Personal Learnings in Venture Investing (Part 1)

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Most family offices that we work with were built on entrepreneurial wealth. The owner(s) typically built a business - often VC- or PE-backed - and successfully grew it until an eventual sale, which realized life-changing amounts of capital for the owners. In fewer cases, the family built a business and still own it, instead drawing investable capital through dividends over years and decades (think your typical German Mittelstand company).

In either case, their entrepreneurial background leads them to what might be the most entrepreneurial asset class of all: Venture capital. They like the prospect of working closely with founders that remind them of themselves in their early days, and which they can advise through the highs and lows of an entrepreneurial journey.

Yet despite the fact that those entrepreneurs have substantial experience as operators, they often have little or no experience in actually being an investor. And in no asset class can a lack of investing experience be more (financially) painful than venture capital. 

So in this series, let me share with you the learnings from my time as a venture investor in both private and professional capacities. We’ll start with the ‘strategic’ level (Learning #1), move on to the sourcing side (Learning #2 and #3), and then conclude today’s article with experiences in due diligence (Learning #4). In the next edition, we’ll cover portfolio management, including the fabled Power Law, and finally, my experiences when it comes to an exit.

Let’s dive in!

Learning #1: Does VC make sense for me?

After 50+ venture investments, both as a family officer and as a private investor, there is one thing that I can’t deny: Venture investing is fun. Nothing is more rewarding than working closely with a team and seeing it persevere through challenging times, perhaps even due to the little bit of help that you can give them on your journey. 

Hence, it is unsurprising that affluent investors, with or without family offices, are drawn to venture investing. Especially for those investors coming from entrepreneurial backgrounds, it is a way for them to ‘give back’ and help hard-working founders, and in doing so, they might even find the next Uber, Airbnb, or Coinbase, and make a 100x return on your invested capital. However, when we actually speak to these individuals about why they invest in venture capital, the actual reasons are harder to come by. We like to look at this question in the context of Investment Objectives: First, find out why you are investing across your entire portfolio (generate income? Grow your assets to a certain size, i.e. from eight to nine figures? And/or maybe invest in things that align with your purpose?) - and second, think about which investments can help you achieve these objectives.

And in the case of venture, we often see at least some degree of mismatch. Younger entrepreneurs might invest substantial amounts of capital into start-ups and VC funds, but when challenged about what they actually want to achieve, their Investment Objective might actually be much more conservative (i.e. ensuring that you have sufficient investment income to cover your cost of living). Or in the case of family offices, we see that the owner family might like the idea of supporting entrepreneurs, but might in practice struggle with the high default rate of individual investments.

If you asked me and my colleagues, we’d describe venture capital as the following:

• Return-oriented: You’re trying to find the next Uber or Airbnb - i.e. a 5x, 10x, or even 100x return.
  

• Risky: More than half (!) of start-ups fails to generate a positive return (i.e. a 0-1x return on invested capital). It’s the Power Law at play: Few investments return all invested capital, and generate excess returns.
  

• Illiquid: As an angel investor, you might hold a tiny minority stake (0,5-5,0%) in a highly risky, early-stage, and often unprofitable company. Especially the non-winners are hard, if not impossible, to sell at a reasonable price.
  

• Complex: Direct investments are mostly bilaterally negotiated investments between you and a founding team - and bring a number of challenges with them if done right, such as sourcing them in the first place, but also due diligence and monitoring.

Venture capital can be extremely rewarding - but if you are unable to accept the aforementioned characteristics, venture capital might simply not be for you. 

Learning #2: Know What You Are Looking For

Another fun thing about venture investing: There is an investment out there for almost any specific flavor you might be looking for. Early-stage biotech companies in Europe? Series A telecommunications firms in Africa? Or a pre-IPO US software company? Anything you’re looking for, you can likely find.

And perhaps that’s the key to our next learning: You should think about what you are looking for.

Are you a successful post-exit entrepreneur looking to pass on experience within your industry? That is totally fine - but be mindful that you might create a bias to your industry. Since an individual’s network is typically also limited to one part of the world, you might also create an unwanted geographical bias.

Or you want to play it ‘safe’ and invest in later-stage, established firms, such as Series C/D or even Pre-IPO companies. You’ll likely avoid more ‘existential’ risk than you would at an earlier stage, but you might also be missing out on the first 90x of a company generating a 100x return for its investors. 

Once again, a few categories by which to go:

• Stage: From Pre-Seed (i.e. just a team with an idea), to Seed (first signs of validation), to Series A (typically some sort of ‘product market fit’), to later stages all the way to Pre-IPO.
  

• Industry: Software as a service, healthcare, but also sub-industries, i.e. SaaS specific to a certain sector. (Make sure to avoid the ‘flavor of the month’ unless you have better knowledge and access than others.)
  

• Geography: A single country (i.e. Germany), a region (like Europe), or perhaps even globally if it fits your other criteria.
  

• Type of Opportunity: Is it a regular deal, like a pre-seed round? Is it a bridge round for angel investors between milestones? Or is it maybe a ‘special situation’, i.e. a company that is pivoting and thus offering an attractive valuation to risk-savvy investors?

Once again, there is no right or wrong here. There is also nothing wrong with not being specialized in one of those cateogries, i.e. being industry-agnostic while focusing on companies in your home country. But my personal experience has shown that not knowing where to focus can be dangerous: In one of my last family office jobs, we initially invested in anything from incubations to pre-IPO rounds, and only later found our focus in early-stage investments within our niche. The ‘non-core’ investments, to the most part, didn’t do terribly (i.e. none of them defaulted right way), but we ended up with a notable amount of capital locked up in companies in which we could neither add value nor exit.

Learning #3: Don’t Be Reactive, Be Proactive

So you’ve defined your allocation to venture. You know which type of company/deal you want to invest in. And you’ve let the world know you’re open for business - you’re ready to invest!

If your experience is anything like mine, you will not have an issue with the quantity of dealflow. No matter if its my business email or my private email, I receive multiple investment opportunities a day. And even if you apply the filters you set from Learning #2, there’s a good chance that you’ll be left with multiple days per month that technically fit your criteria.

But rather than rejoicing at the abundance of dealflow, I advise you to be cautious. 

First, while the hurdles to investing in VC are typically low, the hurdles to getting out are much higher. As I mentioned earlier, the typical angel investor owns a low single-digit percentage stake in a business with no way to get out and very limited influence in the company’s daily business. Be mindful that any investment you make might cause you work for years to come.

Secondly, be aware of adverse selection. Especially if you are new to venture capital investing, those founders cold emailing you are likely not messaging you because they think that you are the very best investor on their cap table. If anything, it is the unfortunate opposite: They messaged dozens, if not hundreds, of prior investors who all turned them down, leading them to finally reaching out to you. This might change as you become more established and known, but never fully goes away.

Investors who don’t follow this approach (as I also did before!) end up with investing much more money into venture than they originally wanted. They see multiple investment opportunities, and all of them look good - so why not invest into all of them? At best, you end up deploying your capital more quickly than initially intended, leaving you with vintage year risk. At worst, you simply haven’t learned yet what a good company actually looks like, and end up overallocated to subpar deals. So my advice to you. Don’t invest in all the deals you like, but pick the very best one from your selection at hand. Or to phrase it differently: Don’t be reactive, be proactive. 

• Once again, know what and what not to invest in. The more specific you are, the better you can filter your dealflow - giving you more time for fewer opportunities to vet more closely.
  

• Get over the urge of liking every deal. If you have multiple deals you like, think about which one of them is the very best deal.
  

• Know your portfolio strategy. We’ll touch more on that in our next edition, but in short: Know how many deals you want to do a year, and stick to it. I can tell you from personal experience that especially in venture, the ‘once in a lifetime’ deals come along more often than you’d think.
  

• Don’t wait for deals to come to you, but go out and find them before they hit the market. Speak to other angels and family offices so they know what you are looking for. Speak to founders in your network so they can know when their peers should think of you. 

Learning #4: There Are No Stupid Questions

During my time investing in venture, I’ve often heard a variation of the following sentence:

When you invest in venture as a business angel, you have to accept that good founders will share as little information with you as needed. But that doesn’t matter - don’t ask stupud questions, and just make sure you are on board.

Or to phrase it as one entrepreneur told me: Some founders are simply assholes, but that doesn’t matter if they are good at business. 

Maybe they had another experience, but that has not been my experience at all - if anything, it’s been the opposite: Good founders want to take the time to speak to their prospective investors. They want to make sure that all questions are answered, and/or might even appreciate the questions raised by experienced entrepreneurs-turned-investors. They want their investors to be in the loop, and to challenge them, especially when times get hard. And while they might negotiate hard when it comes to the commercial terms of their financings - as they deserve to do! -, they stay fair and don’t see a negotiation as a zero-sum game, they want both sides to win.

Or to say it differently: There are no stupid questions to ask in a due diligence, and beyond. You are entrusting founders with substantial sums of capital, and the least they can do in return is answer the questions about their business model. 

I will admit: Some of the deals that I refused due to a lack of sufficient answers did indeed turn out to be lucrative. But a far larger number of companies did end up not doing well. Moreso, almost all of the deals that I did that went against this learning (i.e. deals with a lack of information and/or substantial levels of founder control) ended up going wrong in some regard. It’s painful to lose a deal because a company doesn’t find PMF - but it’s even more painful to see a founder use the funds as their ‘piggy bank’ with no way for investors to intervene.

However, it’s also important not to take this too far either - you need to stay founder-friendly. Especially for a small, early-stage ticket, make sure not to waste a founder's time with questions to which they will simply not have an answer to at this stage. Never forget that early-stage investing is extremely risky, so while the founders will likely do their best to make the company succeed, they might simply not know yet what it actually takes to be successful. Don’t waste a founder’s time with an abundance of questions, especially if you’re not even sure if you’ll do the deal or not.

Finally, let’s hone in on a much-discussed topic of early stage due diligence: The financial plan. 

Many VCs and founders say that a financial plan is essentially worthless at the early stage - after all, there are so many known and unknown variables that a financial plan will almost never be accurate in any way. And I agree with that statement - but I would still ask for a financial plan. For two reasons:

• First, to make sure that the founders did their homework. Did they do some quantitative research to understand what the drivers of their industry are? What type of business model will they use to monetize? And what are the key drivers that make their business successful? In practice, the assumptions can vary substantially, and they often do - but having some sort of financial plan shows that the founders know how certain variables might influence the business model.
  

• Second, to show how they’ll spend the money. If I entrust a founding team with my hard-earned money, I want to know that they have an idea on how to best use that capital. Is it hiring a team? Is it performance marketing? Or perhaps for some models, its hardware? Having a financial plan gives me confidence that the team doesn’t just know how they’ll spend the money, but that they also know how much money they need to reach their next milestone. If they don’t raise enough money, they might need more until they’ve hit the necessary proofpoints. If they’ve raised too much money, it might mean that they either don’t have a plan, might dilute more than needed (which you typically need to make up for later as an angel by allowing for more ESOP/VSOP), and/or might’ve set their valuation too high.

Of course, things need to be viewed in light of the individual opportunity. While a more proven company (think Series A and beyond) should definitely have a Head of Finance/CFO building a detailed model, a very early-stage deal (think a team and an idea of an idea) might not have a financial model yet - and that can be okay. And of course, one financial plan is not like the other - a “back of the envelope” calculation might be more valuable to a start-up than a 50-sheet monstrosity. 

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That concludes our learnings for today. In the next edition of this article, we’ll dive deeper into the topic of portfolio construction, including the fabled Power Law. Finally, we’ll speak about what to do as an angel when your first exit happens - and how you might even be able to proactively create liquidity in exit-poor times. Stay tuned!

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