Picking the Right One
A deep dive. Guidance for the Individual Accredited Investor investing directly into venture companies.
It rained all day during a recent client trip to Austin, TX. After a long morning of travel, I worked my way through a jam-packed schedule. As my road-weariness set in, I begrudgingly looked forward to my final meeting. But, as luck should have it, that final meeting turned into a fated one, as I sat with a twenty-something who managed their family office's large portfolio of venture capital in the booth of a Mexican restaurant. For the next two hours, my new friend and I wore out the shoes of our waiter whose endless bowls of chips and salsa fueled our conversation about the right way to do venture capital (a term interchangeable with start-up or early stage investing). The conversation's biggest takeaway: if you can, make direct investments (ownership) vs. pooling investments (funds)... and think strategically about the right approach.
i3 has been advising families since 2007, with our core services grounded in family governance, asset management, reporting and/ or underwriting/ due diligence—and over the course of the last 13 years, we’ve done the same for hundreds (if not thousands) of folks/ individuals who are seeking venture capital opportunities. As of 2021, i3 advises on or manages more than $500,000,000 of commercial real estate for families and more than $50,000,000 of private investment ranging from start-up, early stage and/ or growth companies.
While venture capital firms are historically the first stop for those who want to invest in venture capital, new venture capital investors (e.g. family offices and high net worth families) are the future of start-up and early stage companies. So, if you’re anything like my twenty-something friend (overloaded on chips and salsa), what is your very first step in allocating your capital into start-ups or early stage companies? Engage an experienced securities attorney in your area. They’ll inform you of your state’s Blue-Sky laws and what it means to be an Accredited Investor. Once you know the ground rules, you can begin your foray into venture capital.
When investing in venture capital companies, your best deal is only as good as the best deal you have access to. To succeed as a venture capital investor, you must capitalize on your existing network, share an existing network with someone else, or construct a new network of professionals who are involved with start-up or early stage companies seeking capital. Your success stems from a good pipeline of opportunities. Once professionals know that you are in the market, your Inbox will pile high with new investment opportunities.
While the quality of your deal is contingent on your network and your access, you need to build a team capable of underwriting, due diligencing, executing and managing the investment from origination through disposition. Because of the nature of these investments—no cash flow, high risk and long-term horizons for return of capital—you’ll want to run a low-cost model. This means: keep your overhead low, and adopt the philosophy of “pinching every penny” or “bootstrapping”. For context, it is common for one person to review 500 to 1,000 deals each year, and to perform all related underwriting, due diligence, execution and management of the ongoing investment with experienced legal and tax counsel close by. In addition to your internal team, start to engage with a network of former executives, industry experts, and other investors to educate you—and maybe even co-invest. While finding your one internal full-time employee to manage your deals, like my twenty-something friend In Austin, you may also consider a hybrid of the pooled investment (fund) vs. the individualized team. The hybrid platform is something that i3 offers, which comes with the ability to rely on an outsourced team to execute your clear vision and defined objectives. With an internal and external team structure in place, you’ll face the most challenging part: building a pipeline.
In the venture capital industry, those who have the deal flow lead those who do not. Being an investor in a blind pool is not direct investing. Direct investing in venture capital (and for that matter, any private investment) is defined as having direct and individual ownership in the entity, or with a small group who may also have direct influence on decisions made by the company’s leadership (e.g. board positions). After filling your pipeline with opportunities and setting a clear vision for the direct investment of capital, you must rely on your team to filter through the pipeline, select the companies that fulfill your vision and objectives and execute the transaction.
When growing your pipeline, it is important to define the amount of capital that you and/ or your team are comfortable allocating. There is not a magical formula to calculate this number, each investor is different. Some investors allocate larger portions of their net worth than others. I’ve found that those who make lower allocations of their net worth (3% - 5%) have less experience and use funds to get exposure to venture capital. Those with larger allocations (5% and up) are more experienced and active in this asset class. The more they have allocated to this asset class, the more they consider it a career. Most venture capital firms review three (3) to seven (7) deals a day and may only invest $25,000 to $125,000 in 20 - 50 of those over the course of a year. In our experience, one or two deals will generate (with a little luck), at least, a 4x multiple. Ten percent of your deals will survive and flounder. Ninety percent of your deals will fail with a total loss. Some venture capital firms prefer more concentration and involvement in the growth of the company; in these scenarios, the investor tends to be very active and participate in several rounds of funding for the company. This typically means they’ll participate in seed capital (start-up), series A, B, C, (growth capital) and so on and so forth. Each round of money raised by the subject company has a different purpose, one of which may be to buy out the previous round of investors. You (and by extension your team) will be asked to make decisions to invest into start-up and early stage companies—decisions that are made within hours or days of the pitch being made.
Capitalizing on your pipeline, broadly speaking, will require four (4) core competencies:
Understand the disruption
Underwriting/ due diligencing
Properly structuring your investment
Leveraging your brand or connections to add value to your investment (AKA: Being an Influencer)
These four (4) competencies are generally at the core of a large family office or venture capital firm; however, they rarely offer them on a ‘separate account’ basis. In other words you have to rely on a blind pool to access and leverage these competencies. In our case i3 offers these competencies to individual investors on an outsourced platform (e.g. i3’s DIPCO platform).
Understand the Disruption
An early stage and / or start-up company’s value is based on the problem its service or product is solving (disrupting), their potential market share, and the sum of money required to reach these goals. To Understand the Disruption and its impact, we must first understand how the target company anticipates turning the service and/ or product into revenue dollars and, eventually, profits. Or, how the target company becomes a strategic benefit or threat to a larger, competitive company. Your upside as the investor is at the exit, which may come at various rounds of funding or upon a disposition of the company. Before Amazon purchased Ring for $1 billion, the brand was passed over by Mark Cuban and other Shark Tank investors who are supposed to be the smartest in the business. Imagine missing out on that “one in a million” opportunity. To assess the true value of a deal, investors must proceed with confidence, calculation, and willingness to learn quickly about products, services and their respective markets.
And then there is the ‘ole ‘gut instinct’. That’s the feeling that some people get when they first hear of a new or emerging business, or when they’re able to realize the potential of an idea before it ever becomes a business. Gut instincts are dangerous, but when used correctly, they can impact the speed and reliability of a decision.
Underwriting/ Due Diligencing
“Measure twice, cut once” is our philosophy. After reviewing a pitch, you’ll hopefully be greeted with a full file of business plans, financial pro formas, legal documents, and the like. Your team, who will be small and nimble (reminder to keep costs low), will digest these documents and chart the course of the investment. But it won’t be the MRR/ ARR growth rates, CAGR, gross margins, expense ratios, NOI, EBITDA, FCF that will matter the most, in fact that’s the easy part. The challenge lies in two (2) critical components of the underwriting and due diligencing (“UDD”) process; the first, understanding the disruption, which we previously covered. The second is believing in the people—namely in the founders and their management team’s leadership style. A start-up and early stage company is only as successful as its leaders’ ability to execute on their business plan and strategy. Listen to your gut instinct about the product, and about the people making the ‘ask’.
How to Structure the Investment
While most start-up and early stage companies clearly define their parameters for accepting investment money (e.g. convertible debt, membership interest, royalties, stock, loans, etc…), the opportunity to negotiate might present itself. This will be dependent on their time frame for receipt of capital and how bad they need it. If you find yourself in this position, involve your tax and legal counsel, as there are many tax advantages to different capital structures.
How to Use Your Brand or Connections to Add Value to Your Investment (Being an Influencer)
As both a human and a venture capital investor, you'll likely be attracted to investment opportunities within the industries you are familiar with by trade or by experience. Allocating capital to start-up and early stage companies within your existing spheres of influence will further support your investment’s probability of success. As an influencer, your network may (should) positively impact the growth, expense, and thus the subject company's net income trajectory. Being an influencer comes with a two-fold responsibility. The first is bearing in mind how, what or who you are influencing as this will affect the financial and behaviour/ cultural aspects of the company (i.e. company values). It’s best to ensure that your values and the subject company’s are aligned, which is more relevant today than any other time in history due to our many social, policial, and environmental divides. Your second responsibility: consider if your personal brand is more powerful than the subject company’s. Is (or will) the company be able to deliver on the demand that you help generate? Social media platforms and the advent of the “Influencer” can take a start-up from tens of thousands in revenue to millions—with just a few Instagram posts. This is particularly relevant if you are a local, regional or national celebrity….or planning to be one.
A venture capital investor is blessed with more than just capital, but also a keen eye for disruptive products and services, an intuition for people who will take a product or service and make it a great company, accompanied by an appetite for high levels of risk and the patience to allow the companies and those running them to mature. Not every investor is made this way, but I’ve never met an investor who does not understand the “greater the risk; the greater the reward”. All investors realize that only one in hundreds (if not thousands) of early stage/ start-up companies will generate monster returns; however, saying the words “I lost my money” and experiencing the actual loss of capital are two very different things. So, take your first steps into venture capital wisely and with caution, knowing that venture capital is at the core of the American entrepreneurial spirit. If you use, like, and or love Facebook, Airbnb, Dropbox, etc, you have a venture capital investor to thank.