Question

Discuss how venture capitalists reduce their risk when investing in startup businesses. Justify your answer citing appropriate examples from Saudi Firms.

Answer 1

Solution:

A venture capitalist is a private equity investor that provides capital to companies exhibiting high growth potential in exchange for an equity.Venture capitalists(VC) are willing to risk investing in such companies because they can earn a massive return on their investment if these companies are a success.VC experience high rate of failure due to the uncertainity that is involved with new and unproven companies.

Venture Capital is a risk v/s return business and venture capitalist invest at diff. levels of the risk spectrum.They reduce risk by investing at low valuations so that when one company is ultimately sold or goes public at a high valuation it makes up for a number of other companies that go out of business.

Also venture capitalist invest through the comapny issuance of preferred stock .If a company is sold or liquidated the prefered stock is paid back before the common stock.An early stage investor would likely be the first in a company at the preferred stock level.So they would invest in the 'A' round of the preferred.

If a company goes on to raise subsequent capital as it develop,each subsequent issuance has seniority in liquidation to the prior round of preferred stock. So the next round of capital raised is the round 'B' and then 'C' round and so on.

Let's say the round A investor put their money in when the comapny was pre-revenue and invested $500000 valuing the company at $2 million and they own 20% of the company.A few years go by and the comapny raised a B,C and D round of Venture capital at increasing valuations.The company now has $30million in revenues and is growing by 30% annually.The E round investor invests $10 million at a $150 million valuation and owns a bit over 6% of the company.

Let's say something highly unlikely happens like a global pandemic(Covid-19) and the company is in extreme distress, so sells to large comapny for $10 million . In this case,assuming their are no creditors, the $10 million would all go to the sereies 'E' venture capitalist, the last investor.If it's sold for $20 million then the series 'E' gets the first 10million and balnce goes to the next most recent investor.

Venture capitalist reduce risk based by investing in different valuations and stages of a company development and structurally through the use of the security(preferred stock) used to make an investment.