Invest Like a Venture Capitalist

Here's a look at how to go for VC-style returns in your portfolio.
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Many consider venture capitalists to be the rock stars of the investing world. The perks of success in this field can be impressive to say the least -- a jet-set lifestyle, money to burn and entrepreneurs clamoring to have their ideas heard by you; that's the allure of venture capital ( VC).

But how can that world translate into gains for your own portfolio? It can, if you know where to look.

From VC to IPO and Beyond

About a decade ago, a couple of students living in California decided to create a business based on a new search engine they developed called BackRub. Just one problem: Neither student had the money or experience to develop their technology into a profitable company. These days, that company -- now known as

Google

(GOOG) - Get Report

-- is a Wall Street darling, due in no small part to venture capital. And Google is no exception; it's hard to name a technology or life-sciences company that VC hasn't affected.

Venture capital firms (whose partners are known as venture capitalists) invest in high-

risk, high-potential companies including

start-ups, such as Google. Venture capital falls under the umbrella of

private equity , because the investment opportunities aren't publicly available and can't be made as easily as buying

shares of a

stock.

Capital-hungry entrepreneurs turn to VC firms for a couple of reasons: funding and professional guidance. VC firms are willing to provide funding to companies that don't have the history to get funding elsewhere (quite a bit of funding too; according to the National Venture Capital Association, VC firms provided $26.4 billion in 2006).

And to help ensure that a company succeeds, venture capitalists also provide guidance to those companies whose management doesn't have the know-how to run a profitable business on its own. (To learn more about entrepreneurs and small business, check out

TheStreet.com's Small Business Management Series

.)

According to Steve Bernardez, a principal at ONSET Ventures, "VCs strive to personally and actively add value to their portfolio companies. ... We take an active role in accelerating the

growth of our portfolio companies in a variety of ways over and above financing them, such as assisting with strategy formation, recruiting and business development."

There are definite differences between VC and investing in the stock market. Bernardez explains, "Investments in private companies can take years to get

liquid, while public stocks can be traded intraday. Historical financial information on public companies can be easily accessed, while for start-ups it's nonexistent. Private companies don't have

analyst coverage, while most

larger-cap public companies do."

But for all the differences between VC and public investing, there are impressive similarities.

The Venture Capitalist Approach

As investors, we often see the practices of business and investing as two separate worlds, it's important to remember that behind those stocks that we trade are corporations that make business decisions each and every day (see

"Talking to Management"). So a lot can be learned from the way venture capitalists approach their decisions to fund companies.

"There is an extremely high correlation in both these worlds: Luck. Luck is everything," explains Guy Kawasaki, author, blogger and managing director at Garage Technology Ventures. Kawasaki says, "No entrepreneur truly knows in advance what the outcome will be. Roughly 100% 'know' they'll go public. Roughly 0.5% actually do. Insisting that you 'know' doesn't show determination and guts. It shows you're clueless about what it takes to build a successful company."

What, then, can be used to gauge a company's potential from the perspective of a venture capitalist?

Ben Choi can tell you. Choi is a senior associate and Kauffman Fellow at Storm Ventures. Choi says, "At a high level, I look for passionate and committed entrepreneurs who are building a technology-based product that has the potential to deliver significant value to the market."

According to Choi, "great management, strong technology and big market" are important factors in his search for investment worthy companies. "There are many investment opportunities, so I focus my time on companies who are building businesses around real technology that will enable them to grow rapidly," Choi says.

Now if you think that all this VC talk could never apply to your own portfolio, think again.

Your Own VC-Style Portfolio

While there are public investments to be had in general private equity, such as

Blackstone

(BX) - Get Report

and now

KKR

(see

"KKR Files for IPO"), as well as (to some extent) venture capital with

MVC

(MVC) - Get Report

and

Harris & Harris

(TINY)

(for example), you might find some nice rewards in structuring your current portfolio like a venture capital fund. Here are three things to consider when you're picking venture-capital-style stocks for your own portfolio:

1. Get comfortable with high risk.

If high risk isn't your cup of tea, VC-style investing might not be a good strategy for you. Venture capitalists look for companies with higher risks than someone who is squeamish about losses or fast-approaching retirement should undertake.

2. Look beyond the numbers.

Numbers are a big part of investing (see

quantitative analysis ), but they're not everything. Bernardez explains that "somewhat qualitative milestones, such as market validation, product development progress, team recruitment and business model validation" are valuable ways that venture capitalists look at start-ups with no financial track record; they're also a way for you to weigh non-financial data when making investment decisions about public companies.

3. Ride the VC wave.

For venture capitalists, the real payday can come when a company they've invested in privately goes public via an initial public offering (

IPO). These IPOs can also lead to a big payout for you -- if you choose wisely. According to Choi, "Ultimately, you want another company or the public markets

IPO to put a value on the growth of a portfolio company." With 26 VC-backed IPOs in the second quarter of 2007 alone (according to a report by the National Venture Capital Association), it shouldn't be too hard to find a stock that will help you get in touch with your inner venture capitalist.

So, What's the Next VC Frontier?

Over the past several years, the business world has seen a resurgence of interest in tech-based start-ups. Investments from VC firms have increased 33% since the post-bubble lows of 2003, suggesting to investors that more tech stock offerings may be on the horizon.

Companies that are making moves include players in what's known as Web 2.0. Big Web sites such as Facebook and Digg, and even lesser known sites such as 37signals, are ushering in a new wave of Web-based applications that are being adopted by millions. With the acquisitions of YouTube (by Google), MySpace (

News Corp.

(NWS) - Get Report

, Skype (

eBay

(EBAY) - Get Report

), and Del.icio.us (

Yahoo!

(YHOO)

) as examples of nascent technologies that have made their original VC investors a mint, the future looks bright for the new wave of tech-driven companies.

Still, start-ups are a tricky business and can remain that way even down the road when they go public. Even so, you can see why the venture capital game is so popular. While it's certainly not an approach for everyone, looking at stocks the way that a venture capitalist approaches potential companies to fund can lead to some exciting gains in your personal portfolio.

At the time of publication, Jonas Elmerraji had no positions in any of the stocks mentioned in this column, although positions may change at any time. Elmerraji is the founder and publisher of Growfolio.com, an online business magazine for young investors.