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 big part of our daily lives. These companies were backed by venture capital firms and are now listed on the public stock markets.
The primary differences 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 offers high rewards but comes with high risks as well. The best part of venture capital is that the return potential is the best among all other classes of assets.
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 shares of the business that can generate returns and 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 through a venture capital vehicle, 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 return.
Also, the valuation of a company in the early stages tends to be very fluid. This may refrain venture capitalists to know the true worth of their holdings for several years.
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 investing in smaller 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.
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 historically been 10% annually.
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 valuations ranges from 1x to 5x which 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. It can also shoot up to 10x to 20x for 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-up investments, 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.