Venture capital 101

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(FORTUNE Small Business) -- Dear FSB: I am considering investing money into a friend's company, that recruits college students to mentor and influence middle and high school students how to become better leaders. The company is for-profit and generates revenues through speaking engagements and leadership conferences. I believe this company will be very successful in the future. I know that venture capital firms get their returns by selling their businesses or in initial public offerings (IPOs). I don't foresee either any time soon for this company. If I were to invest my money, how would I get a return on my investment?

- Andrew Bouldin, Knoxville, Tenn.

Dear Andrew: The short answer to your question is that you might never see any return on your investment in your friend's company, according to Philip Bronner, a general partner at Novak Biddle Venture Partners in Bethesda, Md. Despite newspaper headlines about eye-popping IPOs and instant fortunes linked to the venture capital business in recent years, Bronner said that even the best VC firms lose money on most of their investments. The trick is that they manage to offset those losses with just a couple of big hits.

"If you've got ten deals, you hope that one or two are home runs, then you've got two or three that are reasonable deals - maybe you get your money back out of them. The rest are complete wipe-outs," he said. VC firms do reams of research up front to try to limit the number of bad deals, but it's often difficult to predict which companies will sink and which will sail.

In other words, donning the mantle of a venture capitalist isn't something you should do lightly - and it isn't something you should do with money you can't afford to lose. "The way to think about it as a personal investor is that you should allocate a very small part of your net worth, and when you allocate it, be prepared to lose it all," Bronner says.

The other factor that keeps the venture capital business the province of the very wealthy is the length of time it might take to realize a return on your investment. As you note, VC firms typically make money as a result of some kind of liquidity event - either an IPO or a sale. But even if you're fortunate enough to back a hit company, you might have to wait six or eight years for a payout. There are rare instances where venture funded firms become profitable enough to buy out their investors, but that is rare. In the meantime, you shouldn't expect to see any return on the money you put in, beyond the heartfelt thanks of your friend.

That said, Bronner agrees that there is money to be made in education. Novak Biddle is a major backer of education startups, and has scored successes with educational software maker Blackboard Inc. and other firms. "It's a very large market, and one that's in a state of transition and turmoil," he said. "That provides an interesting opportunity for investment."

Before you invest, Bronner advises that you take a good hard look at the company and people you will be investing in. "You've got to understand the entrepreneur," he says. "Both his core capabilities and his domain expertise."

Beyond that, you should learn as much as possible about the size of the market your friend's company is playing in. How much money is there to be made in it? "When you're investing at this early stage, given the challenges and the likelihood of failure, you need to be able to make at least 10 times your money," says Bronner. "So you need a large market." Also consider what it is that your friend's company has that's unique and that would be hard for competitors to copy once they've figured out that he's on to something. The Web is an excellent source of information, but the best way to learn about the company is to speak directly with people who are familiar with it.

Should you decide to invest in the company after all that, Bonner recommends talking with a good attorney who can help you understand the capital structure of the business and the nature of the risk that you're taking on with the investment. Good luck!