Why co-investing with the leading venture capital firms does not always guarantee profit
By Vlad Tropko, Partner at Digital Horizon VC
Venture investment always involves risks, which is why investors — especially beginners — are looking for guidelines on how to make decisions. Oftentimes, whatever prominent figures do (you might remember how Elon Musk’s tweets moved the prices of Tesla shares and Bitcoin), along with actions of the leading funds like Sequoia, DST Global, and others, becomes the baseline for less experienced investors. However, following someone else is not enough to make money on venture investments. It is important to understand why large investors are investing in a particular company and how this aligns with their overall strategy.
Behind the scenes of a deal
High competition — fighting both for investor funds and good startups — forces venture capital funds to continuously look for new ways to improve their investment strategy. As a result, some deals can solve non-typical problems and only bring profits within the “ecosystem” of a particular fund. Yet the same deals may be less profitable or even unprofitable for other investors. Here are some examples.
Researching the business. Funds often see early-stage investments as intelligence operations. This helps investors learn about a company from the inside and enter the project earlier than their competitors. In this case, the main thing isn’t maximizing the profit. This explains why large fund managers started investing as business angels more often.
Large funds are usually diversified. There are often several “sub-funds” within them: some invest in early-stage companies, others — in more mature businesses. Surely, with early-stage investments, you can get the highest ROIC multipliers: you can earn 50–100 times more than was invested, for example, turning $50,000 into $10 million. However, the funds make the bulk of their money much later, when investments grow to tens or even hundreds of millions dollars. For example, Tiger Global sacrifices relative returns for absolute returns. The fund enters a large number of large deals, maintaining a yield of about 20%. It reportedly makes more money than its competitors do due to a large number of deals.
A stepping stone for another goal. Participation at certain rounds helps funds strengthen their network by developing relationships with founders and other funds. In the future, having a good investment image will help you get the best deals under the best conditions. This is especially important when it comes to deals where competition is strong and only the biggest players have the opportunity to compete.
“Unicorns” in the investment portfolio can also help to attract LPs (Limited Partners) — investors who contribute money to VC funds. For instance, Andreessen Horowitz used this tactic at the beginning of their journey: they invested in companies with high valuations and overpaid for entry. Therefore, according to rumors their first funds show a lower return than the following ones.
Experiments. Large venture capital funds are constantly looking for something new to improve their investment strategy. By experimenting, they hope to “capture alpha” — the additional return on investment hidden in “blind spots” that other investors are disregarding.
That’s what happened to Uber: in the beginning, the company was cheap as nobody believed in its unconventional business model. But Benchmark Capital made the right decision by investing $9 million in round A in 2011 and then making additional allocations in each subsequent round. After Uber’s IPO, Benchmark Capital’s stake valuation rose to an astounding $6.8 billion.
On average, large funds spend 5–10% of their investment budget on experiments. But only those with a visionary look will succeed in “capturing alpha.” In most cases, when a fund dabbles in a new industry, their investment risk is much higher. This is important to take into account when deciding to follow after a fund.
An even riskier experiment — almost to the point of being too risky — is making hype-motivated investments when funds are afraid to miss an opportunity that everyone is talking about. A striking example is the non-fungible tokens — NFTs.
How and where should business angels invest?
The formula for success that high-profile funds follow lies not in individual deals but in the overall strategy — investing in many projects in industries where you have expertise. And this approach is suitable even for small investments.
For instance, one well-known private investor was casually writing out checks at nightclubs. To him, those were just “quick checks” that he could afford with no regrets if they failed. The strategy worked because the investor contributed money to tens or even hundreds of companies. But business angels that followed him and invested in only a few of those projects were often unsuccessful.
Of course, private investors usually have fewer companies in their portfolios than funds do. Therefore, learning how to objectively evaluate startups is twice as important for business angels. For this, you need to spend at least one or two days a week looking for new projects and communicating with their founders. Alternatively, you can consider companies that have been initially assessed by experts:
- Crowdfunding platforms. Today, the most popular ones are Crowdcube with a minimum investment of £10, and Republic where you can invest $50–250 on average. Crowdfunding platforms only feature startups that have successfully passed the initial assessment.
- Business angel clubs. These communities educate aspiring venture capitalists and offer to invest jointly with cooperating funds and more experienced angel investors.
- Venture funds. A fund’s team will assess a startup’s financial and business model and create a differentiated portfolio. LPs with large checks can count on additional capital for co-investments in certain deals along with the fund.
When beginner investors approach venture funds, many of them dream of finding their own Uber or Facebook and becoming a part of a big story that will change the world. But in reality, most of the money comes from companies that most people will never hear about. Therefore, if you want to increase capital through small checks, it is better to focus on researching the market instead of obsessively looking for “unicorns” and trying to enter a round together with the leading funds.
Author: Vlad Tropko, Partner at Digital Horizon VC