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How To Invest In Venture Capital

Venture capital is catching a buzz in the headlines recently, with Garry Tan’s $300,000 Coinbase investment translating to over $2.4 billion in public markets, and Peter Thiel’s $2,000 Roth IRA clocking in at over a whopping $5 billion today.

Additionally, interest and money invested in venture capital have been growing dramatically. Through Q1 of 2021, global venture investments reached $125 billion, representing a 50% increase quarter-over-quarter and a 94% increase year-over-year.(2)

In today’s post, we will be discussing: 

  1. The venture capital landscape and industry dynamics 
  2. Returns, assumptions, and risks for this asset class
  3. Different options and considerations for making investments in venture capital
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Despite the flashy reports from Forbes and TechCrunch, dramatic buzzwords, and money seemingly being printed hand-over-fist, many of us are well aware that the investments that drive headlines are few and far between. In fact, many venture capitalists invest assets with the assumption that, even if diligence is conducted properly, many of their early-stage startup investments will fail due to the myriad of risks that startups face. 

Based on a study of 1,119 early-stage technology companies from CB Insights, about half of startups fail to raise their second round of financing, and only about 1% reach a “unicorn” status of achieving a $1 billion or higher company valuation. So, in providing some initial context, the name of the game is truly “slugging percentage” and not “batting average” i.e. it’s about the magnitude, not the frequency of success. 

If that’s the case, what is so enticing about investing in venture capital as an asset class? 

For starters, the potential returns for investing in private companies can provide very wide dispersion, especially when compared to public market investing. This means that the top 10% of venture investors can enjoy significantly higher returns when compared to the top 10% of public market investors. This can be largely attributed to private vs. public market inefficiencies, driven in part by advantageous access to certain startups and investment firms. While all publicly traded companies in America are known, there is a greater opportunity for excess returns in identifying and sizing into investments in private markets due to informational asymmetries and betting on “difference-makers”.  

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Five successful past examples(4):

  1. WhatsApp: Sequoia Capital invested $60M, worth roughly $3B after acquisition.
  2. Facebook: Accel Partners and Breyer Capital invested $12.7M which ultimately turned into $9B (Accel also sold $500M of shares in 2010, pre-IPO). Peter Thiel also became a Facebook investor in 2004 with an initial investment of $500,000 at a $5 million valuation. When Facebook went public in 2012, Thiel sold 16.8 million shares at the IPO for about $640 million.
  3. Tencent: Naspers invested over $30M in Tencent Holdings in 2001. Even with ongoing share sales through the years, Naspers and Prosus currently own about $200 billion of stock in Tencent Holdings. 
  4. Cerent: Kleiner Perkins, who had invested $8M for a fully-diluted position of a 30.8% equity stake in the company, resulted in a future position worth $2.1B after an acquisition by Cisco in 1999.
  5. Snap: Benchmark Capital Partners, which invested $13.5M in Snap Inc’s Series A, grew to be worth $3.2B at the time of IPO in 2017.

Important considerations

Given that investing in private companies entails giving up complete control of capital until a liquidity event (i.e. public listing or acquisition), often taking 10 years or more, a handful of important considerations ought to be reviewed prior to implementing your investment strategy:

  1. Without a great network of entrepreneurs or investors, finding high-quality startups to invest in can be extremely difficult. Initially, you may have conversations with a founder who is interested in accepting your capital. However, if larger, better-established players in the space catch wind of a promising company, smaller investors can be pushed out.
  2. Investment decisions are frequently invalidated until many years later, at which point you can measure the effectiveness of decision-making. This makes it hard to iterate on an investment process quickly and can take several years to validate your process and hypothesis.
  3. The highest quality deal flow is mostly owned by the highest quality VC firms. This makes sense, given that successful founders want to optimize for the best possible resources, network, advice, and tilt the odds of growing rapidly in their favor. 
  4. Most people don’t have tens of millions of dollars ready to invest. So, in order to maintain a diversified portfolio of companies (i.e. 30 or more investments), each check you’ll be writing will be smaller than institutional investors competing for the same deal.
  5. If you’re writing smaller checks, founders and investors usually opt to bring in the people who can add the most value to the relationship (i.e. Do you have a strong talent network to help with hiring new team members? Do you have a significant social media presence to help with distribution? Can you make introductions to other large investors down the road, or provide other partnership introductions?).
  6. Piggy-backing on successful investment firms can be a winning approach. If you can create relationships with the investors that have access to high-quality startups and are willing to accept your capital, there can be a few key advantages:
    1. They enjoy economies of scale that you do not, and can sometimes negotiate more favorable pricing and terms for the deal;
    2. Successful, established firms have significant insight into private companies and the landscape that they’re investing in. As opposed to public companies, who have strict rules to adhere to when divulging information about their company, VCs can enjoy a constant flow of information and data from their portfolio companies. This results in a breadth of market and product data that you likely don’t have access to either;
    3. Much less time needs to be committed on your side. These firms have analysts and partners with deep understanding and expertise who can i) source investment opportunities, ii) efficiently do due diligence on any investments that may be of interest, and iii) maintain a steady stream of information for investors and take care of all reporting and tax considerations.
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What are my options?

With these considerations in mind, the options you have for investing in venture capital are as follows:

  1. Invest directly in a venture firm’s core fund. In this option, you are providing the VC firm with capital and they make investment decisions on a discretionary basis (without your consent). In this way, you can achieve a diversified portfolio with a firm you trust and the time commitment is little to none after the initial paperwork is done.
  2. Identify, pitch, and close investments yourself. As mentioned above, this requires quite a strong network of both founders and other investors who might be interested in partnering with you. There’s also a significant amount of time required for introductions, follow-up meetings, due diligence, and expertise in how to structure the investment properly. 
    1. Here’s an article from Carta (from a founder’s perspective) on two common methods of financing, SAFEs and convertible notes: https://carta.com/blog/convertibles-safes-priced-rounds/
  3. Co-investing and Syndicates. With co-investing and syndicate deals, there is a nice balance between being in a decision-making position and gaining access to the networks of other investors (either individuals or venture firms). This has been rapidly increasing in popularity given that you’re able to:
    1. Construct a diversified, high-quality portfolio of private companies without an established network; 
    2. Gain access to the same opportunities as top-tier investors and utilize their insight and due diligence;
    3. Maintain control over the number of positions in the portfolio, the stage of the companies that you’re investing in, and focus on specific investment themes;
    4. Increase the number of investment opportunities you’re seeing dramatically by utilizing several syndicates or co-investment firms;
    5. Better test your investment hypothesis/ investing process.
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References: 

  1. The Venture Capital Funnel”. https://www.cbinsights.com/research/venture-capital-funnel-2/. Accessed 1 July. 2021. 
  2. Global Venture Funding Hits All-Time Record High $125B In Q1 2021”. https://news.crunchbase.com/news/global-venture-hits-an-all-time-high-in-q1-2021-a-record-125-billion-funding/. Accessed 1 July. 2021.
  3. VC Fund Returns Are More Skewed Than You Think”. https://sethlevine.com/archives/2020/10/vc-fund-returns-are-more-skewed-than-you-think.html. Accessed 1 July. 2021. 
  4. The 45 Best VC Investments Of All Time & What To Learn From Them”. https://www.cbinsights.com/research/best-venture-capital-investments/. Accessed 2 July. 2021. 
  5. “Tencent Is a $43 Billion Headache for Its Biggest Backer Naspers ….” 13 May. 2021, https://www.bloomberg.com/opinion/articles/2021-05-14/tencent-is-a-43-billion-headache-for-its-biggest-backer-naspers-prosus. Accessed 5 Jul. 2021.

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