The article concerns the question – How Do Investors Make Money Using Risk Capital? If you wish to make money using Risk capital, you can join a pool called Venture Capital Firm. A Venture Capital Firm or Risk capital Firm is group of like minded investors who work together and invest in various profitable ventures. On an average the returns for venture capital firms are so large, that they multiply the money invested by about 90 times in a short span.
In a difficult market like we have now, it is easy to pick good companies cheap as the valuations are very low. Unlike 1995 -1997 when most companies traded at huge valuations, very good companies are looking for lot less money now. If you wish to invest now, look for companies that are looking for first round of financing. In general, if you begin with 100 firms you will finally invest in 1.
Before you freeze in the ideas that you want to work with, find all about the industry, idea and management team that has come to you. You can know a lot about the team and idea from pitch. Entrepreneurs size people in this pitch only. As an investor with risk capital, you need not sign the term sheep or letter of intent in first meeting itself. You can sign it, post the pitch has been made and you have discussed the idea threadbare with the entrepreneur.
Once you have worked with a company for sufficient time, you will have to take it to IPO. The real way that you will make good money using your risk capital is by going for an IPO. When you take a company public, you can get good valuations and sell of your stake for lot of money. Other then the sell of stake, there is Liquidation Preference. Liquidation Preference is a clause that is always built in the agreement wherein you will get x times of your equity when the company does an IPO.
Let us look at a typical example. Say you use USD 1 million as Risk Capital for Company A and get 50% of the equity. This means that you will have valued the firm at USD 1 million (this assumption is valid for small investors too!) Now post the IPO, you see valuation of firm reach USD 5 million. With help oft his clause, you will have right to withdraw USD 3 million (if x is 3). This is your share of money in addition to value of 50% stock. When eBay was listed the venture capitalists made more then USD 500 million on their investment.
IPO and Liquidation Clause help investors recoup profits for their risk capital investments. This method explained in last para applies to companies which are acquired also. It is not necessary that IPO is required for unlocking the true potential of a good company. One can look at selling of the company to new investors or competition. In some cases, one may need to do two to three rounds of funding before the company becomes ready to go public or saleable. Investing in Risk Capital is a high return and high risk game.