The One Fundamental Every Venture Capitalist Should Know
What makes Venture Capital so unique?
When promptly asked, most experienced investors don’t know an objective answer to this question. Some will state that Venture Capital (VC) is technology investments, other will say that it’s research and development (R&D) financing, and many will argue that it’s early-stage investments. None of these answers are wrong. However, all ignore the core fundamental behind VC investments.
What Differentiates Venture Capital from Other Sorts of Private Equity?
Venture Capital is a sort of Private Equity (PE) investment.
Private Equity is capital that is not noted on a public exchange. It is an illiquid asset class, what means that you can’t buy and sell at your free will. PE finances projects in growth stages when risks of failure are moderate. Expected returns are high and concentrated around the center of a normal distribution.
Venture capital is also capital that is not noted on a public exchange. It is less liquid than Private Equity. VC finances projects in its earliest stages when the risk of failure is very high. Returns can be extraordinary, but can only be achieved in rare opportunities, or in the “tail of the distribution”.
To learn more about return distribution in venture capital, please read my answer to a reader’s question “Chasing Extraordinary Returns”. If you believe I should dig deeper into this matter, please add a comment below.
These differences are good reasons for a distinction. Yet, they aren’t core finance fundamentals that differentiate venture capital from other investments.
The Nature of an Investment
Investors allocate resources according to an expected risk-return balance. In private equity, there are many investment alternatives, such as real estate, growth capital, mezzanine financing, leveraged buyouts, distressed, or even venture capital. Most investment discussions only bring expected returns to the spotlight. An effective approach indeed, but a shallow and risky mindset.
According to a disciplined investor’s philosophy, one should first ask:
Where will my money go? What will it be used for? Why will it return a gain or a loss?
With those answers in hands, an investor can make a disciplined decision of what risks to incur and target an expected return. As for any other investments, venture capital follows a road with clear signs of the where, the what and the why of your investment.
The Where
In venture capital, your money is going into the account of a startup, managed by supposedly great entrepreneurs. Great entrepreneurs are fast-paced bright visionaries, stubbornly convinced of a new market opportunity. They can envision a startup that will become a Category King.
“Category Kings design a great category, a great product and a great company all at the same time.”
— Play Bigger: How Pirates, Dreamers, and Innovators Create and Dominate Markets. By Al Ramadan, Dave Peterson, Christopher Lochhead, Kevin Maney
The What
Questioning the destination of your investment sheds light on the core finance fundamental that differentiates venture capital from other sorts of investments.
What will be the uses of this investment’s proceeds?
A startup rarely generates cash from its operations. Once in a startup’s account, your investment will be used for a risky business. The startup will use it primarily for expenses such as payroll, advertising, utilities, and administration. On an expense report, Operating Expenses (OpEx) are subdivided into categories such as fixed and variable expenses.
Different from other sorts of equity investments, it is unlikely that a startup makes large deployments for capital expenditures. Non-operating expenses, also known as Capital Expenditures (CapEx) can be tangible or intangible assets.
A startup employs the investment’s proceeds on operating expenses.
Operating expenses aren’t refundable. You will not be able to recover the money expensed by a startup, unless it builds an IP, registers a patent, or achieves other sorts of tangible or intangible assets that you can sell. Here is where the big difference resides.
Your investment will be expensed.
Traditional equity investments generally invest in businesses that generate cash-flow. The business’ cash-flow finances their OpEx. With a solid balance sheet, they can access debt to finance working capital. These businesses raise equity to finance primarily CapEx. Therefore, equity investments are non-fungible within the business.
Venture Capital generally invests in startups that don’t generate cash-flow. Startups can only finance their OpEx with equity. Given that they don’t have a solid balance sheet, they have limited access debt to finance working capital. These startups have low CapEx needs and generally don’t raise equity to finance CapEx. The only capital they have available to finance the entire operation is equity. Therefore, equity investments must be fungible within the startup.
Venture capital investments must be fungible within the startup.
The Why
Is there anything more attractive than helping bright young minds succeed, while making extraordinary returns?
It is an honorable cause, but returns are still the ultimate driver for investments. No matter how tempting an opportunity is, investors need to see a clear path to liquidity and to realized gains. A venture capitalist goes a long way from investment to harvest. We enjoy the road more than the arrival at destination.
Venture capitalists don’t work sitting behind a computer. Through a constructive approach, we support stubborn and brilliant visionaries. Opening doors, fostering investment rounds, and leading to liquidity, venture capitalists work in a very specific manner to make startups thrive.
Each Venture is Unique
I work closely with emerging startup ecosystems and I have seen a lot of wrongdoings. I respect all investors willing to help startups thrive, but there is a lot of technical knowledge behind venture capital investing. Debt paradigms should not be replicated into venture capital. Private equity mindset should not guide your investment decision.
Venture Capital is a Unique Investment Alternative. It is a risky undertaking where money is raised for a purpose, but can easily be used for another. Failure and frustration lead to extraordinary success in venture capital.
If you agree, please help spread the word!
Derek L. Bittar is the co-founder and managing partner of IndicatorCapital. He writes and travels with the mission to help entrepreneurs thrive in emerging startup ecosystems.
This story is published in The Startup, Medium’s publication followed by over +256,410 people.
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Important Disclaimer
This story (or article) has been prepared for informational / entertainment purposes only, and is not intended to provide investment advice or any offer or sale of any investments. This story is the author’s opinion and is for information purposes only.
