Venture capital firms provide startups with funding in exchange for equity. While this may sound risky, it can yield massive returns for VCs. Most of a VC fund’s returns at a portfolio level come from a single stand-out successful investment. This phenomenon is known as the Pareto principle. Operational risks are one of the most important factors in determining a startup’s potential for success. VCs prioritize operational risks based on their severity.
Investing in Startups
As tempting as an injection of cash can be, taking venture capital money means bringing in more stakeholders. It brings more opinions and demands to a startup, which can distract from its goals and lead to misguided decisions. Brad Kern does careful due diligence on a business, looking at the strength of its team, the size of its addressable market, scalability and competitive advantage. Those like him will also look at past investments’ history and ensure they have enough dry powder to invest in follow-ons (backing another round of investment in a portfolio company without being diluted).
In return for their money, VCs typically expect a ten times return on their invested capital. In addition, they will naturally want to take a 40% preferred equity position, meaning they will hold a larger share of the company than the founders. It also comes with some protection, such as a liquidation preference, which simulates debt and gives it the first claim on the company’s assets should it go bankrupt.
Investing in High-Growth Companies
VCs look for entrepreneurs with disruptive ideas to existing business models and create clear competitive advantages in the marketplace. Those who do well can generate significant and disproportionate benefits for society. The VC industry has earned the reputation of being “high risk, high reward.” But it’s not as glamorous as the mythology that depicts Arthur Rock riding into town on his horse to save entrepreneurs from certain doom. Today, most VCs are professional managers with banking and operating experience rather than cowboys.
In addition to the risk of losing their capital, VCs need more resources to build portfolios that achieve targeted returns. The odds of success are very low, as evidenced by the fact that most venture deals return less than their investment. To meet their goals, VCs must avoid the sunk-cost fallacy and ensure they have enough dry powder to invest in follow-on rounds for those few home-run deals.
Investing in High-Risk Companies
Venture capitalists occupy a distinct niche in the marketplace between sources of funds for innovation (chiefly corporations, government bodies, and the entrepreneur’s friends and family) and the traditional, lower-cost sources of capital available to ongoing concerns. Their success depends on the ability to earn consistently superior returns on inherently risky business ventures. Operational risks include the ability of the management team to execute the startup’s strategy and vision. They also include assessing the startup’s business model and market. Investors in VC deals typically expect a multiple of their original investment in return for financing their company. It creates significant pressure for startups to grow quickly to generate the returns investors require. Moreover, high growth rates can also threaten the stability of the company’s financial performance. As such, operating risks are important for VCs to assess.
Investing in High-Risk Startups
As a result, investors need to have the financial capacity to weather the losses (as well as the potential gains) that accompany investing in startups. VC attrition is high, and it takes time to see returns on an investment. Often, entrepreneurs outgrow their initial funding rounds and must invest more capital in future rounds to continue growing the company. It can lead to dilutive ownership stakes for founders, who may lose control and voting rights over time. Investors in a startup will also need to have a good understanding of the technology or industry that a company is targeting, as VC funds are unlikely to back companies attempting to grow within low-, no-, or negative-growth market segments. Genetic engineering companies are a case in point; these are very hard to develop and require years to get to the point where they can be sold or taken public. Many VCs avoid this risky investment and prefer to stick to high-growth sectors.