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Venture Capital Firms, an Investors view

I was approached by a startup fund with a view to taking a position. It was something I was very interested in having decided some time ago to look at co-investment options. The fund was launched in 2014 by the founder who started investing his own money and soon outgrew his limited funds, so was looking at expansion by taking external investment.

I soon got to realise that they were moving too quickly. Rapid growth in companies is highly desirable, but in the case of a fund, you need some time and history to understand your success rate.

There was evidence of lack of experience in the world of investing, with some small tells and some larger. Success of individual investments were isolated and seen out of context to the entire fund or process. The fees were naive and standard rhetoric was used instead of considered, refined objectives.

 

Let me explain further:

Firstly, they were aiming for companies with potential for a 10 X return. The industry norm is 20 X, as typically over time, 5% success rates are typical, so with a 20 X return, you are looking to break even.

Also, they stated they were looking for exceptional entrepreneurs. That is assumed by most new investors to be highly desirable until you use big data to analyse the entire startup eco system. It turns out, that this is one of those “Unknown knowns” things you know, that are untrue. Over the last 60 years of tech startup companies, almost without exception, the companies that succeed and thrive are the ones that are in the right place at the right time. Who runs them, it turns out, is mostly irrelevant. Until you have history and experience and access to big data, this is not something that you would understand, let alone believe.

Also, they were looking for companies that had “Proven Business Models”. Yet that is at odds with the disruption model of their target companies. Again, until you start deep thinking, the above phrase sounds rational and comforting, when actually it is the enemy of a creative, disruptive businesses.

The last major issue was fees. They charged the startups 2% on monies per annum and investors 20% from their return.

That sounds normal until you start analysing it. First of all, with a typical return around the 10 years mark, 2% per annum equates to 20% over time. And that money is not being charged to the startup as they don’t have any money to pay the bill, the fees are being charged to the investor through the startup.

Lets analyse that fee further. On a £30M fund the fee represents £600K in year 1. Investing in 15 companies, your fees are going to be £40K per startup, which represents costs of approx £27K + 1.5 X markup per company. That’s exceptionally high admin fees for a startup, but when you add that cost in each year, it becomes exorbitant. Remember, these are startups, so due diligence is negligible, your primary costs are going to be search fees to find the companies to invest in.

 

Next, a performance fee of 20% on investors return. that would be fine if the fund manager were risking their own money, or had penalty clauses on failure, but for no risk, taking 20% of the investors highly risked money is unacceptable. That combined with the founders fees represents a total “tax” of 40% before inland revenue get a look in.

So here’s the interesting part. Like most industries, margins in the investment community are low. If you can keep costs including fees at a minimum, reduce outgoings and invest wisely, you can achieve a good return. But, if you treat investing as a service, the primary winners become the investment firms, taking fees and shares of return irrespective of their performance. Investing effectively becomes gambling for the investors, only making money if you happen to back a mythical “Unicorn” company.

If an investment firm is not invested in the same companies you are at the same rates you are, there is no incentive to work hard to achieve the success you need to survive and ultimately thrive.

 

In conclusion, I would suggest investing should be done in the investment companies themselves as they have a strong, stable business model, while their clients, the investors become their income and the startups become the commodity traded.

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