For simplicity, venture capitalists invest in the future. They invest their money, time, and resources in future management, technology and ideas with the hopes of generating a return for their investors and themselves upon a liquidity event.
Venture capitalists are able to reduce risks by pooling their capital and resources with other venture capitalists. The required returns are particularly high because investments are being made in ventures that are rather risky as these are companies, management teams, products, ideas, and technologies that are still in their formative stages against the backdrop of ever present change and competition.
When considering the investors’ required returns, fees, and venture capitalists’ required returns, investment opportunities have to yield greater than 25%-30% to become attractive. This means the venture capitalists’ expectations decide if the investment is worthwhile. This also means a great many products, ideas, and technologies are forgone because the expected returns are simply not high enough, not because they are not potentially profitable, viable future businesses.
This creates a bottleneck to future innovation and growth. There are only so many new ventures that can yield greater than 25-30% returns. Venture capitalists returns are usually skewed. For example, out of a portfolio of 10 ventures, 7 may fail while 3 succeed. This is a loss-to-success ratio of 70%/30%. However, the returns on the successes can be great enough to offset the losses and this is what attracts venture capitalists – frequency vs. magnitude.
With such constraints, venture capitalists can in fact overpay for these ventures when considering the price paid-to-equity ratio. This can cause venture capitalists to all target the same opportunities leading to not only overpaying but also a myopic focus on unicorn companies. There are only so many unicorn companies that come to fruition whereby an investment strategy based solely on unicorns is not very stable.