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How venture capitalists make their investment choices

02 November, 2016

An entrepreneur looking to develop his or her business needs investment, and venture capitalists (VCs) are often the best people to turn to.

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However, they are wise people and they will not back a business unless they are sure it has potential for success. Therefore any entrepreneur hoping to attract their support needs to know just what the typical VC is looking for, and how they make the decision as to which businesses to invest in- and which to pass over.

What is a venture capitalist?

Venture capitalists are investors that back entrepreneurs financially in return for a stake in their business they hope will eventually earn them a sizeable profit. This profit is often achieved via the company being sold on to a large corporation at a profit, which the VC will take a share of. Sometimes the VC is bought out and the controlling factor of the investment passes to another company. It's worth noting too that behind most venture capitalists are investors that provide the VC with its funds. They trust the venture capitalist to make decisions on their behalf, and while they accept that there are risks and that there will be losses, they expect to make a profit in the end.

Studying the market

An example of a successful venture capitalist is Hiruy Amanuel, a co-founder and managing partner in the Silicon Valley VC firm AJ Ventures. Amanuel recently invested in augmented reality company Meta, but only after spending two years studying the emerging technology market. AJ Ventures typically focus on the consumer and investment markets, but always choose their investments very carefully. Amanuel himself is also a philanthropist who supports educational and technological initiatives in East Africa.

High growth

VCs usually look to invest in successful people with a proven business track record. Their aim is to help promising new companies get to the next level by developing their infrastructure to become saleable properties. To this end they typically invest in high growth markets- that is, sectors experiencing a boom period. During this time the difference between those companies that will succeed in the long term and those that will fail is often negligible, and VCs aim to cash in their investment before this difference becomes apparent.

VCs will generally further protect their position by negotiating a preferred equity ownership position. This gives them preferential treatment should the company lose value or go into liquidation, but also if it proves to be successful in the long term.

Assessing risks

A high-risk business is attractive to a VC because it offers the possibility of high returns. However, this risk needs to be balanced against reliability. For an established company this can be measured by studying product sales, profits and cash flow to arrive at a measure of value. With a new company, however, a VC generally arrives at a decision by looking at the management team- their personal track record, their strategy, and the confidence they generate.

A smart VC would rather invest in good management than in a good idea with bad management, and ideally good management in a high growth market sector. Solid market analysis can help convince them of a project's potential, as can a demonstrable competitive edge. Ultimately, having the right team in place at the right time is the best incentive for pulling in the VC investment an emerging company needs.   

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