Venture capitalists look to invest money in start-up companies which they believe have the potential for high returns. For this reason, venture capitalists grant venture capital generally given two conditions: that they have ownership in the company commensurate with the share of venture capital they provide (often 50% ownership or more); and that they receive a rate of return on their invested money commensurate with the risk.
If the venture capitalist feels that his investment in a company will yield consistent, high returns year after year, he is likely to maintain his share of ownership in the company. In many cases, however, venture capitalists maintain their ownership of a company only until the company is ready to issue an IPO (Initial Public Offering) or be sold to a buyer. In this instance, the venture capitalist sells his ownership for the proceeds from the IPO, or to the buyer as the case may be. This subsequently allows him to take the money he's made and look for new prospective start-up companies in which to invest.
To illustrate, suppose Bob, a venture capitalist, meets with the directors of start-up company XYZ. Having seen XYZ's current operations and long-range business plans, Bob decides to invest $1 million in XYZ. In return, Bob is automatically granted 50% ownership in the company as well as a 20% annual return on the money he has invested in exchange for the risk he knows he is taking. One year later, XYZ has successfully reached a level of productivity and positive cash flow that allows it to survive on its own. The board of directors, along with Bob, decides it would be best to raise funds for continuing expansion through the issuance of an IPO. Bob subsequently receives $1.25 million (the $1 million he initially invested plus the 25% return).
Answer the questions
If Bob will get an annual return of 20% on the money e has invested, how much money will he earn after one year?
Do you consider fair this percentage that is delivered annually? Justify your answer and present your best arguments in case of disagreement.