Venture capital is money provided by investors to startup firms and small businesses with perceived long-term, high-growth potential. This is a very important source of funding for startups that do not have access to capital markets.
Although these investments are much higher risk than public market investments, they also tend to have much higher expected return potential. This high-risk, high-return-potential asset profile makes it very important to take a portfolio approach when making venture investments.
Venture Investing has become a very important source growth capital for the US economy over the last 30 years. More and more innovation is happening outside of large corporations and inside small, nimble startups. Do you wonder why that is the case?
Large public companies have what is known as a “cost of capital”. This cost of capital is distributed between the cost of any outstanding debt (the “interest rate”), and the required return on equity. The lower the cost of capital for a public company, the higher the stock price. This is because the company’s stock price is calculated by discounting the projected earnings by the cost of capital. A lower discount rate equals a higher price.
So, you can understand why big public companies are incentivized the keep the perceived risk of their earnings streams low, resulting in a lower weighted average cost of capital, and .... you guessed it .... a higher stock price. The greater the uncertainty, the greater the cost of capital. And it is for this reason that enterprise managers prefer that “innovation” and the additional risk that comes with it, happens off their balance sheet.
Enter the venture capital market. This is a “special” pool of capital specifically designed to handle the high-risk, high-return nature of the innovation economy. And although some venture-backed companies eventually go public, the vast majority are acquired by public companies one their growth is large and stable enough to be “accretive” to earnings without increasing the perceived risk of the cash flows.
This is also why we have a record number of US employees working at “money-losing” companies. All that investment that used to happen within a public company, now happens outside the company, at a startup. And then all those “losses” are recouped when the startup sells to a larger company that can integrate what it has built profitably into its much larger machine.
And that my friends, it what venture investing is all about.
Topics: Venture Investing