term paper B

What Drives Venture Capital

In recent years, venture capital has become an essential capital source for start-up compa-

nies, especially in cases where they do not have access to bank loans, capital markets, and other

debt tools. The venture capital industry is primarily composed of four key players, entrepreneurs,

private investors, venture capitalists, and investment bankers (Buchner at al. 522). Entrepreneurs

require funding, investment bankers require the companies to sell, private investors want returns,

and venture capitalist creates a market for the three, making money for themselves. For investors,

especially those who are not experts in investing, identification of a viable business opportunity

usually poses a challenge. This is basically because most investors are usually afraid of losing their

savings, something which can easily happen if all considerations are not taken into account. The

risks are usually higher with new ventures, which paradoxically are usually very promising. One of

the ways on which investors usually manage risk is by diversifying their investment portfolios.

Any business venture is usually accompanied by some degree of risk. The risk is usually

higher with start-up ventures. Most new entrepreneurs are usually excited upon starting a business

venture, and for this reason, they are usually optimistic and fail to take into account factors that may

have a significant impact on the returns of the venture. Venture capitalists, on the other hand, tend

to predict the worst possible scenarios. Merging the two is thereby recommended to create a bal-

ance.

One of the ways in which venture capitalists usually mitigate risks is through diversification.

This paper will examine capital ventures with the hypothesis that diversification reduces risks in

venture capital investments.

Essentially, diversification minimizes risk by the allocation of investment across different

industries, financial instruments, and other classes. The goal is usually to maximize returns through

investment in different areas that would react differently to a common event. No single model fits

all scenarios, thereby necessitating the need to have several models to cater for different circum-

stances. Although diversification offers no guarantee that there will not be losses, it is an essential

component of venture capitalists achieving long-term financial goals while ensuring that risk is

minimized.

To understand how diversification minimizes risk, consider a company such as Berkshire

Hathaway. One of Berkshire Hathaway’s key competitive advantages is diversification. Although

Berkshire Hathaway is fundamentally an insurance company, it sells underwear, homes, energy,

furniture, and private jets. The company’s CEO, Warren Buffet, is widely known for being a propo-

nent of diversification accompanied by value investing. Diversification implies that in the event that

market conditions are unfavorable for one type of product (or service), it is favorable for the other.

For instance, if Berkshire Hathaway is making losses in selling homes (via Clayton homes), it is

unlikely that the company will also be facing similar conditions with selling its Duracell batteries.

Essentially, diversification enables investors to minimize risks by increasing a company’s sources of

revenue (Jaffar et al. 1325).

Diversification is also essential for venture capital investments to survive in case of a finan-

cial crisis. The 2008 financial crisis, which adversely affected the venture capital sector, is an ex-

ample of why diversification is crucial for the long-term survival of ventures (Jaffar et al. 1328).

The industry took a hit because of the heavy reliance on institutional investors for funds, who, in

turn, exercised a significant control over business decisions. The venture capital ecosystem has

changed significantly today with the emergence of many startups that are valued as highly as a bil-

lion dollars. These unicorns are bound to attract different players. For such startups, diversification

is essential to ensure that their returns are, to some degree, guaranteed since such ventures usually

face risks that may make their durability questionable.

Venture capital investors usually encounter risks of two natures: systematic and unsystemat-

ic risk. Systematic risk is the risk that cannot be diversified. It is influenced by factors such as ex-

change rates, inflation, political instability, etc. the second type of risk, unsystematic risk, is the risk

investors are concerned with since it can be diversified (Jaffar et al. 1330). The risks of this nature

are usually characteristic to a given country, economy, market, industry or market. Financial risk

and business risk usually cause this type of risk. Thereby, investing in different assets implies that

they will not be affected in a similar way by market occurrence. Unsystematic risk is exemplified

by a comparison of stocks and bonds (Jaffar et al. 1330). The two are usually affected differently by

factors such as inflation and exchange rates. For this reason, an investor may diversify by investing

in the two portfolios since their prices tend to move in opposite directions. Investing in the two of-

fers insulation against great losses since if the prices of stocks fall, the price of bonds will rise.

The management of diverse portfolios is usually cumbersome. This is especially for in-

vestors with several investments and holdings. The reason for this is that every individual invest-

ment requires its own analysis.

Although diversification may lower the risks involved in venture capital investing, it may

also prevent venture capital investors from obtaining the maximum benefits from their investment.

Studies carried out revealed that venture capitalists usually get compensated when they exert more

effort and show great expertise as opposed to diversifying away from the risk (Buchner et al. 524).

Value-adding knowledge brought along by venture capitalists is usually beneficial and could be the

key to increasing returns. Essentially, in some cases, the involvement of venture capitalists in help-

ing mitigate risks and generally restructuring of a company is usually worthwhile.

Diversification may also limit innovation. The reason is that innovation is usually encour-

aged when there is a focus on the development of one particular field. Diversification limits the de-

velopment of expertise in a given area as relatively less effort is exerted in a given are in compari-

son to a case where there is no diversification.

The hypothesis that diversification minimizes the risk in venture capital investments was

confirmed. It was established that diversification lowers the risk by minimization of losses through

investment on diverse portfolios. However, it is not always the case that diversification is the best

alternative for investors. Diversification may be excessively hectic, and it does not favor innova-

tion.

Diversification presents a unique opportunity for both talented entrepreneurs and venture

capitalists. Diversification will increase the attractiveness of new ventures since venture capitalists

are assured that there is minimal risk and that they will get desirable returns on their investment.

Some very talented entrepreneurs, engineers, etc. can be able to invest since the greatest impedi-

ment to investing in this group is usually the fear of losing all their savings.

With diversification, venture capitalists can augment great ideas from entrepreneurs with

their business and financial skills. Most entrepreneurs usually fail due to believing that their ideas

alone are the reason for their success in business. With the correct business and financial guidance,

these entrepreneurs can turn their innovations and ideas into profitable ventures. Also, diversifica-

tion can also help increase the sales made with a given product without necessarily investing in an

entirely different portfolio. For instance, a company such as Coca-Cola can increase its market by

increasing the range of flavors of soft drinks made by the beverage company. Essentially, entrepre-

neurs and venture capitalists should embrace diversification not only as a means of mitigating risk

but also as a tool to improve their market strategy.

Works Cited

Buchner, Axel, Abdulkadir Mohamed, and Armin Schwienbacher. "Diversification, risk, and returns

in venture capital." Journal of Business Venturing 32.5 (2017): 519-535.

Jaffar, Yusuf, Ginanjar Dewandaru, and Mansur Masih. "Exploring portfolio diversification oppor-

tunities through venture capital financing: evidence from MGARCH-DCC, Markov switch-

ing, and wavelet approaches." Emerging Markets Finance and Trade 54.6 (2018):

1320-1336.. 


Outline

1. Introduction

2. Hypothesis

3. Discussion

a. Why diversification is important

b. Types of risks

c. Challenges of diversification

4. Conclusion and opportunities moving forward

5. Works Cited