Beyond ‘Shark Tank’: What you should know about venture capital

Surely you’ve seen an episode of “Shark Tank,” where a nervous-looking group of  entrepreneurs   stands before a panel of investors and waits for them to tear apart their business. If a panelist chooses to invest in the product, he or she becomes a venture capitalist (VC) in that business, expecting a strong return (25 to 35 percent) on investment. But what the camera doesn’t capture are the lengthy procedures behind striking a deal with a VC.

“Shark Tank,” at its core, is a TV show. It is geared to keep the audience engaged, create excitement and drive viewership. Only a small percentage of entrepreneurs even make it onto the show out of the nearly 45,000 that apply every year. Those who don’t make it onto the show join the thousands of other  entrepreneurs   seeking traditional venture capital to fund their business dreams.

So, what does that look like off-screen? Whether you’re seeking venture capital for a new business or looking to make a healthy investment, there are some things to keep in mind.

What is venture capital?

Venture capital is financing that investors provide to start-up companies and small businesses thought to have huge growth potential. This investment tends to have more inherent risk because these companies are still in their infancy or need an infusion of capital to take the business to the next level. There is no guarantee that the investment is going to pay off.

Most investors are lucky to simply get their original capital returned, while many never see the money back. VCs are in the game for results like those of legendary start-ups Twitter, Facebook and Spotify, all of which hold billions of dollars’ worth of value. But, the likelihood of a payout greater than $1 billion is less than a quarter of a percent.

Start-up founders typically pitch potential investors with a strategy. If they are successful, the investors might help them at various stages, from seed to growth. Early-stage investors will cut smaller checks to support the company. But once a brand is a bit more established, the owners are likely to ask for more funding from a VC.

The two common types of venture capital are equity and convertible debt. Equity is essentially owning stock in the company, while convertible debt has a repayment date in the future.

History

The first publicly owned venture capital firms began in the U.S. in the early 1900s. Frenchman Georges Doriot, known as the “Father of Venture Capitalism,” founded the American Research & Development Corporation in 1946. The idea was to encourage private sector investment by those other than the extremely wealthy — namely, soldiers returning from World War II. As a public firm, the American Research & Development Corporation ultimately shuttered, but not before providing inspiration for ventures on the West Coast, which depended heavily on the military industry.

The Small Business Investment Act of 1958 was spurred by the race to the moon and provided the impetus for venture capital to grow closer to what it is today, with less paperwork and incentives for managing partners.

A record year for venture capital

In 2018, a record $131 billion of capital investments were made in U.S. companies. Companies known as unicorns, or those worth $1 billion or more, were responsible for 25 percent of that capital last year. And exit values have increased by $37 billion since 2013. It’s a popular funding option without the strict rules of other fundraising methods, and it doesn’t look like it’s going away anytime soon. If you’re an entrepreneur looking for someone to invest in your company, just remember that the investors don’t always get it right. There are plenty of people who were turned down by investment banks and well-off investors time and time again who went on to be more successful than they ever imagined.

Before investing

If you are considering investing as a VC, talk to your financial adviser first. He or she will have access to information you don’t have. Private investments can create diversification for the right client, but also know that you should not take your decision to invest lightly. Unicorns are more difficult to find and invest in than most people think.

John Lueken is the executive vice president and chief investment strategist at CapWealth. This article was published in The Tennessean on March 10, 2019.