism to be in place as the venture markets emerge and increase focus on start-up and expansion capital investment. Mr. Nuechterlain postulates that earlier-stage overseas venture capital investment will increase as barriers are reduced or removed, but their governments will "need to remove myriad regulatory impediments to entrepreneurs in order to foster venture capital activity on a par with the United States."

Is this financial services on the Internet "craze" for real?

Internet traffic is currently growing at 300 percent a year, even though a large population already uses the Internet. The Internet represents the fastest growing communications technology adoption of the historically popular media. Morgan Stanley Technology Research estimated that globally there were 35 million e-mail users and 9 million Web users in 1995 and that by 2000 these numbers would grow to 200 million e-mail users and 150 million users of the Web. In fact, there were over 80 million users in 1998 according to Morgan Stanley. While much of the commercial use of the Internet is primarily for corporate communication by e-mail, broader business applications are rapidly growing because more and more businesses are recognizing that the Internet is a very efficient communications and information delivery system.

To understand the scope of the Internet impact on financial services, one need only look at the booming online brokerage business. Total online brokerage accounts were projected to reach 10.6 million in 2000 and even greater in the future; in fact, Forrester Research predicts that the number of online brokerage accounts will grow to 14.4 million in 2002 with over $688 billion in assets. Driving this growth had been the relative cost of traditional brokerage and online brokerage. At the start of 1997, online brokerage costs ranged between $25 to $60 for a trade of 200 shares at $20 a share, but had dropped to between $8 and $30 by end of the year. This compared to full-service brokerage costs of $115 for the same trade. The growth of the online brokerage business in the second half of the 1990s was a direct result of the general growth of the Internet and the use of it to deliver a wide range of products and services.

In addition to secondary trading in public stocks, online brokerage firms began to get involved with IPOs online. Online distribution of IPOs received major boosts from a variety of sources, including the creation of an online investment banking firm by William Hambrecht (the founder and partner in a major West Coast investment bank); the establishment of an investment banking company E*Offering by highly successful online broker E-Trade; and the successful public offering of Wit Capital, the first online investment bank. Though their presence was much less significant than in the secondary trading of public stocks, online offerings of IPOs began to occur in earnest in the late 1990s, with online brokers like E*trade participating in 65 IPOs valued at $9.9 billion or 29 percent of all IPOs in 1999 through early August.

Though the actual IPO dollars captured by the online brokerage firms only amounted to an estimated 1 to 3 percent of total IPO dollars, forecasts are for online brokerage firms to increase their share to 15 percent within a 3-year period. The implication of online public offerings was highlighted in June 1999 when E*Offering (an affiliate of E*Trade) solely completed an $84 million secondary offering for an Internet bank called First Sierra and only charged First Sierra a 5 percent fee. Historically, IPOs in the United States had carried a standard investing banking fee of 7 percent of the amount raised up to $100 million and amounts above that generally carried a minimum fee of 4 percent of amounts up to $2 billion. Further reflecting the potential of online offerings, major investment banks were buying into the online investment banks, such as Goldman Sachs buying a 20 percent interest in Wit Capital.began in 1995.


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