Are You a Venture Capitalist?

"Venture capitalist." It's right up there in the top-10 list of cool job titles, along with "captain of industry," "steel magnate," and "robber baron."

Who wouldn't want to be a venture capitalist? Wielding millions of dollars. Financing start-ups. Becoming wealthier than in your wildest dreams when you bring the next Microsoft (NASDAQ:MSFT) to market.

Nothing ventured, nothing gained
The job of a venture capitalist, simply put, is to provide the capital necessary to get a private venture off the ground. To invest in a small company with big ideas but generally with no profits in sight. To keep it on life support until it's strong enough to make it on its own -- and then cash out and make a bundle of green.

Should that hoped-for payday arrive, the venture capitalist stands to win a rich reward for his or her patience, faith in the start-up, and, most of all, courage in taking the huge risk of sinking his or her cash into a money-losing venture.

Capital with a capital C-note
But the venture capitalist may face a long road ahead before that payday arrives. The start-up is burning cash like there's no tomorrow, and there's no certainty that its business plan will ever pan out. So in addition to being faithful, patient, and courageous, a venture capitalist must be one thing above all else: rich.

Whether we're talking about a wealthy individual with lots of money and even more time to spare, or a private equity fund managing the dollars of thousands of such individuals, it's money that makes the venture world go 'round. Because in the world of venture capitalists, you have to hedge your bets. Invest all your cash in a single start-up that goes bust, and you're left with nothing with which to rebuild your fortune. So professional venture capitalists invest lots of money in lots of companies, in hopes that on average, enough of the businesses will make it to IPO day to get the venture capitalists off the hook for their losses.

But if -- oh, happy day -- these companies eventually do go public, they no longer need their "angel" investors. They've found a new source of funds. You.

If, after five minutes of playing poker, you don't know who the patsy is ...
From your perspective, an initial public offering may look like an opportunity to buy into "the next big thing." But from the company's perspective, that's not the point at all. The company looks at an IPO as a chance to raise cash quick. Again, from you.

The problem, of course, is that a lot of companies go public when they're still not ready for prime time. The venture capitalists are sick and tired of funding a money loser. They want a return on their investment, but more importantly, they want out. Meanwhile, the company still has electric bills arriving monthly, and every two weeks those darned employees want to see a paycheck. So cash must be found if the company is to stay alive. And that's where you come in.

The next big thing
This, my friends, is how money-losing companies come to market. The analysts, the underwriters, and the companies themselves all trumpet the new company's "potential," the "estimated size of the target market by 2010," the "compound annual rate of revenue growth." But the financial statements tell a different story. Buying into the hype, you may think you're investing in the next big thing. But the reality is -- POOF! -- you've become a venture capitalist, financing a money-losing start-up.

And not just any old venture capitalist, but an undercapitalized (check your brokerage statement), insufficiently diversified venture capitalist at that. Consider the chart below.

Maybe you own one of these companies. Maybe you own two. Maybe you own none. But do you own them all? It's certainly possible that one or more of them will succeed if given enough time. But which one? And if you sink all of your money into one of these names, and it's not the right one, then you could be in some serious trouble.

What's more, even the company that does succeed will need some time to reverse its losses, to start earning profits, and to become a financially sound company. In the meantime, while its losses continue, the company must take on debt or sell more shares -- diluting the ownership stake that you've paid good money to acquire. The alternative is to turn off the lights, show the employees the door, file for bankruptcy, and carry your money into oblivion.

So, seriously. Are you a venture capitalist?
If not, then stop acting as though you've got money to burn. At The Motley Fool, we've been telling you for years that the way to make money in stocks is to invest in financially sound, responsibly managed, profitable companies. Companies with a track record of making money for their owners.

Over the past 14 months, the Motley Fool Inside Value newsletter has beaten the average returns of the S&P 500 by an average 3-to-1 margin. And we've done it not by investing in prematurely public start-ups, but by carefully researching and recommending to our readers high-quality, low-priced, rock-solid performers the likes of Federated Investors (NYSE:FII) -- up more than 12% in the six months since lead analyst Philip Durell picked it.

And here's the good news. This, too, can be where you come in. With just the click of your mouse, you can take a free, 30-day trial of Inside Value. There's no obligation to continue if you're for any reason unsatisfied -- cancel any time in the first month, and you won't pay a dime. But if you like the service, sign up this month and lock in our lowest price ever for a one-year subscription. It's the lowest-risk investment you'll ever make, whether you're a venture capitalist or not.

Fool contributor Rich Smith has no position in any of the companies mentioned in this article. The value of The Motley Fool's disclosure policy is a definite "buy."