Personal Learnings in Venture Investing (Part 2)

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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, generating life-changing exit proceeds 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 classes 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. A few weeks ago, we started with Part 1 of this series, covering learnings such as whether you should invest in VC in the first place, properly filtering your dealflow, as well as asking the right (‘stupid’) questions during due diligence. Today, we’ll cover a few more learnings on due diligence as well as best practices on portfolio construction (the fabled Power Law) and portfolio management.

Let’s dive in!

Are you a family office or affluent investor looking to make investments in individual start-ups and/or venture capital funds, but don’t want to make the common mistakes? Are you looking for someone to help you on your VC investing journey:

• Does VC make sense for my portfolio - and if so, in what size?

• How should I access the asset class - make direct investments, fund investments, or both?

• For direct investments, how should I construct my portfolio? And how do I manage it?

• For VC funds, what should I keep in mind? How do I build a diversified portfolio, and how do I gain access?

• What other pitfalls are their to avoid, in areas such as legal or tax?

We’ve helped numerous clients with their venture investing strategy - based on my own experience supporting and leading investments in companies such as Enpal, MILES Mobility, PowerUs, or Kittl. We’d be happy to support you as well, so don’t hesitate to reach out.

Learning #5: Best Practices in Due Diligence

One thing that I’ve learned as an early-stage investor is that it is often not money that is your bottleneck, but time. Luckily, most of the time spent on an investment is when you make the initial investment - during the due diligence, i.e. when you assess commercial, legal, or financial matters to validate your investment thesis and to avoid any red flags. And it’s here that I often see that ‘entrepreneurs-turned-investors’ make mistakes which in hindsight are very avoidable.

An entrepreneur in my network was introduced to a visionary founder looking to raise an extension to their pre-seed round. The case looked great, the founder was inspiring, the industry similar to where the entrepreneur had made his money. He quickly wrote them a 50K€ check, excited to work together.

But the next month brought a very unwelcome surprise: The company had run out of money. The entrepreneur had covered all commercial questions, as he should (think market size, GTM, marketing channels, etc.), but had simply never asked if there were other investors too, or what their runway was. Turns out that without the ticket my friend wrote, they would’ve simply ran out of money a month earlier - and they also didn’t manage to get on any other investors during that extra month of runway he had given them. (One more reason, in my view, to check the financial plan, as I outlined in Learning #4 last week).

So rather than providing you with yet another due diligence questionnaire, let me instead share with you a few key learnings from my investing journey:

Other Investors: While I hate the ‘herd mentality’ of venture capital, you should unfortunately lean into it as an angel investor, as you likely don’t have time nor capacity to guide a founding team as a lead investor would. Make sure that the other investors aren’t just uncles and cousins, but fellow entrepreneurs or executives with relevant industry experience. If there is no lead investor (i.e. a VC or experienced family office), make sure there’s one or more individuals who feel responsible to speak for the investors as a whole (for example a ‘full time’ business angel). It’s also not uncommon in such a case to have a pooling of voting rights, i.e. to transfer decision-making power for non-financial decisions to a certain party.

Runway: As outlined above, make sure to know how much money the company has in the bank. Unless you have extremely high conviction, don’t just invest on your own, but make your commitment contingent on other investors joining as well. Ensure that the runway is sufficiently long - ideally 12+ months.

Deal Structure & Control Rights: Know your differences between a convertible loan and an equity round. The former is more flexible, but typically does not give you actual influence in the company’s day-to-day (unless added as an explicit right). The latter is more explicit, but can be more complex and expensive to implement. There are also key tax differences on gains and losses (which my colleague Tamara would be happy to share with you.) Unless you want to be very involved, don’t ask for any non-standard control rights. Typically, you’d see a 1x non-participating liquidation preference (i.e. you get your money back or participate pro-rata in any proceeds, whichever one is larger), a pro-rata right (i.e. you can atleast maintain your percentage stake in the company by participating in future rounds), and certain approval rights (i.e. an investor majority required for a sale of business or subsequent financing round). 

Information Rights: I’m not the first person to say this, but can only repeat it - there is no bigger red flag for a start-up than not sending regular investor updates. When you invest in a start-up, ensure that you receive regular investor updates. They don’t have to be fancy presentations or video calls, even a simply email every month highlighting successes (what went well - closed deals, new investors, new hires, etc.), challenges (what didn’t go well - PMF issues, failed deals, etc.), and financial KPIs (revenue, burn, and resulting runway) can be enough. Nothing is worse than not hearing from a founder for months, only for them to get back to you asking for money. If a founder refuses to provide regular reporting, don’t make the investment. As I outlined in Learning #4 - great founders want to keep their investors informed.

Last but not least - be diligent, but trust your gut feeling. Chances are it served you well in your prior time as an investor, so rely on it as an angel investor too. Any time I ended up making an investment despite having a bad gut feeling, things went sideways in some shape or form. One of the first investments I made in my last family office job was into a company founded by a serial entrepreneur. It was during the hype days of 2020/2021, so investor rights were notably slimmed down (think no binding information rights, no liquidation preference, high entry valuation, etc.), but against my instinct I helped finalize the investment. A few years later, things are not going terribly, but certainly not great - but the fact that we don’t have a liquidation preference means that we will likely not see any of our money for years to come. Should’ve trusted my gut.

Learning #6: The Power Law and Portfolio Construction

Venture capital is an asset class that doesn’t have returns akin to normal distribution. Most start-up fail and thus return little to no of the invested capital, while the few positive outliers (think Uber, Airbnb, or Coinbase) drive returns that more than offset the many failed investments. This distribution of returns is commonly called the Power Law (which is very well explained in the book of the same name). I like to look at things from a quantitative perspective, so let’s do the same today - by using data shared by David Clark of the Venture Fund of Fund VenCap. 

Let’s first again look at the worse-performing deals. In the case of VenCap, 53% of their 11,350 (indirect) portfolio companies failed to generate returns sufficient to return invested capital (and VenCap, which has been around since 1986, is likely picking above-average fund managers, which might have a positive effect on their loss rate.) Before even diving into the return expectations for well-performing deals, we can already see the Power Law in action: To generate a fund-level multiple of 3x or better before fees, the remaining 49% of deals need to generate significant returns to offset deals on which VCs lose money.

What does significant mean? We can again see this in VenCap’s data. In their funds, 19% returned between 1 and 2x, 16% returned between 2x and 5x, and 12% of deals returned more than 5x of invested capital. If we want to achieve a 3x multiple before fees, we can use simple math to calculate what average returns the “Above 5x” deals need to generate:

Hence, using Vencap’s figures and our target return of 3x (before fees), the remaining 12% of the fund would need to generate an average return of ~15,75x to reach its 3x target return. 

With a typical VC fund consisting of 30-40 portfolio companies, that would mean that we have ~3-4 portfolio companies with this double-digit multiple. Realistically, however, the distribution is even more extreme, where just one portfolio company (~2% to 2.5% of the fund, so 1 in 40-50) drives a substantial part of the fund’s performance. This is also consistent with the return expectations of a VC fund, which tries to size (and value) its investments in a way so that a single deal, if it’s a home run success, can return the entire fund. 

We can extend our prior table, and once again use simple math to complete the calculation:

In other words, if we assume that 10% out of the 12% in VenCap’s “above 5x” multiple achieved an average return of 7,5x, that would mean that our remaining single deal (i.e. 2% of the fund) would need to achieve a staggering 57x (!) return for us to achieve our performance goal of 3x.

This outlier-driven nature of VC has a profound impact on the distribution of VC fund outcomes, and accordingly, the performance of VC in investor portfolios. Some outliers can drive significant returns, even in excess of this hypothetical 57x multiple. But likewise, the absence of an outlier return means that the fund will struggle to achieve its desired returns. But how does this affect you as an angel investor?

First, you should make sure to spread your bets. As we outlined above, VC funds see roughly 1 in 40-50 investments become a true outlier. If we take into account that there is likely some positive selection bias in VC funds (i.e. they at least filter out the really terrible deals, which some angels unfortunately don’t), the number might maybe be more in the range of 1 in 50-100. Hence, you as an angel should do the same: Don’t make the mistake of making just 5-10 concentrated bets (where a write-off would likely be financially and psychologically painful), but try to diversify as well as you can, as a VC fund would.

Second, make sure that the companies you invest in can be outliers. If I spread my bets, but an underlying outlier can ‘only’ generate 3-5x, it is likely not enough to offset the many more losers. Hence, make sure that the investments you make have the chance to be VC cases, i.e. unicorns with a valuation of a billion euros/dollars or more. If you don’t want to make such bets (I like to call that ‘family office VC’), for example if you can’t stomach writing off more than half of your investments, go back to Learning #1 and rethink if venture capital is right for you.

Learning #7: Best Practices in Portfolio Management

So you’ve built your dealflow. You’ve conducted your due diligence. And you’ve spread your bets. You have a nice, little portfolio of 20-30, or even more, VC bets. What now - how informed should I be? How involved?

In my view, you actually don’t need to be too informed. I often see new angel investors aggressively track every KPI they can get from their portfolio companies (think revenue, burn, etc.), and even to hound founders to provide data in a format specifically fitting their internal reporting. However, I don’t think there is any point in tracking this data - as an angel (with a stake of likely <5%, if not <1%), there isn’t really anything you can do with it. You likely can’t finance the company on their own, nor can you help them ‘right the ship’ if something isn’t going well. In other words - I don’t think you need to aggressively track this data, but of course, you should make sure to have it (see Learning #5 regarding information rights). Having this data is also what’s needed to be able to proactively create liquidity (more on that in #8).

And neither do you need to be too involved. Especially for experienced entrepreneurs, it is clear that their angel investors are not the ones that will guide them in the day-to-day - that is (at least in theory, less so in practice) the role of an institutional investor like a VC fund or a VC-savvy family office. However, they might expect you to help in general topics, as well as those specific to your expertise. General topics include intros to potential investors, as well as sparring regarding company matters (strategy, fundraising, etc.). Expertise-specific topics depend on, well, your expertise - for me as a ‘finance person’, that was topics like reviewing the financial plan or thinking of non-dilutive financing options, but for you, it might be different.

Yet while this looks so simple, things often don’t work out that way - resulting in frustration for the founders and the investors. A few things that I’ve observed, or even experienced:

• Lack of (balanced) information. Founders only share details when things go well, yet don’t share any challenges. Angels understand that they don’t get a balanced picture and withdraw support.
  

• Investors don’t deliver on promises. Something we see especially for new angels - they promise detailed value-add (think a minimum amount of hours per week of coaching etc.) but don’t end up following through.
  

• Founders request support, but don’t use it. One of my personal pet peeves - we had a founder who constantly asked us for strategic support and sparring on a new direction. Hours of workshops later, he hadn’t implemented a single one of our suggestions.
  

• Differences in strategy. Once again, a common mistake for new angels (and one I made as well). An angel ends up investing because he sees clear potential for a certain strategy / go-to-market - which however differs from what the team can do or wants to do. The angel ends up disappointed because the team doesn’t implement the strategy that they never even signed up for. Personal learning for me: Don’t invest in a company under the condition of a strategic shift - it’s the founding team that needs to execute, not you.

As with many things in life, disappointment comes from a misalignment of expectation and reality. So make sure to communicate clearly on what you can and can’t do. Or as one of my old bosses at Goldman Sachs used to say - underpromise, overdeliver.

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I originally planned this as a two-piece series, but now also getting into the final learnings - how to deal with an exit, and how to proactively create liquidity - deserve more words than I could fit into this already lengthy newsletter. So we’ll save the final learnings for Part 3 of this series. Once again, stay tuned!

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