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Understanding Venture Capital Investment and Returns

When I tell friends about my involvement in venture capital, many give a quizzical look. It’s as if they’re asking, “What is venture capital?”

My friends with a little more knowledge might respond, “So, you’re one of those private equity types?”

This confusion and lack of familiarity aren’t surprising.

Investing in Venture Capital: Limited Largely to “Accredited Investors”

Government regulation prohibits over 90% of Americans from investing in private equity or (until recently) in venture capital.

The reason? They are not what the SEC calls “accredited investors.” Only recently did SEC regulations loosen to allow non-accredited investors the ability to invest in venture capital (with tight restrictions).

To be an accredited investor, you must show a(n):

  1. household net worth of more than $1 million (excluding primary residence) or

  2. income of at least $200,000 ($300,000 for couples) over the last two years.

As a reader of Financial Poise, you’re more likely to pass the accredited investor test — now or in the future — so you may want to better understand these kinds of asset classes.

Venture Capital vs. Private Equity

I explain to my friends that, yes, venture capital is a form of private equity. But, it’s also quite different from what most people traditionally refer to as private equity investing.

Venture capital and private equity investors both invest in privately owned companies (as opposed to publicly traded companies as you find on the stock exchanges). Since the government regulates public equity markets more than private ones, it actively restricts who may invest in these private asset classes.

Traditional private equity groups seek investments in established businesses that already deliver operating cash flow. They usually fund their acquisitions with considerable debt, which can be risky. PE firms expect to unlock greater cash returns by improving operational efficiency — in other words, they fix-and-flip business.

Venture capitalists, in contrast, invest in startups and early stage companies. Many such companies don’t yet have positive cash flow. (They may not even have any revenue yet!) It may take years to deliver a positive return to their investors.

In fact, most never will!

Between 80 to 85% of VC-funded ventures lose investor money. Most result in total losses. Yet, on average, venture capital delivers outstanding investor returns.

How Venture Capital Generates Outstanding Returns

Venture capital investment and returns are like a funnel. At the top of the funnel, a lot of ventures get early funding. But very few come out of the other end with positive investor returns. It is hoped that a few big winners — some returning 20x to 30x (or more) the early investment — more than offset all the losers. Historically, that has been the case.

The Thomson Reuters Venture Capital Research Index replicates the venture capital industry as a whole. Based on that index, venture capital investment has on average returned 19.7% per year since 1996, despite the 2000 dot-com collapse and the 2007-09 recession.

Access to Venture Capital for Individual Investors Increasing

Until recently, only major institutions and the ultra high net worth partook in venture capital investment. Even most accredited individual investors had limited access. That’s changing.

Implementation in late 2013 of Title II of the JOBS Act allowed media promotion to individual accredited investors. There are now online venture capital portals where AIs can access a myriad of venture investment choices.

Advice for Prospective Investors

My advice for most individual accredited investors: invest with a reputable professional venture capital firm (some now available online) with a proven long-term track record of success. Look for firms with rigorous deal selectivity.

The successful ones may review a hundred or more ventures for every one they invest in.

In the VC business, the average “win rate” (investments that feature positive returns) is less than 20%. You should look for companies that repeatedly better that mark. (Fortunately, that’s the case for the firm I work with, but there are others out there as well.)

How to Spread Out VC Investments

No matter how high your deal win rate, you need to diversify within this asset class. Putting all your chips on a couple of deals is far too risky.

We wouldn’t recommend a mutual fund or index fund-type approach either. That would mean participating in too many deals that didn’t go through the rigorous screening and due diligence. Those steps are vital to increasing success odds. We recommend instead looking to invest in a proven VC firm’s total portfolio. (Or, in at least five or six deals that appear to have home run potential.)

Above all, don’t invest more in venture capital than you can afford to lose. I suggest not more than about 5% of your total assets unless your net worth is over $10 million.

Despite the asset class’ outstanding returns history, each deal carries risk. Even with a top firm, the five or six ventures you might choose to invest in could all lose. Nevertheless, selecting a good firm along with smart diversification gives you a better chance at the rich returns this asset class can deliver.

About Kenneth Freeman

Strategic adviser to high tech venture capital firm, VCapital, following career as CEO-level consumer products/marketing services executive. Co-author of book to be published in summer of 2017, Building Wealth Through Venture Capital: A Practical Guide for Investors and the Entrepreneurs They Fund.

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