Venture capital investing and buying penny stocks are both high-risk propositions. However, the challenges posed by each type of investment are very different in three key areas.

Liquidity

Liquidity is a relative term with penny stocks, which can be sold at any time as long as there are willing buyers. Being able to trade shares with a couple of keystrokes enables investors to limit losses, take profits and re-allocate funds to take advantage of new opportunities.

The presumption in venture capital investing, on the other hand, is that the holding period after funds are first allocated to a company will last seven to 10 years. The long-term lack of liquidity in venture capital funding tends to increase the level of risk for investors because, generally speaking, they cannot sell shares when companies fail to meet benchmarks, produce inferior products or appear to be running low on cash.

An additional risk posed by a lack of liquidity is that the ownership percentages of early investors can be diluted by subsequent venture funding rounds. When funded companies are growing, expanding valuations tend to compensate for the dilution of ownership. However, when shareholders are locked in to companies that are missing their scheduled benchmarks or experiencing other difficulties, dilution combined with contracting valuations can quickly erode investments made by venture capital firms.

Control

Venture capital companies will usually put forth a set of terms and conditions that must be met by the company in exchange for the investment. Examples of these demands include having a say in the operations of the business, being able to designate a person of their choosing to the board of directors and expanded voting rights.

The ownership stake resulting from the investment, combined with the terms and conditions for funding, give venture capitalists a high degree of control in how money is spent, on major business decisions and in the overall direction of the company. These measures cannot eliminate all the risks involved with investing in companies during their early stages of development, but they can help to mitigate them and increase the odds of success over the long term.

Penny stock investors, on the other hand, have none of the controls in place that venture capital firms insist on prior to making investments. Absent the measures available to venture capitalists, penny stock investors are put in a position in which they have to trust company executives to act consistently in the best interests of the company and its shareholders.

Unfortunately, in the “Wild West” environment that exists on the Pink Sheets and the OTC Bulletin

Board (OTCBB), there is a history of company executives who have worked on agendas that did not prioritize shareholders or company performance. When it comes to the amount of control that investors can exert on companies, penny stocks present a much higher level of risk.

Information

Before committing funds in an investment round, venture capitalists conduct extensive due diligence process to uncover as much information as possible about the target company. The process includes assessments of finances, intellectual properties, vendor contracts, capitalization, key employee contracts and 409A valuations, with the objective of developing a complete understanding of a company’s history, current status and future opportunities.

In penny stock investing, gathering the same type of information prior to making a purchase is rarely, if ever, done. Instead, due to lax reporting requirements and a general lack of disclosure for stocks trading on the Pink Sheets and OTCBB, investors often base investment decisions on third-party recommendations and tips from newsletters, unsolicited emails and advertisements.

Much like the lack of control that investors have with penny stocks, the comprehensive information that venture capitalists use to make investment decisions is replaced by trusting that third parties are providing recommendations and tips based on the best interests of investors. The need or willingness to trust third-party information substantially elevates the risk of investing in penny stocks.

The Bottom Line

Venture capital investing and buying penny stocks share the common traits of accepting high risks while seeking big returns. Beyond these shared traits, the two endeavors are very different and present unique risks. For example, the liquidity of penny stocks, versus long lock-up periods for venture capital investments, mitigates risk to a degree, as investors can sell to stem losses or take profits.

However, the lack of control and information available on penny stocks requires purchases to be based on trust, as opposed to venture capital decisions which are based on hard data. There are often no measures taken to manage risk and protect investments. Due to these key differences, buying penny stocks carries more risk than venture capital investing.

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