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The Cost Of Cash (Business Plus Magazine May 1999, pp 38-39)

Don't bother to look for venture capital unless you forecast
a 1,000% return over five years
BY DARACH McEVOY
 
There is a common misconception that a venture capital (VC) firm's role is to finance start up companies and people with innovative ideas. However it is when the innovative ideas of the entrepreneur have attained some degree of commercial viability that venture capital plays its major role. This investment by venture capitalists is not a long-term project; rather its function is to grow the project to a degree of value and credibility that it becomes attractive to new investors who will buy out the VC's stake at a significant profit. In this process the entrepreneur also benefits.
 
It is not surprising therefore, that the place of venture capital in the marketplace arises from the reluctance of commercial banks to invest in a business which has no hard assets to place against the debt. The venture capitalist's objective is to make the business attractive so that it can be sold later at a significant profit and to encourage the entrepreneur by incentivising him or her. Simply put, this means getting a good return on an investment in a speculative business venture.

Profit Potential
One common myth is that venture capitalists invest in good people and good ideas. While that is true the reality is that they invest in good industries with profit potential. If a venture capitalist decides to invest in technology, he/she will avoid the early stages of development where there is uncertainty about the technology and market demand. In addition, the venture capitalist will avoid the later stages where competition and consolidation rule and growth rates dip significantly.
 
The venture capitalists see their niche in the segment of high growth where an investee company can fill a market need. They will identify management who can deliver to this demand or who can advance the technology to a stage of approval in market acceptance. This achievement may also provide them with an exit opportunity from the investment thus reducing the risk considerably and earning a good return. Alternatively the VC may install a new management team to take the company forward to the next stage of development.

Players

The venture capital industry has four main players: entrepreneurs who need funding; investors who want high returns; investment bankers who need companies to float or sell; and the venture capitalists who make money for themselves by making a market for the other three.
 
In a typical deal, the venture capital fund may buy in at a favourable rate, often ignoring market valuation. They have a blocking right over key decisions by management should the company falter and have to raise additional capital; the venture capitalist will likely be given shares to maintain its equity position. Alternatively if a company is thriving, investors may enjoy the right of further investment at a predetermined price. This means that they can increase their investment at below market price.

Tenfold Return

A venture capitalist who finances the initial two years of a company's start up will expect a return on the order of tenfold over five years.
When combined with the preferred position of the venture capitalist this is expensive capital - something of the order of circa 58% compound interest. This high rate is needed to return fund averages in excess of 20% as the fund will contain a lot of losers and laggards. Only one in ten companies will be a "winner".
 
Darach McEvoy is managing director of
Quaestus, Strategy and Marketing
Consultants