The Venture Capital Myth

The Venture Capital Myth
By
William Cate

No Gold Here

The streets of San Francisco and San Jose, California are not paved with gold. There aren't hordes of angel investors or Venture Capital Firms fighting to fund your startup company. In fact, the Venture Capital Firms are finding it harder to recruit new angel investors. The extinction rate among speculative investment sources is high. In recent years, the replacement rate for risk capital funds has been well below the extinction rate among the current crop of angel investors.

Risk/Rewards Are Poor

The reason that money is hard to find for traditional venture capital project is that the risk/reward ratio is terrible. The odds of winning are about 1-in-100. The return for the 1% of angel investor winners is usually tenfold their original investment. If an angel risks $1 in 100 risk capital investments, they will lose $99. Their one winner will return a $10 profit. The investor is a net loser of $89.

This equation is as true for angels who directly speculate in high risk ventures as it is for those who gamble with an angel group in a venture capital club or as accredited investors risking their money with a Venture Capital Firm. Unless the risk/reward formula changes, as it does with the Global Village Investment Club, angel investors are certain to eventually fall victim to the fact that the odds are against them winning.

Bounty Hunting

Traditional Venture Capital Clubs don't work well for Angel investors. Usually, half the membership of many of these clubs are angel bounty hunters. These pseudo members are seeking angels for their own high-risk projects or they attend the Club meetings to recruit the angel's money into their Venture Capital Firm's coffers. Most of the venture capital investment opportunities offered to the angels make no economic sense. These presentations are strong on cash flow projections and weak on creating the needed cash flow. Over time, most Venture Capital Clubs tend to deteriorate into business social networking meetings. For the angel investor, joining a traditional venture capital club is a major mistake. If the angel hasn't lost his risk capital by avoiding funding all of the Venture Capital Club's companies, he hs always lost this time by attending the monthly meetings.

Wrong Goals

The problem with Venture Capital Firms is that their prime directive isn't to find low risk-high reward speculative investments and make money for the Firm's clients. A Venture Capital Firm's primary goal is to find accredited investors willing to risk their money on management's ability to beat the 99-to-1 odds against success.

Prospective angel investors in most Venture Capital Firms tend to believe that the Firm is paying it's rent in prestigious office space and its army of MBAs with the profits from their past successful speculative investments. This is rarely true. Past profits, as with most businesses, are distributed to the partners in the year in which they occurred. Venture Capitalists usually live off the risk capital of current angel investor clients.

MBAs Are Suckers, Too

Venture Capital Firms are inclined to hire recently graduated MBAs from the best universities in America. The prospective angel client, of any of these Firms, assumes that these dress-for-success stars are there to find the business plans that will make the angel investor richer. In fact, the Firm hired the well-connected MBAs to recruit their network of angel investors into the Firm's client base. When the MBAs from eminent schools have exhausted their network of prospective angel clients, they are asked to seek employment elsewhere. An MBA from an Ivy League University has direct or indirect access to hundreds, if not thousands of angel investors. An MBA graduate from Poverty University lacks access to anyone who is wealthy. It's that simple. Both MBA graduates have essentially the same education. That education doesn't prepare anybody to consistently beat 99-to-1 odds against selecting winning business plans.

Wrong Reasons For Risk

Why do investors risk their money? The investors would say "to make lots of money." They're wrong. Investors risk their money on the perception that they will make lots of money. Their decision is based upon greed, not logic or mathematics. It's an emotional response. Emotions can be easily manipulated. Perception, not Reality, motivateses most people's actions in life. Reality says that you can't consistently make money betting against the odds. This axiom is as true in Las Vegas as it is on Sand Hill. The Venture Capital perception says just the opposite.

Ask not how much money you can make in a risk capital speculation, rather ask how likely you are to lose your risk capital. If the probability of losing your risk capital money is greater than the possibility of making money, don't gamble.

About the Author

He has been the Managing Director of Beowulf Investments [http://home.earthlink.net/~beowulfinvestments/] since 1981 and is the Executive Director of the Global Village Investment Club [http://home.earthlink.net/~beowulfinvestments/globalvillageinvestmentclubwelcome/]
You can email Mr. Cate at: Beowulfinvestments@Earthlink.net

Information Index