A term sheet is often exactly that: a sheet full of terms. As an investor, these terms go beyond simply outlining the percentage of equity received. Investor rights establish the non-equity provisions that investors have to protect against downside risks, manage strategic decision-making, and mitigate future dilution. It is also imperative to understand the meaning of these terms to understand how your investment fares against other investors from preceding or succeeding rounds.
Venture capital traces its history to the mid-1940s when organized investing into developmental stage companies first began. Fast-forward 70 years, and ‘venture capital’ is an umbrella term for a large and multifaceted industry.
Generally speaking, a fund-of-funds is any group that invests in other funds. In venture capital specifically, funds-of-funds function as limited partners (with very few exceptions). Those limited partners receive reports and due diligence documentation whenever the fund is making a new investment as well as periodic reports on the performance of the portfolio as a whole.
Investing in venture capital funds either directly as a limited partner or through a single fund-of-funds can be a great way to diversify your overall portfolio. The high level of risk associated with direct startup investments can make it difficult to start a venture capital arm of your own. Investing in or as a fund-of-funds mitigates that risk tremendously as you are investing in the venture capital fund’s entire portfolio, which could represent dozens of startups. You still have the ability to capitalize on the oversized returns that come from successful venture investing without having to take on the same degree of risk.
Venture capital can be a daunting asset class to analyze. If you are familiar with private equity, you are probably used to judging a company based on detailed financial modeling. With venture capital deals, the numbers and parameters you have for mature companies just don’t exist yet. That doesn’t mean that you can’t conduct a thorough analysis of a company before investing. What it does mean is that you need to have a formal and disciplined process for due diligence that is tailored specifically to early stage companies and startups.
If you are looking into venture capital as an investment opportunity, you are likely aware of other options like private equity and real estate. While these alternative asset classes share some similarities (illiquidity, long investment holding periods), there are distinct differences in structure and investment strategy that are important to consider as you dive into venture capital investing.
One major challenge when investing in venture capital is to remember to stay patient when facing a timeline that could take years to see positive cash flows. This illiquidity is mainly due to the amount of time it takes a startup to go public or even get acquired.
In venture capital, returns follow the Pareto principle - 80% of the returns come from 20% of the investments. Early-stage venture capital firms have often been attractive to investors, providing lower valuations with the opportunity to obtain significant equity ownership in portfolio companies.
In today's Topic of the Month, we take a deeper dive into the numbers posted for a couple investments prior to their IPOs and acquisitions.
How do you positively involve members of an upcoming generation, varying in age and interest levels, in the family office?
There is an often a huge barrier to involving the next generation in the family office or investment business. Incorporating venture capital as a key facet of one's investment strategy engages and informs younger family members to become more involved in the business and leads to a smoother transition in the future.