If you read twenty books on venture capital, you'll probably get twenty different definitions of a VC. We uncover some myths on venture capitalists and what they really are.
By David Lim

Dear entrepreneur,

First of all, let me lay to rest a couple of major myths about venture capitalists (VC):

1) A VC is not some compassionate benefactor to turn to in your financial plight after all the bankers you've spoken to wouldn't give you a loan.

2) Neither is a VC is a benevolent philanthropist who will, without hesitation, fund the next "miracle cure for cancer that may save billions of lives"; or for that matter, give you money for your idea for "the next hula hoop" or "better mousetrap" that you're convinced will instantly sell millions around the world.

3) A VC is not just looking to finance dropout PhD students or eccentric inventors locked away in the bowels of their basements or garages, the typical Hollywood stereotype, and Disney's ever-recurrent favorite movie theme. Frankly, a VC would much rather invest in a teams of professionals comprising technical people and well-heeled, industry- and market-savvy executives who have spent years working in a big company and have decided to leave together to pursue an opportunity they've encountered while at work, boring no doubt, and not the least bit romantic, but with excellent prospects of success.
 

WHAT IS A VENTURE CAPITALIST?

At the end of the day, a VC is fundamentally a professional money manager who invests money entrusted to him or her by investors. In return for investing their money, a VC takes a "carried interest" - a nice term for an even nicer cut of the final profits obtained. And as it is in the fund management industry, the name of the game in the VC investment business is risk, return and diversification.

On RISK

When you ask any investment professional about risk, they will explain to you that on the lowest end of the risk spectrum, you have a "risk-free" investment which is a nice, safe government Treasury bill that guarantees you a safe, but low, return on your money. Money stashed under or in your mattress does not rank above a T-bill because the risk that your house may burn down is higher than the risk of the government collapsing and defaulting on the interest they owe you. A VC's perspective on risk is no different, except that in terms of risk of a startup, it's probably way up there, off the ladder, and hopefully your startup's prospects are held up by more than air, hot or otherwise.

THE RISK-RETURN TRADE-OFF

This oft-quoted financial expression simply means "If you want me to take more risk, I better get a higher return on my money". Let's say you're a wealthy investor and decide to invest in the Internet revolution so you put some money in a venture capital firm in Silicon Valley. Later, the VC invests your money in an Internet start-up with a prospective return of 300% over three years. Across the continent on Wall Street, the technology revolution pushes the NASDAQ technology stock market up 26% per year, equivalent to a 100% return compounded over three years. Pretty good, but obviously the VC's investment in the startup yields much more than the stock market. Nonetheless, it does necessarily mean that the startup is a more attractive investment. It may not make sense for a VC to invest in a startup for an additional 200% return because it comes with A LOT more risk. So the VC had better find a startup that has A LOT more potential return, say more than 800% over three years.

THE VC's BOTTOM LINE

Hence, the whole objective of a venture capital firm is to invest in the stock of a young company for a little as possible (buy low) as sell it for a much as possible (sell high), in as little time as possible. This can be neatly summarized by three letters - the ROI. (Return on Investment), the VC's bottom line.

So, before you make your business pitch to VCs, you'll have to ask yourself "What's my startup's potential return?" Well, you say who really knows? One thing's for sure, for a startup, it's probably as potential as potential can get. However, you think "I have such a wonderful product - I'm sure my company will be very successful!" But you can be sure that ROI is the foremost question on the VC's mind. As a professional investor, his job is to get a handle on the potential return versus the risks of investing in you and your company. Only six in a thousand business plans get to the IPO stage, so the risks are all too real.

However, the most exciting thing for a VC is to discover and invest in one of those six companies because the returns can be beyond spectacular. Imagine if you had given money to Harvard dropout, William Gates III, to enable him to start Microsoft. Potential jackpots are what VCs are always on the lookout for. As an entrepreneur, you have to be realistic however. The next Microsoft, CISCO, or Creative Technology does not come along very often. No matter how much faith you have in the (obvious) spectacular-ness of your Internet business idea, and the overwhelming enthusiasm with which you just know customers will have for your website when you launch it, that the exponentially rising sales forecast you've plotted on your PowerPoint presentation chart is probably NOT going to materialize. Back up your projections with a realistic assumptions, or if you really DO have the "next Microsoft", back up your claim. Most VCs would agree that visionary entrepreneurs always have B.H.A.G. (Big Hairy Audacious Goals), but by the same token, that's not an excuse to suffer from delusions of grandeur.

DO YOUR HOMEWORK!

Any VC worth his salt and his MBA does his homework and checks out your idea, talk to your potential customers, and verifies the capabilities of your management team, and your integrity before investing any money. In VC-speak, this is a called "due diligence exercise". Well, wouldn't you do the same if a complete stranger you just met three weeks ago asked you for five million dollars?

Most VCs list their portfolio companies in their websites, so you can do your homework before stepping into their presentation rooms. Say you do your research thoroughly, make your pitch, and the VC partners say they really like your business concept. They may still not invest. Perhaps they've already invested in a startup in the same industry and are looking to diversify their risk, another critical investment factor. So, even if your business idea and financial prospects are sound, your startup may not fit in to their overall investment portfolio. Sometimes, investment decisions can even be quirky. Some VCs will only invest in startups within an hour's drive from their offices.

Some VCs do not even invest in early start-ups at all. When Steve Jobs and Steve Wozniak made their rounds among Silicon Valley VCs with their prototype Apple II computer, they didn't get a single dollar. Steve Jobs said one VC called him a "Renegade from the human race" and had his secretary check their briefcases as they were leaving his office, just to make sure they hadn't snitched any magazines from the waiting room. A large number of highly successful Silicon Valley companies were never financed by VCs at all, so if you don't get VC money, it does not mean that you can't make it.

CAVEAT ENTREPRENEUR

In the investment circle, the classic counsel is "caveat emptor": Let the buyer beware. This Latin phrase means that the risk you have chosen to take is ultimately yours and yours alone. If you had acted on your stockbroker's recommendation to buy a stock, and if subsequently, that stock plunges, you should not cry foul.

Likewise, as an entrepreneur seeking financing from venture capitalists, your rule-of-thumb should be "caveat entrepreneur".

Get to know as much as possible about the VC from whom you intend to seek funding. After all, it's never, "Goodbye, and thanks for all the millions. See you next time at the IPO!" Remember, once you take that cheque, the VC becomes no less than the co-owners of your business (and your lifetime dreams). Expect them to want a seat on your board of directors. Expect them to voice a different opinion about what should be the best way to execute your business strategy, or how to structure your company. Expect them to tell you to fire your Vice-President of Marketing because they think he's not up-to-the-job and should be replaced immediately - even if that VP happens to be your brother. And if you only later decide to give more stock options as incentives for your employees, don't be surprised if they say, "You'll have to take it out of your share of the company. We agreed that we'll have 60% post-money and that's not open to re-negotiation."

Beware the Faustian deal, dear entrepreneur, and choose your financial partners well. The marriage between you and your VC partner is not “till death do us part", but "till IPO do us part", and it is most certainly for "Richer than poorer".

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Dave is a Singaporean who is passionate about ideas, people and building innovative en