This is the third and final post in a series explaining venture capital. In earlier posts, I explained why venture capital exists and how venture capital is structured. In this post, I cover the investment paths for reaching the outsized potential returns of venture capital.
If you’re a pension fund or endowment fund manager, you’re probably not reading this. That’s because over 30% of venture capital’s funding comes from these types of investors. Which means VCs have been knocking on their doors for years.
If you’re seeking exposure to venture capital, you’re probably interested in getting the ridiculous 100x ROI by investing early in the next Google/Alphabet, Apple, Facebook, or Amazon (all of which have been venture backed). Those potential returns are what brings most investors to the “risk capital” asset class.
In the image below, I’ve identified the investment paths to access venture capital returns. The paths vary based on target returns, diversification preferences, budget, and time commitment. Further down, I cover the benefits and drawbacks of each path. I’ve also included supplemental resources for more research.
With capital markets flush with cash, angel investing has become quite popular. Lower start-up costs also mean there’s plenty of new companies starting up every day.
If you’re considering getting into angel investing, buyer beware. if this is more of a hobby than a dedicated investment pursuit, the risks may be amplified . Before foraying into several angel deals, definitely use the resources below to help you build an investment thesis and budget.
Benefits: It’s exciting to be part of something innovative with high growth potential. Outside of pure economic returns, there are other benefits to angel investing. Educating oneself on building a business, learning about a new product or industry, can be an invaluable return to an investor. If you’re investing in an industry where you have expertise, it may also advance your career or diversify your career options.
Drawbacks: For all its glory, a start-up life’s risks are often overlooked by optimistic investors and founders. Not only do 50% of new businesses in the United States fail within five years but even the successful ones have a journey filled with uncertainty. The lack of resources presents another set of challenges. Start-ups will always need more money to keep growing; usually more than an angel will be able to give. Plus, founders will not be able to dedicate enough time to supporting an angel’s every inquiry and recommendation. Conversely, founders may want more of your time than you are able to devote.
Resources: I highly recommend reading Brad Feld’s seminal book Venture Deals or David S. Rose’s book Angel Investing. If you’re seeking a do-it-yourself guide with equally rich content in audio format, listen to Nick Moran’s The Full Ratchet. Nick interviews leading venture experts and walks through all the mechanics of venture investing. It’s a must for first-time investors, especially those always on the go.
Benefits: By pooling your individual investment with others, you may get preferential terms, information rights, etc. More importantly, syndicated deals allow you to spread your budget for VC exposure across several start-up companies. Depending on the type of angel group, there are benefits of better deal flow, subject matter expertise, and governance from angel group members.
Drawbacks: Raising money without a dedicated fund limits the speed and size by which an angel group can invest. Entrepreneurs looking for faster close rates or committed funding amounts may shy away from angel groups.
Also, successful start-ups need larger amounts of follow-on capital that angel groups are normally unable to meet. Thus, angel groups run the risk of dilution or limited control in the company’s future.
Since start-up costs are cheaper today then ever before, there’s no shortage of deal flow (see chart below). Which means a lot of time is required to screen and vet an investment.
Remarkably, the ratio of Series A to Seed deals grew from 23% in 2010 to a whopping 60% in 2012. This illustrates that lower start-up costs and higher availability to capital have increased the number of companies getting initial funding. However, fewer companies are getting financing in the next round.
Resources: If you’re seeking to physically join an angel group, you can find them here: Angel Capital Association of America If you’re seeking online syndicated angel deals, consider Angel List and WeFunder.
Micro VC & Larger VCs
Benefits: Because it’s a managed investment, the VC will have dedicated full-time professionals for sourcing, vetting, and growing investments. Additionally, with a dedicated fund the VC can quickly deploy capital and do follow-on investments.
Finally, the most sophisticated entrepreneurs know that capital is a commodity so they seek established venture capitalists that add value as partners in their business. Not only does this provide better deal flow to the VCs but also illustrates the benefit of having full-time resources to help identify new customers, partners, employees, etc.
Drawbacks: Like all things in venture – and in startup world – VC funds are still risky. Past performance does not guarantee future returns. The dedidcated fund is a blind pool of future investments which means investors can’t vet or approve each deal. They must buy into the investment thesis the VC has laid out. Finally, some micro VCs are composed of unproven or first-time fund managers. So, investors can’t assess performance for another 5-7 years during a fund’s holding period.
Regardless of the route you choose, be disciplined in setting an objective for your venture exposure. Dedicate an investment budget across several years to maximize return. Allocate capital at similar proportions as pension and endowment funds: 0.5% to 2% of total investment budget. VC investing becomes costly when you’ve over-invested or need liquidity, so plan accordingly.
Have more questions about venture investing? Graphene Ventures can help. Contact us at email@example.com
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