The first thing people seem to think of when they hear the word venture capital is “risk”. This is understandable; most companies at this stage of development do not survive. It’s not uncommon for investors to lose all of their principal.
First and foremost investors in venture capital need to be accredited investors who are prepared to lose their entire investment and must plan on not seeing any return on their investment for many years, if at all. Anyone who understands those risks and is still considering an investment in venture capital must deploy sound investing fundamentals that include diversification and comprehensive due diligence.
What does it mean for a security to be illiquid?
When a company’s securities are “illiquid,” it means that investors cannot sell the securities they own in that company to get their cash out of the investment (even at a loss) whenever they want to. They have to wait for either a “liquidity event,” like a company sale or IPO, or find a willing buyer on their own. This makes the investment riskier than typical investments in publicly salable securities such as stocks sold on the NYSE or NASDAQ markets, registered mutual funds, or similar investments where there is a ready market for the securities.
A company may be illiquid because:
- The sale of its shares is not allowed under applicable securities laws
- There is no active market where its shares are bought and sold on a regular basis
Whatever the reason, buying and selling shares in an illiquid company is more difficult than what most investors are accustomed to.
Liquidity is significant concern for startup investors since venture capital investments can take several years to yield a return and investors are usually unable to sell their securities in these companies prior to their liquidity events. This means that investors in illiquid securities must have sufficient other assets that are liquid to meet their financial needs.
If you are considering an investment in iSelect Fund, you should work with your financial advisor to determine an appropriate allocation of illiquid securities based on your unique financial needs and portfolio of investments.
What is an Accredited investor?
Investing in many private offerings is limited to “accredited investors”. People are often confused about the meaning of this term, so I’d like to take this opportunity to define the meaning that most frequently applies.
An accredited investor, in the context of a natural person, includes anyone who:
- earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, OR
- has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).
On the income test, the person must satisfy the thresholds for the three years consistently either alone or with a spouse, and cannot, for example, satisfy one year based on individual income and the next two years based on joint income with a spouse.
Why is this important? Well, the accreditation threshold exists to protect investors. In our industry, investors should be able to absorb any potential losses and tolerate the relative illiquidity of the venture capital asset class.
Why is due diligence essential to investing in private securities?
Due diligence is a rigorous process to evaluate the risks and opportunities associated with a company’s business plan, verify the statements made by the company as to its business prospects and core technologies, and test management’s mettle by asking detailed questions regarding their business and their ability to respond to adversity.
This is a critical but time-consuming part of the venture investing process. According to the Ewing Marion Kauffman Foundation, investors who spend more than the median of 20 hours on due diligence perform better than those who spend less than 20 hours, and those that spend more than 40 hours outperform their peers by a large margin.
Why is diversification necessary to manage risks?
If you invest in one or only a few venture capital stage companies, you will almost certainly lose your entire investment. Putting all your eggs in one basket is almost always a bad strategy. In the world of venture capital, making investments in one or only a few companies is the surest way to lose all of your money quickly. Venture capital funds manage this risk and frequently enjoy significant profits by spreading their investment dollars around, taking lots of bets on many opportunities.