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Venture Capital and the Czech Republic

The venture capital market in the Czech Republic has expanded in recent years but there are still obstacles thwarting its development. This overview discusses venture capital financing issues for entrepreneurs, but it also raises some salient points about attitudes, dealflow and the stock market, that institutions investing in the Czech Republic should take note of.

What is venture capital?
In continental Europe, venture capital and private equity are synonymous, but in the USA venture capital is defined more specifically as a special branch of private equity, focusing on financing small, innovative businesses in their initial growth phases. Venture capital is invested in companies run by managers that aim to make a long-term profit. Very often, the way of achieving maximum profit is to sell the company at a certain phase of its development. Building up a business for the purpose of turning it into cash at the right time is common abroad, but sporadic so far in the Czech Republic. Venture capitalists can only achieve the required return on investments by selling their ownership shares in companies. The better prepared a company is for its future sale to a strategic partner or flotation on the stock exchange, and the more the company's management is oriented towards this objective, the more willing venture capitalists are to invest.

Venture capital as a company's partner
Unlike other financing instruments, the success of venture capital investment is not based on the company repaying funds including an agreed fixed return (loan interest, leasing coefficient, etc). A venture capital fund makes money if the value of the company goes up. It therefore has the same goal as the company's other co-owners and will act as a business partner.

Before providing financing, venture capital fund managers familiarise themselves in detail with the company and its key managers. They are under obligation to find out the company's risks, weaknesses and strengths. Before providing finance, a detailed financial and process audit is usual, as is personal acquaintance with the company's key suppliers and customers, a detailed analysis of its marketing strategy, understanding of the competition and market trends, an independent appraisal of the technical parameters for the company's products and services, obtaining personal references for key managers, etc.

Detailed due diligence is essential to generate confidence in the project. On the basis of this confidence, venture capital investors are then ready to support the company through any unexpected short-term problems, and thanks to their detailed knowledge of the company, their recommendations and consultations are invaluable. A good relationship between company management and fund managers is essential if their investment is to be successful.

After providing financing, access to regular information on the state of the company is also important for venture capital investors. The company is usually obliged to provide monthly financial information and management statements, informing investors without delay of any important events. Venture capital fund managers are usually active in the company's boards, jointly deciding on fundamental strategic steps. They work to supplement the company's management team with new people, providing expertise in areas of management that were previously weak. However, they do not usually take over the company's operational management.

Various financial instruments for companies' various needs
Like all other financial institutions, venture capital funds have a clear definition of the opportunities suitable for this kind of financing. Few businessmen today would go to a leasing company to ask for an export loan or an export bank for factoring receivables. Similarly, venture capital can't be used for financing business plans without long-term competitive advantages that establish the potential for the company's rapid expansion.
Venture capital is not suitable for typical family businesses such as shops, restaurants, small hotels, garages, etc. Nor can it be counted on for real estate transactions. It is reasonable to look for a venture capital investor for projects in IT, the application of technological innovations and patents and in building up networks of sales outlets and services - in short, everywhere where there is a potential for sales and profits to multiply each year.

Unlike current practice by certain other financial institutions, venture capital investors emphasise an appropriate choice of financing instruments, corresponding to the way in which the company will allocate the funds acquired. If a promising and expanding company urgently needs to buy or reconstruct real estate to achieve its business plan, it should first of all agree on covering that part of its needs with a mortgage bank, while the purchase of technology should be covered by leasing or a bank loan, etc. Before approaching a venture capital fund, a company should have discussed or ensured financing from other sources, including making maximum use of its own resources and its main owners' savings.

Venture capital is closely connected with the public capital market (the stock exchange). One of the stock exchange's fundamental roles is to act as a source of capital for companies to finance their expansion, by subscribing newly issued shares. Venture capital fulfils this function before a company floats on the stock exchange, with flotation being one of the standard opportunities for paying venture capital investors.

The Czech capital market does not fulfil these functions. On the contrary, many Prague Stock Exchange representatives believe that venture capital can play an important role in taking small, illiquid companies off the public capital market. Once again, this is an attempt to use venture capital to supplement another financing instrument that is non-functional at present. Taking companies off the Prague Stock Exchange is a side effect of certain investments by venture capital funds into management buyouts or development and rescue deals.

Understanding the risk
Venture capital funds knowingly accept a high degree of risk. By investing to increase a company's registered capital, they subordinate their own returns to other companies or individuals that are also providing finance. If a company has payables on loans, compulsory leasing payments and payables due to the state and business partners, it will pay these before paying its venture capital investors. If the company does not make a profit, if it does not have enough cash to pay out profit, or if it is not possible to sell the ownership share in the company for a good price, the venture capital investor loses out.

The provision of venture capital therefore improves a company's image with financial institutions and business partners. It is natural that venture capital can only be invested when a company has a strong competitive advantage and an exceptionally capable management team. The high appreciation of funds invested can be expected to compensate for the high level of risk.
It is not usual to consider an investment successful if it does not achieve an at least 30 per cent average annual increase for the funds invested (the internal rate of return). It is however necessary to be aware that this yield is not paid by the company, or the other co-owners, but by whoever buys the fund's shareholding. The other co-owners achieve at least the same appreciation of their ownership shares as the fund.

Conclusion
The risk in venture capital must be understood. Venture capital investors must be convinced of the exceptionally low risk of management failure, legal complications, failure of the marketing strategy, the emergence of financial problems and all other factors threatening the fulfilment of the business plan, to be willing to risk subordinating their returns to the company's other partners.

The basis for businessmen to decide on whether to use venture capital should be whether they can earn more with it than without. If their company is high-growth in nature and they are in business to get rich, they are suitable partners for venture capital investors.

Sources of further information on venture capital are the new directory of the Czech Venture Capital Association, representing ten venture capital providers in the Czech Republic and ten associate members, and the web pages www.cvca.cz and www.notesnet.cz/frk.

© Radek Laštovicka is an investment manager at Risk Capital Fund Ltd in Praque. Reprinted with the consent of the author May 2001.