Why startups without exit potential do not receive funding from venture capitalists

As part of their investment decision, VCs examine possible exit options and times for a later sale of the equity investment. These considerations are included in the valuation of the startup seeking capital and thus influence the VCs  investment decision (cf. Ermisch/Thoma 2002, p. 24). The reason for this is the business model of the VCs, the key feature of which is the limited investment period of the equity investment (cf. Kobel 2005, p. 159).

The VCs objectives

With their business model, VCs basically pursue various derivative and original objectives. On the one hand the derivative objectives are the investment objectives of the fund investors, who provide the VCs with financial resources as a fund investment. The original objectives, on the other hand, are the investment objectives of the VCs, which they pursue with their investments in innovative startups (cf. Schefczyk 2000, p. 19). Without going into all the objectives of the VCs and its fund investors in this article, the overriding objective of both parties is always to achieve an appropriate return by selling the equity investment after a certain investment period. The joint return target is therefore the point at which derivative and original objectives overlap (cf. Middelberg 2012, p. 21). The successful sale of the equity investment at an attractive price can therefore be understood as the overriding objective of the equity investment by VCs, as no return-oriented VC enters into an equity investment for charitable reasons (cf. Boué 2008, p. 39).

The VCs goal is always to generate a return for themselves and their fund investors that reflects the risk of the investment.

The potential return that VCs generate for their fund investors does not come from ongoing dividend or interest payments. Only when the equity investment is later sold are the increases in value generated up to this point in time realized and paid out to the fund investors (cf. Krecek 2005, p. 22). The higher the risk of the investment, the higher the expected return for the VCs has to be (cf. Boué 2008, p. 14).

Conclusion

In summary, the exit option is essential for VCs for the following reasons. The exit serves to generate liquidity in order to pay out the fund investors at the end of the fund term and to be able to make new investments. Successful exits serve to enhance the reputation of the VCs and are essential with regard to the launch of new funds, the attractiveness for innovative startups seeking capital and a good relationship with the capital market and strategic investors (cf. Kobel 2005, p. 159). 

Startups seeking capital that offer no prospect of a successful exit are therefore not of interest to VCs.

Reference(s):

Boué, Andreas R. (2008): Wie komme ich zu Venture Capital? Praxisratgeber mit Insidertipps für die erfolgreiche Kapitalakquise, Wien.

Ermisch, Ralf/Thoma, Patrick (2002): Zehn Schritte zum Venture Capital. Ein Ratgeber für junge Technologieunternehmen, Heidelberg.

Kobel, Magnus (2005): Pre-IPO-Finanzierungen durch Venture-Capital-Unternehmen. Eine phasenspezifische Analyse der institutionenökonomischen Risiken des Investors, Bayreuth. 

Krecek, Michael (2005): Venture Capital aus Investorensicht. Entscheidungstheoretische Analyse von Strukturen und Vertragsklauseln, Wiesbaden.

Middelberg, Nils (2012): Erfolgsfaktoren bei der Investitionsmitteleinwerbung von Venture-Capital-Gesellschaften. Eine Mixed-Method-Analyse, Wiesbaden.

Schefczyk, Michael (2000): Erfolgsstrategien Deutscher Venture Capital-Gesellschaften, 2., überarbeitete und erweiterte Auflage, Stuttgart.