Venture Capital Vs Public Stock Markets: An Overview
Social media platforms such as Facebook, Twitter, Instagram, Snapchat, and Pinterest are now household names. They have become a staple of our daily lives. These companies were backed by venture capital firms and are now listed on the public stock markets.
The primary points of difference between venture capital and stock markets include the risk and return profile as well as access. Let’s explore how the two are related to each other.
How Does Venture Capital Work
Venture capital is an asset class offering high rewards but comes with high risks as well. The best part of venture capital is that the return potential tops among all other classes of assets and it remains uncorrelated to any returns received from other asset classes.
Venture capitalists usually invest through a venture fund or a specific purpose vehicle in companies with innovative ideas and technologies. With this funding, venture capitalists receive the shares of the business that can generate returns that can be sold later. To boost the odds of procuring good returns, venture capital firms have a diverse investment portfolio.
Another important aspect of venture capital is the time horizon in which it works. If you invest in venture capital, you must be prepared to lock in your money for a prolonged period. Typically, it takes around four to ten years for receiving any kind of returns. Also, the valuation of the companies in the early stages tends to be very fluid which may refrain the venture capitalists to know the true worth of their holdings for several years.
Related: what is pre-seed funding, what is seed funding
How Does Investing In The Public Stock Market Work
The stock market, on the other hand, works with the shares of public businesses. For investments in public stock markets, the investor will need some capital and a broker account. Quite similar to venture capital, those who invest in stock markets aim to build a diversified portfolio to keep risks at bay while ensuring good returns. The level of risks involved with the public stock market is dependent on the particular stock that the investor selects. But the general rule of thumb is investing in well-known and established businesses is much more rewarding compared to small companies.
Investors generally factor in the revenue trends of the company, market caps, rivals, and alterations in the value of the stock from time to time. But a major difference between venture capital vs public stock market is that the investors of stock markets cannot access the management team of the business for helping in the evaluation process.
Business Valuations And Return On Investment Compared
For those companies that are listed as public businesses, the value is calculated on the multiple of the earnings before receiving taxes, depreciation, and interest or on some other multiple specific to that particular industry. Stock market returns vary a lot but the average stock market return on investment has been 10% annually historically.
Business valuation is never an easy job and this is particularly true in the case of startups with meager or no profits. On average, the revenue multiple for startup valuation ranges from 1x to 5x that has a very slow rate of growth amounting to around 10 percent a year. But it can be around 6x to 10x for those that have a growth rate between 30 and 40 percent a year. The same can shoot up to 10x to 20x for the startups that show a growth rate of 300 to 400 percent a year.
Steve Anderson is an investor at Baseline Ventures and he invested $250K into Instagram. If he didn’t make any follow-on investments into the company, the return on his investment when Facebook bought Instagram would be $120M divided by $250K or a 48,000% return (source).
The top five publicly traded businesses including Google, Apple, Microsoft, Amazon, and Facebook set out as startups powered by venture capital. In essence, the nature of venture capital is to work on prolonged-time horizons.