Investing in Venture Capital

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‍TL;DR: Investing in venture capital (VC) can provide a compelling opportunity for investors seeking alpha through a high return, high-risk investment class that often locks up capital for up to 10 years. If you have excess cash from previous investments or recently experienced an exit or other form of financial windfall, you may want to start diversifying and investing in venture capital (VC). VC represents the opportunity to invest in the future, in innovation across the earliest stages of company formation. There is no right or wrong way to build exposure to this attractive growth market segment. Still, there are several factors that you should consider as you embark on this investment: 1) structure (fund-of-funds, single fund, or co-investment), 2) a specialist (either sector or geography) or generalist firm; 3) early- vs. late-stage; & 4) a large platform firm, a small niche firm or a solo GP. 

So what is a VC fund?

VC funds are investment vehicles that pool money from limited partners (LPs) to invest in startups with high growth potential. In general, VC and private funds differ from public securities in their structure and liquidity. Venture capital funds are known as ‘drawdown vehicles,’ meaning capital is drawn down, or called, over time. This means that when the VC fund invests in a transaction, the LPs will need to provide capital - often on short notice. The typical period for calling capital, or the ‘investment period’ of a fund, is anywhere from 3-5 years. 

From a liquidity standpoint, these funds are generally referred to as ‘lock-up vehicles,’ meaning there will be no return of capital until the end of the fund life or when the company experiences a liquidity event,  as there are no interim liquidity provisions for these funds. The fund life is generally ten years, with the potential for extensions until all the underlying positions are sold. 

What is the proper structure for me?

The first decision to make is how to approach the VC landscape. While all forms of VC investing are passive (other than directly owning enough shares in a company to personally hold a board seat), as an investor, the structure of how you invest in VC will often be determined by how much involvement you want in the portfolio construction and your comfort level in selecting these investments. 

• If you are new to VC, it might make sense to invest in a fund-of-funds, which will provide broad diversification across many funds. In this structure, the fund-of-funds manager selects several underlying VC funds, and investors get exposure to all of the underlying companies that each fund manager invests in. That said - the downside of fund-of-funds is that investors often are paying fees to both the VC fund partners and the fund-of-funds management. 
• Investing in single funds is a more concentrated but still diversified approach. In this structure, you invest with a manager with a specific strategy at a particular point in time, and they invest in several companies based on their prescribed strategy. While you won’t get as much diversification as you would with a fund-of-funds, most managers invest in at least 15 companies (and often considerably more). 
• Lastly, if you have the access and the experience (and the risk tolerance), you could invest directly into a single VC-backed company either directly or through a co-investment agreement. 

Each has benefits and drawbacks, but each does represent an efficient way to add VC to your investment portfolio. 

Why would you want to invest in a VC fund?

Investing in VC funds gives LPs a few advantages:

• Diversified exposure: most companies have a minimum check size for investment. By pooling your money with other investors, you get more exposure to multiple early-stage companies than as a direct investor in start-ups. Also, more and more companies are staying private for longer, meaning you can’t invest in them on the public markets. To get exposure during a company’s rapid period of growth, you often need to invest in the company via a VC fund before the company becomes public. 
• Access: presumably, the brand, reputation, and connections of the VC fund manager can get you into deals you wouldn’t get into otherwise. For example, a fund manager might have previous work experiences at a successful startup like Stripe or Airbnb and be able to source new startups from those networks.
• Resources and staff: appropriately investing in venture capital requires time and expertise, which means full-time, technical, and experienced staff. Fund managers stay abreast of industry trends and continuously meet founders, identify interesting companies, determine which of these companies are worth investing in, and ultimately ‘win’ the opportunity to invest. Beyond that, once they’ve invested in companies, VC funds put resources into helping them grow (operating partners on staff, CEOs on call, recruiting, introductions to later stage investors, etc.). These resources should increase the likelihood that the investments pay off.

What are the downsides of investing in VC funds?

Investing in VC funds carries many of the same risks that are inherent in investing in private funds:

• Illiquidity: VC fund investments lock up capital for the full fund life - a period that can stretch beyond a decade. This means you as an investor cannot need this capital for any other purposes for potentially the entire duration of the fund life (although most funds generate some liquidity starting in year 5 or 6). A Financial Advisor can help create and manage a cash flow plan to both ensure liquidity for capital calls and no liquidity shortfalls during the lock-up period. While you do sacrifice liquidity as an investor, the lock-up structure allows fund managers to invest in private companies for the long-term, letting them grow from very early-stage ideas to large, multi-billion-dollar companies. (VC is a high risk investment class as the vast majority of funded companies do not become multi-billion dollar enterprises).

• Discretion: you don’t have a say in the manager’s investment decisions as a limited partner. A critical part of the process is trusting that the fund manager has the selection skill required to identify promising companies.
• Higher fees: like most private funds, VC funds charge two levels of fees. The management fee funds the firm’s business operations (generally around 2% of committed capital) and tends to be higher than its public market comparables. In addition, VC funds charge a performance fee called carried interest. Carried interest is the VC fund’s share of the gains (usually 20% or more) generated from the portfolio investments. If a VC Fund had 20% carried interest and an LP invested $100,000 that became worth $500,000, the VC fund would keep 20% of $500,000-$100,000 or $80,000 and the LP would get $320K, the 2% management fees need to be repaid prior to the GP receiving any carry.  
• Vintage risk: Compared to other assets like real estate, there can be a stark difference in the performance of funds from the same VC firm. Market cyclicality brings considerable risk. A fund investing during a period of higher relative valuations may be challenged to generate top-tier returns. The same is valid to some extent for other investment vehicles, but even more so for private funds (especially VC), where exit markets, either via public market (IPO) or through M&A (acquisition), often feel a more significant impact from cyclical factors and macroeconomic pressures. 
• Greater risk of loss: unlike other alternative investments, VC is often referred to as a ‘power law’ asset class. This means a few investments generate the bulk of returns. In a VC portfolio, there will likely be many losses that are hopefully outweighed by a few ‘home runs.’ This structure makes it an especially risky asset class and demonstrates why many investors choose a fund of funds or investing in a VC fund rather than direct investing into individual companies. 

Should I invest in a specialist or a generalist fund?

While the evidence shows that specialist managers who focus on one distinct geography/region or one particular sector do not significantly outperform generalists, this question should fundamentally be guided by your investment objectives.

Most financial advisors suggest that investors should maximize diversification. You need to be aware if you are concentrated in specific sectors or geographies in your existing investments and ensure that your diversification into VC doesn’t accidentally over-expose you to sector or geographic risk. A financial advisor will inspect your entire investment portfolio to identify and re-balance these concentrations. Therefore, the question is not “Should I invest in generalists versus specialists?” but rather, “What investment provides the best diversification and returns for my portfolio?” Are you outsourcing the diversification to your managers or are you doing it yourself?  

The risks and benefits of specialist funds beyond the concentration in your portfolio are:

Risks of specialists: 

1. Tunnel-vision and local optimization. The best-performing “tech” manager in a 1999 vintage fund might have underperformed the overall market (hence you would have been better in just about any generalist fund).
2. Rigidity and overly sector-specific thinking/biases could leave a manager flat-footed in response to sweeping industry changes, 
3. The potential to miss the ‘hot’ area (because you’re in a specialist fund)

Benefits of specialists: 

1. The power to invest behind themes that you find particularly attractive where you allocate and weigh sectors however you like. 
2. Specialists bring domain depth to better assess risks before investing. 
3. Technology is no longer a monolith as it was two decades ago. Each facet of the technology ecosystem comes with its nuances, and to excel in them may require more specific knowledge. 

The risks and benefits of generalist funds are:

Risks of generalists: 

1. Can be ‘tourists’ in markets they don’t know well, 
2. broad diversification across sectors and geographies can dilute overall returns, and 
3. challenging to construct a team of experts in all areas, so there will be some blind spots.

Benefits of generalists: 

1. greater likelihood of capturing the ‘hot’ market segment 
2. less impacted by being over-concentrated in the ‘bad’ segment. 

To complicate matters, many firms would regard themselves as ‘multi-sector specialists,’ more concentrated than a generalist fund but one that specializes in multiple areas. For example, a firm may have distinct skills and talented professionals across biotech and consumer technology. This structure may allow them to capture some of the benefits of specialists and generalists. Still, this model requires precision around organizational development (making sure there is similar depth in each vertical) and capital allocation decisions (is there a fight over which segment to invest in?).

Should I be investing in early-stage or late-stage VC funds?

The risk/return balance looks different for an early-stage vs. a late-stage VC investment. In general, VC is predicated on achieving an abnormal distribution of outcomes where outperforming managers can generate either an above-average number of home runs per fund or a greater magnitude of return in those home runs. 

Some early-stage funds apply a ‘spray and pray’ approach, investing in many companies with the hope that one or two will generate outsized home run outcomes and thus carry the return of the fund. While it is true that the loss ratio for early-stage companies remains relatively high, most early-stage funds have a more targeted approach in terms of sourcing (leveraging brand or network), analysis (looking at the specific skills of the team, size of target addressable market, and need) and growth (providing expertise in hiring, product development, go-to-market strategy) to increase their chances of success. 

In contrast, late-stage investments have reached product market fit and are likely growing. Hence, investors in these companies are more focused on underwriting progress and execution rather than the viability of the underlying technology in a business. In addition, these companies have more available data, meaning investors can see how well the company is performing on metrics like customer retention, engagement, etc. With this comes lower risk than early-stage companies and commensurately more modest returns, though the timeline to an exit (either via IPO or corporate acquisition) is shorter. 

How does early vs late-stage VC funds translates into risk profile and returns for LPs

In summary, early-stage and later-stage investing often play complementary roles within a portfolio. Early-stage funds might have a higher percentage of their companies that fail—but the ones that succeed generate a higher return. Late-stage funds expect to have lower losses, but their biggest “wins” generate less upside due to having a higher entry-point valuation since they are investing in a company that already has a proven product. (See below for an illustration of how expected loss ratios decline in line with underwritten returns.) Often, which approach—early-stage or late-stage investing—brings higher overall returns depends largely on the skill and selection of the individual manager.

How should I compare solo GP funds vs. firms with a team of investors?

Traditional VC firms follow the model of private equity firms, meaning they’re made up of a group of people (rather than a single investor). Firms have taken many different forms. The largest firms, such as a16z or NEA, have raised considerable capital, built out various specialized functional groups, and have large teams of investors. Other firms, like Benchmark or Union Square Ventures, have intentionally stayed small in terms of capital raised and the number of professionals. 

While each firm has its own individual structure, being part of any firm does provide advantages:

• Institutional brand/reputation: generally, firms are focused on building a brand that will ultimately serve as their legacy and be long-lasting. If successfully constructed, the brand and its reputation alone will serve as a draw for promising entrepreneurs, leading to potentially higher quality deal flow. In addition, for founders and entrepreneurs, even if an individual partner leaves, the firm will still provide resources and support to preserve their brand. “Brand” in this model typically accrues to the firm, which can persist for decades. (This arguably helps solve a principal/agent problem for founders: Knowing the firm cares about its long-term reputation, higher quality founders may bring them attractive investments. Funds with strong brands often have early access to successful repeat founders.)
• Specialization benefits: at a large firm, you can have an accounting/finance department that focuses on managing the funds’ capital; an IR team that gathers assets and produces events and investor communications; an in-house “operations” team that manages companies after they have been bought. Everyone can focus on what they are best at (rather than relying on one person to do it all). 
• Scale benefits: larger firms generally have more tenure and, by nature, might have an extensive alumni network. Firms also have more professionals and can benefit from multiple voices and collaboration to unearth and put into practice best ideas. With more capital, multiple offices, and a broader reach, these firms can often accrue more knowledge and expertise.

Disadvantages of a larger firm might include: 

• Inertia: particularly with larger firms, they are typically slower to move than individuals, partly by design, with more decision-making checks and balances in place.
• In-attention: if improperly managed, firms can give founders the feeling they are being “handed off” to different or perhaps more junior professionals. Partners, with pressure to source more opportunities to deploy capital, do not engage sufficiently with their portfolio. 

It’s important to note that competition among VC firms is particularly intense today—there has been a lot of “dry powder” raised to invest money in startups. This has recently led to a trend where “founders get to pick their investors” and often do so based on personal relationships. However, this trend tends to reverse in bear markets.

This market circumstance sets the stage for the Solo GP Model, which prizes founder relationships, agility, and hands-on leadership, as well as an emphasis on personal brand to generate new investment leads. 

Advantages of a Solo GP might include:

• Personal brand/reputation: in this model, Solo GPs can control and rely on their individual brand and accrue a level of star power and reputation that attracts founders who want to work with him/her. 
• Holistic involvement with outsourced operations: the Solo GP can act as a combined acquisitions/operations team and devote his/her entire focus to helping her portfolio companies succeed—whether by lending her specific expertise in a particular area or making introductions to others in her network. More recently, with the advent of service providers that can handle operational tasks (fund formation, legal, money movement, etc.), the Solo GP has become a viable alternative to a firm model.
• Alignment benefits: solo GPs come from various backgrounds but tend to have strong operational experience, making them more attractive to founders who might feel like they benefit from specific company-building expertise and founder empathy.

Bottom Line

There are many factors that an investor should consider as they contemplate investing in VC. There are many ways to invest in this market segment, and there is no ‘right’ way to do it. Consider your own goals, including your broader portfolio, your liquidity needs, and your expectations to build the best VC investment strategy for you.

A financial advisor can recommend a strategy that aligns with your risk tolerance, existing concentration and personal goals. Explore an advisory relationship with experts in managing illiquid tech equity here. 

To learn more about venture capital, join Allocate's upcoming Venture 101 education series on October 12. Register here.