Venture v. Private Equity Capital

When YOU are the Venture Capitalist

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I’ve spoken many times about the changes coming to venture funding companies.  But, the point of view I’ve presented has always been from the entrepreneur’s side.

But, many of my clients- and many of you- are the ones who provide the money to these new companies.  And, there’s plenty to consider when this is the case.

For years, we actually provided services to a prominent venture capitalist.  (Sorry, I didn’t run this by him to get permission to use his name or even his corporate affiliation[s]).  At times, we also worked with another venture funding entity- but in technical areas vastly different, so there would be no conflicts of interests.  It was our job to examine the potential investments from both a technical and financial point of view.

Venture v. Private Equity Capital

The questions were pretty standard; the answers weren’t:

How did the company’s product or service stack up against what was already available?  What were the barriers to entry for other companies to enter this marketplace?  Were the needs of the customers- both from existing products and services as well as the new venture- being met?  How many of the wants (all the needs had to have been provided) did the offer satisfy?

Could the founders take the company from their idea to at least $ 1KK in sales?  And, what about their chances to reach $ 10KK?  Could the same founders team make it to $ 100KK?  Was there sufficient cash in the treasury (after the investment) to make these thresholds?   Was the proposed burn rate realistic?

These are but a few of the questions.  And, to be honest, these venture capital entities and individuals were pretty sophisticated.   They knew about many different markets and industries.

That’s one of the big questions you- as a potential investor- are going to have to make.   The first- and biggest consideration- you need to evaluate before you provide dollar one is:  Do you understand the business?  Because this new venture is not going to be liquid; investing in this firm is not the same as buying shares of stock in a public company.   You may be the holder of this asset for 3, 5, or even 10 years before you can obtain an exit (other than the demise of the venture).  As such, you need to understand the business and the business model.  (Or, you need to hire folks like us to help you keep abreast of the firm and its actions.)

And, since the new venture funding rules only stipulate you need something on the order of $ 100K in net worth or net income, this investment can turn your life sour in a heartbeat.  (It can also make you pretty rich, if things work out.)

So, another question is will your risk your retirement account equity on this new venture?  You do know that the rate of failure for new businesses is some 50% over the first 60 months of their existence.   Can you afford to lose your entire investment?

And, how many such investments will you examine before you invest in any single idea?  I can’t speak for you, but most venture capitalists examine 50, 100, 200 deals – and choose only 1 or 2 with which they will become involved.  Are you so prepared?

You also need to do your homework.  That means reading the prospectus and the business plan.  But, that’s just for starters.  You have to examine the industry for the venture.  How crowded is it?  Is it ripe for a “Black Swan” event?  Can this company easily enter the field and achieve its promises?

Can you get your investment back in time for your retirement (if you are using your IRA)?  Or, do you have enough other cash to shield you from pain if something changes in your own life? (Remember, there won’t be a secondary market for your investment for a potentially very long time.)

Plus every one of those questions we posited in the 4th and 5th paragraph of this blog need answers.  That also means evaluating what happens if the bar moves up a little- or how long the window of opportunity stays opened?

Once you have these questions answered, your analysis demonstrates that your investment will be relatively safe, and there is a reasonable upside, then- and only then- hand over your investment money.

Caveat emptor.

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