Venture Capital: What Is It and What Are the Risks?
Venture capital can create impressive returns for investors, but it also carries notable risk. Let's take a closer look at the pros and cons of VC investing.
The world of venture capital (VC) is often seen as glamorous and extremely profitable. Indeed, most folks know about Elon Musk and his many successful ventures. Tesla (TSLA) started out as a private VC investment that Musk bought into and it now boasts a $1.1 trillion market cap.
Musk's non-public companies, SpaceX and The Boring Company, are also funded by venture capitalists and are still growing. These investments have helped him become one of the richest people in the world.
However, many people may not be as familiar with the huge risks associated with venture capital investing. For example, many private companies, including those backed by Musk, require a steady stream of cash to keep the lights on.
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So, what is venture capital exactly?
Let's take a closer look at the appeal of venture capital investing as well as some of its common pitfalls.
What is venture capital?
Venture capital investing is one of the mainstays of a capitalist society. From the days of J.P. Morgan, who financed U.S. industrial activity in the late 1800s, VC has been the bedrock of new capital formation and backing successful, growing companies.
At its most basic level, venture capital is money invested in a project, such as a startup or small business.
Since the early 1980s, the majority of the most successful venture capital investing in the U.S. has been in the technology sector, as well as biotechnology and related healthcare areas.
Just one example of this is Google – now Alphabet (GOOGL) – which was founded after a VC investor gave two college students a $100,000 check. Alphabet is now a trillion-dollar publicly traded company.
Today, venture capital firms rarely take as many risks as early tech investors. They often look for companies that have substantial upside and already have revenue or revenue potential right around the corner.
VC investors tend to look for companies that provide either a new solution or a disruptive way of attacking huge addressable markets. In short, they are seeking the potential for large upside or scale, either in terms of customers or revenue.
This is what sets them apart from smaller-scale private company investing, or angel investing, where the upside may not be as clear.
As a result, many venture capital firms will often work together to make sure that these companies have plenty of capital to fund their operations. Some of the biggest VC firms include Andreessen Horowitz and Sequoia Capital.
The risks of venture capital investing
One of the biggest risks with venture capital – and one that is often overlooked – is the drain that research and development can have on finances.
For instance, say a startup is developing a software solution to an existing technology problem and it needs to test its solution on existing clients. The bugs associated with downtime and failed software can sometimes lead to uneven revenue or no revenue at all. The VCs backing the company need to invest more money in order to keep the initiatives going.
Another common risk is the technology itself. Often patents in a startup tech company end up being challenged, or the technology can be stolen, copied or "leapfrogged" by competitors.
One of the more notable instances of this was when BlackBerry's (BB) physical handset phones were challenged by Apple's (AAPL) new iPhone. In 2009, BlackBerry's global market share was around 50%. By 2013, it had dropped to less than 3%. And in 2022, BlackBerry stopped producing its mobile devices.
Another challenge venture capital investors face is with growth and related personnel issues. For example, even if a company has a successful product in the market, it might not be able to find the capital needed to maintain its operations.
This can also lead to other issues, including not being able to find raw materials, or even personnel to produce the software or products. And, of course, there are always due diligence issues with venture capital investing. Is the person or team you are backing worth trusting with the money invested? And can they effectively turn an idea into a real company?
To help mitigate these risks, venture capitalists and the businesses they are investing in must have detailed plans on how the money will be used throughout each stage of funding.
How can I benefit from venture capital investing?
One way to benefit from VC investing is to join a local angel investing group. This will allow you to learn about various companies in your area that are looking for capital and how to potentially get your foot in the door.
However, there are no publicly traded venture capital firms focused exclusively on startup companies. The closest to this are some closed-end funds (CEFs) that invest in private companies as business development companies, or BDCs.
These public BDCs tend to put their money in distressed private companies. Moreover, they must abide by the rules of regulated investment companies. These can include real estate investment trusts (REITs) that are required to distribute 90% of their income to stakeholders as dividends.
The bottom line is that the venture capital arena is probably best left up to the large VC pools that can withstand significant valuation declines. Typically, it is not uncommon for one successful investment to emerge for every 10 to 15 or more failures within a pool of VC funds.
In my own experience as a director, chief strategy officer and investor in a number of private companies, venture capital investing is very risky. The upside may be worth it, but it takes a special type of patient investor that can successfully navigate through the sea of risks.
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