What is venture capital?

You have heard the phrase used quite a lot? But what is venture capital?

You hear it all the time in conversations about investing in ‘sexy’ tech companies. This isn’t a million miles off what Venture Captial. A lot of said sexy tech companies did receive venture capital funding, well before they were listed on the stock exchange.

Quite often, we take for granted that we can invest in companies on the stock market. Those who have got round to regular investing will be well-versed in investing in indices or company stock (here I explain why I invested in Diageo – before Covid-19!!)

It is important to remember that fantastic companies were not just born mature. At some point they were a company in a garage somewhere. At some point Amazon made less money than your local hairdresser; one cannot imagine that was for very long. Venture capital is this ‘start-up’ phase of a company.

According to Investopedia (the dictionary for finance matters):

“Venture capital is a form of private equity and a type of financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. Venture capital generally comes from well-off investors, investment banks and any other financial institutions.”

For the sake of all technicalities, it is just a form of direct company investment / private equity. It is private funding that investors are willing to extend to a company in order for the company to meet their financing needs. Common needs in the early years of their careers.

Now that we have answered what is venture capital, let us have a look at what function it performs and how you could get involved.

What function does Venture Capital perform?

Venture capital plays an important role in the economy. As venture capital is put into young and growing companies, it is often associated with innovation. Young and growing companies that have a bright future are often innovating and trying to disrupt an industry. Economics 101 suggest that in order for economic growth and prosperity we require innovation. This is to increase productivity and provide new goods and services.

Investments in early stage companies only comes to 0.2% of GDP. That isn’t a large investment, but the return is 11% of all jobs and 22% of revenues. This is because these companies (namely Google, Amazon, Facebook, Airbnb) were given a significant investment in their early days to help them grow their companies. Often, this venture capital investment allows them to focus on growth whilst not worrying about turning a profit every month. Amazon went 14 years before it was profitable.

Early days of Amazon did not look like a $1trn company

Venture capital doesn’t always work

Uber raised $1.25m at a valuation of $4m. It has hit heights on wall street of $80bn. Those who invested $10k in the early rounds would have stakes worth $200m today.

The 12 largest listed US tech companies are worth more than all the others put together.

This is a staggering statistic. I’ve not gone through the pain of checking that it is true… however I’ve calculated that the top 5 (Apple, Microsoft, Amazon, Alphabet and Facebook) are comfortably larger than the next 30, so this will almost definitely hold.

The main problem with this, is that it does prove that there is a concentration of returns. 12 of the best companies have become bigger than all of the others combined. Those ‘others’ are no doubt a fantastic selection of companies that will have given investors a fantastic return. But they will be the ‘12’ that represent the pick of the bunch for the next level down, and so on. Nobody who works in Venture Capital Investments are in any denial, the vast majority of investments do not deliver incredible returns. Studies have showed that roughly 50% of VC investments return less than they invested.

Some say it is Pareto’s 80/20 principle. Another field say that out of 10 investments, 5 go completely south, 4 do well and 1 goes crazy good. I’m not convinced that there is a ‘formula’. I think it is more down to how you analyse and select your investments.

Can normal people invest in Venture Capital?

Yes and no.

No: most venture capital firms have very large minimum investments. A minimum contribution of £250,000 is common for individual investors. Unless you have a net worth of comfortably seven figures, this is too much. Furthermore, these same venture capital firms get access to the best deals. Unless you had some personal connection with the founders of Uber, Airbnb, Facebook and the like, it is extremely unlikely you would of come across the opportunity to invest.

Yes: there are opportunities, though. Through crowdsourcing websites like Seedrs, Crowdcube and Fundable. These are marketplaces for investments in early stage companies. Some recent success stories in the UK include FinTech companies Revolut and Monzo. Both started on crowdsourcing websites and undoubtedly returned 50x+ returns to those who got in early.

In one of my earliest posts, listing different ways to invest, I mentioned the idea of investing in start-ups. I am not a financial advisor so please do your own research and accept the risks that come with any investment.

Let me know if you have any experience in investing (or maybe raising) venture capital funding and how you have fared!

This Post Has 4 Comments

  1. Not investing early in a unicorn or faang is a bit like regretting not buying a winning lottery ticket. Hindsight tells us all this stuff was obvious but tomorrow’s unicorns are still going to be ignored until we always knew that they’d be the next big thing.

    1. J

      Agree but with a slight caveat.
      In that prior to the lottery event, you are completely guessing.
      Whereas when I first came across Apple / Microsoft / Facebook, I could of put it enough research to get comfortable with investing. Having said that, here I am giving an example with hindsight. It’s a powerful thing, as you say.

      1. There’s a huge amount of effort put in to raising capital.
        From experience in my industry; you could tell which businesses were putting themselves up for sale by the swish new logo and marketing spend.
        An attractive investment is sometimes all about the image.

        1. J

          That is very true.
          I guess one could say that if you’re an investor, if that fancy marketing spend and hype building generates you sufficient returns, it’s all fine?

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