Understanding venture capitalists' decision environment: evidence from Central and Eastern Europe

A R G U M E N T A OECONOMICA N o 1-2(1 8 )2 0 0 6 PL ISSN 1233-5835

Dariusz Klonowski*

UNDERSTANDING VENTURE CAPITALISTS’

DECISION ENVIRONMENT: EVIDENCE FROM

CENTRAL AND EASTERN EUROPE

T h is a rticle exam ines the d e c isio n criteria environm ent as p erc e iv e d by investm ent o fficers from venture capital firms op era tin g in the most d e v e lo p e d ven ture capital markets throughout th e Central and East E uropean (CEE) region, w ith an em p h a sis on Hungary, Poland, th e C zec h Republic and S lo v a k ia (response rate o f 56% ). W h ile the tw enty-six in v estig a ted criteria have proved to b e u sefu l in outlining the v en tu r e cap italists’ d ecision m aking en v iro n m en t, the study c o n fir m s that venture ca p ita lists ad d ress three types o f d ecisio n risk in their investigation: entry risk, operating risk, and e x it risk. T h e paper provides further e v id e n c e to dem onstrate that th e CEE countries sh o u ld n o t be treated as o n e “h o m o g e n e o u s b lo ck ” by venture ca p ita lists. Venture capitalists o p era tin g in the CEE region ex h ib ited sig n ifica n t differences w ith rcsp cct to the relative im p o r ta n ce they assigned to the various d e c is io n criteria.

K e y w o r d s : venture, cap ital, d e c is io n -m a k in g , Eastern, E u r o p e

IN T R O D U C T IO N

T h e p ro c e ss used by v en tu re capitalists to m ake in v estm en t decisions e n c o m p a sse s the heart and soul o f venture capital in v e stin g (Tyebjee and B runo, 1984; Fried and H isrich , 1994; Hall and H o fe r, 1994). V enture cap italist practitioners often reg ard the venture c a p ita l process as a co m b in a tio n o f art and science. T h e science relates to th e application o f specific a n d concrete d ecisio n criteria to a d e ta ile d and technical in v estig atio n o f the m arket o r industry com petition, te ch n ical issues, the firm ’s fin a n c ia l perform ance, an d its valuation (T y eb jee and Bruno, 1984; Hall and H o fer, 1993; Fried and H isrich, 1994). By re ly in g on internal and external reso u rces, venture c a p ita lists are able to reach d e fin ite yet technical c o n c lu sio n s. T here are, how ever, aspects o f the a sse ssm e n t o f the firm or its b u sin ess p lan that are more d iffic u lt to ascertain. T he art o f venturing relates to the “ s o ft” , unquantifiable, less tangible, n o n -c o n c re te, and subtle

e v a lu a tio n em bodied in the assessm ent of people, d e a l term s, negotiating ta ctics, and the “ investm ent sto ry ” (Sandberg et al, 1988; Riquelm e and R ic k a rd s, 1992; Smart, 1999). T h is may be regarded as venture cap italist’s in tu itio n and be appropriately called experience-driven judgm ent. S tew art (1 9 9 9 ), and Shepherd and D o u g las (1999) argue th at traditional approaches b a se d on a concrete assessm ent o f tangible criteria m ay be less reliable and re le v a n t to venture capital d e c isio n making.

W h ile there are num erous studies that detail the decision criteria em ployed by venture capitalists in W estern European countries (fo r review of academ ic literature see Muzyka et al, 1996; Boocock and W oods, 1997), the decision criteria used by venture capitalists in their investments in C E E firms are not well understood. The studies by K arsai et al (1997), K arsai et al (1998), and Bliss (1999) provided a useful background on venture cap italists’ decision process. Karsai et al (1997) focused on the general evolution o f the venture capital m arket in Hungary and pointed to some screening criteria used by local investors. Karsai et al (1998) focused on the screening and valuation approaches used by venture capitalists in H ungary, Poland, and Slovakia. They noted som e d ifferences in the way venture capitalists process deals in the three countries and in com parison to the UK. Bliss (1999) focused on the investm ent process and decision criteria used by venture capitalists in Poland. H e also outlined som e unique criteria used by local venture capitalists such as risk of governmental influence, an untested legal system , and quality of m anagem ent.

T h e objective of the study is to focus on the key e le m e n ts of the venture c a p ita l decision-m aking p ro c e ss across various C E E co u n tries. Specifically, the p a p e r exam ines the d e c isio n criteria environm ent as perceived by venture c a p ita lists m aking in v estm en t decisions in C E E countries, including H u n g a ry , Poland, the C zech R epublic, and S lovakia, w hich have the m ost d e v e lo p e d venture capital in d u stries. Six groups o f d e c isio n criteria (m arket and p ro d u ct, entrepreneur an d m anagem ent, stra te g y and com petition, v a lu a tio n and returns, deal, an d other) are ex am in ed w ithin the context o f v e n tu re capital investm ent in d ifferen t countries.

1. DECISION MAKING CRITERIA

E xtensive research has been conducted to exam ine the importance o f the various decision making criteria used by venture capitalists in W estern countries. The field research can be separated into three broad areas: 1) studies assessin g venture perform ance and returns (Dorsey, 1979; M acMillan et al,

1988); 2) research focusing on the venture capital process and the decision m aking environm ent (Riquelme and Rickard, 1992; Hall and H ofer, 1993); and 3) literature focusing on the evaluation o f venture capitalists’ investment decision criteria (T yebjee and Bruno, 1984; M acM illan et al 1985; M uzyka et al, 1996).

R e search investigating the v e n tu re capitalists’ d ecisio n environm ent has evolved o v e r tim e, yet has p ro d u c e d a m odestly sim ila r set o f decision criteria. T h re e distinct phases o f research can be id en tified . The earlier studies c o n d u c te d between the 1970s and 1980s focused on identifying the criteria u se d by venture cap italists in evaluating p o ten tial businesses and asc e rtain in g th eir relative im p o rta n c e through the u sa g e o f descriptive statistics. T h e second wave o f re se a rc h in the field fo c u se d on the use of linear statistic a l m ethods to c o n d e n se the decision c rite ria into identifiable groups. T y e b je e and Bruno (1 9 8 4 ) used factor an aly sis to identify five groups o r c rite ria that reflect five ty p e s o f risk in v enture cap ital investm ent: m an ag em en t risk, investm ent risk, com petitive risk, o p eratio n al risk, and cash out risk . M acM illan et al (1 9 8 5 ) em ployed a sim ilar ap p ro ach and came up w ith s im ila r decision criteria as a result of using fa c to r an aly sis, a process focusing o n the im portance o f m anagem ent, m arket, p roduct, external en v iro n m e n t, and cash out. In 1996, M uzyka et al, in an attem p t to advance prior re se a rc h in the field (w hich previously concentrated on the usage o f a “ laundry list” o f decision criteria), em ployed conjoint an a ly sis to describe the d e c isio n m aking process by m e asu rin g the relative im p o rtan ce o f criteria w ithin a tra d e -o ff environm ent. T h e study identified sim ilar category g ro u p in g s (product-m arket, strateg ic-co m p etitiv e, fund), b u t also introduced new o n es (fin an cial, m anagem ent team , m anagem ent c o m p e te n c e, and deal). A sim ila r tech n iq u e was em ployed by R iquelm e and R ic k a rd s (1992). W hile co n sid e ra b le insight had been sh e d on the decision m a k in g process by the m iddle o f th e 1980s, academ ics w e re dissatisfied with re se a rc h initiatives in the field. S an d b e rg et al (1998) n o tab ly stated that p rio r research had “failed to capture and convey the richness, subtlety and discernm ent em bodied in the venture c a p ita list’s decision process and criteria” . Such a statem ent undoubtedly underscored the researchers’ inability to fully quantify the com plexities of the venture cap ital decision process. R esearch in the last years o f the 1980s focused on verbal protocol, a technique based on active interaction betw een researchers and respondents (Sandberg et al, 1998), in an attem pt to further expand the understanding o f the decision criteria environment.

T h e stu d y focuses on six g ro u p s o f decision c rite ria that could be co n sid ered im portant and follow s th e research m ethodology used by M uzyka et al (1 9 9 6 ). Firstly, product and m ark et criteria are o ften considered as the

m ost im portant variable fo r successful v en tu re-b ack ed com panies and in v estm en ts (Tyebjee and B ru n o , 1984; Fried and H isric h , 1994). D efining m ark et size, growth, cu sto m er interests, and o th er v ariab les such as these h elp s to forecast o p p o rtu n ities and enables e n tre p re n eu rs and venture c a p ita lists to understand the d riv in g forces of the m ark et. Secondly, the p re se n c e of m anagem ent is se c o n d only to the m arket as the m ost im portant v aria b le for venture capitalists to consider. In o rd er to succeed in business, m a n ag em en t needs ex perience, education values, track record, capability in p ro c e ss m anagem ent, and, p erh a p s most im portantly, a c le a r vision. This is o ften supplied by the e n tre p re n eu r, who starts the co m p an y and pursues b u sin e ss action that is o p p o rtu n ity driven. A strong m an ag em en t team is also n e c e ssa ry for a successful co m p an y , since venture ca p ita lists tend to finance e n trep ren eu rial teams ra th e r than solo e n trep ren eu rs (Baum ol, 1968; M acM illan et al, 1985; M u z y k a et al, 1986; R o u re an d M aidique, 1986; S m a rt, 1999). Thirdly, b u sin ess strategy deals w ith th e w ay in which a firm c o m p e te s in a given industry. T h e strategy must sp e c ify w hat resources are n e e d e d and how they w ill b e obtained, since lim ited resources may be a v a ila b le . W ithout a strong b u sin ess strategy to deal w ith im portant business issu es, a business venture ca n n o t grow and th e re fo re will not survive (M itc h e ll, 1991). Fourthly, s tro n g returns from a v e n tu re capital investm ent are critical to financiers. R etu rn s are influenced by business valuations v e n tu re capitalists assign to th e entrepreneurial b u sin e ss at the point o f c lo sin g the deal (Tyebjee and B runo, 1984; Fried and H isrich , 1994). Fifthly, v e n tu re capitalists are c o n c ern ed with deal criteria. A docum ent called the T e rm S h eet sum m arizes the te rm s o f the proposed in v estm en t and lays out th e p rin cip les that govern the relationship betw een a v en tu re capital fund and a c o m p an y . The docum ent in clu d es inform ation on th e sh areh o ld ers’ level o f p ro te c tio n , budget, strategic d ecisio n approval p ro c e d u re s, investor rights, and e x it m echanism s (K irilen k o , 2001; S tro m b erg and Kaplan, 2003). L astly , there are other crite ria such as financial m e a su re s, strength o f local e c o n o m y , and venture cap ital fu n d s’ specific c rite ria that are considered (T y e b je e and Bruno, 1984; M u z y k a et al, 1996).

2. RESEARCH METHODOLOGY

T h e prim ary purpose o f th e study was to d e fin e the decision criteria e n v iro n m e n t as perceived by v en tu re capitalists o p e ra tin g in the CEE region and to identify differences in th e w ay venture cap ita lists approach these local

m arkets. T h re e hypotheses g u id e d the design o f th e m ethodological approach a n d statistical analysis.

T h e first hypothesis related to the decision en v iro n m e n t and specific c riteria u s e d by venture c a p italists in their investm ent d ecisio n s. It was h y p o th esized th at venture cap italists w ould make their d e c isio n s on the basis of the c rite ria identified in p re v io u s research studies and c o m m o n ly applied in w estern m arkets. This reflected the fact that m any v e n tu re capital firms are e ith e r ru n or supervised by w e ste rn investm ent p ro fe ssio n a ls and that these p ro fe ssio n a ls would ten d to apply business e v a lu a tio n techniques applied in o th e r countries. E v id e n c e from studies in w e ste rn countries confirm s th a t venture capitalists u se sim ilar criteria in d iffe re n t m arkets. The first re se a rc h hypothesis is stated in th e null form as fo llo w s:

H I n v e s t m e n t criteria applied by venture capitalists in Western Europe appropriately describe the decision environment in the CEE region.

T h e se c o n d research hypothesis d ealt with the a p p lic a tio n o f these criteria to actual in v estm en t projects. P re v io u s studies and a c a d e m ic research (see T yebjee a n d B runo, 1984; M acM illa n et al, 1985; M u z y k a et al, 1996) confirm th a t venture capitalists fo cu s on groupings o f risks in their in v estig atio n o f potential in v estm en t prospects and th e final investm ent decision. It has been found th at in stead of focusing .on a general “ laundry list” o f c rite ria , venture cap italists focus on m oderating risk s in key areas. The seco n d research hypothesis is therefore stated in the null form as follows:

H2: There are groupings o f decision criteria that can be discerned fr o m available data.

T h e th ird research h ypothesis w as concerned w ith th e way venture cap italists ap p ly these criteria to specific countries in th e region. It was further h y p o th esized that v en tu re capitalists would c o n siste n tly apply the sam e c rite ria in their analysis o f key decision areas a n d across various cou n tries in the C EE region. W h ile limited research e x ist (B liss, 1998; Karsai et al, 1998) to support the fa c t that venture c a p ita lists recognize local realities in th e ir decision m aking, th e hypothesis w as b a se d on the fact that all the m a rk e ts under study d e v e lo p e d at the same tim e a n d have relatively h o m o g en o u s m acroeconom ic in d icato rs. C onsequently, th e dynam ics o f the venture c a p ita l environm ent w o u ld likely be the sam e. T h e third research h y p o th esis is stated in the null fo rm as follows:

T h e sam pling fram e in th is study included the 1 12 investm ent officers e m p lo y e d in venture cap ital firm s targeting H u n g ary , Poland, the C zech R ep u b lic, and Slovakia. T h e targ et population w as d eriv ed from a variety o f d iffe re n t sources, including a m em bership list o f local venture capital asso c ia tio n s and the B ook o f L ists, published by N ew W orld P ublishing, w h ich is regarded as the m ost com prehensive b u sin e ss directory in the C E E reg io n . T he list was also cross-referenced w ith o th e r sources to assu re c o m p le tio n . V enture capital firm s focusing on d iffe re n t stages of com pany d e v elo p m en t were also in clu d ed in the study (seed financing accounted fo r 0.5 p ercent o f all the respondents; start-up fin an cin g - 14.7 percent; e x p a n sio n financing - 6 4 .6 percent; replacem ent cap ital financing - I 1.0 p erc e n t; buyout financing - 8.6 percent; undeclared - 0.6 percent), en su rin g not o n ly the integrity o f the d a ta , but also the re lia b ility of the results.

A m ail questionnaire (included in A ppendix A ) was sent to the in v estm en t officers in a personally addressed en v elo p e, along w ith a c o v e rin g letter. The first sectio n o f the questionnaire pertained to six g ro u p s o f d ecisio n criteria that c o u ld be considered im p o rtan t when investing in C E E countries. T hese included: product and m ark et criteria (m arket size, m a tu rity and grow th, d e g re e o f market d e v elo p m en t, types of p roduct, seaso n ality ), entrepreneur an d m anagem ent c rite ria (leadership p otential, tra c k record, quality o f m anagem ent, co m p eten cies, experience), strategy and com petitive criteria (strateg ic positioning, co m p etitio n , ease of m arket en try , strength of suppliers and distributors), v alu atio n and returns crite ria (b u sin e ss valuation, po ten tial returns, com petition fo r the deal), deal c riteria (sta g e o f investm ent, in v e sto r protections), an d o th e r criteria (financial m e asu res, strength of local econom y, venture cap ital fu n d s’ specific criteria). In th is section, a seven-point L ikert scale was u sed by each firm to rate the im p o rtan ce o f the tw en ty listed decision c rite ria ; "1" denoted "very u n im p o rtan t" and "7" d e n o ted "very im p o rtan t". The design o f the q u estio n n aire was based on th e literature review . T h e questionnaire w as p re ­ te ste d and subsequently refin ed on a sample o f th re e venture capital firm s (n o t included in the study). T he second section o f the questionnaire d ealt sp ecifically with venture cap ital firm s’ d em o g rap h ic data. In this sectio n , clo sed -en d ed questions w ere used to characterize th e respondents and th e ir firm s. T he dem ographic p ro file included q u estio n s regarding the p referred sta g e s o f investm ent, the n u m b er of years o f in volvem ent in the v en tu re cap ital industry, the n u m b e r o f com pleted investm ents, the nu m b er o f e m p lo y ees, the IRR ex p ectatio n s, and the p ro fessio n al background o f resp o n d en ts (i.e. edu catio n , y ears o f experience).

A c c o rd in g to different in d u stry sources (lo cal venture capital asso c ia tio n s, local new spapers, B o o k o f Lists), there are b etw e e n 95 and 104 v enture c a p ita l funds operating in C en tral and Eastern E u ro p e (H ungary: 36- 38; P o la n d : 33-35; the C zech R epublic: 17-19; S lo v a k ia : 9-12). The o b jectiv e o f the study was to s o lic it responses from the e n tire population o f v enture c a p ita l funds operating in the region. Tw o q u e stio n n a ire s were sent to each v en tu re capital fund to random ly selected in v estm en t officers in these fu n d s. It was conjectured th a t w hile the responses in the dem ographic section re ceiv ed from the sam e fu n d were expected to be the sam e, the resp o n ses related to the im p o rtan ce o f specific p ro b lem s w ere likely to be different, reflecting diverse b ack g ro u n d of investment o fficers w orking in the sam e fund. In total, 200 questio n n aires were sent out to 100 venture capital funds, y ie ld in g an initial response o f 47.5 percent (95 respondents). Follow-up phone c a lls w ere made and resu lted in 17 additional responses, increasing the response rate to 56.0 percent. T his response rate is co n sid ered acceptable.

T h e statistical analysis w as d o n e in stages and w as p erfo rm ed with SPSS. The o b je c tiv e o f the first stage o f analysis was to d e v e lo p a concise set o f v ariab les to be used for fu rth er an aly sis. A fter e sta b lish in g a strong set o f d ecisio n criteria, m ultiple a n a ly se s o f variance, and fa c to r analysis were p e rfo rm ed . T he factor an aly sis w as used to in v e stig a te the underlying stru ctu res o f the tw enty-six in v estm en t decision criteria, so that one might gain a g e n e ra l understanding o f th e decision environm ent and the differences in the p ercep tio n s o f the d ecisio n criteria for different ty p es o f respondents. The reliability of the construct w as assessed using C ronbach alphas. The m ultivariate analysis was successfully used in studies perform ed by MacM illan et al (1985), Riquelme and R ickards (1992) and M uzyka et al (1996).

3. RESEARCH RESULTS AND DISCUSSION

3.1. Decision C riteria and their S tructure

M a n y factors influence the fin al investm ent d e c isio n s m ade by venture capital firm s. Principal fa c to r extraction with v arim ax rotation was p e rfo rm e d . U sing a factor lo a d in g o f 0.50 as the c u t-o ff fo r inclusion w ithin a facto r, th e decision criteria sep a ra te d three factors, c o n firm in g H ypothesis 2. T h e first factor was labeled “e n try risk” and e x p lain ed 28.5 percent o f the variance. T h e second factor w as concerned w ith “o p eratin g risk” and e x p la in e d 14.8 percent o f the v arian ce. The third fa c to r was term ed “exit risk” a n d explained 19.2 p e rc e n t o f the variance. T h e tw enty-six decision

c rite ria used in the q u estio n n aire provided a c o m p reh en siv e set of decision c rite ria to be used by local v en tu re capitalists. T h e p ercentage of variance e x p la in e d by the three fa c to rs was equal to 62.5 percent, a favorable c o m p a riso n to Tyebjee and B ru n o (1984) - 60.4 p e rc e n t - and M acM illan et al (1 9 8 5 ) - 60.5 percent. T h e results confirm ed th a t the list of standard d e c isio n criteria successfully u se d for the analysis o f investm ent decisions in w estern countries is useful in assessing investm ent projects in the C E E reg io n . T herefore, H ypothesis 1 w as confirm ed.

Table 1

F actor and reliability an alysis for investm ent decision criteria and three factor groups.

Decision C riteria F actor L oad in gs Entry Risk Factor Loadings Operating Risk F a cto r L oad in gs Exit Risk

Market size and growth dynamics D egree o f market consolidation Product or service seasonality V alue-added products or services

0 .853

0.579 0.548

0.518

Entrepreneur’s leadership potential 0 .8 2 9

Complementary management team 0.735

Industry experience 0.502

Track record o f success 0.651

E ase o f market entry 0.634

D efcndable market position 0.543

Market share 0 .843

Nature and degree o f competition 0.583

Strength o f suppliers and distributors 0.780

A vailability o f business plan 0 .548

Expected rate of return 0 .5 4 9

A bility to cash out 0 .7 7 0

Com petition for the deal 0.521

Valuation 0.543

D egree o f investor protections 0.745

A bility to influence operations 0.875

Stage o f investment 0 .5 1 2 0 .872

A bility to force exit and exit potential 0 .7 6 9

Investment scalability 0.543

Strength o f financial performance Strength o f local economy

Business agrees with fund’s constraints and objectives 0 .507

0.873 0.542

C ronbach’s a 0 .8 0 5 2 0.7945 0 .7 6 4 5

Percentage o f variance explained E igenvalue 28.5% 13.27 14.8% 7.43 19.2% 8 .56

Total percentage o f variance explained 62.5%

T h e re a re m any factors in flu e n c in g the final in v estm en t decisions made by v e n tu re capitalists. Entry risk ten d e d to be related to th e assessm ent of two areas: th e com m ercial attra c tiv e n ess of the investm ent (the “com m ercial p ro p o sitio n ” ) and project “d o -a b ility ” . T he key areas re la te d to assessing a p ro je c t’s attractiv en ess are the en trep ren eu r and m a n ag em en t (as well as their track record), m arket size an d grow th (as well as m ark et share), and, last but n o t least, the availability o f a com prehensive b u sin ess plan. The second asse ssm e n t area w ithin th is factor relates to an assessm en t by the fund p e rta in in g to the probability o f the project being co m p leted . In other w ords, th e seco n d area relates to th e fu n d ’s ability to su ccessfu lly com plete the deal o n term s satisfactory to venture capitalists. T h is com ponent generally relates to deal issues involving financial co n tractin g , namely stru ctu rin g , pricing (business v alu atio n ), and ex p ected returns. V enture cap italists m u st be assured, w ith sig n ifican t rights and p ro tectio n s, that they have n e g o tia te d the best deal. T h e assessm ent o f a v e n tu re capital fund’s ability to su ccessfully execute th e deal is im portant s in c e the risk o f not c o m p le tin g the project is n orm ally regarded as above a v e ra g e in the venture capital in d u stry . T his is often d u e to potentially u n su ccessfu l negotiations or the te n d e r approach com m only u se d in privatization, p ro c e sse s in the CEE region.

O n c e th e in v estm en t is c o m p le te d , venture c a p ita lis ts sh ift th eir focus to o p e ra tio n a l issues. V en tu re c a p ita lis ts will c o m m o n ly ask them selv es, “Is th e c o m p a n y (and thus th e in v e stm e n t) p e rfo rm in g in acco rd a n ce w ith the b u s in e s s plan upon w h ich th e d ecisio n to in v e st w a s ta k e n ? ” The o p e ra tin g ris k relates to the a s s e s s m e n t o f the firm ’s p o te n tia l fo r future b u sin e ss fa ilu re or u n d e rp e rfo rm a n c e . In assessin g th e s e o p e ra tin g risks, key fo c u s w a s given to the m a c ro c o n sid eratio n s lik e ly to in flu en ce the fin a n c ia l p e rfo rm a n c e o f the b u s in e s s , nam ely the c o u n tr y ’s econom ics p e rfo rm a n c e , m arket and c o m p e titiv e co n sid e ra tio n s, a n d m anagem ent e x p e rtis e in th e industry. A ll th e s e factors are lik e ly to in flu en ce the stre n g th o f th e co m p a n y ’s fin a n c ia l p erfo rm an ce an d e x it o p p o rtu n ities. V e n tu re c a p ita lis ts are ab le to te s t the reliab ility a n d stre n g th o f their in v e sto r p ro te c tio n s, e sp e c ia lly w h e n the bu sin ess is u n d e rp e rfo rm in g . M any o f th e rights ag re e d u p o n betw een b u s in e s s ow ners and e n tre p re n e u rs p ro v id e v e n tu re c a p ita lists w ith a d d itio n a l po w ers and re m e d ie s in th e event that a v e n tu re capital b ack ed b u s in e s s ex p erien ces o p e ra tio n a l p ro b lem s. U n d er s u c h circu m stan ces, v e n tu re c a p ita lists may d e c id e to c h a n g e the b u sin e ss le a d e r or the e n tire m a n a g e m e n t team th ro u g h th e c h a n g e o f co n tro l rig h ts .

T h e th ird area of concern an d risk for venture c a p ita lists relates to the re a liz a tio n o f their investm ent w ithin a reasonable tim e fra m e - the exit risk. W h ile v en tu re capitalists view investm ent from a long te rm perspective, they are n o t operating investors, a n d m ust secure w ays o f selling their shares w ith in a targeted investm ent h o ld in g period. M any tim e s, venture cap italists’ p a rtn e rs have a different p ersp e c tiv e on holding. F o r ex am p le, they may be a ttra c te d by a future d ividend stream , the ability to w a it for a “p referred” b u y e r o r the ability to retain co n tro l of the business, a n d the status and self- fu lfillm e n t that goes with it. T h is difference in o p in io n on the value o f an “ u n so ld sh are” means that the e x it issue is often one in w h ich the interests o f v e n tu re capitalists and b u sin e ss ow ners diverge m o st. It is, therefore, im p o rta n t for both parties to discuss each o th e r’s requirem ents and e x p e c ta tio n s early in the p ro c e ss and come to a m utually satisfactory so lu tio n . In certain circu m stan ces, venture capitalists a re entitled to a “d rag a lo n g rig h t” , where they fo rce an exit through the sa le o f all shares in the b u sin e ss to a strategic investor.

3.2. Decision C riteria across the CEE Region

O v e ra ll, the ven tu re c a p ita lis ts that w e re su rv e y e d e x h ib ite d s ig n ific a n t differen ces as to th e ir opinions on th e re la tiv e im p o rtan ce o f d e c is io n criteria. At the 10% level o f sig n ific a n c e , v en tu re c a p ita lists o p e r a tin g in various c o u n trie s d iffered on 16 o u t o f 26 decision c rite ria (s e e T a b le 2). F u rth e rm o re , th e re was sig n ifican t d isa g re e m e n t ab o u t th e r e la tiv e im p o rtan ce o f th e to p 10 decision c rite ria . T a b le 2 presen ts th e m e a n sc o re s across v a rio u s decision c rite ria , a lo n g w ith sta n d a rd d e v ia tio n , ranking. T he d e c is io n criteria not o n ly p ro v id e an insight into th e sp e c tru m and im p o rta n c e o f the various d e c isio n p ro cesses u tilized by v e n tu re c a p italists, but a lso o u tlin e the v ary in g ty p e s o f ch allen g es th e y are lik e ly to e n co u n ter in th e s e countries. T h e th re e m ost im p o rtan t d e c is io n c riteria for e a c h c lu s te r are noted b e lo w . O ne o f the m o st n o tic e a b le features p e rta in s to how venture c a p ita lis ts op eratin g in th e C z e c h R ep u b lic and S lo v a k ia hav e the highest o v e ra ll im portance ra tin g s fo r th e ir problem s (c o m p a re d to H ungary and P o la n d ) in tw enty o f th e tw e n ty -s ix decision c a te g o rie s .

T a b le 2. M ean sc o res in k ey d e c is io n criteria u sed by venture ca p ita lists in the C E E region

D ecisio n C riteria H u n gary P o la n d T h e C zech R ep u b lic Slovak ia R an k M ean SD R a n k M ea n SD R an k M ea n SD R ank M ean S D

Market siz e and growth d ynam ics** 1 6.07 0.45 4 5.71 0.65 3 6 .1 6 0 .5 2 5 6 .17 0 .6 7

D egree o f market consolidation** 4 5.96 0.87 13 5.41 0 .72 12 5 .9 0 0 .67 11 5.93 0.61

Product or service seasonality*** 13 5 .49 0 .6 4 25 4 .1 8 1.17 19 5 .6 8 0.71 17 5 .7 4 0 .7 0

V alue-added products or services 18 5.07 0.81 5 5.63 0.93 22 5 .5 7 0 .8 0 20 5.65 0 .5 3

Entrepreneur’s leadership potential*** 5 5.93 0.45 1 5 .8 9 0.37 I 6.21 0 .4 6 3 6.27 0 .4 3

C om plem entary management team ** 14 5.37 0 .67 10 5 .4 9 0 .22 2 6 .18 0 .2 8 1 6.33 0 .4 8

Industry experience 15 5.32 0.75 3 5 .7 4 0 .34 16 5 .7 7 0 .67 12 5 .9 0 0 .8 3

Track record o f su ccess 6 5 .86 0 .5 6 2 5.75 0 .56 26 5 .28 0 .7 8 2 6 .28 0.31

E ase o f market entry** 2 6 .02 0.35 15 5 .26 0 .6 0 15 5 .8 2 0 .6 7 13 5 .86 0 .5 9

D efen d ab le market position* 23 4 .57 1.09 21 4 .7 4 0 .72 21 5 .6 0 0 .53 21 5 .6 4 0.61

Market share** 3 5 .99 0 .42 6 5 .6 0 0.46 8 5 .98 0 .45 4 6 .2 2 0 .5 5

Nature and degree o f com petition 17 5.17 0.98 16 5.21 0.71 14 5 .8 6 0.81 24 5.47 0 .9 0

Strength o f suppliers and distributors* 19 4.98 0 .73 22 4 .5 6 0.88 18 5 .6 9 0 .78 14 5.85 0 .5 4

A vailab ility o f business plan 26 4.28 1.23 26 4 .1 2 0.75 9 5 .97 0 .5 4 10 5.99 0 .7 9

E xpected rate o f return** 9 5 .70 0.63 14 5 .37 0.58 4 6 .1 2 0 .4 7 7 6 .0 9 0 .6 3

A b ility to cash out*** 25 4.31 0 .5 4 17 5 .07 0.74 10 5 .97 0 .67 15 5 .8 4 0 .8 9

C om petition for the deal 8 5.71 0.61 18 5 .0 4 0.65 13 5 .8 9 0 .8 9 18 5.73 0 .5 4

V aluation** 10 5.63 0 .7 4 8 5 .55 0.41 11 5 .9 4 0 .7 3 16 5 .7 9 0 .7 0

D egree o f investor protections*** 11 5.58 0.49 9 5 .52 0.67 5 6 .0 7 0.63 6 6.13 0 .5 2

A b ility to influence operations*** 24 4 .37 0 .63 19 4 .9 4 0 .87 6 6 .0 4 0 .3 2 8 6.01 0 .5 9

S ta g e 'o f investment 21 4.75 0 .7 9 20 4 .8 0 0 .5 4 20 5 .65 0 .5 6 23 5.53 0 .8 4

A b ility to force exit and exit potential* 22 4 .6 9 0.95 7 5 .58 0.65 7 6.01 0 .6 7 19 5.71 0.71

Investm ent scalability 12 5.51 0.67 11 5 .47 0 .54 17 5.71 0.71 9 6 .0 0 0 .7 4

Strength o f financial perform ance 7 5.78 0 .5 4 12 5 .43 0 .56 23 5 .43 0 .5 6 22 5.58 0 .7 3

Strength o f local econom y 16 5 .26 0.63 23 4 .4 7 0 .63 24 5 .42 0 .6 0 25 5.41 0 .8 9

F und-com pany fit* 20 4.81 0 .76 24 4 .3 6 0 .87 25 5 .3 2 0 .5 6 26 5 .40 0 .2 6

S ig n ific a n c e le v e ls: * P < 0 .1, * * P < 0 .0 5 , *** P < 0 .0 1

S ou rce: o w n c a lc u la tio n s b a sed on research data from the q u estio n n a ir e

VO

o

F o u r m arket and co m p etitiv e decision criteria w ere am ong the top five d e c isio n criteria in H ungary, w ith market size an d g ro w th dynam ics, and ea se o f m arket entry b ein g ran k ed num ber o n e a n d tw o, respectively. V e n tu re capitalists are lo o k in g for markets that h a v e been increasing at sig n ific a n t growth rates in th e past and from w h ic h strong grow th is e x p e c te d to continue in the foreseeable future. T h e perform ance of th eir p o rtfo lio com panies in the m ark et sectors and the ch a lle n g e o f identifying b u sin e sse s that are strong p e rfo rm e rs are two reasons w h y venture capitalists a ttrib u te im portance to m ark et considerations. T h is is confirm ed by the re la tiv e ly high ranking o f th e co m p an y ’s past fin a n c ia l perform ance. T his fin d in g is consistent with e a rlie r studies outlining a d im in ish in g quality o f p ro je c ts available to venture cap italists. The issue re la te d to m anagem ent and e n tre p re n e u rs is considered as a secondary issue in com p ariso n to m arket c o n sid e ra tio n s. Local venture capitalists confirm th at w h ile having talented and ex p erien ced m anagem ent personnel is critical to any business, finding s tro n g and experienced se n io r m anagem ent - e sp e c ia lly in the areas o f fin a n c e and accounting - w ith western business ed u c a tio n (i.e. an M B A d e g re e ) is less problem atic th a n in other m arkets, such as Poland. T he high ra n k in g o f the deal c rite ria is a natural p ro g re ssio n from m arket c o n sid e ra tio n s. O nce a good d eal has been identified a n d venture capitalists hav e been granted ex clu siv ity to negotiate it w ith entrepreneurs, they b e c o m e concerned with w h e th e r the deal works in te rm s o f potential returns and b u sin e ss valuation.

V e n tu re capitalists in P o lan d are prim arily c o n c e rn e d about the quality o f e n tre p re n e u rs and m anagers. Polish venture c a p ita lists believe that a su c c e ssfu l venture is based on a strong m an ag em en t team and a driven e n tre p re n e u r with a successful track record. V en tu re cap italists are looking fo r in d iv id u als or m anagem ents team s that have b een in operation for a n u m b e r o f years and have p ro v en them selves c o m p e te n t m anagers. M ore im p o rta n tly , they look for “ o p erato rs” and not ju s t visionaries. V en tu re c a p ita lis ts also search for b u sin esses in which s tro n g senior executives c o m p le m e n t the leading e n tre p re n eu r and execute th e crafted strategy. In sh o rt, local venture cap italists are looking for “s e ria l” entrepreneurs and m a n a g e rs, and tend to bet on solid m anagem ent te a m s. T he second m ajo r d e c isio n -m a k in g theme relates to m arket co n sid eratio n s. As is the case in H u n g a ry , venture capitalists in Poland rank the im p o rtan ce o f m arket size and g ro w th dynam ics highly. T h is is done to en su re th e grow th of the top line an d im prove p rofitability. V enture cap italists also wish to avoid “ co m m o d ity -ty p e ” products o r services with few o r no value added

com ponents. They prefer to financially back businesses that can be differentiated from other m arket offers and where consum ers perceive a valued-added component. Ranked at number seven are the provisions related to exit enforceability. Venture capitalists commonly try to negotiate strong exit provisions (such as “drag-along” rights) and will rarely proceed to deal closure w ithout such protection.

V enture capitalists in the C zech Republic and Slovakia are generally concerned with all issues related to management, m arket, and deal considerations. This is reflected by the high average scores of the decision criteria exam ined. It is necessary to stress the im portance of investor protections. Venture capitalists in these markets are relatively new and less familiar with market conditions, and tend to “over-protect” themselves against any adverse conditions in the legal documentation. Investor protections are also extended to situations where venture capitalists are concerned with having the ability to influence the company’s operations in the case of any material underperformance from the agreed action plan.

CONCLUSIONS

The tw enty-six decision crite ria have proved to be very useful in outlining the decision m aking environm ent for ventu re capital firms operating in the CEE region. T he study confirms that instead of checking off individual risk factors, venture capital firms try to address three fundam ental types of risk in th eir decision process: en try risk, operating risk, and ex it risk. The percentage of variance ex plained by the three factors w as equal to 62.5 percent. T he entry risk relates to the assessment by venture capitalists of the com m ercial attractiveness o f an investment and th eir ability to complete the deal. The operational risk relates to venture c a p ita lists’ focus on any potential operational challen g es they may encounter d uring their holding period, as well as w ays in which they are able to p ro tect themselves against underperform ance, a likely harbinger of low returns. The exit risk relates to the venture capital firm ’s ability to successfully exit the investment.

The countries in the CEE region cannot be treated as one homogeneous “block” . V enture capitalists operating in the C E E region exhibited significant differences as to the relative importance of decision criteria. In short, they apply different decision criteria to analyze investment opportunities in the various countries of the CEE region. In spite of

concurrently developing m arkets, similar efforts to use public capital to rejuvenate entrepreneurship, and relatively hom ogenous macroeconomics, each country has its unique features. Venture capitalists must learn to understand these features if they are to improve th eir chances of successful investm ent in these countries. A better understanding of country-specific decision criteria can help to properly mitigate risks.

T he study has numerous implications for academ ics and practitioners. For academ ics, the study highlights the differences and similarities in the way venture capitalists in the C E E region make their investm ent decisions. The study also identifies the m ain types of risk venture capitalists attempt to hedge against. While the study raises more questions than it answers, it highlights many areas o f potential research in the CEE region. Areas pertaining to the returns achieved by venture capital firms operating in the region may be of some im portance, and can be explored in at least three d ifferent manners. Firstly, w hile over $1,226 billion was invested in the m arket between 1998 and 2002, limited evidence exists to suggest how successful venture capital firm s in the region really are in terms of returns. T he key research question relates to whether or not local venture capital firm s are sufficiently com pensated for the risks they are taking in the region. Due to potential problems with return disclosure on the part of venture capital firms, a case-study investigation of the m ost successful firms in the region would have to be perform ed. Secondly, various venture capital firms operating in the region developed and executed different entry modes into the m arket. It would be interesting to research w hich o f these methods was m ost successful. This m atter would be o f high importance to any practitioners about to enter the market. Thirdly, this study outlines that unique market characteristics may be responsible for different developments in the CEE markets, their potential, and, consequently, their returns. U nderstanding the various com ponents of the environm ent is likely to im prove venture capitalists’ success rate.

F o r practitioners, there are numerous implications. Firstly, the investment approach and decision criteria successfully used by venture capitalists when m aking investments in W estern Europe are generally helpful in detailing the decision environment in the CEE region. H ow ever, rather than using a system that “checks-off’ each o f the potential risks, it may be worthwhile to con sid er investment challenges in terms of three m ain themes: entry risk, operating risk, and exit risk. Such a classification m ay prove to be a useful fram ew ork for analyzing investm ent opportunities, and is likely to be quite intuitive for local venture capitalists. Secondly, each o f the countries in the

CEE region represents a unique market with its ow n characteristics,

challenges, and opportunities. Understanding these unique market

characteristics is the only way that venture capitalists operating in the region can im prove their chances o f successful investm entsand exits. It would be a m istake to treat the C E E region as a hom ogenous investment environm ent.

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Received: October 2005, revised version: April 2006

APPENDIX A

Research Questionnaire

Section 1

B elow is a list of problem s commonly encountered by venture capital (V C ) funds in different countries of Central and Eastern Europe.

Please circle the number on the scale which best indicates the importance of the problem under each classification. The num ber 1 will reflect a very unim portant problem, w hereas the number 7 will reflect a very important problem .

1. M arket size and growth dynamics in industry in which investee firm operates in

2 3 4 5 6 7

2. Degree o f market consolidation in industry investee firm operates in

2 3 4 5 6 7

3. Investee firm ’s product or service seasonality 2 3 4 5 6 7 4. V alu e-a d d ed products or serv ices p ro v id ed by investee .

firm

2 3 4 5 6 7

5. Existence of entrepreneur's leadership potential in investee firm 2 3 4 5 6 7 6. Existence o f complementary management team in investee firm 2 3 4 5 6 7 7. Industry experience of entrepreneur and management in

investee firm

2 3 4 5 6 7

8. Track record o f success for entrepreneur and management in investee firm

2 3 4 5 6 7

9. Ease o f m arket entry into industry investee firm operates in 2 3 4 5 6 7 10. Investee firm ’s ability to defend its m arket position 2 3 4 5 6 7

11. Investee firm ’s market share 2 3 4 5 6 7

12. Nature and degree of competition in industry investee firm operates in

2 3 4 5 6 7

13. Strength o f suppliers and distributors co-operating with investee firm

2 3 4 5 6 7

14. A vailability of business plan in investee firm 2 3 4 5 6 7 15. VC fund’s average expected rate o f return (IRR) from its

transactions

2 3 4 5 6 7

16. VC fu n d ’s ability to cash out from deals (i.e. redemption or dividends)

2 3 4 5 6 7

17. C om petition for deal from other VC funds 2 3 4 5 6 7

18. V aluation o f investee firm 2 3 4 5 6 7

19. D egree o f investor protections negotiated with shareholders of investee firm

2 3 4 5 6 7

20. VC fu n d ’s ability to influence operations o f investee firm 2 3 4 5 6 7

21. Stage o f investment in investee firm 2 3 4 5 6 7

22. VC fund’s ability to force exit and exit potential from investee firm

2 3 4 5 6 7

23. Investment scalability (i.e. investing in tranches) 2 3 4 5 6 7 24. Strength o f financial performance o f investee firm 2 3 4 5 6 7

25. Strength o f local economy 2 3 4 5 6 7

26. The fit between VC fund and investee firm 2 3 4 5 6 7

Section 2

I. W hich categ o ry below best d e sc rib e s your fund’s preferred stag e o f investm ent in

[count ly]?

[ ] Start-up

[ ] Expansion

[ 1 Replacem ent

[ ] Buy-out

[ ] O ther

2. F o r h o w many years has your fund been involved in venture cap ital investing in [country]!

[ 1 1 - 2 years

[ ] 3 - 4 years

[ ] 5 - 6 years

[ ] 7 - 8 years

[ J > 8 years

3. H ow m any transaction has y o u r fund completed in total in [country]!

[ j 1 - 5 transactions

[ 1 6 - 1 0 transactions

[ 1 11 - 15 transactions

[ 1 16 - 20 transactions

[ 1 > 2 0 transactions

4. H ow m any full (not partial) exits h as your fund achieved in [country]!

[ ] 1 - 5 exits

[ ] 6 - 10 exits

[ ] 1 1 - 1 5 exits

[ ] 1 6 - 2 0 exits

[ ] > 2 0 exits

5. W h at are your fund’s IRR ex p ectatio n s in [country]!

[

[ ] 2 1 - 2 5 %

[ ] 26 - 30%

[ ] > 30%

6. H ow m any full time professional s ta ff does your fund em ploy in [country]!

7. W h ic h category best describes the average level o f ed ucation and years o f experience o f y our fu n d ’s professional staff in [country]!

1 - 3 4 - 6 7 - 1 0 > 11 Education [ ] Undergraduate degree [ J Graduate degree [ 1 Ph.D.

I 1 Professional desig n atio n [ ] Other Y ears o f Experience [ J 1 - 2 years [ 1 3 - 4 years I 1 5 - 6 years [ ] 7 - 8 years [ ] > 9 years