Tackling the innovation focus continuum; implications for ...539238/FULLTEXT01.pdf · implications...

Tackling the innovation focus continuum; implications for change in

venture capitalists' investment models

JOHAN LENNEFALK DAVID TÖRNQUIST

Master of Science Thesis Stockholm, Sweden 2012

Hantering av kontinuumet för innovationsfokus; implikationer för

förändring i riskkapitalisters investeringsmodeller

JOHAN LENNEFALK DAVID TÖRNQUIST

Examensarbete Stockholm, Sverige 2012

Hantering av kontinuumet för innovationsfokus; implikationer för

förändring i riskkapitalisters investeringsmodeller

av

Johan Lennefalk David Törnquist

Examensarbete INDEK 2012:49 KTH Industriell teknik och management

Industriell ekonomi och organisation SE-100 44 STOCKHOLM

Tackling the innovation focus continuum; implications for change in venture capitalists'

investment models

Johan Lennefalk David Törnquist

Master of Science Thesis INDEK 2012:49 KTH Industrial Engineering and Management

Industrial Management SE-100 44 STOCKHOLM

Examensarbete INDEK 2012:49

Hantering av kontinuumet för innovationsfokus; implikationer för förändring i riskkapitalisters

investeringsmodeller

Johan Lennefalk

David Törnquist Godkänt

2012-06-13

Examinator

Terrence Brown

Handledare

David Sonnek Uppdragsgivare

Kontaktperson

Sammanfattning Innovation har länge ansetts vara den kritiska drivkraften bakom ekonomisk tillväxt och värdeskapande. Emellertid, för att uppnå en innovativ status, krävs kommersialisering av en uppfinning genom att tillföra kapital och strategi. Kapital existerar i flera olika former, dock fokuserar denna uppsats på området riskkapital, och hur denna typ av finansiell backning kan analyseras och hanteras. Häri presenteras kontinuumet för företagskaraktäristik, där innovation inom affärsmodeller och teknik representerar de två ändpunkterna. Syftet var att undersöka om det fanns signifikanta skillnader mellan riskkapitalisters investeringsmodeller, när ett företag rör sig längs det ovan nämnda kontinuumet. Semi-strukturerade intervjuer användes och tolkades oberoende av författarna, genom att använda kodord, för att förbättra objektiviteten. Uppsatsen berör främst företag inom industrin för informationsteknologi, där analys har gjorts på fyra av de största aktörerna inom marknaden för riskkapital i Norden. Ett Nordiskt fokus, kombinerat med en hastigt utvecklande industri, resulterade i att signifikanta skillnader, i riskkapitalisters investeringsmodeller, identifierades; vilket gav implikationer för både teori och praktik. Dessa skillnader identifierades att härstamma från de initialt anammade riskprofilerna, som sedan påverkade alla andra områden inom investeringsmodellen. Nyckelord Riskkapital, Venture Capital, Investeringsmodeller, Teknologisk Innovation, Affärsmodellsinnovation, Kommersialisering, Kontinuumet för företagskaraktäristik, Innovationsfokus, Urvalsprocess, Risk och Portfölj, Investeringsfaser, Kapitaltillskott, Strategitillskott, Exit-strategi, Norden, Sverige.

Master of Science Thesis INDEK 2012:49

Tackling the innovation focus continuum; implications for change in venture capitalists'

investment models

Johan Lennefalk

David Törnquist Approved

2012-06-13 Examiner

Terrence Brown Supervisor

David Sonnek Commissioner

Contact person

Abstract Innovation has been considered the critical driver behind economic growth and value creation for a long time. However, in order to achieve an innovative status, the commercializing of an invention is required by injecting capital and strategy. While capital comes in many forms, this thesis focuses on the field of venture capital and how this type of financial backing can be analyzed and managed. Herein, the company characteristics continuum is presented, where business model innovation and technological innovation represent the two extremities. The purpose was then to investigate if there are significant differences in the venture capitalists' investment models as one moves along the aforementioned continuum. Semi-structured interviews were used and interpreted independently by the authors, with respect to coding units, in order to enhance objectivity. The thesis mainly targeted the information technology industry, where analysis was conducted on four of the largest actors on the Nordic venture capital market. The Nordic focus, combined with the rapidly moving industry, resulted in that significant differences, in the venture capitalists' investment models, were identified; giving implications both for theory and practice. These differences were identified as stemming from the initially adopted risk profiles, which then affected all other areas of the investment models. Key-words Venture Capital, Investment Models, Technological Innovation, Business Model Innovation, Commercialization, Company Innovation Characteristics, Innovation Focus, Screening Process, Risk and Portfolio, Investment Stages, Capital Contribution, Strategic Contribution, Exit Strategies, Nordic, Sweden.

Preface

After a finished Master’s thesis at KTH Royal Institute of Technology, we wouldlike to thank the people that made this thesis possible. First of all, our sincerethanks go to David Sonnek at SEB Venture Capital, who, apart from being the onethat initially sparked the interest for venture capital three years ago, has guided usthrough the entire process. This includes everything from inspirational meetings,that helped us understand the industry, to helping us approach the other actorswithin the field.

We would also like to thank Terrence Brown, for the academic guidance andfeedback regarding the thesis, as well as the interview respondents Conor, Crean-dum, Northzone, and SEB Venture Capital; for letting us in and supplying us withinsights vital to our findings.

Stockholm, May 2012

vii

Contents

Preface vii

Contents viii

List of Figures x

List of Tables xi

1 Introduction 1

1.1 Problem formulation . . . . . . . . . . . . . . . . . . . . . . . . . . . 21.2 Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41.3 Delimitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41.4 Disposition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

2 Frame of reference 7

2.1 Definitions of innovation . . . . . . . . . . . . . . . . . . . . . . . . . 72.2 Definition of venture capitalist . . . . . . . . . . . . . . . . . . . . . 82.3 The evolution of venture capital . . . . . . . . . . . . . . . . . . . . . 92.4 The investment characteristics of venture capital . . . . . . . . . . . 10

2.4.1 The institutional nature of venture capitalism . . . . . . . . . 112.4.2 Asymmetric information . . . . . . . . . . . . . . . . . . . . . 132.4.3 Performance of venture capital . . . . . . . . . . . . . . . . . 152.4.4 Macro-e�ects on external stakeholders . . . . . . . . . . . . . 162.4.5 Supply and demand of venture capital . . . . . . . . . . . . . 18

2.5 Investment models . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192.5.1 The screening process . . . . . . . . . . . . . . . . . . . . . . 202.5.2 Risk profiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222.5.3 Investment stages in venture capital . . . . . . . . . . . . . . 252.5.4 Capital contribution . . . . . . . . . . . . . . . . . . . . . . . 292.5.5 Strategic contribution . . . . . . . . . . . . . . . . . . . . . . 322.5.6 Exit strategies . . . . . . . . . . . . . . . . . . . . . . . . . . 34

2.6 Research questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

3 Method 37

viii

CONTENTS ix

3.1 Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383.2 Sample selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383.3 Data collection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

3.3.1 Interview areas aimed at the venture capital firms . . . . . . 393.4 Data analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

3.4.1 Reliability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413.4.2 Validity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413.4.3 Generalizability . . . . . . . . . . . . . . . . . . . . . . . . . . 42

4 Results 43

4.1 Company profiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 434.2 Investment models . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

4.2.1 The screening process . . . . . . . . . . . . . . . . . . . . . . 444.2.2 Risk and portfolio . . . . . . . . . . . . . . . . . . . . . . . . 514.2.3 Preferred investment stage . . . . . . . . . . . . . . . . . . . 574.2.4 Capital contribution . . . . . . . . . . . . . . . . . . . . . . . 594.2.5 Strategic contribution . . . . . . . . . . . . . . . . . . . . . . 624.2.6 Exit strategies . . . . . . . . . . . . . . . . . . . . . . . . . . 65

5 Analysis 69

5.1 Screening process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 695.2 Risk and portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 705.3 Preferred investment stage . . . . . . . . . . . . . . . . . . . . . . . . 725.4 Capital contribution . . . . . . . . . . . . . . . . . . . . . . . . . . . 735.5 Strategical contribution . . . . . . . . . . . . . . . . . . . . . . . . . 745.6 Exit strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

6 Conclusion 77

7 Discussion 81

7.1 Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 817.2 Critique of method . . . . . . . . . . . . . . . . . . . . . . . . . . . . 817.3 Further research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 827.4 Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

7.4.1 Entrepreneurial . . . . . . . . . . . . . . . . . . . . . . . . . . 837.4.2 Venture capital . . . . . . . . . . . . . . . . . . . . . . . . . . 847.4.3 Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

Bibliography 87

Interviews 93

A Venture Capital Investor Questions 95

List of Figures

1.1 The trade-o� between the di�erent characteristics . . . . . . . . . . . . 31.2 The company innovation characteristics (CIC) continuum . . . . . . . . 3

2.1 The institutional nature of venture capital as described by Zider (1998) 132.2 The valley of death (Wessner, 2005) . . . . . . . . . . . . . . . . . . . . 142.3 The entrepreneurial gap (Kluge et al., 2000) . . . . . . . . . . . . . . . 172.4 The venture capital investment process and the possible outcomes (Zacharakis

and Meyer, 2000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202.5 The venture capital investigation process as described by Zacharakis and

Meyer (2000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212.6 An actuarial model used to aid in the screening process as described by

Zacharakis and Meyer (2000) . . . . . . . . . . . . . . . . . . . . . . . . 222.7 The risks a�ecting venture capital as described by Fiet (1995) . . . . . 232.8 Company development phases as described by Christofidis and Debande

(2001); Mackewicz & Partner (1998) . . . . . . . . . . . . . . . . . . . . 29

6.1 Main di�erences with regard to the adopted risk profile summarized . . 79

x

List of Tables

2.1 Venture characteristics identified by Ruhnka and Young (1987) amongthe stages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

2.2 Major goals/benchmarks identified by Ruhnka and Young (1987) amongthe stages. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

2.3 Major risks identified by Ruhnka and Young (1987) among the stages. I= Internal and E = External. . . . . . . . . . . . . . . . . . . . . . . . . 28

5.1 The return on investment multiples in relation to the investment stage 725.2 Investment stage focus . . . . . . . . . . . . . . . . . . . . . . . . . . . 72

xi

Chapter 1

Introduction

For a long time, innovation has been considered the critical driver behind economicgrowth and value creation (Schwienbacher, 2008). However, innovation involvessubstantially more than simply a technical invention. In order for an invention tobe truly innovative, there are several inputs that need to be considered.

Apart from a strategy and the idea or invention itself, there needs to be financinginvolved as well. While financing comes in many forms, this thesis focuses on thefield of venture capital (often called VC) and how this type of financial backingcan be analyzed and managed. As a financial and strategical facilitator, venturecapital clearly plays a big part in the modern society, especially within the field ofinformation technology.

One might believe that money is the main hurdle that prevents success, andthat stronger financial backing implies better capabilities. However, historical casestudies have often proved that a major money focus will make the innovation pro-cesses similar to gambling (Hargadon, 2005). This is an area where venture capitalhistorically has added value, to make sure that there is a balance between capitaland strategical contribution.

Therefore, the question of how to manage this type of funding is critical. There-fore, this thesis aims to map the complex environment within the venture capitalfield. Several factors exist as to why the landscape is complex; e.g. the institutionalnature, the involvement of di�erent industries, the asymmetric relation among theagents, and the macro-e�ects. However, the main focus will be on how the invest-ment models vary, with regard to the type of innovation, within the informationtechnology industry.

The interest for the area of venture capital has always been present due to theentrepreneurial spirit within the Nordic information technology industry. Herein,the interaction between information technology and venture capital has helped tofacilitate start-ups such as Spotify, Skype and the like.

1

2 CHAPTER 1. INTRODUCTION

1.1 Problem formulation

Much has changed since the dawn of venture capitalism, especially when the in-dustry of information technology is considered. The evolution of this industry hascreated an infrastructure that has enabled innovation to emerge both cheaply andquickly. Generally, the venture capital industry has become more complex, as men-tioned earlier; hence, the investment models need to be adjusted appropriately.

The challenge with venture capital firstly concerns the process of selectingprospects worth investing in, and secondly to de facto facilitate the investmentsin order to achieve returns in the future. These are problems that venture capitalfirms have to deal with on a daily basis. Thus, relevant investment models arebeneficiary. With regard to venture capital, it is desirable to find a balance betweenthe capital and strategic input. Excess spending will never compensate for the lackof adequate strategic and managerial input and vice versa. The strategic factoris therefore considered to be part of the investment model, due to the nature ofthe venture capital investment vehicle, where the investor enters into a partnership.Thereby, the venture capital firms also invest human resources apart from simplycapital.

One might believe that the most straight-forward approach to become a success-ful and innovative organization is to invest vasts amounts of money in top-of-linescientists and engineers, isolate them from the rest of the organization, give them adiscretionary amount of time and money, and wait for the results (Hargadon, 2005).However, this approach is problematic due to the lack of a relevant understandingof business models to support the processes. Strategic and managerial implicationsneed to be considered as well in order to succeed. Thus, to find a beneficiary balancebetween capital and strategic input is of great importance.

In order to tackle this challenge, a deductive approach to the situation is taken.This results in a fundamental hypothesis upon which this essay is based; businessesare either focused towards technological innovation or business model innovation.Certainly, these restrictions would be too harsh to fit large corporations with severalproducts and services; the hypothesis is designed for young companies which onlymight o�er one, or very few, products or services. The combination of these fociare then projected onto a single dimension continuum, as aggregated into figure 1.1.Therefore, the proposed hypothesis is that the investment model changes as onemoves along this continuum. Figure 1.1 illustrates the company innovation charac-teristics (CIC) continuum as a non-liear trade-o� between technological innovationand business model innovation.

1.1. PROBLEM FORMULATION 3

Company Innovation Characteristics Continuum

Business Model Innovation

Tech

nolo

gica

l Inn

ovat

ion

Figure 1.1. The trade-o� between the di�erent characteristics

If the area of information technology is considered; it is hypothesized that there existtwo types of extremities regarding the companies. Firstly, there are those which arefocused towards fundamental technology development and are often highly researchdependent. This means that they enable other areas of business to prosper as aresult of their contribution. Secondly, there are those companies which dependon the existing technology to support their business model. Thus, the latter areenabled by technology.

Furthermore, it is also hypothesized that these two extremities can be seen asendpoints on the company innovation characteristics continuum; see figure 1.2. Thepositioning of a company on the continuum depends on the innovation focus of thecompany. If a firm mainly focuses on business model innovation, it is preferablypositioned close to the right. However, if the company in question is more focusedtowards technological innovation, it should be positioned to the left. Since fewcompanies are likely to be focused exclusively towards one type of innovation, acontinuum is used.

Technological innovation

Business model innovation

Enables technology Creates infrastructure

Enabled by technology Utilizes infrastructure

Figure 1.2. The company innovation characteristics (CIC) continuum

With regard to the continuum, the hypothesis has been established through discus-sions with a practitioner; namely David Sonnek–Head of technology investments atSEB Venture Capital. However, there is no scientific research backing the existenceof such a continuum presented in figure 1.2, compared to the two-dimensional modelin figure 1.1.


As argued by Slack and Lewis (2008), and initially stated by Skinner (1969),there is a trade-o� at the e�cient frontier ; it is not possible to “have everything”,due to the nature of being “technically constrained.” Therefore, “we must sacrificeone to get the other.” The company innovation characteristics (CIC) continuumcould be interpreted as moving along the e�cient frontier, where trade-o�s aremade when moving towards the extremities.

The pre-hypothesized continuum can therefore be seen as a simplification ofthe two-dimensional trade-o� space, seen in figure 1.1, which has been createdby establishing face-validity with practitioners. However, the purpose is not toinvestigate the existence of the aforementioned continuum, but to conduct researchregarding the two innovation foci. This hypothesis could be seen as a pre-hypothesisthat will be used as if it were true. Hence, rejecting HP 0 and accepting HP 1.

HP 0: The venture capital landscape cannot be represented by a continuum; wherethe extremities are technological innovation and business model innovation.

HP 1: The venture capital landscape can be represented by a continuum; where theextremities are technological innovation and business model innovation.

Based on the company characteristics continuum, as can be seen in figure 1.2, thepurpose of this thesis is to investigate the following hypothesizes:

H0: There are no significant di�erences in the venture capitalists’ investment mod-els as one moves along CIC continuum.

H1: There are significant di�erences in the venture capitalists’ investment modelsas one moves along the CIC continuum.

If significant di�erences can be identified along the CIC continuum, it would bepossible to rationalize investments to a further extent.

1.2 Perspective

This thesis mainly takes the perspective of the venture capitalist, where companiesalong the CIC continuum represent the domain of investments; it will mainly includecompanies within the information technology industry. Thus, it omits other popularareas of venture capital, such as bio-tech, med-tech, and clean-tech. Since the focusis on the venture capitalists’ investment models, taking this perspective is relevant.Neither the fund investors, typically pension funds, nor the entrepreneurs have amajor influence on the shaping of these investment models.

1.3 Delimitations

The delimitations, those that actively are chosen upon in order to limit the scopeof the research, mainly involve the chosen industry and the geographic location of

1.4. DISPOSITION 5

the study. As mentioned earlier, information technology will be the focal industry,where the analysis will be performed on the Nordic venture capital market. Sincethe industry scope is narrow, the resulting generalizability may be impaired by thestudy. However, venture capital has historically been very well represented bothwithin the information technology industry and in the Nordic region. Accordingto Antonczyk and Salzmann (2012), Sweden, Norway, and Finland are among thetop five countries in the world when it comes to venture capital availability. Fur-thermore, Denmark is found at the 9th position. The results were extracted fromthe World Economics Forum’s Global Competitiveness Report 2008–2009 and re-flect how easy it is for entrepreneurs with innovative, but risky, projects to findventure capital. These results emphasize the high representation, and the actuality,of venture capital in the Nordic region. Thus, it should still be possible to drawconclusions reflecting the venture capital situation within this region.

Moreover, the study will only include the venture capitalists’ current portfoliosand funds, excluding historical data. Timewise it would be beneficiary to analyzeportfolios from an entire market cycle, including one period of slowdown and oneperiod of growth. This way, factors such as the influence from the current economictrajectory could be accounted for, and also other macro-economic factors. However,since a fund usually lasts for more than five years, the chosen content will reflectvarying economic situations either way. Moreover, combined with the fact thatseveral portfolios and funds will be analyzed, with di�erent initiation dates, thiswill also contribute to minimizing the specific influence from systematic risk andinaccuracy regarding the phenomenon being studied.

1.4 Disposition

In order to ease the reader’s process, of understanding the vast material that hereinis presented, a thorough approach has been taken. Firstly, the theoretical frameworksets the stage by explaining relevant concepts that are critical, in order for the readerto understand the data that has been collected. The results are then presentedseparately for each company, in order to give a straight-forward view of the data, andto highlight what separates them. The analysis section then aggregates these results,in order to create a synthesized view of the situation by connecting it to the initialproblem formulation and research questions. Lastly, the conclusion summarizesthe findings and relates them to the hypotheses. By adopting this structure thepurpose is to make sure that the process, of converting individual interview resultsinto a coherent picture of the situation, is fully explained and can be followed andunderstood.

• Frame of reference: Precedent research is presented starting with generaltheory regarding innovation, venture capital, and characteristics concerningthe latter. The frame of reference is then narrowed down to focus on in-vestment models and details regarding the specific factors. The section is


wrapped up by presenting the research questions and then motivating howthey contribute to the field of research.

• Method: Describes how the research is conducted. The section mainlypresents how the interviews are made and interpreted. Also, the choice ofsample is described.

• Results: The empirical results are presented by putting each factor in theinvestment model in relation to each respondent. The factors that constitutethe investment model relates to the observed pattern in the frame of referencesection.

• Analysis: The empirical results are synthesized for each respondent withregard to the research questions and hypotheses.

• Conclusion: Briefly summarizes the report, with regard to the research ques-tions and hypotheses.

• Discussion: Implications, critique of method, and further research is pre-sented herein. The section contains general reflections about the thesis’ con-tent.

Chapter 2

Frame of reference

The frame of reference intends to create an initial mapping of the complex ven-ture capital environment. It starts out by introducing definitions and descriptionsregarding innovation and venture capital. This is followed by identification of theventure capital characteristics, as an innovation facilitator for commercializing in-ventions. Lastly, a deeper analysis of the investment models’ constitution is pre-sented.

Section 2.5 is explicitly connected to the main topic of this thesis. However, itis critical to realize the importance of the implicit areas leading up to 2.5, and thecomplexity of these; to fully understand the inner workings of the venture capitallandscape, within the complex environment.

The last section, research question, is placed at the end in order to clearlyillustrate what is missing in precedent research; thus, highlighting the importanceof this study.

2.1 Definitions of innovation

“The only constant is change, continuing change, inevitable change,that is the dominant factor in society today. No sensible decision can

be made any longer without taking into account not only the world as itis, but the world as it will be.”

Isaac Asimov

As Isaac Asimov stated, innovation is inevitable and has undoubtedly been partof our evolution. One of the first to define innovation was Schumpeter (1934). Hedefined an economic innovation as the introduction of a new good or new method ofproduction, opening of a new market, the conquest of a new source of supply, or thecarrying out of a new organization. According to Schumpeter (1934), innovationoften involves combinations of existing resources.

If more modern definitions of innovation are considered, they deal with – asbriefly mentioned in the introduction, the process of commercializing ideas and

7

8 CHAPTER 2. FRAME OF REFERENCE

scientific inventions and thereby introducing them to the real world. The purposeof this is to capture the value from the innovation and let the creators, e.g. thefirm behind it, reap the the benefits. According to Trott (2008), innovation isthe combination of a theoretical concept, a technical invention and a commercialexploitation.

“Innovation is the process of turning ideas into reality and capturingvalue from them.”

Tidd and Bessant (2009)

It is important to di�erentiate between an invention and an innovation. An in-vention could precede an innovation by years and represents the actual scientificfindings.

“Invention is the first occurrence of an idea for a new product orprocess, while innovation is the first attempt to carry it out into

practice.”

Jan Fagerberg (2005)

As discussed by Trott (2008), an innovation does not neccesarily have to be aproduct. The typology of innovation involves several possibilities, and can either bea product, process, organizational, management, production, commercial marketing,or a service innovation. If the innovation typology is related to the CIC continuum,proposed in this thesis, all these types can be fitted.

2.2 Definition of venture capitalist

It is important to define the venture capitalist concept before proceeding. Whilethere exist several definitions, one by Gupta and Sapienza (1992); Perez (1986) andPratt (1987) is as follows:

“Those organizations whose predominant mission is to finance thefounding or early growth of new companies that do not yet have access

to the public securities market or to institutional lenders.”

Another definition by the European Private Equity and Venture Capital Association(EVCA) presented by Christofidis and Debande (2001), defines venture capital as:

“A subset of private equity investments made for the launch, earlydevelopment or expansion of a business.”

2.3. THE EVOLUTION OF VENTURE CAPITAL 9

Private equity is in turn defined as equity capital to enterprises not quoted on astock market. These definitions are important to distinguish between since figuresfor private equity frequently are quoted, without explicitly separating them fromthose of venture capital. If one is to consider the investments in venture capitalexclusively, the EU is far behind the figures found in the US (Christofidis andDebande, 2001).

Furthermore, Gupta and Sapienza (1992) suggest that venture capitalists addvalue by:

• bringing investors and entrepreneurs together in an e�cient manner;

• making superior investment decisions than limited partners would make;

• providing non-financial assistance which in turn enhances survival.

While these suggestions not will fit all venture capitalists, they give a hint of theirpurpose. The ultimate measurement of success then, ceteris paribus, would be howwell a venture capital firm manages to make the investment decision and how ef-fective the post-investment advice is. Roure and Keeley (1990) even claim that afirm’s success can be predicted from the content within its business plan. Hence, toimprove the investment decision means to improve the venture capitalist’s perfor-mance (Zacharakis and Meyer, 2000).

2.3 The evolution of venture capital

Ehrenfeld (1990) has summarized an article with the wisdom of Georges Doriot,commonly known as the father of venture capital, and who founded the first publiclytraded venture capital company; American Research and Development Corporation.Ehrenfeld (1990) argued that knowledge alone can be almost useless; without acatalyst or a fulcrum, it will not be possible to leverage from it. This is whereventure capital comes in handy and, according to Ehrenfeld (1990), the U.S. islargely built upon it.

Cornelius (2005) states that the first usage of the term “venture capital” was ina discussion between J.H. Whitney and Benno Schmidt in 1946. Having inheritedUS$ 179 million, a fund was developed with the purpose of supplying capital tothose who had di�culty obtaining it by traditional means.

However, the situation of today is quite di�erent from back in the 1940s. It isargued that the dawn of venture firms came along during the 1960s, in the wake ofthe defense industry as above mentioned. This was the time when the era of thesemiconductor industry essentially was funded by venture capital, in Silicon Valley,California.

The article, in the Wall Street Journal (2009), continues by describing that ven-ture capitalists are a critical ability for the American economy. Even though theearly-stage investments average around $3 million or less, they play a big role in the


reason as to how the U.S. economy has managed to grow faster than other industri-alized economies for decades. This has resulted in that more than 20 % of the U.S.gross domestic product is generated by companies once funded by venture capital.Examples of successful start-ups include companies such as Microsoft, Google, Dell,Facebook, Apple and the like. In total, the venture capital industry invested $28billion in start-ups in 2008 (Wall Street Journal, 2009; Schwienbacher, 2008).

2.4 The investment characteristics of venture capital

Today, most of the entrepreneurs and management teams that form new companiescome from corporations or universities (Zider, 1998). The reason is that nearly allbasic research money, and therefore invention, comes from corporate or governmentfunding. However, these institutions are not good at turning them into new busi-nesses. Therefore, the entrepreneurs feel that the advantages of staying within theacademic world, or at their former company, are limited when it comes to com-mercializing their ideas. This is where venture capital enters the picture, becauseventure capital has no such limitations.

Venture money plays an important role since it funds the next stage in theinnovation life cycle period; the stage in a company’s life where the innovation iscommercialized. As a consequence, venture money is not long-term money. Theconcept is based on investing in a company’s balance sheet and infrastructure untilit reaches the size and credibility of being sold. The selling can be done eitherdirectly to a corporation or by letting the public-equity markets step in and provideliquidity, through an initial public o�ering (IPO). Hence, the role of the venturecapitalist is to buy a stake of the company, nurture it for a few years, and then exitwith the help of an investment banker (Zider, 1998).

However, “to buy a stake of the company”, typically means that, in a typicalstart-up deal, the venture capitalists invest $3 million, over two-three years, inexchange for a 40 % preferred-equity ownership position. Furthermore, in returnfor this financing, the expected return over the next five years is 10 times theinvestment. Therefore, combined with the preferred position, this is a very highcost of capital corresponding to a 58 % annual compound interest rate. However,this is required in order for the venture capitalists to deliver average fund returnsabove 20 % to their venture capital fund investors (Zider, 1998).

It is indeed possible to question the high cost of capital; however, the alternativesgiven are not exactly great. Furthermore, many entrepreneurs understand the risksof starting their own businesses. Therefore, they do not want to put their own, ortheir family and friends’ money at risk. Unfortunately, some also “recognize thatthey do not possess all the talent and skills required to grow and run a successfulbusiness” (Zider, 1998).

As a consequence, the high interest rates can be motivated by the high risksinherent in start-ups. On average, the businesses only succeed one in ten times.Therefore, traditional credit institutions such as banks cannot o�er regular loans

2.4. THE INVESTMENT CHARACTERISTICS OF VENTURE CAPITAL 11

since laws are limiting the interest rates o�ered by banks. Moreover, banks usuallyrequire hard assets in order to secure the debt. However, in the information-basedeconomy of today, few lean start-ups have any hard assets (Zider, 1998; Christofidisand Debande, 2001).

To be able to succeed, the venture capitalists focus on the middle part of theclassic industry S-curve. This enables them to avoid both the early stages, withuncertain technologies and unknown market conditions, and the later stages withslow growth rates, market maturity and consolidations. Therefore, venture capital-ists invest in industries with growth potential since this is where the S-curves areto be found (Zider, 1998).

Thus, “regardless of the talent or charisma of individual entrepreneurs, theyrarely receive backing from venture capital if their businesses are in low-growthmarket segments.” Moreover, many imagine the venture capitalists as experiencedadvisors for the companies they fund. However, this clashes with their schedulessince they can manage up to ten companies simultaneously. This is a result fromtheir financial incentives of being a partner in the venture capital firm. Therefore,the more money they manage, the less time they have to nurture and advise en-trepreneurs. This has resulted in “virtual CEOs” being added in order to help outwith counseling of the firms, replacing the traditional role that venture capitalistsused to have back in the day (Zider, 1998).

This type of counseling for entrepreneurs, in the seed stage, can involve thedevelopment of an innovative idea, a prototype, writing a business plan or launchingthe company. In other words, it is not only capital that the entrepreneur needs inorder to evolve; expertise and a large amount of time is also required. This issometimes referred to as the three Ts of venturing: Time, Talent and Treasure(Amit et al., 1990).

2.4.1 The institutional nature of venture capitalism

Venture capital traditionally has been associated with risky investments that po-tentially can bring high returns, mainly within technology. However, as early asin the 80s, the industry was described as becoming more structured, mature ande�cient. Hence, those writing about venture capital started di�erentiating betweentraditional, or classic, venture capital versus the modern venture capital of today(Brophy, 1981, p. 26). Since other investors sought to take part in the growing ven-ture capital industry, money flooded. However, these new managers traded higherreturns for lower risk by limiting what could be made with the capital, as requestedby e.g. pension funds. Furthermore, many of the new managers only had 2-3 yearsof working experience and came from business schools, in contrast to the older gen-eration of managers with 15-20 years of experience from business. Therefore, thenewer type of venture capitalists tended to accept less risk, and instead focused oninvestments made in the later stages of business development as described by Diz-zard (1982, p. 117) and Kotkin (1984, p. 66). Since they were trained in decreasingrisk, they also used diversification as a strategy, which meant investing in a variety


of industries. This new trend marked by MBAs doing relatively conservative invest-ments, compared to the classic venture capital, focused more on conserving wealth,than to overcome the pitfalls faced by the investee companies in their growth.

Even so, Sørensen (1987) concludes that experienced investors are more likelyto sort out inherently better companies from the market, which succeed in goingpublic. Thus, experienced investors add more value to the investee companies thaninexperienced investors do (Sørensen, 1987).

According to Zider (1998), the four main players within the venture capitalindustry, as can be seen in figure 2.1, are:

• Entrepreneurs

Entrepreneurs need funding for their firms, and crave venture capital compa-nies that want to invest in their ventures.

• Investors who want high returns

These investors include pension funds, insurance companies, family o�ces,sovereign wealth funds and endowment funds (Taylor Wessing, 2009). Typi-cally, the venture capital fund being invested in represents a small percentageof the institutional investors’ total funds, placed in the high-risk end of aspectrum divided into di�erent funds. In exchange for these high risk profileinvestments, they expect a return of between 25 % and 35 % per year duringthe lifetime of the venture capital fund (Zider, 1998).

• Investment bankers

The investment bankers’ task is to sell companies. Hence, they need a supplyof companies to sell.

• Venture capitalists

venture capitalists make money by providing and capitalizing o� of the needfor a market by the other three actors.


Entrepreneurs Venture capitalists Investment bankers

Corporations and government Private investors Public markets and

corporations

Ideas

$ $

IPOs

$ $ $ $ Stock

Figure 2.1. The institutional nature of venture capital as described by Zider (1998)

2.4.2 Asymmetric information

For many firms, the only solution to the early-stage capital gap – often called theValley of Death (see figure 2.2), is venture capital. However, in the competitiveworld of early-stage financing, the potential investors find themselves in muddy wa-ters with conditions far from ideal. Many investors are therefore scared away by theless-than-perfect information in combination with risky and unvalidated ideas. Tohelp the entrepreneurs, some countries have developed programs including awardsfor innovation; e.g. in the U.S. where the Advanced Technology Program and theSmall Business Innovation Research Program play a key-role in early-stage financ-ing and signaling of new information to the markets. Hence, they both financeand increase the information available to the public regarding new technology andpotential for new ideas (Wessner, 2005).


Federally fundedresearch creates

new ideas

Capital to developideas to innovation

Productdevelopment and

innovationNo capital

Figure 2.2. The valley of death (Wessner, 2005)

Amit et al. (1999) present a theoretical framework that views asymmetric infor-mation as the central feature of venture-capital investment. There exist two typesof asymmetric information: hidden information that will lead to the selection oflow-quality items (also known as adverse selection) and hidden action where oneparty prior to a transaction makes an action not observed by the other party (alsoknown as the moral hazard).

“Moral hazard and adverse selection create market failures inentrepreneurial financing, which might lead many worthwhile projects

to be unfunded or underfunded.”

(Amit et al., 1999)

Depending on how skilled the venture capitalists are, the risk of asymmetric in-formation can be reduced. In general, they often dig deep into the risks of thecompanies they invest in. Thus, the very existence of venture capital firms canpartially be attributed to the fact that they are superior to unspecialized investors(Amit et al., 1999).

According to Amit et al. (1999), venture capitalists are better at avoiding asym-metric information than other investors. In general, this advantage is easier toexploit in later-stage firms than in start-ups.

Amit et al. (1999), also present a model that predicts a negative relationshipbetween the share of venture-capital ownership and the firm’s performance. Thismodel is supported by data from the Canadian venture capital industry.


2.4.3 Performance of venture capital

Benson and Ziedonis (2009) investigate 34 corporate investors and 242 acquiredtechnology startups from the acquirer’s perspective. The authors find that the per-formance of the acquisitions heavily relies on the internal knowledge base of theacquirer. This can be related to the fact that when venture capital investmentsincrease, relative to the total R&D expenditure of the firm, the performance even-tually decreases. This emphasizes that venture capital investments rely on morethan simply capital, and as such can act as a mechanism for strategic renewal im-plementation.

Benson and Ziedonis (2009) also find that firms consistently engaged in venturefinancing receive larger returns than firms engaged in occasional investments.

Caselli et al. (2009) examined 37 venture capital backed firms that went publicon the Italian Stock Exchange between 1995 and 2004. These 37 firms were paired,by a statistical matching procedure, with 37 non-venture backed IPOs during thesame period. The purpose was to highlight how venture capital a�ects the firms.

According to Caselli et al. (2009), the degree of innovation among firms is im-portant during the selection phase for the venture capital firms. However, whenthe investment is made, the firm being invested in does not promote further inno-vation but rather chooses to focus on improving economic and managerial aspects.This was demonstrated by comparing the amount of patents among the ventureand non-venture backed firms before and after receiving funding. Before funding,the venture backed firms registered more patents than its non-venture backed twin,while dropping below after receiving funding. This is also a factor in the selectionphase among the venture capital firms, since the firms with the highest growthpotential are the ones that get selected; the number of patents is only one out ofseveral measurements. Furthermore, R&D and past development were other factorsconsidered vital.

On the other hand, sales show that venture capital backed firms experience a5.5 % increase over the non-venture backed firms. According to Caselli et al. (2009),this is a result of the venture capitalists trying to maximize the value of the futureIPO. The venture capitalist therefore focused mainly on marketing and sales ratherthan on R&D or technical and patentable innovation. However, these results onlyreflect situations where IPOs were the exit strategy.

“Our analysis of venture capital backed firms suggests that we canexpect higher failure rates among these firms than in the population of

new firms.”

(Amit et al., 1990)

As stated above, according to Amit et al. (1990), the success rate among venturecapital backed firms is not higher than for conventionally funded firms; the failurerate is actually higher. The reason for this lies in the di�culty for the venture


capitalists to assess the ability among the entrepreneurs. The most promising en-trepreneurs also tend to neglect o�ers from the venture capitalists due to the currentinstitutional structure of the venture capital industry (Amit et al., 1990).

Allen and Hevert (2007) carried out a performance investigation of corporateventure capital programs in the information technology industry. The investiga-tion contained 90 U.S. information technology firms during 1990-2002. Allen andHevert (2007) found that the timing of initiation within the venture capital cycle,the program scale, the annual investments, the write-down and the harvest behav-ior were associated with di�erences in returns. If the initiation timing within theventure capital cycle is considered, Allen and Hevert (2007) argue that, a late initi-ation can destroy direct value on the program. The venture capital cycle is derivedfrom trends in annual investments and returns, also know as boom-and-bust cycles(Gompers, 2002). The cycle considered in this investigation is 1990-2002.

The program scale, measured by the cumulative investments, showed that smallprograms generated attractive returns. Small programs included cumulative invest-ments under $95 million. However, small programs may su�er from lacking internalcredibility. Allen and Hevert (2007) suggest that $100–500 million of cumulativeinvestments over several years are likely to be required in order to deliver economi-cally significant direct returns and generate a smaller set of in-the-money strategicoptions.

2.4.4 Macro-e�ects on external stakeholders

From the macro-economic perspective, Wasmer and Weil (2000) find a significantpositive impact from venture capital; both on short-term and long-term employ-ment. This positive impact from venture capital was shown as early as during theWorld War II, when government contracting resulted in successful innovative in-dustrial ventures that previously had been considered too risky to finance (Reiner,1991).

According to Trott (2008), the US currently spends 2.6 % of GDP on R&D,and is growing rapidly. Japan is even ahead of this number with a spending of2.9 % of its national wealth. Europe is far behind at only 1.9 %, with the EUpledging to increase Europe’s state and private R&D spending. Furthermore, astudy by the European Commission finds that businesses’ R&D expenditures in theUS are 73 % higher than that in EU, while growing by almost three times betweenthe years 1995 to 1999 (Trott, 2008). However, some argue that something else isneeded, since it is hard to make companies spend more money on R&D, when theeconomy is weak and the stock market conditions are uncertain. Also, Gomperset al. (2008) argue that venture capital investments are increased when the publicmarket becomes more favorable. The reaction is especially significant among theventure capitalists with the most industry experience. Gompers et al. (2008) statethat this is consistent with the venture capitalists’ rational responses to attractiveinvestment opportunities, signaled by public market shifts.

Therefore, the European Commission propose the American way of building a


large venture capital industry. Historically, the venture capital funding has beenvital to the growth of the US economy. However, in the EU it only accounts for0.004 % of GDP. Hence, the need for venture capital is clear and the Commissiontherefore recommends governments to set up schemes to attract venture capital forstart-ups (Trott, 2008).

There are also di�erences between countries in the EU, where the venture cap-ital development is higher in countries with an equity market culture, such as theUK and the Netherlands. Hence, France, Germany, Belgium and Sweden have aless developed venture capital culture, but are rapidly catching-up. As recentlypresented by Antonczyk and Salzmann (2012), the situation has now changed po-sitioning Nordic countries, such as Sweden, among the top markets. Moreover,there is a “potentially strong correlation between the development of venture capitaland investments by pension funds and other institutional funds in venture capital”(Christofidis and Debande, 2001).

In the heart of venture capital, Silicon Valley, 73 % of all companies that haveannual sales of more than $50 million were established after 1985; see figure 2.3.Contrastingly, in the German tech-cities Munich and Stuttgart, only 17 and 20 %reach this league. These types of companies are the most likely to grow at above-average rates. Moreover, unlike most established companies, tech companies arealso the most likely to raise employment levels (Kluge et al., 2000).

Kortum and Lerner (1998) state, in a massive examination of over twenty in-dustries over three decades in the U.S., that venture capital accounts for about 15% of industrial innovations. Furthermore, the amount of venture capital activity inany industry significantly increases the rate of patenting. Also, Kortum and Lerner(1998) argue that the R&D funded by venture capital is constantly more productivethan that funded inter-organizationally by corporations in the U.S.

27 3142

69 75 76 80 83

73 6958

31 25 24 20 17

567 908 139 1954 390 1095 354 382

Percent�of�companies�with�annual�sales�exceeding�$50�million.Source:�Dun�&�Bradstreet

Companies�founded�before�1985

Silicon�Valley Boston Austin�� London��Düsseldorf��Paris��Stuttgart��Munich

Figure 2.3. The entrepreneurial gap (Kluge et al., 2000)

However, there are some things being done in order to increase the situation inEurope, e.g. in Munich – Germany, stakeholders have realized the inter-dependence


of start-ups, regional development and specific industries. Hence, it has becomethe fourth-largest information technology center in the world, after Silicon Valley,Boston and London. This was achieved through early-stage targeted investmentsby the state government. This led to the attraction of a cluster of companies withinthe information technology industry. Similarly, within the aerospace technology, adepartment was set up in order to transfer knowledge from institutes into poten-tial start-ups, and connecting these as suppliers of technology to established localbusinesses (Kluge et al., 2000). Conclusively, this shows that a clear strategy isneeded in order to achieve innovation in a broader sense. There are several waysto get there, but they all need a clear path, such as the focus on venture capi-tal as a very capable, and historically successful, way. This, in combination withhigh-tech research clusters, such as in Germany, seems like a potential long-termstrategy. Unfortunately, there is a trend towards a growing size of both venturecapital funds and individual investee deals, which typically discriminates againstsmaller investments in technology start-ups. There is also a trend among US firmsto exit through an IPO, contrary to the EU region where “trade sales“ are morecommon (Christofidis and Debande, 2001).

2.4.5 Supply and demand of venture capital

Christofidis and Debande (2001) have identified several factors that a�ect the de-mand side of venture capital, and hence a�ect its expansion.

• Fiscal

Reductions in capital gains tax and the general attitude towards stock optionsa�ect the underlying incentives for venture capitalists when starting new firms.

• Regulatory

Labor market flexibility which enables employers and employees to quicklyadapt to changes and company law which eases the creation of start-ups.

• Infrastructure

Regional science and technology parks, research institutions in combinationwith incubators in order to encourage the commercial applications and theinteraction between venture capitalists, entrepreneurs and researchers.

• Exits

Su�cient stock market liquidity, with listing and reporting criteria integratedthroughout the Europe region via institutions; which encourages venture cap-italists to exit through the IPO route.

• Investee management

In order to ensure funding, the entrepreneur needs to be able to draw attentionto the firm and develop a viable business plan that communicates the realvalue-added of the product or service and a clear path towards profitability.

2.5. INVESTMENT MODELS 19

Furthermore, the investee’s management team must be able to prove technicalexcellence.

Likewise, there are factors suggested by Christofidis and Debande (2001) that a�ectthe supply side of venture capital and hence drive the development.

• Fiscal

Tax reliefs for private investors and business angels ease the funding of venturecapital funds.

• Regulatory

Less restrictions put on pension funds, to invest in venture capital, and ini-tiatives to diversify the supply of venture capital; e.g. from state-sponsoredfunds. Also, reinforcements done to the protection of intellectual property,which both encourage investments in intangible assets and enable such tosecure investments by constituting collateral.

• Exits

There is a strong correlation between the public and private equity markets.Therefore, a stock market fall reduces the possibilities of successful IPOs andthe subsequent recycling of capital back into new venture capital funds. More-over, the reduction of liquidity leads to a shortage of credit which makes itharder for firms to finance their growth stages, and thus more bankruptcies.

• Cultural

Promoting the creation of angel investor networks to create venture capitalfunds by experienced entrepreneurs in order to invest in start-ups. Evidencesuggests that serial entrepreneurs, that themselves have benefited from venturecapital investments, are the best qualified fund managers.

• Venture Capital Fund Management

The thorough due diligence process requires managers to have a deep andtechnology specific knowledge, in order to avoid simply mimicking the markettrend (in order to avoid e�ects such as the dotcom-bubble). The venture cap-italists need to adapt their investment models to the specific growth pattern,industry, and the need of capital of the investee firm. Furthermore, they needto have a sense of the exit route, and the path needed to achieve it; e.g. bybuilding a platform that can be utilized in order to gain critical mass and thenaccelerate towards an exit.

2.5 Investment models

The following section thoroughly investigates the investment models used by venturecapitalists. The section is divided into six main areas, namely the screening process,risk profiles, investment stages, capital contribution, strategic contribution, and exitstrategies.


2.5.1 The screening process

According to Gupta and Sapienza (1992); Perez (1986) and Pratt (1987), successfulventures provide a high return, while “living dead” (Ruhnka et al., 1992) and failedventures result in a loss of all or part of the investment. The process of investingand the possible outcomes are presented in figure 2.4 as described by Zacharakisand Meyer (2000).

VC

Succesful venture

Failed or”living dead”

Invest

Don’t investNo loss

No return

Good return

No return

Figure 2.4. The venture capital investment process and the possible outcomes

(Zacharakis and Meyer, 2000)

According to Kunkel and Hofer (1991); Sandberg (1986) and Timmons (1994), thesurvival rate of venture capital-backed firms is much higher than those of othersources. Therefore, the venture capital decision process has been investigated thor-oughly within literature. However, venture capital-backed firms still fail at 20 %. Inaddition, another 20 % of the firms within the portfolio do not provide any returnto the venture capitalists at all. Thus, there is room for improvement within theinvestment process (Zacharakis and Meyer, 2000). However, this contradicts earlierresearch by Amit et al. (1990), which stated that the success rate among venturecapital backed firms is not higher than for conventionally funded firms.

A common approach to the three staged investment process begins with screen-ing, as can be seen in figure 2.5. Here, the venture capitalists screen vast amountsof proposals in order to assess their viability. On average, only 8-12 minutes arespent when assessing a business plan (Sandberg, 1986). Within this time frame,attributes such as key success factor stability, lead time, competitive rivalry, edu-cational capability, industry-related competence and the interaction of timing aresought after, since they are identified as the most important factors when assessingthe profitability of a new venture (Shepherd et al., 2000). The ventures that passthe initial stage proceed to the more thorough due diligence process. Finally, forthe firms that pass the entire process, the venture capitalist and the entrepreneur


negotiate the terms of the investment.Since the due diligence is extensive and the negotiation may take time, it is

important to minimize the e�ort spent on the initial screening process. Yet, it isimportant to be careful in order to not eliminate potential opportunities prema-turely.

Screening Due diligence Negotiate terms of the investment

Figure 2.5. The venture capital investigation process as described by Zacharakis

and Meyer (2000)

One solution to this problem could be to use actuarial decision aides, which aremodels that decompose a decision into components, to assist in the screening pro-cess; as described by Zacharakis and Meyer (2000) that can be seen in figure 2.6.These components could be cues that recombined can predict the outcome. Morespecifically, an “actuarial (statistical) models refer to the use of any formal quanti-tative techniques or formulas, such as regression analysis, for ... [deciding] clinicaltasks” (Elstein and Bordage, 1988). Hence a model of this kind, within the scopeof a venture capital investment, could take into consideration the entrepreneur(s),the product and the market etc. Models such as these are already in use withinmany fields; e.g. at banks, within lending, and psychology. Another popular areaof usage is within insurance in order to evaluate a potential customer. The modelshave been found to be very reliable and “often outperform the very experts thatthey are meant to mimic” (Zacharakis and Meyer, 2000).

In the example, given by Zacharakis and Meyer (2000), in figure 2.6 the fac-tors entrepreneur/team, product/service, market and financial are decomposed intoquantitative measures that are used in order to predict an expected outcome, whichis later compared with the actual outcome.

In a study, performed by Zacharakis and Meyer (2000), 53 venture capital-ists participated where 50 ventures were judged on their success potential. Thesefirms were also analyzed by two di�erent types of actuarial models; one bootstrapmodel that used factors identified as the most important when making investmentdecisions, and one model derived by Roure and Keeley (1990). The first modeloutperformed all but one participating venture capitalist whereas the second modeloutperformed over half of the participating venture capitalists. Hence, the implica-tion is that a properly developed actuarial decision model might aid in the screeningprocess. While the models weigh all attributes consistently and the same, humansmay be biased and therefore interpret information. According to Dawes (1988) andDawes et al. (1989), this bias may be attributed to the fact that decision makerstend to recall past successes rather than failures. Thus, the idea is that these mod-


els could be used by low level employees during the screening process to free seniorassociates’ time.

Actual outcome

Entrepreneur/Team

Product/Service

Market

Financial

Expected outcome

JudgementCriterion variable

Information cues

Figure 2.6. An actuarial model used to aid in the screening process as described by

Zacharakis and Meyer (2000)

An important conclusion drawn by Zacharakis and Meyer (2000) is that vast in-formation hinders the decision process for venture capitalists, while most peopleparadoxally claim to prefer more information at hand. As the information factorsincreased from five to eight, the accuracy of the venture capitalists predictions de-creased from 39.5 % down to 30.9 %. Therefore, a model to aid in screening processeases the task of processing the data, in a consistent way, which minimizes bias.

2.5.2 Risk profiles

Fiet (1995) identifies two types of risk: market risk and agency risk. The formerdepends upon the size, growth and accessibility of the market; it is based on theexistence of a market need. Competition also comes into play with unforeseenactions a�ecting the market risk. The latter concerns the degree of uncertaintythat either the entrepreneur or the venture capitalist will pursue their own interests,instead of complying with the contract for venture capital. However, in the researchconducted by Fiet (1995), agency risk is referred to as mainly being caused byentrepreneurs pursuing their own interest at the expense of the venture capitalists.This is a problem since it is di�cult to monitor the possible divergent interest ofinvestors and entrepreneurs.


The author proposes a model on risk avoidance based on three constructs: in-vestor type, market risk and agency risk, as seen in figure 2.7. Investor type iscoded as a dichotomously variable representing either a venture capitalist or a busi-ness angel. The market and agency risks were measured indirectly using severalsub-factors as described below:

Market risk is constituted of the following factors:

• Many current competitors

• Many potential new competitors

• Competitive products/services that are ready substitutes

• Weak customer demand for product/service

Agency risk is constituted of the following factors:

• Entrepreneurs and venture capitalists having di�erent cash flow objectives

• Entrepreneurs and venture capitalists having di�erent profit objectives

• Manipulation of profitability

• Short-term self-interest seeking by the entrepreneur

• Contractual ambiguities

Market risk Agency risk

Venture captal investor type

MR1 MR2 ... MRn AR1 AR2 ... ARn

Business angel/venture capital firm

Figure 2.7. The risks a�ecting venture capital as described by Fiet (1995)


Chang (2004) investigated how alliances could decrease risk among investments inInternet startups. Chang (2004) specifically analyzed the importance of venturecapital financing and strategic alliances when acquiring resources necessary for thegrowth of Internet startups. The IPO was used as an early stage performance mea-surement of the Internet startups, and for controlling the IPO market environment.Environmental factors that may influence the incidence of IPO are firstly the generalIPO market itself; both entrepreneurs and venture capital firms are more willing togo public in a rising market. Secondly, the population density is defined by howmany firms there exist in a specific market nice at a given point in time. High pop-ulation density will imply an increased competition. Chang (2004) considered boththese factors and argued that the time to make an IPO was positively influencedby:

• The better the reputation of the participating venture capital firms, andstrategic alliance partners, were.

• The more money a startup raised.

• The larger the size of a startup’s network of strategic alliances.

Firstly, Chang (2004) states that reputation among the funding venture capitalfirms and the partners in the strategic alliances are of great importance for theIPO. Chang (2004) shows that venture capitalists with a success rate of 30 %,instead of the average 10 %, generate an IPO rate that is 2.12 times higher thanthe average. A similar e�ect could be seen with regard to the strategic alliancereputation. By partnering with prominent partners, the startup benefits from thereputation of these and builds a stronger external perception of itself. Thereby,gaining ability to access additional resources that can contribute to growth (Baumet al., 2000; Baum and Oliver, 1991; Gulati, 1998; Miner et al., 1990).

Secondly, the results stated by Chang (2004) suggest that the amount of moneyraised was significantly positively correlated with the likelihood of going public, andmore money would speed up the potential IPO.

Lastly, strategic alliances can provide both legitimacy and needed resources fora start-up. Moreover, the larger the network is, the faster it can go public (Chang,2004).

Also, Aldrich and Fiol (1994); Deeds et al. (1997a,b); Zimmerman and Zeitz(2002) state the importance of gaining legitimacy and thereby overcoming the li-ability of newness. The results presented by Chang (2004) suggest that one ad-ditional partner in the strategic alliance network would increase the likelihood ofgoing public by 1.17. The purpose of partnering with prominent firms could be e.g.to access social, technical, and commercial resources that normally require years toaccumulate (Chang, 2004).

In summary, Chang (2004) claims that a firm that can reap the benefits fromboth venture capital financing (including cash as well as complementary resources)


and alliances (providing legitimacy) on average will go public more quickly than astartup that lacks them.

Another approach to reduce risk is by using milestones, as mentioned by Claytonet al. (1999), which will be described in section 2.5.4.

2.5.3 Investment stages in venture capital

Ruhnka and Young (1987) did studies with the purpose of validating venture capitaldevelopmental stages. Researchers have for a long time predicted that the process ofnew ventures could be chronologically predicted by an evolvement through variousfunctional and strategic developmental stages. Ruhnka and Young (1987) analyzedthe perceptions of the CEO or managing partner of 73 U.S. venture capital firms,which possessed comprehensive experience with longitudinal venture development,in order to validate the hypotheses of developmental stages. Ruhnka and Young(1987) investigated whether venture capital firms di�erentiated stages in the devel-opment process. Ruhnka and Young (1987) categorized the venture stages amongfour di�erent factors: name of the stage, distinguishing characteristics of venturesin that stage, key developmental goals or benchmarks typically accomplished in thatstage, and the major risks involved.

The venture capital developmental model presented by Ruhnka and Young(1987) consists of five distinct sequential stages, here briefly summarized:

• Seed: Idea or concept only

• Start-up: Business plan and market analysis completed

• Second round/stage: Market receptive, some orders/sales

• Third round/stage: Significant sales and orders

• Exit: Break-even or profitable

Ruhnka and Young (1987) found strong consensus on distinguishing characteristicsof ventures in early stages of development, key developmental goals or benchmarks invarious stages, and major developmental risks associated with each stage. Consensuson developmental characteristics diminished somewhat in later stages.

In the tables 2.1, 2.2, and 2.3 results from the study by Ruhnka and Young(1987) can be seen in-depth. In each category the answers are ordered from top tobottom according to the response rate.

The study made by Ruhnka and Young (1987) omitted influence factors suchas organizational structure, management styles, and control systems for develop-ment. These factors are arguably of major importance for the growth, survival, andfinancial success of new ventures.

The stages that companies pass through during their growth, as illustrated infigure 2.8, are associated with di�erent types of risk. Hence, investor types vary


Seed

Start-up

Second

Third

Exit/bridge

Venture

Characteristics

Ideaor

conceptonly

38,2%

Businessplan

andmarket

analysis

completed

31,2%

Market

receptive,

some

orders/sales

26,2%

Significant

salesand

orders

23,8%

Break-evenor

profitable

21,7%

Nomanagement;

founders/

technicians

only

25,9%

Prototype

under

evaluation/beta

testing

20,0%

Marketingpush

needed

17,3%

Needto

increase

sales/broaden

market

15,2%

Salesvolume

increasing

14,5%

Prototypenot

developed/tested

16,3%

Management

team

incomplete

17,6%

Full

management

teaminplace

13,7%

Company

profitable

ornearly

profitable

14,6%

Needto

improve

balancesheet

forIPOor

sale

13,0%

Businessplan

notcompleted

8,9%

Productready

tomarket,

someinitial

sales

10,6%

Ramp-upin

manufacturing

needed

11,3%

Erratic

earnings/need

working

capitalto

grow

13,9%

Established

product

13,0%

Someinitial

development

done.

Prototype,

market

research

6,7%

Prototypenot

completed

10,0%

Prototype

ready

11,3%

Management

completed/

revamped

9,9%

Additional

product

development

underway

11,6%

Nosignificant

investmentyet

3,7%

Developing

market

strategy

6,5%

Business/

marketingplan

verifiable

6,0%

Product

development

completed

6,6%

Seasoned

management

11,6%

Initial

production

runs

2,4%

Break-evenis

insight

5,4%

Second

generation

product

underway

3,3%

Investor

liquidity

needed

5,8%

Norevenues

yet

1,8%

Business

plan/management

requires

adjustment

4,2%

Ramping-up

production

2,6%

Fiveyears

ormorein

business

2,9%

Needworking

capital

3,6%

Company

increasingly

complex/less

entrepreneurial

2,6%

Growthexceeds

cashflow

2,9%

12-24months

inbusiness

1,2%

Notprofitable

yet

2,6%

Problems

establishing

product/

inadequate

management

2,9%

Companyis2-3

yearsold

2,0%

Buildingsales

force

1,3%

Needtomodify

orreposition

product

1,3%

Table2.1.

Ventu

re

ch

aracteristics

id

entifi

ed

by

Ru

hn

ka

an

dY

ou

ng

(1987)

am

on

g

th

estages.


Seed

Start-up

Second

Third

Exit/bridge

Major

Goals/Benchmarks

Produce

working

prototype

32,4%

Completebeta

testing/get

productready

tomarket

28,8%

Achievemarket

penetration

andsales

goals

40,8%

Achievesales,

growth,market

sharetargets

34,6%

Establish

profitability

forIPO,LBO,

ormerger

56,1%

Market

assessment

25,2%

Makeinitial

sales,verify

demand

23,5%

Reach

break-evenor

profitability

18,5%

Begin

window-dressing

forIPO,

buyout,or

merger

23,4%

Increase

marketshare

14,0%

Assemble

management

team,and

structure

company

20,1%

Establish

manufacturing

feasibility

20,9%

Increase

production

capacity/reduce

unitcost

13,8%

Achieve

cashflow

break-even,

profitability

20,6%

Turnaroundor

salvagethe

company

10,5%

Develop

detailed

businessplan

18,0%

Build

management

organization

17,0%

Buildsales

force/

distribution

system

12,3%

Increase

manufacturing

capacity

7,5%

Diversify

products

10,5%

Initial

production

andmarketing

4,3%

Develop

marketingplan

7,8%

Replace

management/

execute

“get-well”

plans

4,6%

Turnaround

company/

reposition

product

7,5%

Beginmajor

expansionof

company

8,8%

Securefunding

fornextstage

2,0%

Follow-on

productunder

development

3,8%

Introducenew

product

6,5%

Firstproduct

readyfor

market

3,1%

Meetunit

cost/profit

margingoals

3,1%

Tabl

e2.

2.M

ajor

goals/b

en

ch

marks

id

entifi

ed

by

Ru

hn

ka

an

dY

ou

ng

(1987)

am

on

g

th

estages.

28 CHAPTER 2. FRAME OF REFERENCESeed

Start-up

Second

Third

Exit/bridge

Majorrisks

I.Workable

prototype

cannotbe

produced

26,7%

I.Betatests

unsatisfactory/

specifications

notmet

21,1%

I.Founders

arepoor

managers/

inadequate

management

team

19,4%

I.Founders

cannotmanage

formalsystems

25,8%

E.Can’t

increaseor

sustainmarket

share

38,8%

E.Potential

marketnot

largeenough

21,7%

I.Founders

can’tmanage,

can’tattract

keymanagement

17,8%

E.Productnot

sufficiently

competitivein

market

18,0%

E.Inadequate

sales/market

share

20,4%

E.IPOwindow

shuts/can’t

establishexit

vehicle

22,4%

I.Development

delayed,funds

runout

15,0%

E.Potential

market

size/sharenot

economically

feasible

16,4%

I.Manufacturing

coststoo

high/inadequate

profitmargin

12,2%

E.Unanticipated

competition

16,1%

I.Inadequate

management/loss

ofkey

management

18,4%

I.Product

cannotbe

producedat

acompetitive

cost

10,0%

I.Cashused

up,can’t

attract

additional

funding

10,5%

E.Market

notasbigas

projected/slow

marketgrowth

12,2%

E.IPOwindow

shuts/noexit

vehicle

11,8%

I.Eroding

margins/

inadequate

financial

controls

16,3%

I.Founder

cannotmanage

development

10,0%

I.Inadequate

marketing/sales

volume

lessthan

break-even

9,9%

E.Marketing

strategy

wrong/inadequate

distribution

10,8%

I.Cannot

achieve

adequate

profitmargin

10,8%

E.Technological

obsolescence

4,1%

I.Cannot

attract

fundingfor

nextstage

7,5%

I.Product

notcost

competitive

8,6%

I.Excessive

burn

rate/inadequate

financial

controls

9,4%

E.Technological

obsolescence

10,8%

E.Technological

advance/market

shiftmakes

concept

obsolete

6,7%

I.Unanticipated

delaysin

product

development

7,9%

E.Unanticipated

competition

arises

7,9%

E.Market

sector

goesinto

recession/

economyslumps

4,3%

I.Ideanot

goodenoughto

attractrest

ofmanagement

team

2,5%

E.Competition

developsfirst

7,9%

I.Technical

bugshamper

production

5,8%

E.New

technology

obsoletes

product

4,3%

Table2.3.

Major

risks

id

entifi

ed

by

Ru

hn

ka

an

dY

ou

ng

(1987)

am

on

gth

estages.

I

=Intern

al

an

dE

=E

xtern

al.


greatly, in accordance with their risk profiles and the firms’ capital needs, across thecontinuum of actors (Mackewicz & Partner, 1998; Christofidis and Debande, 2001).

Venture capitalBusiness angels

Immediate family and friendsSavings

Banks quasy equityVenture capitalBusiness angels

SubsidiesGrants

Banks subordinated and mezzaine loansVenture capital

SubsidiesGrants

Capital markets high yield bondsStock markets

BanksPrivate equity

Venture capital

Seed Start-up Second-/Third stage Bridge

Fund

ing

need

s

High

Low

Risk profile

Low

High

Type of financing

Early stage Expansion & growth Later stage

Figure 2.8. Company development phases as described by Christofidis and Debande

(2001); Mackewicz & Partner (1998)

During the studies, made by Gompers (1998), high returns were identified by theventure capital industry, due to the surging market for venture-backed initial publico�erings. Also a more beneficial tax reduction on capital gains was introduced.Combined, these two factors led to a dramatic increase in the venture capital com-mitments (Gompers, 1998). The growth in demand for venture capital servicesresulted in changes in the terms and conditions. According to Gompers (1998),both increases in the profits, retained by venture capitalists, and partnership agree-ments, which eased in restrictiveness, could be seen. Implications from a growth indemand for venture capital services are, according to Gompers (1998), substantiallylarger fund raising by the venture capitalists and an increasing pressure to find in-vestments. In turn, this leads to venture capitalists including later stage investmentswithin their scope in order to expand the range of potential investments.

2.5.4 Capital contribution

Costs and benefits

According to Bunduchi et al. (2011), the magnitude of both costs and benefits relieson the process of technological innovation adoption. In the beginning of the tech-nology evolution, the main cost focus is on the development cost, the cost of capital,ethical costs (e.g. privacy and health concerns) and simple direct implementationcosts such as hardware, software and installation costs. However, as the innovationevolves from early adopters to early majority, the cost focus switches towards ini-


tiation costs and both direct and indirect holistic implementation costs in order tocreate awareness (Bunduchi et al., 2011).

A similar change, with regard to benefits, is noticeable when switching fromdirect benefits to indirect benefits. Here, direct benefits account for transaction,production and savings costs while indirect benefits relate more to internal e�ciencyand relations among the supply chain members. (Bunduchi et al., 2011)

Pitfalls from too big investments

“Project teams with too much money may keep going in the wrongdirection for too long.”

(Anthony et al., 2006)

Anthony et al. (2006) highlight the importance of the size of the investments. Withscarce resources, novel approaches may emerge that otherwise not would have beendiscovered. Also, companies that think they are following an “invest a little, learna lot” approach might actually fall into one of the three classic traps: (Anthony etal., 2006)

• Unwilling to kill projects that have fatal flaws

• Commitment of too much capital too soon

• Fail to adopt the strategies even in the face of information that suggests theapproach is wrong

The best way to avoid these mistakes, according to Anthony et al. (2006), is to bethorough and cautious with the investments, which means rapidly answering to theprogress and experiments.

“The problem wasn’t just turning [the experiments] on, sometimes itwas turning them o�.”

(Anthony et al., 2006)

Strategical approaches with capital

Clayton et al. (1999) highlight the importance of not overfeeding new enterpriseswith capital in order to make them grow rapidly. The reason for this is that mostsenior managers of large corporations believe it is an advantage to be in a financiallystrong position when boosting new enterprises. In general, access to capital isconsidered to be a competitive advantage while scarce resources are believed to bean obstacle.


However, lavishing capital does not naturally imply success. Clayton et al.(1999) emphasize that scarce resources is likely to be a success factor when devel-oping new businesses. In the venture capital way of funding, a large focus is onlowering the risk by portioning limited amounts of capital throughout the process.

One major risk with over-financing is that the new enterprises might try to de-velop an entire platform of products, infrastructure, and hire sta� needlessly beforethey have a single successful product on the market. In this way, market initiationis often postponed, which results in a late market validation. Clayton et al. (1999)present an example where General Electric, a company with a traditional corporatemindset, tries to venture a factory-of-the-future. Instead of focusing initially on de-veloping a successful product, the company spends $ 35 million on a headquartersbuilding and fills it with employees.

The venture capital way would instead be to create a single niche winner to actas a start of a platform. An example of this is how Amazon.com’s story of successstarted with a focus in the niche of online book sales, thenceforth attacking relatedmarkets. Thus, a limited amount of capital forces the organization into a coherentfocus on a principal product.

Another complication that too much capital can incur, is a focus on in-housedevelopment. This would imply that the organization may lose the opportunity ofutilizing superior solutions on the market. Also, the organization will expose itselfto all the risk.

A typical milestone-based approach to funding ventures is, according to Claytonet al. (1999), a good heuristic for how venture capitalists should invest when theventure is initiated. Such milestones could be:

• Validation from the market and technology

• Proof of economic viability

• Explosive revenue growth

• Sustained earning growth

The level of capital at each milestone increases as the new business succeeds andthe risk decreases. The exact amount of time between each milestone varies acrossindustries. Prior to market and technology validation, there are phases of idea andteam development, which not incur any investments. It is important not to allowfor funding prior to achieving the milestones, since the need for additional fundingat this stage could be a sign of the business not performing well. Even so, dependingon the risk profile of the venture capitalist, additional funding might be tempting togive in order to not lose the investments made so far, instead of acting rationally andcutting one’s losses and killing o� the project. Furthermore, according to Claytonet al. (1999) it is important to involve the right kind of people and partners in theteam.


2.5.5 Strategic contribution

Bottazzi et al. (2008) argue for the importance of human capital in venture cap-ital and investor activism. According to Bottazzi et al. (2008), independent ven-ture capital firms are more active than captive firms, such as bank-, corporate-, orgovernment-owned. Bottazzi et al. (2008) state that investor activism is positivelyrelated to the success of portfolio companies and that prior business experience isan important predictor of an active investment style among the venture capitalists.

The financing gap of potential businesses has typically been filled early-stage byventure capitalists in developed economies, such as United Kingdom, Canada, andthe United States (Wright and Robbie, 1998). However, when emerging marketsare considered, a fundamental and comprehensive institutional transformation of-ten characterizes the maturing economy (Ahlstrom and Bruton, 2006). Ahlstromand Bruton (2006) address how the di�ering environment, in emerging East-Asianeconomies, and how informal institutions and networks, can tackle the problem withweak formal institutions and what the implications are for venture capital.

Both in emerging and developed economies e�ciency and accessibility to in-vestors are vital. However, in emerging markets, Ahlstrom and Bruton (2006) arguethat venture capitalists need to have a higher focus on employing personal networksin order to carry out needed activities; namely to select, monitor, add value, andsomeday exit. The importance of personal connections and relationships with en-trepreneurs, government o�cials, and customers are likely to be more important inemerging markets. Furthermore, Ahlstrom and Bruton (2006) highlight divergencein the emerging market venture capital practice in several specific areas:

• Less formal institutions can sometimes substitute the weak or lacking of formalinstitutions.

• Informal ties to entrepreneurs and their families act as a tool for monitoring,and allied actors such as customers and the government are linked by personalconnections.

• Informal cultural-cognitive factors often create the requirement for existingrelationships, in order for firms to achieve funding.

• A less regulated and established venture capital industry. Relationships andsimilar institutions are then much more likely to be of greater importance.

The performance of the venture needs to be measured in order to evaluate its success.According to Clayton et al. (1999), it is important not to exclusively measure fiscalfactors, and compare key performance indicators to those of well evolved largecorporations. New businesses are rarely comparable to evolved organizations, sincerevenues and profits could be years away. A relevant measurement could instead behow well the venture has performed at attracting partners and external talents.


“If you find good people, they can always change the product. Nearlyevery mistake I have made has been picking the wrong people, not thewrong idea... Most entrepreneurs have no problem coming up with a

good strategy, but they usually need all the help they can get indeveloping and implementing the tactics that will make them successful

in the long run.”

Arthur Rock

The diversity factor is also important since it highlights that people involved prefer-ably should have experience from creating something new. To employ the everydaysenior manager who is great at handling evolved corporations, or people with similarbackgrounds to investors, is not always the way to go.

“The last half century has seen the emergence of a new model ofbusiness innovation featuring the convergence of entrepreneurs, rapid

technological change, and venture capital.”

(Engel, 2011)

Engel (2011) highlights the importance of strategy as an input to innovation andpresents a model covering the ten key venture strategies, in order to create valueand commercialize innovations quickly.

• Invest In Teams: With a top performing team, missteps could be recognizedand handled early. Ventures often involve the top 1 percent performers.

• Invest In Markets: Large and, most importantly, growing markets should bethe focus.

• Eliminate Pain: Concentrate on real pains and a possible solution to theserather than just enhancements.

• Focus On Customer Development, Not Product Development: Ongoing cus-tomer interaction should complement the product development with the cus-tomer development seen as an interrelated process.

• Dedicate Resources in Stages: Partition the investments and increase them asthe risk decreases when the market is more defined.

• Fail Fast: Kill the risky projects before investing too much capital.

• Speed is Everything: In order to precede competitors, time is the real enemyfor a start-up.

• Pour It On: Once market validation is achieved, more generous investmentsshall be made to boost growth.


• O�er No Lifeboats: Founders should not have the possibility to sell shares tooutsiders.

• Be Always Selling But Never For Sale: The value of a start-up is not reliable.Therefore, to behave as if the company is for sale destroys value.

The essence of these messages is that venture capitalists mainly invest in a teamand a market, with the exception of the bio-tech industry.

“Rarely will you hear a venture capitalist say that he invests principallyin the technology.”

(Engel, 2011)

Engel (2011) emphasizes that most disruptive innovations are a combination oftechnical and business model innovations. Concluding, the importance of marketorientation and rapid-cycle innovations are highlighted. Moreover, venture capitalis a great way for partnerships, collaborations and acquisitions.

2.5.6 Exit strategies

Schwienbacher (2008) shows that more innovative and profitable ventures are likelyto go public than firms with projects of an imitative nature. This can induce anagency problem since the entrepreneur receives private benefits from aiming at anIPO instead of a trade sale; e.g. in the form of staying in control of the company.Therefore, the entrepreneur might choose to favor business and R&D strategies thatmake an IPO more likely. Moreover, this can result in riskier strategies that aimat excessive innovation. Therefore, the fact that venture capitalists want to selltheir share in the businesses they fund – after the R&D stage, might a�ect theinnovation strategies that the entrepreneurs choose to pursue. Thus, it also a�ectsthe outcomes on the product market .

Studies, examining 433 IPOs, made by Gompers (1996) suggested that compa-nies backed by young venture capital firms are younger and more underpriced attheir IPO. Gompers (1996) defines a young venture capital firm as either less thansix years old or if it only has initiated one fund. With regard to the venture capi-talists, the studies by Gompers (1996) suggests that, young firms have been on theboard of directors a shorter period of time at the IPO, holds smaller equity stakes,and times the IPO to precede or coincide with money-raising for follow-on-funds.According to Gompers (1996) these indications of di�erences between young andestablished venture capital firms are consistent with the predictions of grandstand-ing, a formal model first developed by Gompers (1993). The grandstanding modeldemonstrates that young venture capital firms are willing to incur costs by takingthe portfolio companies public earlier rather than wait and maximize the return.The studies made by Gompers (1996) hypothesizes the grandstanding model andsuggests that an earlier IPO depends on the fact that a younger venture capital

2.6. RESEARCH QUESTIONS 35

firm aims to establish a reputation and successfully raise capital for new funds inthe future.

When an IPO, as exit strategy, is considered it is sometimes of interest to un-derprice the shares. Aggarwal et al. (2002) argue that this phenomena is done bymanagers, that usually have agreed to initially waive their right to sell their shares,to strategically maximize personal wealth when selling their shares on the expira-tion date of the lock-up period 1. According to Aggarwal et al. (2002) there hasbeen a historical norm for underpricing shares of about 15 %. However, in recentyears, a new phenomenon has emerged in the form of extreme underpricing. In thecase of extreme underpricing, first-day prices could be underpriced by more than50 % (in some situations). The purpose of underpricing is to create an informa-tion momentum by attracting attention. Hence, shifting the demand curve for thefirm’s stock outwards. This generates higher prices at the lock-up expiration, whenmanagers will have the first opportunity to sell. Underpricing will then generatehigher returns on the lock-up expiration date, thereby a substantial underpricingcan be accepted. Aggarwal et al. (2002) find a positive correlation between a highermanagerial ownership and first-day underpricing in the research made on a sampleof IPOs in the 1990s.

2.6 Research questions

Precedent research has investigated many aspects of venture capital, such as char-acteristics, investment models, and performance. However, few have considereddi�erences in investment models, among the venture capitalists, with respect to theinnovation focus of funded companies. Furthermore, there is an absence of researchcovering the Nordic region. With regard to the hypotheses, presented in section1.1, and the gap in precedent literature, this theses aims to answer the followingresearch questions:

• How are the investment models constituted, in relation to factors identified inprecedent research?

• How are the investment models a�ected by companies positioned di�erentlyalong the CIC continuum?

1The period of time where certain stockholders have agreed to waive their right to sell shares

in a public company

Chapter 3

Method

This section describes how the research was conducted, and why the chosen tech-niques were used. The main research activities supporting the study can be seenbelow.

• Pre-study

• Literature review

• Development of research design with assistance from practitioner

• Four semi-structured interviews

• Interview transcription and coding of the data

• Data analysis

Due to the vastness of the area of private equity in general, and venture capital inparticular, a pre-study was made prior to writing this actual thesis. The purpose ofthe pre-study was to create an overview of the complex venture capital environment,and to identify problem areas worthwile investigating. The the pre-study resulted inthe delimitation to focus on the investment models; hence, these became the mainfoci of the literature review.

The literature review and the development of the research design were donesimultaneously, accompanied with constant feedback meetings with a practitioner,namely David Sonnek–head of technology investments at SEB Venture Capital.During these feedback meetings, it became clear that it would be of interest to relatethe investment models to the adopted innovation focus; also the CIC continuum wasdeveloped.

In this section, the data collection and data analysis will be described in-depthin order to allow for the reader to fully understand the process. The thesis itselfwas gradually developed throughout the entire process.

37

38 CHAPTER 3. METHOD

3.1 Methodology

Under the positivist paradigm, everything origins from theories. Therefore, re-search made today focuses on either explaining or predicting phenomena (Collisand Hussey, 2009). The consensus of interpretivism is that the social reality is as-sumed to exist in our minds. Thus, it is highly subjective and multiple (Collis andHussey, 2009).

Morgan and Smircich (1980) present a continuum of paradigms, where posi-tivism and interpretivism are placed at the extreme end-points. Many new paradigmshave emerged over the years, resulting in that researchers nowadays are less likelyto adopt the pure extremities—such as positivism or interpretivism.

The purpose of this research was not to adopt any of the pure extremities,but instead a paradigm that stems from both positivism and interpretivism, asmentioned above. The approach was to utilize scientific and traditional methods.The empirical evidence was derived from semi-structured interviews, which belongto the positivist end of the continuum. However, the subjective influence derivedfrom the interviews contributed to a slight shift towards the interpretivist end ofthe continuum.

3.2 Sample selection

The sample of venture capitalists included actors involved in the Nordic marketwhose investee companies’ business area lies within the information technology in-dustry. The sample selection was made with assistance and recommendations froma practitioner, David Sonnek, and consisted of four Nordic venture capital firms, asseen below:

• Conor

• Creandum

• Northzone

• SEB Venture Capital

It is worth mentioning that these four venture capital firms represent the major partof the venture capital market in the Nordic area, despite the fact that they onlyare four. What was important, apart from working with a sample representing theNordic market, was to include actors that invest both in business model innovationand technological innovation.

3.3 Data collection

In this study, the chosen approach was to adopt is the interview methodology,targeting a sample of the venture capital population. The purpose of the interview

3.3. DATA COLLECTION 39

process was to collect primary data that could be analyzed, in order to generalizeover the population (Collis and Hussey, 2009). In this case, primary data consistedof interviews targeted directly towards the venture capitalists. These interviewscontained questions investigating the venture capitalists’ investments models, andmore general questions regarding the companies in their portfolios.

Semi-structured interviews were used, meaning that they were planned in ad-vance so that the same questions were asked to all the respondents, similar to howquestionnaires are designed. Also, the interviews were structured in such a way sothat each section was assigned a certain amount of time. This implied that thetotal amount of time for each interview was the same, and that each section re-ceived equal attention by all respondents. However, for each section there was abu�er allocated, with the purpose of acting as a room for deeper elaboration, if theinterviewee had more to add than what was asked in the question.

Since several venture capitalists were interviewed, one set of interview questionswas prepared in order to ask all interviewees the same questions. In order to achievea smilar environment for all the interviews, the venture capitalists were interviewedon-site, in the venture capitalist firms’ o�ces. The interview with the practitioner,involved during the early stages of the study–David Sonnek, was made on the samepremises as all the other interviews, and the interview was separated from the othermeetings. The exact questions in their fullest form can be seen in Appendix A.Therefore, the main areas of interest are only presented briefly below.

3.3.1 Interview areas aimed at the venture capital firms

Every question below is asked with respect to the CIC continuum.

• Portfolio

What kind of companies are mainly invested in; what is their core activity?

• Investment model

– Decision aids in the screening process

What factors are considered in the screening process? How is the processmanaged? Do venture capital fund investors put restrictions on the typesof companies invested in? How does the current economic situation a�ectthe process?

– Risk profile

How does the venture capitalist determine risk; which factors define therisk profile? Is there any correlation between the venture capitalist’s riskprofile and the company type chosen to invest in? To what extent isportfolio theory present in the venture capitalist’s choice of investments?By what other means does the venture capitalist try to reduce risk in theportfolio?


– Preferred investment stage

Does the venture capitalist prefer a specific investment stage? Does theinvestment stage vary within the venture capitalist’s portfolio? Is thereany correlation between the investments and the company types chosen?

– Capital contribution

How is capital deployed over time during the investment process? Isthere any correlation between the timing of capital contribution and thecompany type? Are di�erent guidelines used for capital input dependingon the company type?

– Strategic contribution

Apart from capital, what strategical capabilities are added/invested?

– Exit strategies

Which is your preferred exit strategy? Is there any correlation betweenthe preferred exit strategy and company type?

3.4 Data analysis

In order to collect as much primary data as possible, the interviews were recorded.These recordings were then transcribed into documents, which were interpreted withrespect to each area and question. The two authors interpreted each interview in-dependently and made conclusions only when the same result was achieved in orderto ensure objectivity; thus minimizing the possibility of skewness in the analysis,and enhancing rigidity.

The qualitative empirical results derived from the interviews were analyzed withrespect to their content. The content analysis aimed to identify shared coding unitsamong the respondents, in this case words or phrases. Conclusions were drawnwhen actors shared similar investment approaches and answered the questions withthe similar words or phrases; e.g. emphasizing the same coding units. The twoauthors validated the similarities independently.

The interpretation also consisted of summarizing the information from the in-terviews and grouping it into appropriate sections for easier analysis. Then, itwas aggregated in order to draw broader conclusions regarding the venture capitallandscape. The answers were derived from the two main sections in the interview;questions regarding the portfolio and questions regarding the investment model.These two sections were then merged into the following sub-groups: the screeningprocess, preferred investment stage, risk profiles, capital contribution, strategic con-tribution, and exit strategies. Thus, the approach was deductive in the sense thathypotheses were proposed which then were compared with the observed processes.However, here was also an inductive element where the observed processes resultedin patterns (Trochim and Donnelly, 2006).

3.4. DATA ANALYSIS 41

3.4.1 Reliability

According to Collis and Hussey (2009), in order for a research result to be reliable,the study has to be reproducible and give the same result. It is also important torealize that reliability is of varying importance depending on the type of study thatis being carried out. While positivist studies tend to have a high reliability, thoseunder an interpretivist paradigm tend to put less weight on reliability due to thevery nature of interpretations. Since qualitative studies not have to be reliable inthe same sense that positivist studies have; the focus is instead placed on whetherthe interpretations of the observations can be explained and understood. As aconsequence of interpretations a�ecting the research results, replication is thereforehard to achieve in a positivist sense. Thus, protocols and procedures are of greatimportance in order to establish authenticity of the findings (Collis and Hussey,2009).

In the study conducted in this thesis, the reliability is considered to be highsince a researcher using the very same questions hypothetically could repeat theinvestigation and ask the same companies and persons; hence it would be possibleto extract similar data if the same method approach was used. Also, a third partycould re-analyze the recordings and transcriptions, by a content analysis approach,and come to similar conclusions; thus, keeping a high level of reliability. Since thestudy is time-dependent, the latter approach would be more appropriate in orderto render the same results.

3.4.2 Validity

Validity describes how accurately the research findings reflect the phenomena beingstudied. Put in another way, it reflects whether the measurement actually measureswhat is intended to measure.

While it might be challenging to achieve high validity in a positivist study, dueto a bigger focus on accurate and reliable measurements, interpretivists instead tryto gain full access to the knowledge and create a more coherent understanding of acertain phenomenon. Therefore, the interpretivist paradigm consequently involveshigh validity (Collis and Hussey, 2009).

By interviewing several venture capitalists, validity is considered to be high.However, there is no way to know for certain that the answers, regarding the venturecapitalists’ investment models, actually describe their true models used. Further-more, they might not be able to accurately describe their own practice in words.

As described by Kollmann and Kuckertz (2010); Shepherd (1999), earlier ven-ture capital studies occasionally received critique for the retrospective approachtaken to research; e.g. by constructing questionnaires or interviews regarding pastdecision processes. The validity has then been questioned since these studies relyon retrospective self-completed questionnaires instead of authentic observations ofthe decision processes. These methods can result in that venture capitalists de-scribe how they believe they decide, instead of describing how they actually reach


decisions. In general, venture capitalists tend to over-stress criteria irrelevant tothe day-to-day decision making while leaving out significant criteria concerning theprofitabiliy and survivability of a company. Therefore, the validity is at risk sincethe phenomenon being studied not might be described accurately.

As mentioned in the problem formulation, in section 1.1, the pre-hypothesisHP 1 is used as if it were true in this thesis. However, the pre-hypothesis wasvalidated to a further extent by establishing face validity during interviews withthe practitioners; implying that it seems to make sense and to be valid (Salkindand Rasmussen, 2007). Based on that, the hypothesizes H0 and H1 were able to betested.

3.4.3 Generalizability

Generalization concerns the field of applying research results to cases or areas be-yond the situations examined in the study. One example is to draw conclusionsbased on a small sample and apply the results on the entire population. Therefore,in research done within the positivist paradigm, it is of interest to determine howconfident one is regarding the characteristics of the sample in the context of theentire population. This is often done through statistical analysis as described byGummesson (1991), but this is only one out of several approaches. On the otherside of the spectrum, within interpretivism, it could be possible to generalize fromvery few cases or observations, if the underlying interactions and characteristics ofthe phenomenon being studied have been captured. This naturally requires a deepunderstanding of the theories, concepts and patterns that constitute the foundationof the field (Collis and Hussey, 2009).

Since previous research concludes very di�erent results, due to the varying natureof the venture capital landscape, the conclusions drawn in this thesis might not begeneralizable to other industries or regions. However, as mentioned earlier, thechosen sample represents a major part of the Nordic venture capital market; hence,enhancing the possibility of generalizing if the Nordic market is considered.

Chapter 4

Results

This section starts out by briefly presenting the di�erent profiles of the interviewedcompanies. Afterwards, the results are presented by dividing the data into thedi�erent factors of the investment model. The results are presented separately foreach company, in order to achieve higher objectivity by minimizing the e�ects ofinterpretation; thus, not aggregating the results from several actors at this stage.

4.1 Company profiles

Common for all respondents in this study is that their investments are technology-focused, either towards fundamental technology innovation or technology relatedbusiness model innovations. Investments can also target objects whose character-istics typically involve a combination of the two, as described by the companyinnovation characteristics (CIC) continuum, defined in section 1.1.

Northzone is a venture capital firm that makes investments targeted at bothextremities of the continuum. However, according to Northzone, recent trends inthe venture capital industry seem to be towards a more comprehensive businessmodel innovation focus. Nowadays, the IT infrastructure is developed enough thatcustomers, familiar with the Internet, support business model innovations such ase-commerce and cloud services etc. Thus, the power of the current infrastructuremakes the timing perfect for business model innovation investments.

SEB Venture Capital’s portfolio di�ers slightly from its competitors on theNordic market, since it mainly is focused on fundamental technology innovations.A few investments have been made within business model innovation, where mostof them are located somewhere in the middle of the CIC continuum; thus, having atechnology-focused influence. The reason as to why SEB Venture Capital, comparedto its competitors, have chosen a major focus on fundamental technology innova-tions is because the competitive environment has become tougher in the businessmodel innovation segment. Thus, possessing a more di�erentiated position in thetechnology innovation segment make them stand out from the crowd, resulting in acompetitive advantage.

43

44 CHAPTER 4. RESULTS

Initially, when the Creandum fund was created, the strategy was to invest inearly-stage high-tech companies. Therefore, between 2003 and 2006, 10 investmentswere made within that particular segment. Out of these, the biggest company hadrevenue of 3 MSEK at the time of the investment; thus, very small and technolog-ically focused firms were chosen. Back then, the fund investors were mainly con-cerned with questions such as to what extent there existed new technology, patentsand how long the technological advantage would last. However, the strategy hassince changed, and the aim is now to invest in the best entrepreneurs; regardless ofwhich underlying aspect that generates value. This has resulted in a shift towardsinnovation within the companies’ business models, instead of within technology, andalso a move towards later stages of investment.

Conor mainly focuses on investments towards technology-focused innovations.This higher level of innovation gives a competitive advantage, beneficiary whensmall actors take on local and international markets, according to Conor. A smallcompany on a new market has several operational disadvantages. Thus, with ahigh level of innovation in the form of a fundamental technology, such an advantageis believed to compensate. However, there is nothing that formally restricts Conorfrom adopting an approach more towards business model innovation, optimal wouldbe to include everything.

4.2 Investment models

The empirical results, with regard to the investment models, are categorized amongsix main categories, and could be seen as the main areas constituting the invest-ment models. The six categories also relate directly to the research on investmentmodels, in the frame of reference, and aims to connect the catergories with the CICcontinuum. Among the categories, the empirical results from each venture capitalfirm is presented separately.

4.2.1 The screening process

Northzone

The screening process is constituted of three important factors, according to North-zone; presented below in descending importance:

• Firstly, the people behind the potential investment object is analyzed. Dothey possess star quality, drive, knowledge and ambition to succeed with theircompany?

• Secondly, the market is considered. How big is it? Which other actors exist?How big is the window of opportunity?

• Lastly, the product or service is considered. Since the product/service is easierto modify than the team or the market, it has less priority initially.


When the companies that seek funding present themselves, they typically use areversed order; compared to the screening priority mentioned above by Northzone.These firms usually forget, or barely mention, the team behind the company.

An appreciated factor in the screening process is also the ability to scale inter-nationally. Northzone has vast experience from taking firms globally, with partnersspread around the world, and is always tempted by a company that has proven tosucceed in the home market and simply need financial power and knowledge in or-der to expand globally. Also, international scalability is often a deal-breaker whichallows for an investment to be profitable.

Another factor relevant for the venture capital firm during the screening process,which might be overseen by the entrepreneur, is the overhead cost of distributing.Some products may be inexpensive to produce, but the cost of selling and marketingit can be “horrific” (e.g. business software). On the other hand, there is Spotify,which still not has spent a single penny on marketing, and the company has almostno costs related to attracting new customers.

According to Northzone, the venture capital screening process is standardizedto a certain extent. In other words, there is a best practice in use. However, itis important to distinguish between their processes and a fully structured process,most likely to be found in a strictly controlled research lab environment. Venturecapitalists are business people where feeling, guts and experience count as much asthe quantitative analysis.

Northzone emphasizes the importance of avoiding principles when selecting in-vestment objects for the portfolio. They refer to an interview, made by Burlinghamand Gendron (1989), with Steve Jobs and his famous quote:

“You can’t just ask customers what they want and then try to give thatto them. By the time you get it built, they’ll want something new.”

(Steve Jobs, 1989)

In order to spot new innovations, it is important to stay open-minded. Therefore,it is impossible to have fixed parameters of what investments should be targetedtowards when looking for new opportunities. This is especially important whenconsidering that the investment objects might o�er products or cater to needs thatcustomers not yet are aware of. However, Northzone asks core questions whenselecting investments which, as mentioned above, involve both technology-focusedinnovations and business model innovations.

Apart from the actual screening priority list, Northzone acts in a fund structurewhich puts a few underlying requirements on the fund from its investors; in orderto make the portfolio well-diversified. Thus, the investment objects need to haveharbor di�erent characteristics, be in di�erent maturity stages, and have di�erentrisk profiles in order to create a balanced portfolio. Therefore, entrepreneurs areturned down if the proposed opportunity clashes with a few of these diversificationrestrictions on the portfolio; even though it might be a great company. This may


be due to a skew risk balance in the portfolio or longer time to commercializationthan the fund allows. However, exceptions can be made if the entrepreneur presentsan exceptional idea.

According to Northzone, there are no formal explicit restriction on the fund, andthe fund investors are not involved in any investment decision. However, implicitly,there are underlying requirements that make Northzone avoid anything that “notis good for you”; such as gambling, tobacco companies etc.

With regard to the screening process and the macroeconomic environment, thereare two sides to the problem. From the entrepreneurs’ perspective, they are encour-aged by Northzone to not care at all.

“We tell our entrepreneurs to ignore the economic trajectory, because itwill ignore them.”

(Northzone, 2012)

From the perspective of the the venture capital investor, the macroeconomic situa-tion plays a major role, especially when considering fundraising. Today, the marketis reflected by high beta values, in other words high volatility – governmental bondsincluded. Also, investors are concerned with liquidity. However, liquidity is some-thing venture capitalists cannot o�er, compared to liquid assets on the stock marketwhere a professional investor easily can get out of a position. This implies that pro-fessional investors are dedicating capital on a long-term basis when choosing theventure capital option. However, the investors don’t need to take decisions actively,which may be appreciated.

SEB Venture Capital

SEB Venture Capital states that, during the screening process, the actual technologyor business model innovation is of most importance, in other words the productor service itself. Secondly, the market is examined and especially the industrialrelevance and scalability opportunities. Industrial relevance is especially important,since investments mainly are done in business-to-business companies. Questionsthat also are considered during market examination could be:

• Who will use it and how many?

• Why use it?

• How will it be distributed?

• How will it be marketed?

The team around the innovation is not screened explicitly, but rather seen as ahygiene factor ; an investment based simply on a great team is never an option. A


hygiene factor is considered to be the primary cause of unhappiness on the work-place; whereas motivators act as the primary cause of satisfaction. Hygiene factorsthat are extrinsic to the job include: company policy and administration, super-vision, interpersonal relationships, working conditions, salary, status, and security(Herzberg, 2003).

The ability to commercialize an innovation globally has a major weight in thescreening process, and is often a prerequisite; especially if the innovation has atechnology focus. This is important since a global commercialization might benecessary in order to simply reach break-even; thus, covering the commercializationprocess costs. A business model innovation, on the other hand, can sometimes becheap enough to be profitable on a local market.

SEB Venture Capital avoids investing in technology that is far from commer-cialization, thus time-to-market is a critical factor. The optimal case is when acompany already has initiated its commercialization process.

The screening process is seldom completely ad hoc-adjusted, certain factors ex-ist, rooted in the company culture, that form a best-practice process. In otherwords there are certain guidelines that constitute the screening process and the duediligence.

Since SEB Venture Capital is a bank-owned venture capital firm, it has some in-vestment restrictions inherited from its owner. All investments made have to repre-sent something that the entire organization can be a “proud owner” of, and typicallythe investments have the same underlying restrictions as an ethically bounded fundhas. However, with business model innovations, it is easier to move into somewhatof a gray-zone. Thus, it sometimes implies tougher considerations.

With regard to the economic climate, the guideline is to invest in technologythat would be relevant, regardless of the current macroeconomic situation. A ratherpessimistic view of the macroeconomic situation is adopted, implying that therealways will exist bubbles in the marketplace; currently there is one within the spaceof Internet-based business models.

“Currently companies, such as Spotify, are driven towards marketdomination rather than profitability, on an extremely high level of risk.”

(SEB Venture Capital, 2012)

The purpose is neither to adapt late nor to predict the bubbles. Thus, the focusis on macro-independent technology. However, there is always the belief that sometrends, rather than bubbles, are expected to persist. Those trends naturally a�ectscreening processes.

Creandum

When evaluating a potential investment, several factors are evaluated; e.g. in thecase of Spotify, vital factors included whether the company could transform the


market, and sign contracts with the biggest players within the industry. Thus, thetechnology was not the critical aspect.

The main factors taken into consideration are the team, the market and theinnovation. Moreover, it is critical to be able to obtain new customers quickly at alow cost; such as the case with Spotify – a low marginal cost for customer attraction.

Furthermore, both the innovation and the team has to be A grade, it is notpossible to have an “A team with a B product”. A company’s o�ering should bebetter, or preferably even “much better” than the competitive o�erings.

There is an awareness that not all companies in the portfolio will perform great,hence the companies that succeed need to become huge. As a guideline, Creandum’sownership in a company has to be able to reach a valuation of a few of hundredMSEK, which results in a non-investment in many, otherwise potential, opportu-nities. A prerequisite for achieving this target valuation is scalability, which ofteninvolves international expansion. However, what happens in most cases is that thepotential market turns out to be smaller than required, which then prevents aninvestment. Simply put, very few companies in Sweden or in the Nordic regioncan achieve a valuation of a few billion SEK by only addressing the local market.In turn, the required valuation is derived from the required return on investmentmultiple which lies in the range of 10-50.

Consolidation within a particular business segment usually occurs among the toptwo-three firms. If these are American companies, it is usually not enough to buildthe biggest company in Europe, since the acquiring companies not will be interestedin paying a high price. However, it is usually not a “clear cut” since it is di�cult todetermine these conditions; sometimes it still might be worthwhile. Apart from theabove stated factors, time-to-market is extremely critical. It is simply not possibleto “sit and wait” for a product to be ready based on an assumption that someone,somewhere will buy it.

Together, these factors make up the best-practice used by Creandum in order toevaluate potential companies in the screening process. However, everything is notblack and white; sometimes there are companies that not “tick all boxes” but thatstill are interesting.

The companies that make it through this initial phase are put on a Hot List.Out of the approximately 500 companies that are evaluated each year, 10-15 areHot Listed. They are then o�ered a term sheet with the contractual conditions,followed by a due diligence. In the end, only 3-5 investments are made per year.

Even though some companies might appear very interesting, there are formal re-strictions on the fund, due to moral and ethical reasons. Since 95-97 % of the fundingcomes from pension funds, and also from American funds with strict requirements,Creandum is prevented from investing in gambling, arms and genetically modifiedfoods and crops.

In order to communicate a clear focus, and to achieve an edge in the venturecapital marketplace, Creandum has decided to not invest in life science (e.g. drugs),medtech and energy (i.e. oil & gas). This way, a narrow focus is achieved thatcommunicates that Creandum is the best suitable partner to team-up with for the


entrepreneurs. It also creates a profile that is credible for the fund investors; e.g.the pension funds.

A final remark is that there is a big gap between academic research and commer-cialization. When academic spin-outs state that a product is ready, it is often farfrom a product in the sense that it is commercially sellable. Generally, it is di�cultto make these ideas “take-o� ” due to the lack of inherent scalability and the timeit takes to create a product that is possible to sell.

Conor

Conor mainly looks for two di�erent cases in the screening process; either the inno-vation has to address a large actual problem on an existing market, or the innovationhas to address a new market. Regardless of the scenario, the problem has to be ofsu�cient magnitude in order to create a foundation large enough to build a companyfrom. To address a new market is riskier since, apart from a relevant innovation andbusiness model itself, the timing has to be right as well. A worst-case scenario wouldbe to run out of capital when the timing is correct, creating lucrative possibilitiesfor new investors to acquire the remains of the company cheaply.

Another major factor in the screening process is that the innovation itself hasto grow faster than linear. In other words, the product or service is not allowedto require large overhead costs in the form of personnel, implying that a turnoverexpansion always is preceded by an equal expansion of the work force. A lineargrowth such as the one described above will, in the end, produce a weaker re-sult than expected due to the concept of decreasing marginal utility (Giavazzi andAmighini, 2006); therefore, linear growth is not accepted. Furthermore, the level ofbureaucracy and overhead is assumed to increase along with the scaling.

“In reality it will become worse than linear, because employee number500 is not as good as employee number 50.”

(Conor, 2012)

International scalability is of great importance in the screening process, since 99cases out of 100 are intended to expand outside of the local market, making ita deal-breaker. Therefore, it necessary to evaluate the viability, timing and risksassociated with an international expansion; shall the company initiate the growthfrom day one or shall it wait a few years down the road? Moreover, there are severalreasons as to why only companies with the potential of a global expansion would bepreferable; e.g. that the costs implied by technology-focused investments implicitlyimply that the Nordic market is too small to make them profitable. Moreover, it ishard to imagine a product that would be suitable exclusively for the local market;with the exception of being tightly consumer-related.

However there is only one major reason as to why an investment in the commer-cializing of products or services in the native market could be well-suited. This has


to do with a pre-defined exit strategy; global actors are assumed to, in an integra-tion race, buy smaller established companies rather than to set up local businessesfrom scratch. In that case, the downside is that the acquirer mainly is interestedin the consumer base and the turnover; not necessarily the company in its entirety.Therefore, aiming to build a company with the mindset of later becoming acquired,in this manner, is considered to be a risky strategy.

The customer base is an important factor that is highly valued during the screen-ing process. Therefore, in order to de facto evaluate an investment object, it is vitalto contact customers – or potential customers, despite the fact that a final productnot yet is available. It is only through a dialogue with existing customers thatConor can obtain a general view regarding the experience related to a product orservice, and then assess if it is suitable for the market. Theoretical analysis and astrong self-conviction simply cannot compensate for the lack of customer reflectionsand thoughts.

However, there is one type of business model innovation that typically is avoided;those who use a temporary opportunity window, often caused by a skewness in themarketplace due to the inertia of major players. One such example is the segment ofmobile payment solutions, where small companies utilize the absence of inexpensiveand flexible mobile solutions among the big players; typically a mobile phone isthe only prerequisite. However, the reason as to why the big actors on the marketcharge more is typically not based on higher production costs; it is simply a matterof profit maximization, which they get away with since there initially are no cheaperalternatives. If the big players choose to make a move against these new actors,they have such a vast customer base that economies of scale still will maintain theirprofitability.

“If any of the big actors responds quickly enough, they will simply usetheir billion dollar muscles and crush you.”

(Conor, 2012)

If the big actors decide to close the temporary window of opportunity, there is noPlan B. Thus, once again highlighting the binary risk attached to business modelinnovations.

With regard to the two di�erent extremities on the CIC continuum, the maindi�erence is considered to be time-to-market, where a technology focused innovationis allowed to take longer time. However, this is not considered to be a deal-breakerin the screening process. Even if a business model innovation may seem attractivewith a potentially less expensive and faster process, it is not preferred over a tech-nologically innovative company. Regardless of the company type, the complexityand risk of commercializing a product or service is assumed to be the same, due tothe importance of understanding the surrounding ecosystem and its value chain.

The screening process is standardized to a certain extent, such as to specifictollgates. However, a certain amount of gut feeling is always present, especially


during the initial screening process when evaluating the team behind the innovation.During this process, the importance of the team is emphasized.

“In contexture, a certain level has to be reached and one thing cancompensate another, but there is nothing that can compensate for a

totally incorrect team.”

(Conor, 2012)

There is always the possiblity of completing a team, but the ground has to besu�cient enough to build on in order to engage in the executive team.

However, some restrictions exist in the screening process, both defined inter-nally and externally. Internally, choices are self-made in order to avoid biotech andmedtech. However, there are companies in the portfolio that develop technologyused in the drug industry; but in that case the customer could be anyone in needfor semiconductors. External restrictions exist as well, from the fund investors, thatprohibit from investments e.g. in the weapon, tobacco, and gambling industry.

Lastly, the e�ects of the macroeconomic environment are highlighted. Optimalwould be to invest as much as possible during a weak economic climate, when thecompetitive climate is beneficial. Thus, the investments could be made at a low cost.However, raising funds in a weak economic climate is more complicated due to theunderlying mechanisms and psychology among the fund investors. Mechanically,there are prohibitions from allocating more than a certain quote in private equity; aweak economy would imply that the nominal value of the allocations would be lessthan in a strong economy, since the total nominal value of the portfolio then wouldbe greater. Thus, resulting in even smaller investments in private equity to avoidover-allocation. Psychologically, fund investors, such as a pension funds, believe itis safer to invest in interest bearing funds during a weak economy.

4.2.2 Risk and portfolio

Northzone

Northzone defines two main categories that investments are targeted towards: game-winners and game changers. A game-winner is typically a company that not possessa unique position on the market; instead it can obtain the quickest growth among theactors. Furthermore, such a company is on the move already, has a well establishedexecution process, is growing, and has customers as well as a working businessmodel. The intention with the investment is to increase the financial capabilitiesof the company in order to grow more rapidly. The financial factor is especiallyrelevant due to the window of opportunity; thus, it is needed in order to make aquick move before the competitors have a chance of reacting. Fulfillment of all othercriterions therefore becomes obsolete if the company cannot finance to react to theopportunity.


A game-changer, on the other hand, is typically a unique actor that changes anentire industry; in a disruptive manner. The way Spotify changed the way peopleconsume music, and how artists are paid, is a great example of a game-changer; ita�ected the entire value-chain. Spotify also used a new business model innovation,which was vital since the technology behind it not was unique; it was simply utilizedin an e�cient and e�ective manner. Both game-winners and game-changers arepresent in the CIC continuum of investment objects.

With regard to risk, Northzone categorizes investment pospects among threethree dimensions seen below:

• Technology risk: Concerns the technology behind the product or service (e.g.its competitiveness or uniqueness). Time-to-market is considered to be themost critical factor, where many companies fail to adapt to the window ofopportunity.

• Business model risk: Concerns whether the product or service can be prof-itable as well as consumer behavior (e.g. willingness to pay and buy again).Consumer behavior is the most di�cult factor to evaluate, since human natureand “what is going on” is hard to concretize.

• Execution risk: Concerns problems with the responsible people and their ca-pacity.

These three risk categories are judged and quantified on a low-to-high scale, wherethe judgment naturally relates to the required return on investment multiple. North-zone states that a low-risk profile typically requires a multiple of only 5, whereas ahigh-risk profile typically requires a multiple of roughly 25 in order to be justified.

As mentioned in section 4.2.1, risk diversification and reduction are vital factorsfor the portfolio. During the beginning of the 21st century, many venture capitalfirms did not diversify their portfolios, and only made homogenous investments(e.g. only early stage mobile technology). The e�ect of a misjudgment then hada severe impact. As mentioned in section 4.2.1, Northzone tries to diversify andminimize risk in their portfolio by investing in game-winners and game-changers;in di�erent stages and markets. By doing this, the company reduces exposure tosingle segments, and also reduces the liquidity problems mentioned in section 4.2.1;since the time to commercialize the investments will vary. This results in exits beingspread out over time, where the first one typically occurs after three to four years.This contrasts with early venture capital funds, as illustrated by the quote below.

Early venture capital funds were perceived as stating:“Give us capital and then we will see what happens in 10 years.”

(Northzone, 2012)


Another measure taken in order to reduce risk is to engage in investment syndicates.In this way the funded company will have a stable owner base with more resourcesattached, which reduces the risk exposure for the other investors as well.

SEB Venture Capital

Risk is generally considered to be the probability of losing money, which is espe-cially crucial on a portfolio level. SEB Venture Capital is probably more risk avertthan many other actors in the industry, based on the fact that investments rarelyare made if the outcome has a high probability of turning out zero. The aim istherefore to make investments that create fundamental company value, such as acore technology, acting as a lower limit for the return. Thus, SEB Venture Capitalavoids investing in companies that potentially could turn out to be worth nothing.

As mentioned in section 4.1, the majority of the SEB Venture Capital portfolioconsists of technology focused companies, in contrast to those of competitors. Whileother venture capitalists have become more avert when it comes to technology risk,SEB Venture Capital states that their unique selling proposition is the ability toevaluate the technology related risk and distinguish between “good” technologyinnovations and “bad” ones. Thus, keeping a majority of the investments in thisparticular category. Competitors, however, are abdicating the technology focusin favor for an increased exposure to market related risk, which simultaneouslyeliminates technology risk.

In order to decrease the risk furthermore, a diversified portfolio approach isadopted. Typically the highest returns are smoothed out by using diversificationthrough various yield and risk profiles. Moreover, the portfolio is diversified withrespect to di�erent industries, customer segments, and business models. However,the industry diversification can sometimes be slightly disregarded from, if synergye�ects could occur in the portfolio as an e�ect from doing the investment; thesynergy itself will then decrease the risk.

Another aspect to risk minimization is syndication, which is preferred comparedto being the sole investor. Apart from a more stable owner base, syndication alsoimplies extended managerial and financial capabilities.

The risk profile chosen by SEB Venture Capital is designed to generate a returnon investment multiple of around 3-5. In rare cases, a multiple of 10 can be achieved,the so-called “home-run” factor. However, the portfolio theory approach aims togenerate a residual value of at least 70 % of the initial investment, despite anycombination of external factors. Since the venture capital portfolio is included inthe bank’s overall portfolio the return on investment requirements are di�erentthan those of pension funds. This is due to the nature of the pension funds, whichtypically have a heavily weighted exposure to governmental bonds and debt, as wellas listed assets. Thus, it makes the pension funds more absorbent to minor, withrespect to portfolio quota, losses in private equity.


Creandum

Risk is generally not considered to be a problem as long as the potential upside isbig enough; with a return on investment multiple in the range of 10-50. There aretwo areas of risk that Creandum not is keen on financing though; team risk andtechnology risk. Regarding the former, if one or several key individuals initially needto be replaced, an investment is not made. Simply put, it takes too much time andresources away from the core activities. As for the latter, prototypes that “simplyhave to be validated on a larger scale” or “need to be created in hundreds or hundredsof thousands” harbor great amounts of uncertainty and are inherently too risky tofinance. The risks that do receive financing are mainly market risk and scaling.Naturally, as the risk goes down, so does the return on investment multiple; later-stage investments seldom o�er a 50 multiple. However, the traditional valuationbased on the technological advantage can sometimes be applied in order to achievethese levels, but it is continuing to become increasingly obsolete.

In order to decrease risk, several approaches are used. Even though Creandumsometimes is the sole investor, syndicates of international investors are commonlyused. Moreover, business angels are often invited to join in the investment andpossibly also take place on the board of the investee company. Thus, it is both away to decrease risk and a way to allow for better scalability, by inviting externalpersonnel that can assist in the process.

The general investment profile is split into three buckets: consumer, softwareand hardware. After learning from earlier mistakes and then shifting the investmentstrategy, 5 % is at maximum put into hardware. However, early consumer roughlyrepresents 30-35 % of the investments. This is a natural result since value can becreated early in consumer products, compared to that of hardware. Unfortunately,in hardware, there is a risk that no value will be created at all during the entireinvestment period. This is a problem since follow-up investments usually are madewhen the value of the company can be proved to progress; the initial investmentis made on one level of valuation, and the next investment should be made on ahigher level of valuation. Compared to when the fund was initiated in 2003, moreenergy is spent on understanding the underlying value creation process, as well asthe required time and capital requirements on a deeper level.

Apart from the above stated three buckets, diversification is done by investingall the way from early-stage to later-stage. However, there are not thousands ofpotential investments available; thus, if a very attractive investment object surfacesthat not exactly fits into the portfolio strategy, it might still receive funding. Con-clusively, the portfolio ideology is more of a guideline than something followed verystrictly.

Conor

Risk is defined among four di�erent categories, as seen below, and is evaluated ona low-to-high scale.


• Technology risk

• Business risk

• Ecosystem risk

• Team risk

There is no precise correlation between the assessed risk and how large the returnon investment multiple has to be.

The purpose of the risk evaluation, apart from residing in the investment processitself, is to assess weaknesses and make up a plan for the future. Furthermore, itaims create a coherent picture of the entrepreneurs, prior to making the potentialinvestment, which is of great importance to do. Thus, it contributes to minimizingthe operative problems that could be faced when the process is initiated. The planis to address the nearest future, but it is also critical to ensure that the commonlong-term vision for the company is shared by the entrepreneurs as well as theinvestors. By doing so, it decreases the risk of conflict when the plan eventuallyfaces problems.

In order to decrease risk, to a further extent, there is always a portfolio diver-sification approach present when the investments are made. For instance, diversi-fication is made with respect to the risk profile of the investee companies, severaldi�erent industries, and also with respect to the investee companies’ current tra-jectory. Furthermore, Conor’s technology-focused approach serves the purpose ofreducing risk by aiming to invest in companies that create the underlying technologyfor many business model innovations and business-to-consumer innovations. Thisis exemplified with one of the portfolio companies that delivers technology to otherstart-ups aiming to develop the next generation of social services. It is unlikely thatmore than a few of these will survive, but the technology will then be relevant forthe few that do succeed. The optimal case is when technology is targeted not onlyto companies within the same industry, but within di�erent industries. In the abovementioned case, the o�ering was a database solution, which equally well could beused in several industries; such as in the telecom or insurance industries. Thus,implicit diversification is possible to achieve through one single investment.

By diversifying into di�erent industries as well as di�erent investment stages,the risks are generally lowered. Therefore, the aim is to avoid investing in two verysimilar types of companies. Firstly, there is a risk of the companies competing.Secondly, they are part of the same ecosystem, which means that they have tosell to similar customers and face similar risks in the marketplace. Therefore, arequirement is to at least invest in di�erent stages; even if the company per seseems interesting, it will generally be refused funding.

Since the venture capital funds have a limited life span, the investments haveto be strategically made in order to fit the companies; an early investment is oftenmade during the first years of the fund, since it normally takes between five to sevenyears for companies to mature enough to exit. After these investments have been


done, the later-stage investments are made which require shorter time to mature.When the fund closes down, the capital has to be returned to the investors, whichmeans that all companies have to be exited by then.

The early stages of investment will generally be expected to result in a 10-20 return on investment multiple while the later stages average around 2-3 timesthe investment. This has to do with the fact that risk goes down as companiesprogress. There are exceptions however, such as when Google, Microsoft or Appledecides to pick up a small company, due to the fact that they have developeda critical component that is needed. However, the investment model cannot bebased on such assumptions; “if it happens, it is like a jackpot.” Many venturecapitalists learned this the hard way, in the crazy era of ’99-’00, when many venturecapital business models were based on investee companies developing a brilliantinnovation, and then “someone throwing billions at them.” However, there was noplan B. Therefore, companies have to be built with the goal of surviving withoutbeing acquired, which minimizes the risk. This strategy might be more costly, butit is certainly better than a possible bankruptcy.

However, for big companies looking to acquire technology, there is seldom aninterest for functions such as sales, logistics or likewise; they simply want to buy theinnovation. In such cases, the technology is only meant to be integrated into a largermachinery of sales, logistic and production, which can be done more e�ciently andcheaper than that of the competitors. Therefore, the acquired companies themselvesare not worth much to these kinds of buyers; value is driven purely by technology.There is another case though, for companies trying to expand into another region;for these types of companies, complete organizations can be of great value.

Generally, when making investments, investor syndicates are used in order toreduce risk. However, it is directly related to the required need for capital during thelifespan of the investment. If the company will need large amounts of money startingfrom day one, a syndicate of investors will be used in order to secure future capitalinjections. The first investment is aimed to last for approximately 18 months, inorder to achieve a few well-defined goals that will increase the value of the companyfor the next-coming investment round. Herein, new investors are always preferredsince they come from outside the process and propose a company valuation almostas if “the market has spoken.” However, if the goals are not met, it will be di�cultto attract new investors, which highlights the importance of fellow investors fromthe beginning in order to ensure another round of funding.

Within the venture capital industry, there is a fondness for using milestones.The problem is that they inherently contain risk if used inappropriately. It is verydi�cult to predict market conditions in advance; thus it is especially risky to steertowards a milestone that possibly is outdated when reached. If investors use mile-stones as a mean of assessing whether additional funding should be granted or not,companies might become too obsessed with achieving milestones; instead of pursuingwhat the market currently demands. Historically, this has indeed happened, sinceinvestors rarely change their mind. This puts the entrepreneurs into an awkwardposition of pursuing outdated milestones, simply for the sake of further investment.


When analyzing companies oriented towards business model innovation, the crit-ical aspect is how easily it would be replicated. A risk within this field is mostlybinary, which is why capital only is allocated for one or two out of three companies;if they cannot prove themselves with the first capital injection, they will be termi-nated. Generally, planning is not done to a greater extent, ahead of time, for futurerounds.

4.2.3 Preferred investment stage

Northzone

With regard to the five di�erent company stages defined in section 2.5.3, Northzoneavoids the seed stage; this is due to the lacking of resources. When administeringa multi-billion fund, every single investment needs to be accountable for severalmillions. With regard to the transaction costs, too many investments would decreasededication among the limited amount of personnel that the venture capital firmpossess. Companies in the seed stage, with only an idea or concept, have a riskprofile too high in order to justify a multi-million SEK investment. Northzonestates that companies in the seed stage are better suited for angel investors.

Generally, it is possible to invest in earlier stages of business model innovation,due to the fact that the confirmation of whether a product or service actually workstypically can be received after a year. By then, it is much more likely to know ifthere is any market traction, if the o�ering has momentum, and if it is receivingany viral distribution. On the other hand, if new technology is considered, thetechnology risk is stacked on top of all other risks, which makes the risk judgmentmore di�cult. A company focused towards technology innovation is more suited fora business angel in early stages.

If the CIC continuum is considered, in relation to the preferred investment stage,it is obvious that an investment targeting a business model innovation can be madeearlier compared to that of a technology innovation.

SEB Venture Capital

The technology team within SEB Venture Capital mainly focuses on second roundinvestments, as mentioned in section 2.5.3, whereas the growth team within SEBVenture Capital focuses on the third round. Naturally though, exceptions havebeen made, where investments were made earlier. However, SEB Venture Capitalis constrained by a cost structure that implies that the high transaction costs oftenmake it unjustifiable to invest in the seed or start-up stage.

If the CIC continuum is considered, in relation to the investment stages, itis less expensive to invest early in a business model innovation. On the otherhand, a business model innovation implies a binary risk to a greater extent thantechnology-focused innovations. Thereby, the desirable risk profile implies a laterstage investment when market validation is received.


Technology-focused innovations are more straight-forward, since it is possible tomake a desktop analysis and then discuss it with people; in order to understand if thetechnology is relevant for a large industry. Business model innovations are concernedmore with consumer behavior, which is a lot more di�cult to understand unless oneis a consumer specialist. Thus, investments in consumer races are preferably doneafter an actual market validation.

Creandum

Regarding the specific stages, investments are made as early as in the stages of ideaand concept, up until the later stages with significant sales and orders. However, itis almost always preferred to be the first institutional investor; to invest after 2-3other investors or when significant capital has already been raised is not attractive.The essential factor behind an o�ering is if it is based on something that customerswant and need, and that there are clear signs showing that. Thus, some kind ofmarket validation is critical.

In order for the entrepreneurs to be in the “driver’s seat”, it is important not todilute their shares; when their ownership declines, the remaining growth curve goesdown. Thus, it is critical to keep the entrepreneurs “jammed-in with lots of skin inthe game.” Linas Matkasse, Appear TV and Its learning are examples of companieswith revenue of more than 100 MSEK that have bootstrapped themselves to theirrevenue, where Creandum has entered as the first institutional investor. This is aperfect situation, since they are validated by the market but need extra fundingand a more professional board. Even though it is a later stage investment, with alower growth potential, these opportunities are always preferred over alternativessuch as a third round investment; “it doesn’t feel fresh.” A company that keeps onstruggling and continuously raises money is generally not the right kind of company.

“If a company in the Nordic region is raising funds for the third timefrom Nordic investors, it is a failed company.”

(Creandum, 2012)

There is no preferred investment stage, but a company has to be able to achieve areturn on investment multiple of 10, even in the later stages of investment. Someventure capitalists might like to throw in a few “safe bets”, to achieve a guaranteedreturn on investment multiple of 3. However, if this is the strategy representing amajor part of the portfolio, and the companies therein have revenues in the rangeof 20-100 MSEK, then it is the wrong strategy. Some companies will inevitably fail,and it is impossible to send 10 times the money back to the fund investors if thisstrategy is used; this is crucial to realize. Neither Creandum nor the fund investorsbelieve in safe bets, those are for other players, which makes the investment profiledi�erent. Thus, one or a few companies need to reach a return on investmentmultiple of 50: “that is how we are rigged.”


As far as technologically oriented firms are concerned, early investments aregenerally avoided. The reasons are that there is a long time-to-market and thatit is highly costly; to simply develop a product and to put it out on the marketcan cost several hundred MSEK. Even to validate the product can be extremelyexpensive. These factors clash with some of the most important aspects, the abilityto quickly and at low cost achieve market validation. Therefore, to back these kindsof companies is not viable in the light of the fund structure and the requirementsput on the return on investment multiples; they require another risk profile. Thislesson was learned “the very hard way” from the first fund of early-stage high-techcompanies.

There are exceptions however; IPtronics is a company that develops a chip,which is an early-stage investment. However, they have experience since earlier,there exists a proven market that they can live o�, and their burn-rate is low dueto a tight and lean budget.

Conor

Conor’s main investment stage focus is towards start-up and second round, withrespect to the definitions in section 2.5.3. In exceptional cases a seed stage has beenfinanced. However, in those cases, certain risks have been minimized, e.g. by awell-known team.

With regard to the CIC continuum, the more business model focused the inno-vation becomes, the later Conor prefers to invest. Since business model innovationsinherently contain binary risk, implying that they could be worth zero in the caseof a failure, market-validation prior to an investment is preferred. Technological in-novations, on the other hand, tend to have an alternative more fundamental value;e.g. if a wireless technology not is suited for the mobile phone industry, it is likelyto suit another industry. Thus, it reduces the risk of an innovation becoming totallyworthless. However, in the Nordic region it is possible to obtain seed capital fromseveral actors, e.g. governmental institutions, which can be an option for businessmodel innovators in the seed stage. If the market eventually validates the productor service, implying a certain customer base, Conor can provide growth capital forlater stages.


Northzone

Since later stages than seed are preferred, due to the managerial preferences men-tioned in section 4.2.3, a venture capitalist may end up not being the sole investor.However, Northzone does not believe this is a problem. What is of great importancethough, is that the allocation of capital is related to this problem. Companies oftenrun out of money and, if the investors not have a bu�er, the situation can be bene-ficiary for new investors. Thus, the negotiation power of both the old investors andthe company will decrease substantially due to the lacking of funds. Several small


Swedish venture capital firms learned this the hard way during the beginning of the21th century. One obvious example is QlikTech, where Accel Partners JerusalemVenture Partners made profits due to the financial weakness of the Swedish actors.

According to Northzone, one major problem with the capital contribution is theamount of capital needed by a company for commercialization; which is why it is ofgreat importance to make a thorough assessment of this need prior to investing, andthen to keep a bu�er. Northzone’s guideline to capital allocation lies somewherearound 70 % initially, and another 30 % in bu�er for follow-ups. The 70 % typicallyaccounts for the first 3 years of investments, whereas a fund often lasts for tenyears. After the initial investments have been made, a new fund is raised while theinvestors wait and support the ongoing fund investment.

Sometimes a milestone-based approach for capital can be used; many such struc-tures exist, but they eventually depend on each and every unique case. However,the purpose is to reduce risk by not binding up excessive capital before certaingoals have been fulfilled. A critical factor with the milestone-based approach is todefine them as clearly as possible by using measurable targets. There should neverbe room for any interpretations regarding whether a milestone has been reached ornot.

If the CIC continuum is considered, Northzone states that technology focusedinnovations always become more expensive. They are inherently more complicatedto assess, and it is di�cult to estimate how much capital a technology-focusedinnovation will need, compared to a business model innovation. The time-to-commercialization also tends to be longer for technology-focused innovations. Witha business model innovation, the risk is more binary and confirmation regardingwhether it works or not can be received quickly after an initial capital injection.With technology-focused innovations, several injections are often needed before aproduct exists.

SEB Venture Capital

Capital contribution is mainly done through one initial single transaction. Excep-tions are typically made when discrepancies in valuation occur between the investorand entrepreneur. In that case, tranches are allocated in a milestone-based manner.When the milestone-based approach is adopted, a sales target is typical measure.

If the CIC continuum is related to capital contribution, it is assumed that thecapital strategy correlates more with the maturity of the innovation, rather than ifit is focused towards a business model or technology. Thus, relating capital contri-bution to how much capital that is required in order to develop an entire company.However, in a less expensive business model innovation, a larger company share maybe feasible quite cheaply, due to the binary risk. Also, a su�cient company sharemay be needed in order to receive a su�cient return, since the return volume maycorrelate with the smaller initial capital requirements; especially if it is a businessmodel innovation targeting the local market. On the other hand, the capital strat-egy involving more expensive technology innovations may allow for a more powerful


syndicate being built in order to match initial capital requirements.Since SEB Venture Capital is part of a bank, compared to fund-supported ven-

ture capital firms, it can utilize its liquidity for future needs. The need for a bu�eris, thereby, not that crucial. Assessment of future capital demand parameters wouldonly imply unnecessary speculation today.

Creandum

For technologically innovative companies, the baseline is that they will need morecapital. However, the current stage and the remaining risk will dictate how muchcapital that is reserved for future investments.

What makes venture capital funds stronger is that they can allocate money forfuture cash injections. In the case of early investments, if 5 SMEK is invested, upto 50-60 MSEK can be reserved for follow-up investments. However, in the case oflater-stage investments, if 50 MSEK is invested, 40-50 MSEK can be reserved forfuture investments.

For private investors, e.g. business angels, few have access to 10 MSEK and areable to reach a company valuation of 200 MSEK. Therefore, it is more common toenter at a valuation of 20 MSEK and invest 100,000-500,000 SEK. In general, theearlier the investments are made the better for private investors.

In order to reduce risk, some companies might use milestones; however, this isnot a preferred strategy at Creandum. One would have to be extremely clever andself-confident if milestones were to dictate the coming years of company developmentand what will generate value in the future. Companies should rather raise moneyon the market and be valued based on what other actors are willing to pay.

Regarding ownership quota, on average 20 % is a preferred ownership percentage.Since the average exit size is known, this is the quota needed in order to achievethe desired return on investment multiples. Every exit should be able to send afew hundred MSEK back to the fund investors, which results in this rough number.Thus, it is never an option to take a majority position; firstly because of the abovementioned preference, and secondly because of the desire for the entrepreneurs tobe in the driver’s seat.

Conor

When committing to an investment, a plan is made to determine in which stage thecapital initially will be injected, and for how many consecutive rounds investmentswill be made. Depending on the type of company, the first round might contain7 MSEK while 3 MSEK is reserved as a short-term bu�er. This is better thanmilestones since negative discussions regarding the non-achievement of these areavoided, instead the additional 3 MSEK can be granted if the board requests it.However, while 5-10 MSEK might be injected initially, 60-65 MSEK is assumedto be required over the entirety of the investment. Since the growth of value in astart-up almost is discrete, based on events such as the product being done, the


first order being received, passing 10 MSEK in sales or similar; consecutive roundsof funding will depend on passing events such as these. If no critical event has beenpassed, it is very di�cult to argue for an increase in valuation; thus, additionalexternal funding is often out of the question. Therefore, timing is not the criticalaspect; to achieve a new valuation due to an event that has occurred, that is thedeal breaker. This is why the “7+3-method”, with its built-in bu�er, is used toensure that these events can be reached.

Typically an ownership rate of 25 % is preferred, ranging from 10 % up to35 %. If it exceeds 50 %, it is a sign that something has gone wrong, typicallydue to a delayed and more expensive production phase. A common plan for futureinvestments is that the same percentage of each investment round is financed. Thus,keeping the ownership rate at the same quota.


Northzone

Northzone, like any typical venture capital firm, works with building companiesfull-time; strategical contributions can thereby be made based on the partners’experience. Every problem that an entrepreneur may run into during the commer-cialization process has likely been encountered by the venture capitalists. Also, dueto the fact that they are experienced and have been in the business for a long time,they have likely built a vast network of resources. If a problem cannot be solvedby the venture capitalists themselves, there is always a solution within the network.Northzone consists of partners spread all over the world, which create a diversifiedknowledge pool and an extended network.

As mentioned in section 4.2.2, a stable and robust owner base can reduce riskas well as increase the entrepreneurs’ negotiation power and legitimacy among cus-tomers and suppliers. To initially be approved by customers and suppliers couldotherwise be challenging, a tough situation for an entrepreneur; since they also needto make a risk assessment, especially if large amounts of capital exchanges are con-sidered. Thus, with a large fund backing it, the company gains credibility on themarket, where potential customers not have to worry about the company being onthe verge of dissolving.

When relating strategic contribution to the CIC continuum, Northzone high-lights the importance of the entrepreneur in a technology-focused innovation. Inthose cases, the entrepreneur possesses the most knowledge about the innovation’score being the actual innovator. This can be compared to a business model innova-tion, where the execution almost is the most important factor. However, executionis something that venture capital firms are likely to strengthen, either through them-selves or via recruitment. The entrepreneur is initially encouraged to be responsiblefor recruitments, especially if it concerns managerial positions; but the recruitingcan actually be a strategic problem. Generally, it becomes easier to recruit the more“body” a company has.


As mentioned above, Northzone would be unable to cope with the amount ofinvestments that would be implied by smaller capital injections. Therefore, a focuson the later-than-seed stages has been chosen. However, despite the fact that a largeinvestment is made, Northzone avoids taking a majority share in their investments.

“We want the team to feel like they are sitting in the front seat driving,and that we are in the back seat.”

(Northzone, 2012)

Northzone states that it is of great importance that the entrepreneurs stay as themajority owner in order to keep incentive levels up.

SEB Venture Capital

Entrepreneurs are often monomaniacs, which means that they are very good atignoring or underestimating the competition, comprehending the hardship of com-mercializing a product, and overestimating the market’s willingness to adopt newtechnology. As experienced business people, SEB Venture Capital knows how tomanage a company as well as doing strategic planning and competition analysis.Therefore, SEB Venture Capital can contribute with vital competence to the en-trepreneurs within these areas. Thus, SEB Venture Capital’s experience withinthese areas can aid the entrepreneurs in the process of overcoming these hurdlessince they have been dealt with before.

When developing a strategy for the company, it is important to be part of theboard which requires at least a 10 % ownership. Generally, 15-30 % is preferred,which means that other investors are present as well; being the sole investor is notvery common. Anything below 10 %, with no place on the board, is simply a passiveinvestment. Entrepreneurs are driven by the desire to succeed with their project,thus a majority ownership for them in the initial phases is crucial. However, the needfor majority ownership declines as the stages in the company progress. In maturecompanies, any professional management team can be in charge of the company,and then there’s nothing preventing a 99 % ownership by the investors. This isuncommon though, since there is a slight technical issue involved with surpassing50 % ownership; the firm will become a subsidy which not is desired.

In companies involved in business model innovation, on the right side of the CICcontinuum, the need for strategic contributions tends to be low; the entrepreneursare generally more sophisticated in their strategy and their visions regarding go-to-market. The financial aspects and a stable ownership are generally factors ofmore importance to these companies. The value of strategic contribution is oftenthe highest in technically oriented companies, which lack some of the strategiccapabilities.

When investing in the early phases, industry contacts and structure are the mostimportant stretegic contributions. However, when investing in later stages, man-


agement capabilities such as how a company is run (operations), how to e�cientlymanage the firm, and how to adopt lean thinking is of greater importance.

Creandum

After investing, Creandum always takes place on the board of the investee company.Mainly three areas are of concern where contributions can be made: strategy, re-cruitment and follow-up financing. The main focus will always be to drive value intothe company. Therefore, the aim is to “help the entrepreneur to navigate along theroad that drives the most value in the company.” Along with strategy, recruitment isan important area of contribution, mainly for the board and the executive positions.Lastly, follow-up financing can be assisted indirectly; by positioning the company insuch a way that the valuation of the company is maximized, and hence more fundingcan be raised. This final remark is more important for the entrepreneurs than theventure capital fund though, since they seldom have the required resources to investthemselves. The initial fund investors, such as Creandum, will keep enough capitalallocated to defend their ownership quota. However, it is a two-way problem bothfor the entrepreneurs and for Creandum, since it is important that the founders’shares not become too diluted.

Conor

In general, it is preferred to build a “real” company in the sense that it actually canmanage to survive based on its own merits. Thus, having customers, revenue, andnot being dependent on another investment round in a certain amount of months.However, this is with an exit perspective in mind. The company is not required tohave everything in place when an initial investment is made, but a customer baseis appreciated as mentioned in section 4.2.1.

When assessing a company, the variable that has the biggest impact is the team;is it complete, experienced and motivated? Some teams are very knowledgeable,driven and have a good industry network while other are not. However, the as-sumption is that several people will have to be recruited. Therefore, this is an areawhere assistance can be o�ered. Conor always takes a place on the board, and takespart in the appointment of the CEO, chairman and other key positions. The goalfor Conor is to always be active within the early stages of development in one ortwo companies. As these mature, less time is required and the energy is put intonew companies instead. If investors from other countries are brought in, e.g. fromAmerica, they are more likely to be able to assist in that particular market as well;e.g. by finding industrial partners in Silicon Valley.

The main di�erence regarding the strategic input and the CIC continuum in-volves the areas of technological development and industrial partners, which simplynot exist in companies found at one end of the continuum. For technologically ori-ented companies, assistance can be given within these areas. However, all typesof companies need help with development of their business models, go-to-market


strategy and how to expand globally; companies have to be run and operated inboth cases, regardless of what their product or service is.


Northzone

The main philosophy of Northzone, with regard to their exit strategy, is that a“good” company always can be sold. Thus, the best exit strategy is to build a goodcompany which, when it is time to sell, will result in options for a sale being there.Entrepreneurs are therefore encouraged to focus on the process of getting there,rather than the exit.

“You should not be thinking about your divorce already.”

(Northzone, 2012)

Northzone emphasizes that certain exits not are better suited for a specific company,in relation to the CIC continuum. The best exit is most likely done when there isa new technology, a new business model, and a new customer segment.

SEB Venture Capital

The preferred exit strategy is to sell the firm as an entity to another company inthe same industry. If that company already is a customer, they have more knowl-edge about the business which generally generates a higher strategic premium whenselling. The worst case scenario is a pure financial acquisition without any strategicpremium. Some people argue that there is no such thing as a strategic premium, butthere is always a reason for acquiring technology or customers within a company’sown industry. The venture capital model is quite di�erent from the private equitymodel, which mainly is based on multiples; how revenue or EBIT is generated is notimportant. Within venture capital, the assumption is that a sophisticated buyer,that understands the business, will buy the company and therefore pay a premium.Generally, companies do pay for technology; however, it is harder to achieve highvaluations for companies based on business model innovation. In the latter case,the potential premium is based on future dramatic growth predictions. Naturally,there is an inherent risk of these predictions not materializing. If this scenario wereto happen, the companies are dead; therefore, the actual risk is high. Investors tendto perceive business model innovation as less risky, even though the historic risk hasbeen high; in contrast, technologically innovative companies always have a residualvalue to default back to since they are based on something fundamental.

Since SEB Venture Capital not is locked into a fund structure, it is possibleto invest in technology that has a longer cycle of commercialization; the risk oftechnology development exceeding time predictions is not critical. This is oftentimesworthwhile, since a trend is to value companies sold as pieces of a puzzle higher


than those sold as stand-alone entities; the latter are simply valued based on theirfinancial merits.

Creandum

The macroeconomic situation does generally not a�ect when investments are made.However, it certainly a�ects when exits can be done; there are only specific marketwindows for the sale of a company, and these are cyclical. Historically, 2005-2006and 2011 were such periods. Therefore, it is important to keep an eye on the exitwindow at all times.

Furthermore, what is critical to understand is the remaining risk in the business;is the remaining upside worth more than the alternative of securing the investmentby selling? As an institutional investor, there is always a contractual control over theinvestment object; therefore the entrepreneurs do not have the possibility of exitingthemselves. Contrarily, Creandum can always exit, even if the entrepreneurs notagree. Generally, companies are sold as entities, i.e. trade sales, instead of beingpublicly o�ered and then noted on an exchange, i.e. by making an IPO; however,there are always exceptions.

The ambition is to always build great companies that potentially could deservea place on a stock exchange. They should be self-sustaining, that is the mindset;not to become a piece of a puzzle that could be sold to Google. If the latter mindsetwere to be adopted, the upside immediately becomes too limited. Therefore, theaim is to create stand-alone entities that show profitability at the bottom row basedon their own merits.

Conor

When considering the companies oriented towards business model innovation, onthe right side of the CIC continuum, an important issue is whether they have auser base. A business model can easily be copied, and without any traction in themarket in terms of users, there is no reason for a competitor to acquire somethingthat can be built in-house. Therefore, when raising capital, it is more important toshow progress in the case of a business model innovation. Thus, exiting a businessmodel innovation typically generates a value estimated based on its customer basesize.

An initial target for an exit valuation is typically 500 MSEK, making a 25 %share worth 125 MSEK. When exiting an investment, industrial buy-outs is themost common method. Thus, this is the planned strategy. However, there are otherways of exiting, such as selling the patents, IPR or technology; this is mainly anoption for technologically “heavy” companies.

When evaluating the IPO track, there are two alternatives; to introduce thecompany on a big list or a small list. The former is only considered if the companyis performing extremely well, with revenues on a massive scale. The latter is more


of a retaliation strategy, used mainly when a company’s predicted growth curve notmaterializes.

A worst-case scenario for an exit is when the company not has succeeded. It issaid that there are two di�erent “schools” for how to approach this problem. Eitherthe company is considered a loss, and further work is simply a “waste of time”,or the venture capitalist feels obligated, towards its investors, to recover as muchas possible from the investment. Conor’s choice of mainly focusing on technologyinnovations, avoiding the binary risk, correlates with the latter.

Chapter 5

Analysis

The analysis intends to synthesize the results, in relation to the hypotheses andresearch questions. As mentioned in section 4.1, the common factor shared amongthe venture capital firms is that, all actors have made investments both towardstechnology innovation and business model innovation. However, two of the fourrespondents tend to have a higher rate of companies focused towards business modelinnovation in their portfolios. Contrarily, the other two respondents have a majorfocus on technology innovations. The strategy of the former type of investment hasrecently tended to increase. Thus, the competitive environment for firms makingthis type of investment has increased.

5.1 Screening process

Common for all respondents, despite where their investment focuses are with regardto the CIC continuum, is that three main factors are considered in the screeningprocess. Furthermore, the screening process is performed in a semi-standardizedmanner featuring elements of gut feeling and experience; apart from the more the-oretical and quantitative analysis. The three main factors can be seen below:

• Innovation

• Market

• Team

Apart from the financial factors, the general constitution of decision-making fac-tors is similar to the actuarial model described by Zacharakis and Meyer (2000).However, the order of priority tends to be di�erent with regard to where, on theCIC continuum, the investment object’s focus is. A major technology focus adoptedby the venture capital investor, such as SEB Venture Capital or Conor, tends toprioritize the innovation over the team; since the actual level of innovation is vitalin that case. On the other hand, business model innovations are dependent on the

69

70 CHAPTER 5. ANALYSIS

execution; thus, making the team essential. However, it is worthwhile noticing thatit never is an option to ignore the team, regardless of which innovation focus that isadopted. With the amount of prospects a venture capital investor usually processin the screening phase, a mediocre team is much more likely to be discarded.

Concerning the market, international scalability seems to be a common deal-breaker. Since the target for the investment is to create a company that is ac-countable for several hundred MSEK in valuation, the Nordic market is seldomlarge enough. Especially when the focus is towards a fundamental technology andcapital-heavy investment; thus, making the required exit valuation even higher inorder to fulfill the profitability target. A business model innovation, on the otherhand, can be cheap enough to be profitable on a local market. However, takingcompanies globally is one of the venture capital investor’s core competences, and itoften seems unreasonably not to aim for it.

Coherent with the view of Shepherd et al. (2000), one important screening factor– the great significance of timing seems to be a common opinion, especially when theinnovation targets a new market. Preferably, the commercialization should alreadybe started; thus, decreasing time-to-market and easing the timing factor. Withregard to time-to-market, technology focused innovations tends to take more time,making the importance for an already actuated commercialization phase greater.Thus, the technology-focused investor tends to emphasize this in the screening pro-cess; e.g. a customer base is of great importance.

With regard to the macro-economic situation, Gompers et al. (2008) arguedthat, venture capital investments are increased when the public market becomesmore favorable. This could be seen especially among the venture capital investorsbacked by funds, namely three out of four, which were dependent on pension fundsespecially. Since the pension funds are restricted from investing more than certainamounts in non-listed investments, fund-raising becomes highly dependent on theeconomic climate and the aggregated value of the pension funds. However, thefourth venture capital firm was a captive investor; thus, not depending on externalliquidity.

The more risk avert technology investors seem to have a higher focus on avoid-ing bubbles and temporary opportunity windows; thus, targeting technologies thatare relevant regardless of the current economic climate. However, some businessmodel innovations can be commercialized quickly enough to utilize a temporaryopportunity window or bubble.

Common for all respondents is that the underlying restrictions on investmentobjects, self-made internal or external ones, are very similar to those of an ethicalfund.

5.2 Risk and portfolio

What di�erentiate the venture capital firms, with regard to their risk and port-folio profiles, are mainly which factors that are considered risky when evaluating

5.2. RISK AND PORTFOLIO 71

a potential investment object. The technologically oriented venture capital firmstake a more risk avert approach, in the sense that they avoid investing in firmswhose residual value has a high probability of turning out zero. Therefore, theynaturally seek to invest in firms with a fundamental value, such as a technologythat hypothetically could be sold separately. Alternatively, the technology acts asan underlying technology for business model innovation companies. This impliesimplicit risk diversification since many customers will use the technology, but somewill succeed and others fail; thus, implying less company specific risk exposure.

On the other side of the spectrum are the venture capitalists who consider tech-nology to be risky in the sense that it not yet is validated by the market. Therefore,they prefer to invest in business model innovations since they are preferred due tothe less expensive validation phase. This relates to Fiet (1995) who argued thatmarket risk was one out of two main areas of concern, the other being agency risk.However, agency risk is not perceived as a major risk factor in this research. Firstof all, none of the respondents mentions it; implying that it not is perceived as amajor risk. The absence of internal conflicts is seen as a prerequisite and is mini-mized by ensuring that vision and strategy are shared prior to an investment. Inthe worst-case scenario, milestones as well as contractual obligations are used asa mean to eliminate this risk, as also presented in earlier research by Clayton etal. (1999). Market risk is furthermore reduced by investing in di�erent customersegments and business models; e.g. software or consumer products. Creandum hasmade the move towards this profile over time, since earlier funds were less successful.Therefore, only 5 % of the total funds are placed in early-stage hardware companies,as opposed to the early days of the 2000s when it represented a major part of theportfolio. Generally, the business model focused firms, the right side of the CICcontinuum, tend to avoid risks regarding both the technology and the team, mean-ing that an incomplete team, experience or competence wise, not will be funded.This observation is aligned with the statement “invest in teams” by Engel (2011),highlighting the importance of investing in top-performing teams. The risk thatcommonly do receive funding is market risk in order to scale-up the production.

Common for all actors is that they distinguish between technology and businessrisk. Furthermore, they agree on the existence of a continuum combining these typesof innovations. What further strengthens the pre-hypothesis is that these two riskfactors are assessed separately.

Portfolio theory is present to the extent that various risk and yield profiles areused to smooth out the investment returns. All of the interviewed firms utilize astrategy of diversifying into di�erent industries as well as di�erent investment stages.This finding is aligned with precedent research by Sørensen (1987) who also findsthat investors diversify by investing in di�erent industries. Moreover, syndicatesare used in order to reduce the risk of future capital injections.

The main di�erence lies in the targeted return on investment multiples, whichcan be seen in table 5.1. Northzone expects a return on investment multiple of 5 forlow-risk investments, whereas high-risk opportunities require multiples of roughly25 to be justified. On the other hand, SEB Venture capital expects a return on


investment multiple of 2-3, and in rare cases 10. This correlates with their riskrequirement of being able to realize at least 70 % of the investment. Creandum,however, does not consider risk a problem as long as the possibility of a massivereturn is possible. Therefore, return on investment multiples are required to bein the range of 10-50 which implies early-stage investments with higher risk. Theinvestments that are made in later stages will naturally not be expected to inhibita return on investment multiple of 50. Conor has no explicitly stated requirementsregarding their return on investment multiple, but expect 10-20 times the investmenton early-stage investments and 2-3 in the later stages.

Early stages (higher risk) Later stages (lower risk)Northzone 25 5SEB Venture Capital 3-5 (rare cases 10) 3-5 (rare cases 10)Creandum 10-50 < 50Conor 10-20 2-3

Table 5.1. The return on investment multiples in relation to the investment stage

As seen in table 5.1 the companies that mainly target technological innovations,namely SEB Venture Capital and Conor, tend to have a lower risk exposure due totheir requirement on residual value. Since it is a requirement, less expensive binaryrisk opportunities are often ignored.

5.3 Preferred investment stage

With regard to the preferred investment stage, it is influenced by the risk profileadopted, to some extent, and where the focus is on the CIC continuum. The di�erentpreferred investment stages among the investors can be seen in table 5.2. The stagesare defined by Ruhnka and Young (1987) as can be seen in section 2.5.3

Seed Start-up Second round Third round ExitNorthzone x x xSEB Venture Capital x xCreandum x x x xConor x x

Table 5.2. Investment stage focus

The seed stage is typically avoided due to managerial issues, and that the com-panies’ cost structures, in combination with the adopted risk profile, not add up.Managerially, it is a question of resources; too many small investments would implya vast workforce simply in order to manage all the investments that a multi-billionSEK fund would account for. A small investment, that seed would imply, wouldresult in a relatively high overhead to match the risk. This relates to the early-stage

5.4. CAPITAL CONTRIBUTION 73

capital gap, called the Valley of Death, presented by Wessner (2005), which statesthat unvalidated ideas scare investors away due to their risky nature. The chosenstrategies for the stages are generally coherent with Zider (1998) who argues for afocus in the middle of the classic industrial S-curve.

The two companies that have adopted a major business model investment strat-egy are convinced that those investments can be made earlier, since time-to-marketis short; thus, a market validation can be received quickly. On the other hand, iftechnology-focused investments are considered, the technology risk is added to allother risks, and time-to-market is longer as well. Thus, technological investmentsare preferably made later, by these two venture capital firms, when technologicalrisk and time-to-market have decreased. The business model investment strategyadopted by these two companies typically increases the risk exposure. However, thereturn on investment multiples increase simultaneously.

The two other companies, that mainly focus towards the technology innovationside of the CIC continuum, have adopted a risk profile that typically makes theminvest later in business model innovations. Thus, they abide the elimination ofbinary risk. Technological risk is considered more assessable, compared to the con-sumer behavior that business models rely on. Also, technology focused investmentsare considered to have an alternative or residual value, in the case of unsuccessfulprogress.

In general, the earlier the investments are made the more suited they become forprivate investors, so-called angel investors. Thus, making seed the primary targetfor angel investors.

5.4 Capital contribution

The tendency seems to be that capital contributions relate to the maturity of thecompany and an assessment of how much the commercialization will cost. Thecurrent state and remaining risk act as a decision-making basis, rather than whereon the CIC continuum the investment prospect is positioned. However, a mutualagreement exists on that technology innovations tends to need more capital in theend, due to the fact that the commercialization takes longer time and therebyextends the maturity time.

Two strategies have been identified in order to answer to the larger capitalrequirements, either fixed injections or fixed ownership. Syndication can be theanswer to a high capital demand. In the end, however, it is the maturity andassessment of each unique case that will steer the capital contribution strategy.

All three venture capital investors that rely on funds for investments emphasizedthe importance of keeping adequate bu�ers. A precarious situation could otherwiseemerge were the venture capital investor can’t financially support the commercial-ization; thus, potentially making the performed investments useless despite thatthe company itself is progressing successfully. Also, new investors can dilute theshares if there’s no available capital in new investment rounds. As mentioned, the


fourth and last venture capital respondent is a captive investor and doesn’t rely onexternal funds; possessing the underlying liquidity of its limited partner.

The capital contribution relates highly to which ownership strategy that isadopted. Also the ownership strategy is dependent on several parameters suchas assessed exit valuation, required return multiples, future capital injections, andrequired nominal return to the investors. Thereby, each case is unique and one so-lution to the capital contribution problem tends to be to raise capital on the openmarket in every investment round; in that way a market valuation can be achieved.A majority stake is avoided by all respondents; being a sign that something hasgone wrong. Typically an ownership between 20-25 % is preferred. This is some-what coherent with the model presented by Amit et al. (1999), that predicts anegative relationship between the share of venture-capital ownership and a firm’sperformance.

Contradictory to some of the precedent research, for instance the one conductedby Clayton et al. (1999), the milestone approach does not seem to be adopted toa large extent; and when it is, it is adjusted to each unique case. The argumentagainst the milestone-based approach is that the complex nature of venture capitalinvestments makes it almost impossible to predict the future events. One actoremphasized that milestones almost exclusively were used when there was a conflictregarding the valuation, between the entrepreneur and the investor. When themilestone-based approach actually is used, the ability to set measurable targets isof great importance in order to reduce upcoming conflicts regarding the fulfillmentof a milestone.

5.5 Strategical contribution

Venture capital investors’ core competence is to develop companies, and to han-dle obstacles related to a commercialization phase. Common for all respondents isthat all their investments are made with the purpose of being active; thus, secur-ing at least a 10 % stake in the company – implying a board membership, whichenables strategic contribution. The main strategical factors identified among therespondents can be seen below:

• Network resources

• Recruitment

• Operations/Execution

• Financial

• Owner base

The, often, monomaniac behavior by entrepreneurs can imply that factors such asplanning and competition analysis are overlooked.

5.6. EXIT STRATEGIES 75

If the CIC continuum and the two extremities are considered, the innovation ismore dependent on the entrepreneurs if the innovation is technology focused. Thisfollows from that the entrepreneurs possess all the essential knowledge and corecompetence. However, their strategy and go-to-market tend to need support andamendments.

Business model innovation, on the other hand, is more dependent on the actualexecution. In this case, industrial partners and actual technological developmentcan be disregarded. However, the entrepreneurs are generally more sophisticatedregarding strategy and visions, but since these aspects are vital for a business modelinnovation, they are likely to be strengthen by the venture capital investor.

As mentioned by Chang (2004) networks can imply both legitimacy and neededresources. Also mentioned by the respondents, is the problem of achieving legiti-macy and to overcome newness, which can be done through a strong owner base.This is aligned with the thoughts of Aldrich and Fiol (1994); Deeds et al. (1997a);Deeds et al. (1997b); Zimmerman and Zeitz (2002).

5.6 Exit strategies

As Zider (1998) argues, the role of the venture capitalist is to nurture the companyfor a couple of years and then exit. Undoubtedly, building a good company is alwaysthe best exit strategy. The aim is therefore often to create an independent entitythat is self-sustaining; thus, reducing the risk by creating a residual value inherent inthe company itself. However, companies positioned on the technology-focused sideof the CIC continuum have more opportunities to sell specific parts, such as patents,intellectual property rights, and the technology itself. Business model innovations,on the other hand, rely on a customer base in an exit valuation situation.

The trend seems to be, regardless of the CIC continuum, that buy-outs wherelarger companies acquire the entity, in a horizontal integrating manner; thus, reap-ing the benefits of a strategical premium. IPOs are seldom performed, contradictoryto the U.S. market, according to Christofidis and Debande (2001). When it does,the company itself needs to be performing extremely well in order to be introducedon a big list.

The technology-focused investors tend to always be concerned with the residualvalue of the investments; thus, always trying to get out the most of the investments.

Chapter 6

Conclusion

To create an innovation, from an invention, implies commercialization which is con-sidered a core competence of venture capital investors. However, there are di�erentways to launch an innovation into the marketplace. The purpose of this thesis wasto describe how the venture capitalists’ investment models vary depending on whichtype of company an investment prospect represents; more precisely, where the mainfocus in on the CIC continuum (figure 1.2). Furthermore, this thesis also addressesthe constitution of the venture capital investment models. In this case, the sampleof venture capital investors was constituted by four of the major Nordic actors,namely SEB Venture Capital, Northzone, Creandum, and Conor.

Based on precedent research, the investment models were divided into six cat-egories: the screening process, risk and portfolio, preferred investment stage, capi-tal contribution, strategic contribution, and exit strategies. Due to the purpose ofinvestigating how the investment models were constituted, and how they varied,semi-structured interviews were used in this research.

Firstly, the technology focused venture capitalists tend to prioritize the inno-vation above the team. Secondly, entrepreneurs have a more important role intechnologically innovative companies, due to the fact that their core knowledge iscritical for the business. On the other hand, venture capitalists focused towardsbusiness model innovation tend to emphasize the team, due to the importance ofexecution.

While international scalability is important for all actors, it appears to be em-phasized more as a deal-breaker for technology oriented venture capitalists. Thesefirms, such as hardware companies, have a longer time-to-market and are generallymore capital intensive over the course of the investment. Hence, they are more costlyoverall, and thereby require a larger market in order to be profitable. However, in-ternational scalability is unreasonable not to aim for, regardless of the innovationfocus.

Timing is considered to be a crucial factor, especially when aiming for temporaryopportunity windows that are present in business model innovations. Technologyfocused venture capitalists tend to avoid bubbles and temporary opportunities.

77

78 CHAPTER 6. CONCLUSION

Common for all actors is that they distinguish between technology and businessrisk. With regard to the pre-hypothesis, all actors agree on the existence of acontinuum which combines these types of innovations.

Generally, technology investors are more risk-avert in the sense that investmentsare made in order to ensure a residual value. Business model focused venturecapitalists, on the other hand, accept binary risk to a certain extent; thus, acceptingto make investments that might result in a residual value of zero. However, binaryrisk acceptance typically results in higher return requirements. This initial decision,regarding the acceptance of binary risk, a�ects all other areas of the investmentmodel, which is summarized briefly in figure 6.1.

In order to further reduce risk exposure, all venture capitalists use investorsyndicates. Since earlier venture capital funds utilized portfolio theory to a lesserextent, this led to lessons learned after the IT boom; therefore, diversified portfoliosare now adopted by all actors.

The seed stage is typically avoided by all actors, much due to the fact that itnot is managerially possible with the current resources. The business model focusedventure capitalists prefer to invest earlier in business model innovations than intechnological innovations, due to the binary risk acceptance, short time-to-market,and the technological risk avoidance.

Technology focused venture capitalists, on the other hand, prefer the opposite,due to the fact that technological risk is considered more assessable, and the binaryrisk avoidance. Therefore, a venture capitalist’s investment risk profile dictateswhich stage that is chosen to invest in.

Moreover, the size of the initial investment in early-stage technology companiestends to be higher than those of business model innovations, due to the combinationof a long time-to-market and the capital-intensive nature of them. Syndication isanother solution answering to the higher capital need. However, the less expensiveinitial validation phase in business model innovation is a tempting factor, apartfrom higher returns, to accept the binary risk.

The purpose of the venture capitalist, regardless of a firm’s innovation focus, isto act as an active investor, supplying more than simply capital, and o�ering a stableowner base that enhances legitimacy. Business model innovators tend to be moresophisticated, with regard to strategy and vision; whereas technological innovatorspossess more core competence, with regard to the innovation itself. Thereby, thetechnological innovations may need more strategic support.

Companies based on core technology inherently have the property of being ableto sell based on their assets; whether it be as the firm in its entirety, in the form ofphysical assets, or in the form of intellectual property – such as patents. Therefore,these types of companies also tend to be worth more when sold. Therefore, sincethe exit valuation tends to be higher, a lower ownership quota is needed in order toachieve the required return levels. However, firms based on an innovative businessmodel heavily rely on its customer base.

The pre-hypothesis, that initially was considered to be true based on one prac-titioner’s suggestions, was strengthened by the empirical findings, implying that

79

face-validity was established. Di�erences in all six areas of the investment modelswere identified, as one moves along the CIC continuum; thus, H0 can be rejectedand H1 accepted.

Conclusively, it all comes down to which risk profile that initially is adopted bythe venture capital investors. The risk profile that is chosen will then cause implica-tions for all other areas of the investment model. In figure 6.1, the main di�erencesamong the areas of the investment model are highlighted, with regard to whichrisk profile that is adopted. The abbreviations in figure 6.1 represent every invest-ment area and innovation focus: RP= Risk & Portfolio, SP = Screening Process,IS = Investment Stages, CC = Capital Contribution, SC = Strategic Contribution,ES = Exit Strategies, TI = Technological Innovations, and BMI = Business ModelInnovations.

RP: Binary risk acceptable?

Yes → BMI

No → TI

SP: Team & market emphasized IS: Early in BMI, late in TI CC: Less capital SC: Strengthens existing competence ES: Value dictated by customer base

SP: Product & market emphasized IS: Early in TI, late in BMI CC: More capital/syndication SC: Strategic input is vital ES: Residual value ensured

Figure 6.1. Main di�erences with regard to the adopted risk profile summarized

Chapter 7

Discussion

7.1 Limitations

A research study naturally has its limitations; one of these being that it is unre-alistic to investigate all venture capital firms, and every investment that has beenmade. Instead, a sample has been chosen to reduce bias. A major limitation is theconfidential nature of venture capitalism. Several reasons exist as to why venturecapitalists not would share information, e.g. the risk of sharing valuable informa-tion and strategies with competitors. Also, the reticence could be an e�ect fromprevious badly performing funds. Furthermore, it could be assumed that the infor-mation shared by the venture capitalists reflects their best performance, in orderto boost their reputation. Therefore, a potential explanation could be the culturalfactor in the industry, where one not is supposed to talk about the performance ofportfolio investments. This problem is highlighted by Hansson (2007), who statesthat science is non-authoritarian which means that there is the possibility of dangerto inter-subjectivity when relying on authorities to a wide extent.

7.2 Critique of method

The venture capital industry rapidly changes, which can be seen when comparingthe findings in this research to those of the early 2000s; likewise, this research mightbe outdated within a similar time span.

In this research only four actors, within the Nordic venture capital industry,were chosen as examples of how the investment models are constituted, which couldresult in a deceptive view regarding how these activities are conducted. The selectedventure capitalists are also active within the same industries, which share similarcharacteristics. Thus, it hinders generalizability regarding venture capital on ahigher level; such as to other industries. By conducting research within severalother industries and segments, it would be possible to draw conclusion and generalizeregarding venture capital to a greater extent.

As for the method used, a more quantitative approach could have been utilized,

81

82 CHAPTER 7. DISCUSSION

which would have allowed for the making of tests regarding the statistical signifi-cance. Furthermore, pilot interviews could have been conducted in order to reviseand perfect the questions, as well as include more areas of interest; such as morespecific questions regarding the return on investment multiples during di�erent com-pany stages. Moreover, it would have been possible to include a few questions withLikert scales or similar, in order to improve accuracy. Also, the research could havebenefitted from more open questions regarding the investment models.

It is challenging to critically evaluate how well the investment models presentedherein are working, since the funds will be closed several years into the future;only then can the returns be analyzed. Furthermore, it is challenging to validatewhether the investment models presented are used as described on a daily basis.Some aspects might be exaggerated while others might be suppressed.

7.3 Further research

This research includes four of the major Nordic venture capital investors. Despitethe fact that the sample represents the majority of the Nordic actors, due to theexistence of only a few in total, the number of external actors investing in the Nordicregion is vast. This fact was highlighted in one of the interviews, where investorsfrom Continental Europe, England (London), and North America were given asexamples of these external actors. Therefore, it would be interesting to include theseactors when conducting future research. Firstly, it would be interesting because ofthe phenomena that evidently drives external investors to the Nordic area in general,and Sweden in particular. Secondly, it would create a comprehensive view of howventure capital in the Nordic area is constituted; thus, increasing the possibility ofgeneralization. Furthermore, the mapping of the investment models might becomemore accurate.

In order to map the venture capital landscape in its entirety, and maximizeunderstanding, it would be preferable to include the entrepreneurial perspective aswell. The focus could then be on how the entrepreneurs perceive the concept of ven-ture capital, rather than on the objective of the investors; thus, identifying potentialdiscrepancies. In that case, it would be interesting to include both entrepreneursseeking funding as well as those already having received it.

Since this thesis uses face validity to accept the pre-hypothesis, it could beinteresting to do a more thorough validation in order to ensure that the venturecapital landscape and its investment prospects actually can be represented by theCIC continuum.

Another interesting area identified in this thesis is the concept of binary risk.The problems faced when evaluating the binary risk, often emerging when investingin early-stage business model innovation, could be an interesting topic for furtherresearch.

7.4. IMPLICATIONS 83

7.4 Implications

The conclusions drawn in this thesis have resulted in implications for the en-trepreneurs, venture capitalists, and researchers, which are presented in this section.

7.4.1 Entrepreneurial

There is an asymmetry regarding the perception of an innovation; the view of thecommercialization phase might di�er greatly between the di�erent agents. This isthe view of venture capitalists, which suggests that the entrepreneurs might have adi�erent view of these potential investors, making them overlook some of the criticalfactors evaluated in the screening process; such as scalability and the possibility tosell the innovation. It is vital for the entrepreneurs to be aware of how this processis conducted.

Furthermore, it is important for the entrepreneurs to realize that they will belegally tied-up, and hence become unable to decide on critical factors, such as exitstrategy; the venture capitalists will always have their say, even though they are aminority owner.

With regard to the adopted risk profile–the essence of the investment models;firms nowadays seem to reduce risk on a higher level, compared to that of precedentresearch. Di�erences can be seen below:

• Validation of technology, and from the market, is appreciated to be done priorto investment

• Proof of economic viability is often a prerequisite

• Everything typically needs to be A-grade in order to justify investments

• The seed stage is typically avoided

In general, the venture capitalists among the respondents tend to be more restrictivewith their investments; e.g. compared to the situation before the dot-com crisis.This is something that the entrepreneurs also need to consider, in order to knowwhich factors that a�ect if funding is appropriate. Mostly, the empirical findingsare aligned with the arguments made by Engel (2011) regarding the strategic con-tributions. However, even more validation is typically required prior to making aninvestment, relating to the venture capitalists’ adopted risk profiles.

If interpreted in an extreme way, the entrepreneurs are simply the raw material,or a commodity, required in order for the venture capitalists to carry out their busi-ness model; to capitalize on growing companies, a view not always shared by theentrepreneurs. Thus, there might exist an asymmetry in the expectations surround-ing the entire process; entrepreneurs might see it as funding for their companies,while venture capitalists see it as an investment opportunity with the purpose ofmaximizing return on investment. The entrepreneurs’ naïve image is askew and

84 CHAPTER 7. DISCUSSION

might result in them not receiving funding due to the overlooking of the, sometimesharsh, process. Venture capitalism is not charity–it is a pure form of capitalism.

7.4.2 Venture capital

As mentioned in the conclusion, it all comes down to which risk profile that isadopted. The adopted risk profile will then cause implications for all the otherfive factors in the investment model. This is something that the venture capitalfirms need to consider in their strategic approach, prior to their investments, inorder to adjust their investment models properly. The major factor that needs tobe considered is whether or not the venture capital firm should accept binary risk,typically inherent when investing in early business model innovations.

Another observed pattern is that di�erent risk profiles, adopted by the venturecapital investors, a�ect the return on investment multiples. As mentioned above,investments in business model innovations tend to incur a binary risk, not mentionedin precedent research, that requires larger return multiples; typically over 10 timesthe investment, compared to the multiples mentioned by Zider (1998).

7.4.3 Research

The venture capital industry is rapidly changing, since the environment constantlyis evolving. Compared to most of the precedent research, this thesis has targetedthe Nordic venture capital market in order to create an up-to-date overview. ANordic focus, combined with the rapidly moving industry, resulted in that thisthesis identified di�erences and implications for research. However, it is importantto view these findings with regard to the delimited area.

The rate of initial public o�erings, as the investment exit strategy, seems to havedecreased greatly; contradicting its popularity in precedent research. Acquisitionsby larger companies are now more common, as the major exit strategy, identifiedin this thesis. IPOs are mainly an option when the investment has evolved into anexceptionally high-performing company. Therefore, future research could benefitfrom focusing more on trade sales, instead IPOs, in order to contribute to the fieldof venture capital, and a better understanding of its characteristics.

Fiet (1995) identified agency risk as a main factor in the risk profile. As men-tioned in section 2.5.2, agency risk is referred to as mainly being caused by en-trepreneurs pursuing their own interest at the expense of the venture capitalists.Identified in this thesis, a major e�ort is spent on eliminating this kind of risk priorto an initial investment. It is therefore essential for the entrepreneurs to share theirstrategy and visions with the venture capitalists.

As a result of the more restrictive investments, and the nature of the preferredlater investment stages, it may be beneficiary to redefine the investment stages. Theearliest investment stages represent that a business plan and a market analysis arecompleted, rather than simply being an idea or concept, as stated by Ruhnka andYoung (1987)–the latter relating more to the seed stage.

7.4. IMPLICATIONS 85

The more restrictive approach to investments has also somewhat eliminated theproblem of over-financing, as identified in some of the precedent research; this mightrelate to the reduced focus on milestones that the respondents have adopted.

While precedent research agrees on a two-dimensional space of innovation withintechnology and business models, practitioners seem to agree on the existence of acontinuum, similar to the one presented herein.

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Hans Otterling. 2012. General Parner, Northzone. Interviewed by Johan Lennefalk& David Törnquist. Stockholm, Sweden, 2012-04-25.

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93

Appendix A

Venture Capital Investor Questions

Below is an exact copy of the questions, sent to the venture capital investors priorto the interviews.

95

Interview Questions

Venture Capital Investor

Johan Lennefalk

[email protected]

David Törnquist

[email protected]

1 Purpose

The main purpose of the study will be to find a potential correlation betweeninvestment model factors and company types. The company type relates tothe placement on the continuum, see figure 1. However, there will also be afocus on the following:

• Mapping the complex, potentially misinterpreted, venture capital land-scape.

• The focal companies for the study will be technologically related.

• The study will, however, not be single-company specific and couldtherefore act as a guideline for several actors within the scope of thestudy.

1.1 The Venture Capitalism Landscape Continuum

In order to map the complex venture capital landscape, among actors in theinformation technology industry, an assumption is made: The investmentmodels vary with regard to where on the continuum the companies’ innova-tion focus is. Two types of extremities have been established; strictly tech-nological innovation and strictly business model innovation. It is assumedthat companies will implement both types of innovation to a certain degree,thereby populating the entire continuum. See figure 1 for the continuum.

Technological innovation

Business model innovation

Enables technology Creates infrastructure

Enabled by technology Utilizes infrastructure

Figure 1: Company innovation characteristics continuum

1

INTERVIEW QUESTIONS

2 Mapping of Investment Characteristics

All questions should be considered with regard to each type of continuum in-vestment (e.g. preferred investment stage for a technology focused companyvs. a business model innovation focused company).

2.1 Portfolio

• What kind of companies do you mainly invest in?

• Could you please place a few of your core portfolio investments on thecontinuum above; with regard to their innovation focus rather thantheir performance?

2.2 Investment Model

2.2.1 Decision aids in the screening process

• What specific factors do you consider in the screening process?

• Is there an established practice in the screening process or is it ad-hocoriented?

• Are there restrictions in the screening process (e.g. from the investorsin the venture capital fund)?

• How does the current economic situation affect the investment com-pany type and the screening process?

2.2.2 Preferred investment stage

The report has established, based on precedent research, the following in-vestment stages and their most significant characteristics:

• Seed: Idea or concept only

• Start-up: Business plan and market analysis completed

• Second round/stage: Market receptive, some orders/sales

• Third round/stage: Significant sales and orders

• Exit: Break-even or profitable

With regard to the above investment stages:

• Do you prefer a specific investment stage?

• Does the investment stage vary within your portfolio?

2

INTERVIEW QUESTIONS

• Is there any correlation between your investments and the companytypes?

• Does the company type affect the desired investment stage?

– In what way?– Is a certain company type better suited for a specific investment

stage?

2.2.3 Risk profile

• How do you determine risk; which factors define your risk profile?

– Determined as risk of negative return?

• Does the risk vary within your portfolio?

– With regard to the previously mentioned core investments?

• Is there any correlation between your risk profile and the company typeyou choose to invest in?

• To what extent is portfolio theory present in your choice of invest-ments?

• By what other means do you try to reduce risk in the portfolio? (E.g.by using investment syndicates, networks or strategic alliances?)


• How do you deploy capital over time during your investment process?

• What is your strategy approach to the ownership quota in the fundedcompanies?

• Does it vary within your portfolio?


• Is there any correlation between your timing of capital contributionand the company type?

• Do you use different guidelines for capital input depending on the com-pany type?

• Are certain milestones used?

3

INTERVIEW QUESTIONS


• Apart from capital, what strategical capabilities do you add/invest?



• Is there any correlation between your strategic input and the companytype?

• Does it vary between companies in your portfolio?



• What is your preferred exit strategy?



• Is there any correlation between your preferred exit strategy and com-pany type?

4

“Nothing endures but change.”

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