Startups are increasingly open to direct investments from family offices, alongside venture funds. Family offices, in turn, are increasingly investing strategic capital, adding value based on their operating businesses and network connections.
The average family office venture portfolio comprises 17 direct investments and 10 fund investments. Unfortunately, I see a lot of investors putting money into companies with surprisingly little knowledge of their financials or other basic information.
Mike Ryan, CEO, Bullet Point Network, observes, “If you are selecting specific companies for direct investment, including co-invests offered by platforms, funds or special purpose vehicles (SPVs), as well as directly sourced deals, you need to vet the investments yourself either using your own team or an outside provider, because you don’t have a fund manager to rely on. While it’s impossible to paint all early-stage VCs with one brush, it’s generally true that their superpowers center around sourcing great deals and evaluating founders at an early stage. When it comes to investing in later rounds at higher valuations after the business is in scaling mode, it can be dangerous to commit without doing serious independent work on the outlook for the company compared to its current (typically high) valuation.”
Three primary concerns I suggest family offices examine when co-investing are:
- Often, the VC fund is invested in a prior round, and it benefits from the paper markup and reputational benefit on completion of the round;
- Funds sometimes want to commit to a larger investment (or to fill a pro rata) to maintain their status or influence; and
- In an SPV, usually the organizing entity is earning fees, which means the organizer is motivated to offer as many SPVs as possible with wide dispersion of returns, because they always have upside optionality on each.
Bringing in an outside provider to help with this due diligence is a popular option. The big strategy consulting firms have built significant practices offering outsourced investment due diligence and analysis as a service: Tiger Global Management is reported to be Bain’s #1 client globally; specialized firms like Accordion Partners offer outsourced transaction modeling and execution; and Bullet Point Network has an analyst team for hire built on a patented software platform. To name just a few.
Ultimately, I see seven main ways that family offices can responsibly invest in early-stage companies, ranked in order of increasing level of time and effort required:
1. Invest in VC funds (or funds of funds) exclusively.
Advantages: Professional management and, crucially, netting of carry. Virtually every financial advisor will tell you not to invest directly in stocks unless you’re a professional stock-picker; invest in funds instead. If that’s true in the liquid, transparent public markets, then it’s even more important in illiquid, opaque private markets.
Disadvantages: You pay a management fee and carry. You need to do proper due diligence on the funds. You don’t have the discretion to make decisions on a per-company level. In addition, small retail investors normally can’t invest in funds because their checks are too small. However, a number of platforms now facilitate direct access to VC funds, such as Allocate, CAIS, Clade, Context365, iCapital Network, OurCrowd, Palico, PrimeAlpha, Republic and Trusted Insight.
Advantages: These established platforms provide steady, pre-diligenced, often high-profile deal flow, with standardized levels of details and disclosures. You have full control to choose whether to participate in any specific investment, normally through a SPV. The platform decides on the SPV’s behalf when to liquidate the investment and distribute the gains (or losses). This level of control enables you to put money into only those investments where you have highest conviction and optionally think you can add the most value.
Disadvantages: Platforms normally charge carry and management fees. Carry is calculated on each investment—not the entire portfolio—even if you invest in multiple SPVs. For example, if you invest equally in 10 companies and 9 fail but one is a 10x winner, you’ll end up paying materially higher fees on the winner than if you invested through a fund structure.
3. Invest in funds and tell them you’re evaluating them based in part on the number of direct opportunities they’ll provide.
Advantages: No extra cost on your direct investments, except to the extent that the fund charges fees on SPVs. If you are a material LP and are actively involved with the fund, this approach gives you much of the insight and influence you’d have with your own staff, without the difficulty of building an in-house VC operation comparable in sophistication to your independent competitors.
Disadvantages: You’ll still face the challenge of getting and responding positively to a request for coinvestors (syndication) before others invest ahead of you, since companies which have secured a reputable lead VC tend to fill up their syndicate extremely quickly.
4. Invest in a fund’s General Partnership.
Advantages: Potential long-term upside from the General Partner’s success in general, not just from a particular fund. A related, simpler option is to extend a working capital loan to a GP, with a pre-agreed-upon multiple, secured against their future carry.
Disadvantages: Far more complex to negotiate.
The last three options require setting up a dedicated person or team, because you’ll primarily competing with institutional players that pursue, exclusively, each of the strategies below. In addition, many family offices find it hard to execute these strategies without giving up some of their traditional, deliberate obscurity. It’s hard to market your firm without a website and other conventional marketing tools after all.
5. Actively look for coinvestment opportunities led by reputable VCs.
Advantages: no management fees or carry. In general, this is by far the most crowded strategy. The reason is simple: the historically best-performing VCs consistently continue to outperform, a level of surety that simply doesn’t exist in most other asset classes. When you can invest alongside these top funds, you’ll likely outperform.
Disadvantages: Adverse selection is a real issue. When VCs are the most confident in an investment, they’ll write a bigger check and invite only their closest allies into the round. Joining syndicates is a hard strategy to execute well without suffering the “winner’s curse,” because the VC industry has so many followers and so few price-setters.
6. Publicize that you’re focused & value-added in a specific industry.
Advantages: This is the standard approach used by professional VCs who are not lead investors. You’re going to get inbound, high-quality requests more often with this focused origination approach. Note, the bar is high for truly adding value to companies; just giving generic advice is insufficient.
Disadvantages: You’ll need to actually deliver on your promises.
7. Lead rounds.
Advantages: Investors who lead get the best deal flow, because they are the engine of our entire ecosystem. One experienced family office CIO told me, “If VCs are fighting it out to get into the best deals, family offices who are not operating like professional VCs will only get the rejects.”
Disadvantages: You are competing with institutional VCs, so you’ll need to devote comparable resources and manpower. Only a small number of family offices have the asset base to justify doing this.