The modern venture capital fund structure dates back to the 1960’s – but change is coming fast and furious! This article can help you make money in venture by conveying an insider’s tips and tricks into how to build a better venture portfolio, while avoiding common mistakes that venture investors all too frequently make.
Venture Capital was once an elite game played almost exclusively by modern royalty. Wealthy blue-chip venture capital firms on Sand Hill Road partnered with wealthy blue-chip banks, pensions and endowments in order to guarantee that all parties involved made a lot of money.
For 50+ years, these General Partners organized funds, stockpiled Limited Partner investors, and, for the most part, followed the 2/20 (2% annual management fee and 20% carried interest – or profit sharing) compensation structure.
But there is nothing the internet hates more than a middle-man. And a Venture Capital (VC) fund sits between the people with the money (the limited partner investors) and the companies that ultimately receive the money (the funded startups).
The Jumpstart Our Business Startups Act (JOBS Act), passed in 2012, arguably began the democratization of venture capital by expanding the list of investors beyond traditional blue-chip institutions. Separately, family offices began investing much more actively, and directly rather than through venture funds, since about the same time.
[Editor’s Note: For more information please see our webinars ‘Alternative Assets Part 1: Investing in Venture Capital, Private Equity, and Hedge Funds‘ and ‘Due Diligence Before Investing‘]
Credit must go to Naval Ravikant, founder of Angel List, for developing a product to fill this direct investing desire, through its ‘Syndicates’ project. These syndicates generally allowed existing individual investors in a company to offer up to new investors, the opportunity to invest in that company’s upcoming financing round. This would be accomplished by the existing investors using their right-to-invest, or ‘pro rata right,’ to let other investors ride their investing coattails, via their syndicate.
Each Angel List syndicate invested in one company through an SPV, a ‘special purpose vehicle.’ An SPV is a venture capital ‘fund’ with one investment but is subject to all of the SEC regulations governing a traditional venture capital fund. These regulations include restrictions on general solicitation, numbers and types of investors, State level Blue Sky filings, Federal Reg D filings, annual tax returns and K-1 preparation. An SPV is a high-cost, high-burden tool for one investment. Yet it remains the only vehicle available for pooled direct investments that comfortably rides the rails of SEC compliance.
After recognizing Angel List syndicates’ popularity, the recently emerged class of small venture funds, the Micro-VCs, began integrating direct investing through SPVs into their models. Why? Two reasons:
Just as Wall Street took low-documentation mortgage loans to excess almost a generation ago, many Micro-VCs are now taking direct investment SPVs to excess.This begs the question: is the GP bringing something special, such as an investment that is otherwise impossible to access? Or is it bringing a commodity, and simply boosting its assets under management to excess, by bringing a pedestrian investment that anyone can access?
In other words, are you being selective and buying this co-investment as a complement to your current portfolio? Or are you being sold something you don’t want or need?
Investing in venture capital is all about pattern recognition.After 20 years, seven venture funds, 100+ companies, and 35 pro rata based SPVs, I have discerned a pattern that can help distinguish between a great co-investment opportunity and one that should send you running. A few things to avoid when you invest in a venture-backed company – because the best way to make money is to first not to lose it:
If you follow the five rules above, you are likely to avoid bad co-investments.
But how to filter for those potentially GREAT investments? Once again, pattern recognition can suggest a few things that most great investments have in common.
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John Backus has been investing in venture capital for over 20 years. His firm, PROOF.VC, is the pioneer in using the pro rata rights of smaller VCs to gain unique access to many of the fastest growing venture-backed companies, while also extending that access to his LPs through co-investment SPVs. Prior to his career as…
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