Personal Learnings in Venture Investing (Part 3)

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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. We followed with Part 2, where we covered best practices in due diligence and portfolio management. Today, let’s talk about the final step of a VC investment - the exit.

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 #8: Best Practices for Exits

Congratulations - one of your portfolio companies is looking to sell. What should you keep in mind as an investor?

Perhaps not just a best practice for when an exit hits, but also earlier in a start-up journey - understand the different positions that shareholders might find themselves in.

First, the founders. They are typically ‘all in’. The vast majority of their assets will be their stake in the business. To them, an exit could be life-changing (if happening on good terms), or can be the destruction of many years of work (i.e. if sold below liquidation preference and/or as a fire sale).

Second, the VC funds. As we described in Part 2, VCs are keenly focused on the Power Law - they need substantial outcomes (think 10x, 50x, or even more) for an exit to move the needle. They don’t want small and/or early exits, as they typically have to distribute most if not all of the proceeds to their investors.

Lastly, you and the other angel investors. If you followed my advice, you are typically well-diversified (think 20-40 portfolio companies), and are not financially dependent on whether your angel investments go well or not (categorized in the Aspirational Bucket of the Aspirational Investor Framework). While you should also aim to generate returns just as VC fund would, you might also be happy with a positive yet smaller outcome. In other words - anything that’s not a write-off is a good outcome.

So with that in mind - how should you behave as an angel investor? In my view, you should always try to be founder-friendly. Especially if it is an outcome that is favorable to you (i.e. return of your capital, or even a gain), you should never stand in the way of an exit. What might be a small check of many to you is many years of work of a founder, and except in few cases, you should not be the one to keep them from it. Make sure you don’t slow down the exit, i.e. quickly reply to information, provide PoAs, be involved as needed but not beyond that). And be happy once that check hits.

Especially for individuals who look to not just be ‘VC tourists’, I can tell you that supporting an exit, whether favorable or not, pays substantial karmic dividends. Founders in that you invested in and that ended up selling their business will likely be grateful and keep them in mind for future opportunities. Founders that you invested in that didn’t have a good outcome but still had an orderly, acceptable outcome (think a fire sale, acqui-hire, or even an orderly winddown), in my experience, are even more grateful.

Most importantly - don’t block the transaction because you are unhappy with an acceptable outcome. Over the years, I’ve seen cases where business angels or even former, non-operating co-founders blocked an exit because they thought the exit presented to them was not satisfactory. But unless you are heavily involved in the business and/or exit process, or are willing to take over the reins from the founders in a truly operational role, chances are you simply don’t have the full information to provide such a judgement. Of course this doesn’t apply if the deal is not fair to all related parties (i.e. extremely favorable to the lead investors, lower sale price because the founders receive a better package at the level of the acquirer later, etc.). As always, trust your gut.

Finally, depending on the size and structure of the exit, also consider getting your own legal support. For large transactions (think a VC-backed, mid/late-stage company), there might be legal representation for a wider group of shareholders, with those lawyers responsible to negotiate a deal for all existing shareholders. However, if you have substantial amounts of money on the line (perhaps this is your Power Law outlier investment with a 100x multiple on your angel check), don’t be stingy and get your own lawyer to make sure you are properly represented. Same goes for taxes, especially on cross-border matters or share deals - where my co-founder Tamara would be happy to support you.

Learning #9: Finding Liquidity in Venture Portfolios

As we touched on in Learning #1, VC is a long-term oriented asset class. It’s especially the outliers that can take considerable amounts of time until liquidity (think 10+ years), while the non-winners likely resolve themselves earlier through liquidations, insolvencies or financially insignificant exits.

If you are investing for the long-term, liquidity should not be a concern of yours, as a well-structured portfolio of direct VC investments should simply liquidate itself. But perhaps you can’t wait the 10+ years. You might need liquidity today, for a certain reason. Maybe you simply realized that some of your older investments don’t fit your investment thesis going forward (i.e. the ‘family office VC’ investments that I spoke about in Part 2). Or maybe you’ve decided that VC isn’t for you, and you want to wind down your portfolio.

However, proactively creating liquidity is very different from one company to another. Remember our graphic from Part 2 showing the breakdown of start-ups into their range of outcome by long-term deal return:

Let’s take a look at each of these categories:

• Below 1x (“Underperformers”): The companies that will likely not make it over the long term. The eventual result is likely a write-off. But what can you do until then? Or is there maybe a way to optimize the result?
  

• 1-2x / 2-5x (“Stable Performers”): Companies that found some sort of working business model, but will likely not generate VC-level returns. Over the long-term, they’ll likely end up being sold for a modest return. But do you want to wait that long?
  

• 5-10x / Outlier (“Outperformers”): The companies that you want to see in your VC portfolio. Think companies with an attractive but maybe not ‘outlier’ return that end up getting sold to PE or a strategic investor over time, or even the ‘moonshots’ that end up selling for billions or even end up going public. Clear winners, where you’d likely be able to take some money off of the table along the way through a secondary. But how do you go about realizing that secondary?

Optimizing for liquidity is something that once again would exceed the scope of this Learning. However, if you’re interested, I’ve wrote an article of its own on the topic - you can find it here. Of course, if you need personalized assistance in finding liquidity in your VC portfolio, don’t hesitate to reach out to us, as it is a topic that we’ve helped numerous family offices and affluent individuals with.

However, since you’re taking the time to read this article, I wanted to summarize some of the key learnings for you here:

In case of the Underperformers, see if there is a way to create a ‘recovery’ greater than 0 by not waiting until the money runs out. While I admire the grit of some of the founders that I had the honor of working with, I did wonder sometimes if waiting until an empty bank account was the best outcome for everyone involved. Same applies to founders who started with a certain business model, quickly realized that it didn’t work out, and then ended up pivoting to a completely unrelated topic with little success.

I’ve had success with suggesting orderly liquidations instead of waiting until bankruptcy, allowing a return greater than 0 (not notable in most cases though). Alternatively, we’ve had cases where it became clear that the business model wouldn’t support a VC case, where we ended up selling back the business to the founders: They were able to keep on running the business (often also on the side as some ‘side income’ to their next project), and we received some of our money back rather than spending it on a case that everyone agreed would not work out.

For the Stable Performers, consider strategic alternatives. In my experience, Stable Performers often see their valuation suffer as it shifts from VC (forward-looking, based on market size and non-financial KPIs) to PE (backward-looking, based on clear trajectory and financial KPIs). For example, one of our most stable growers in my last FO job was a medtech company that grew from ~1M€ in revenue and low negative profitability to 10M€ in revenue and 2M€ in profits - but likely only a modest valuation uptick due to a ‘repricing’ to a PE-like valuation approach based on a multiple of profits.

Hence, the solutions to consider, in my view, should be PE-like as well. I am surprised how few founders consider some sort of management buy-out, i.e. buying out early investors through a combination of earn-out, seller notes, and external debt, to then run perfectly fine, slowly-growing but profitable companies themselves. I’ve helped founders realize such outcomes, buying us out at symbolic but still relevant multiples (think 2-3x) - but most importantly giving them the freedom to run their company as they see fit. Alternatively, you can consider a cap table clean-up. Often in such companies, there might be a non-financial investor (think strategic investor or family office) that might want to increase their stake despite a non-VC return profile. If you can suggest them a deal at a fair valuation, you might be able to get them to buy you and other investors out at a fair valuation.

For outperformers, a secondary sale is the typical way to go - but it might take some effort. To stay in-line with the Power Law, make sure not to sell out of your winners too early. But especially as a company hits its ‘exit trajectory’ (think nine- or ten-figure valuations), you can definitely consider de-risking, especially if the proceeds might recover most if not all of the invested capital across your entire angel portfolio.

If you want to do a secondary at some point, my advice would be simple: Make sure the founder knows! For most companies, you as an angel will have a hard time negotiating your own secondary, but will likely be offered such an option as part of a financing round or a designated secondary round. If a founder knows that you are willing to sell, they can use your stake as a bargaining chip in future negotiations. And perhaps more importantly - if they don’t know, they might simply move forward, giving you no chance to sell. 

In regards to liquidity, one final remark: Don’t forget that VC is a game of optionalities. As mentioned above, taking money off of the table too early might result you in losing further upside for the big winners. Equally, selling out of a Stable Performer might provide you with liquidity over the short term, but might backfire if the company slowly grows into a nine-figure PE exit case. VC is a long-term game, so treat it accordingly, and be careful if and when you really need liquidity - if your portfolio-level way to liquidity is selling direct investments, you likely made a major mistake in your liquidity planning.

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This concludes our three-part series of my personal learnings in venture. I hope you were able to take away something for yourself. As always, if you have any feedback, further learnings, or further questions - let me know!

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