Venture capital investing not for weak-hearted

The returns on early-seed venture-capital investments look so tasty: an average of 69.1 percent in the last five years.

“But averages can be deceiving,´ said Dave Dwyer, founder and partner in Vista Ventures. “If two swimmers start off across the English Channel, one drowns and the other makes it, you have a 50 percent success rate. Cold comfort for the unsuccessful swimmer.”

So it is with venture capital investments. The risk is high, and the fund manager has to look at each investment as having the potential to return the entire fund. Historically, venture-capital businesses have clustered on the coasts, but have cast a broad net to catch the high-risk, high-gain investment opportunities wherever they appear. According to Venture Economics, there was $2 billion invested in the generic “West” (including the Rocky Mountain West and the Southwest, but not California) in 1999. That number grew to $3 billion by the end of the third quarter of 2000.

A subset of the West, Colorado in 1999 ranked fifth nationally in venture-capital investments, and 80 percent of that came from out of state. Framed another way, Colorado remains an importer of capital, an investment colony for the coasts.

“Colorado is under-served in terms of local capital,´ said Dwyer, “leaving the venture market wide open. My partner, Catharine Merigold, and I hope to get in on the better deals.”

So if the market is so wide open, why do other financial institutions and financial advisors not dip into the pot? The problems involve risk and bankability.

Jo-Ellen Thornton, of Thornton Financial, designs and maintains investment portfolios for her clients. “Venture-fund investments are too aggressive for my client base,” she explained. “It doesn’t take any brains to lose money, and while there are many great opportunities out there, the chances of hitting are maybe one in a hundred.”

Dwyer agrees, pointing out that venture-capital investments should be viewed as the 10 percent of a large investment portfolio reserved for “alternative investments” of the high-risk, high-gain variety.

“This kind of investment is not appropriate for money you have set aside for your retirement,” cautioned Dwyer. “You might lose that whole 10 percent, or you might make huge gains.”

Banks also regard venture investing as high-risk as well as incompatible with a bank’s need to evaluate a revenue stream from the borrower.

“A company, particularly one focused on information technology, does not have sufficient earnings in its early stages to service a debt,” explained Hank Rahmig, executive vice president and chief credit officer for Cache Bank and Trust in Greeley. “Venture capital comes in as equity debt, which balances the risk.”

However, the role of banks is not irrelevant in the first stages of a startup company. If there is a typical scenario for a startup business, it goes like this: Someone has a good, but unproven, idea. In order to get a shell on that egg, individuals keep their day jobs and dip into home equity or the savings accounts of family and friends.

“A bank, particularly a community bank that deals regularly with small businesses, can be helpful at this earliest stage by helping a client figure out how to use personal resources,´ said Rahmig. “An individual needs to be able to pay back a home equity loan, and so may want to start a new venture only on a part-time basis.”

A bank might enter the picture again when a new company’s earnings have become sufficient to service the debt.

But cracking open the entrepreneurial egg requires risk capital of the sort a bank cannot reasonably provide. Once that egg is ready to hatch (as what, no one is quite sure), the following elements of a new enterprise are typically in place: the core of a management team, a product and some financing from personal resources. The early/seed venture fund enters the picture for the first “professional” round of financing. Without this risk capital, lots of businesses never make it out of the home office.

“Early/seed funds such as ours rarely supply funds for a building or equipment,´ said Dwyer. “Money goes to paying salaries for the new hires necessary to design software, to covering marketing expenses and to supplying working capital for day-to-day expenses.”

Clearly, venture capital flows into a company before anyone can know if it will prosper. But a fund manager can reduce the risk in various ways. While no exact comparables exist, one fund manager can look at what other fund mangers are doing (possibly with an eye to making a joint investment) and establish some sort of trend. The management team should have a solid track record, and the idea must be good and ready to enter the world running.

“Some good management teams may have a poor idea, and some poor managers a good idea,´ said Dwyer. “We have spider charts to evaluate a number of variables, but for all of that, venture investment is not a science.”

Indeed, the timing on an investment can go sour; it might be too early or too late. Fund managers have to protect the interests of their investors, but if they are overly cautious, they might miss the golden moment to invest in the next E-bay, the highest venture return ever.

And that is the good news. When an investment pays off, it pays off well in ways that favor those who have an equity position in the company. A variety of good returns can come to investors, depending on how the investment was structured. If someone buys the company in four to eight years, investors may receive cash or stock. If the company goes public, investors get stock and may sell it or hold it.

“Sometimes the founders of a successful company will want to buy us out,´ said Dwyer. “The goal is for everyone to do well. In fact, the only downside to managing a fund in Larimer County, which has all ingredients for exceptional growth in information technologies, is that we do not have the resources to invest in all the good businesses.”

In fact, just since the fund became available in the fall of 1999, Vista Ventures has received 170 applications for financing. Dwyer acknowledges that these same companies are likely to have applied to other funds, but even so the response has confirmed Dwyer and Merigold’s collective sense that the time is right. In addition to the fact that the Colorado market is undeserved, a bearish market had pushed down the valuations of private equity companies, making it possible to invest in good companies at valuations favorable to the investor.

Dwyer and Merigold expect to invest in the first quarter of 2001. Stay tuned.