Collateral as a Risk Mitigation Strategy in Venture Capital

In today's economy, many investors are hesitant to get involved in venture capital opportunities because of the risks generally associated with this investment arena. The additional of collateral sometimes provides the impetus to get off the fence and take positive action.

The simple definition of an "investment" is the act of placing at risk an asset (cash or resources) into an opportunity where the investor believes the potential reward or gain outweighs the risks of the transaction. Inherently then, all investments should carry both a potential return and potential risks. Typically, the higher the risks, the greater the potential reward. However, this is not always the case.

Just a few examples might be blue chip investing in companies like AIG, Lehman, or in AAA-rated mortgage backed securities. Of course, in those cases, the presumed risk was actually quite a bit greater than anyone anticipated. Such shocks to the financial system have led many investors to be far more cautious when considering opportunities – and rightfully so. While this certainly isn’t a bad thing necessarily, it has created investor paralysis in quite a few markets and made capital more scarce.

Frankly, there is still a lot of money in the markets just sitting in accounts and gaining less than 1% interest per year. However, much of this money is ‘nervous’ and investors are often waiting in the wings for the ‘perfect investment’ that will likely never materialize. Even ready and experienced investors tend to take quite a bit longer to perform due diligence than in years past. Again, this is not necessarily a bad thing. Perhaps the rush of easy money in the early part of the millennium led to hasty judgments and eventually to investors being left holding the bag when the musical chairs of Wall Street stopped suddenly during the meltdown. The smart money has learned its lesson, but it’s also not sitting in a certificate of deposit earning less than one percent.

Venture Capital Investing has long been a favorite arena for savvy investors. Just about every major business you could name began as a venture capital start-up. The seed money to create most companies starts with an entrepreneur with an idea who finds a willing venture capitalist to take the risk. Unlike the stock market, where automated trading has irreparably changed the landscape, venture capital is typically less volatile, however, it is also less diversified; you’re investing in one company, not dozens.

Of course, not all start-ups succeed, but a typical business doesn't fluctuate in its success based on which government numbers will be released this week, whether or not politicians can agree on some negotiation in DC, or who wins an election here or in some far away country. The stock market, however, is frequently affected by such things - sometimes resulting in wild fluctuations that don't take the fundamental soundness of a particular company in mind. Closely held private companies account for a great deal of wealth throughout the world, and some of those companies eventually go public.

Venture capital investing is not without risks - choosing the right company, the right management team, the right product or market segment, and of course, adequate funding all come into play. This is where an investor's ability to perform proper due diligence is most important. It’s also important, however, to be able to make a decision one way or the other. Apathy doesn’t typically earn a return on investment.

Assuming that 'all the planets align' in a particular venture, the investor still has to decide whether or not to put his funds at risk in the hopes of the expected return and whether or not he/she is comfortable with the risk/reward assessment. Nobody can predict the future of any particular company, but most venture capitalists also keep themselves in the company's communication loop by taking a seat of the company's board of directors or putting controls in place to ensure against bad judgment or embezzlement. At the end of the day, the entrepreneur and the management team have to implement the business plan and remain nimble as the market evolves. Knowing the inner workings of the company can help the investor and his advisors spot problems before they manifest in earnest.

Even in the most perfect scenarios, things change, markets change, consumers change, trends change, regulations change. As an example, if you were the top manufacturer of vinyl records in the 1980s and didn't see Compact Discs as real competition soon enough to make appropriate changes, it didn't matter how good you were at making record albums, you likely went out of business.

Having identified some of these changes in the funding markets, some venture firms have made a move to start providing an additional incentive for investors to get involved in venture capital investing. It goes without saying that venture companies are far more selective in the projects they consider, their due diligence is more extensive, and their demands upon the entrepreneurs and the management teams are more stringent. Some have come to realize that adding collateral to the mix can be the 'secret sauce' to getting investors off the fence and back into the market.

This collateral takes various forms including cross-collateralization with real estate, other businesses, stock swaps, and financial instruments. Perhaps the most unique use of collateral is the addition of hard assets such as fine art, antiques, and even authentic shipwreck treasure gemstones. These hard assets provide the investor with a fallback position - a way to make themselves whole if the venture fails.

The agreements for such collateral vary, but typically include some form of escrow or safekeeping so that the investor is guaranteed possession of the collateral asset if and when it becomes necessary. The investor must be diligent in specifying the definition of 'failure of the business', the conditions that must be present to trigger the collateral’s release, the process of forfeiting the asset to the investor, and what to do with the asset once it is acquired. Many investors see this strategy as a method of buying such assets essentially at a discount and thus look for assets that they'd like to own.

For example, an investor who relishes collecting fine art might look for ventures where significant artwork is pledged as collateral. Those with strong banking relationships might look for financial instruments they can put to good use. Of course, most folks are intrigued by shipwrecks and history, so shipwreck treasure always seems to create excitement and interest. The portability of gemstones adds an additional layer of allure in that it provides its owner with the ability to store and/or transfer his or her wealth with relative ease. High quality gems have been used as a store of wealth for millennia and the same is true today. In all of these cases, the collateral is typically appraised by a respected expert and then reviewed and inspected by another expert who represents the investor in some fiduciary capacity.

In any event, the collateral simply becomes a risk mitigation strategy - a way to minimize the impact of various risks and ensure the safe return of invested resources. Presumably, the collateral is provided such that the disposal of the collateral results in return of the initial investment or at least enough value to compensate the investor for the loss of capital.

In some cases, a multiple of the original investment is collateralized, which provides the investor with upside potential on top of the return of the initial capital. In the case of gems, for example, the upside might be adjusted upward to cover the cost of disposing of the asset or the holding time involved in selling the asset over time. Nothing hurts the value of hard assets, particularly high value rarities, faster than a highly motivated seller trying to liquidate a multitude of assets all at once. In many cases, holding the asset actually increases the value of the asset or its benefits to the owner.

However, one must first approve of the business and the business plan and be happy with the upside provided by the business. The collateral should not be used as the determining factor when making the investment. After all, the upside of the success of the venture will likely far outweigh the eventual ownership of the collateral. The collateral should be the fallback position, not the sole reason for the investment.

At the end of the day, there are many factors that influence what makes a solid investment. Performing your own due diligence, seeking the advice of knowledgeable and trusted advisors, and determining your own risk/reward comfort levels will all serve you well.

Some general things to consider: Venture capital investing is not for everyone and knowing your personal risk profile is a great place to start. From there, consider looking at industries in which you are already familiar or have some personal expertise. If you work in the medical industry, look for medical ventures. The same holds true for manufacturing, film and entertainment, resources and energy, and any other sector that interests you. Picking the right venture can be the most fulfilling (and lucrative) venture on which you ever embark, but it can also be a costly error if the venture fails. Be cognizant of the risks, take your time, and decide what is right for you. Don’t succumb to high pressure sales tactics, artificial deadlines, and be sure that ALL of your questions are answered to your satisfaction. Ask for projections that reflect the worst case scenarios rather than the hopeful best cases. Many entrepreneurs think ‘if you build it, they will come.’ This is rarely the case and nothing takes the place of strong, experienced management, sound marketing and sales strategies, and good common sense. If you don’t understand the business plan, the risks, or the worst case scenarios, don’t make a move until you do.

Disclaimer: Neither the author nor Venture Street is a registered investment advisor. Information herein is provided for informational purposes only and does not constitute or imply an offer to buy or sell securities of any kind. As with all investments, please seek the advice of trusted advisors and counsel before making any investment or signing any contract.