Making direct investments into promising startups undoubtedly has its attractions for family offices (FOs), but on balance, most firms tend to opt for a hybrid approach, by splitting their allocation across direct investments and specialist venture capital funds. In fact, research shows that it is roughly an even split between the two, with FOs on average allocating 46% of their venture portfolio to funds and 54% to direct investment.
This split makes a lot of sense, as covered in previous articles. Setting up an internal venture capital function is expensive, and time-consuming while managing a whole portfolio requires specialist skills and experience. In contrast, VC firms offer a one-stop-shop, where family offices can access all the talent and knowledge they need in one place while spreading their risk over a whole portfolio.
Furthermore, the venture capital industry, particularly in Europe, has matured rapidly in the last five or ten years, with a host of new funds entering the market, catering to different sectors, technologies, and sizes of business. In 2020, European VCs raised more funds than they had in any previous year, despite the impact of the pandemic, and 2021 has got off to a similarly strong start.
This rapid development means that FOs have a greater choice of partners when looking to allocate their funds, each with its own investment strategy, area of focus, and style of working. The key is to find the right fit and then build a productive working relationship with the investment team, both to ensure they get the returns you expect and the involvement you want in picking and nurturing exciting young startups.
Looking into venture capital for your family office? Here are the key considerations to bear in mind:
Know what you’re looking for
Before setting out to find a VC partner, spend reviewing how the VC industry works and the different types of funds available. VC firms tend to specialize based on investment stage (i.e. Seed, Series A, B, C+), geographies, as well as their investment thesis and risk appetite. For example, earlier stage investments may be higher risk, as business models and technology are likely to be less proven. But on the flip side, this means round sizes are smaller, and the chance of higher returns is potentially greater by getting involved early. So, you need to weigh up which stage best suits the funds you have available and your risk appetite.
Firms also vary quite significantly in size and track record, and while it is tempting to opt for the big, established names, you may find you get more access to deals and VC principals by opting for a younger, smaller fund. A final aspect to think about is the types of business you want to support, and sectors you’re interested in getting involved in, to narrow down your search further.
Finding the right chemistry
Just as important as assessing fund strategy is to find the right chemistry with the investment team. It is common for family offices to find venture capital through referrals, or their existing networks, but the most obvious option might not necessarily be the best. If you’re looking to set up two or three relationships, then aim to meet around 10 different funds in the same peer group, to get a feel for their strategy and capabilities, as well as how well you can work together in a mutually productive and beneficial way. Ask plenty of questions around the investment thesis, plans to grow, whether they take a hands-on or passive approach, what their deal flow is like, and of course their past performance.
Look to add value if you can
Investing in startups is exciting and can offer a lot of non-financial as well financial rewards, and it is only natural for FOs to want to feel part of the journey. As a family office, you’re likely to be able to add value to your venture capital partner and its portfolio companies, above and beyond your equity investment, by tapping into your network, suggesting potential deals, and offering insights on focus sectors or deals. If this is something that you’re interested in doing, make sure you raise it at the outset, to ascertain the access you will have to VC principals, communication channels, and your ability to add value.
One additional avenue that may be available, depending on the amount of capital you’re planning to invest, is to take a seat on a firm’s investment committee (IC), to contribute to the formal decision-making process. This will involve more active participation and an additional time allocation on your part to review new opportunities presented by investment managers. It is mostly a smooth process, but it can also lead to a discussion forum where deals get turned down or further due diligence is required before moving forward. Although bear in mind that a seat on the IC normally comes hand in hand with a significant limited partner (LP) commitment or anchor commitment to the fund, plus the FO would also need to have the required skills to participate and contribute in this way.
Develop your own style of communicating
But if the IC isn’t an option, every LP, and particularly FOs, find their own style of working and communicating with VCs, allowing you to add value on a more informal basis. Some FOs prefer regular, formal reporting, while others develop more informal channels, through messaging, calls and regular chats over coffee. You will also find many VCs organise events and gatherings to facilitate networking and an exchange of ideas. Being proactive about getting involved, whether formally or informally, will also ensure you are first in line for any co-investment opportunities, both to increase your stakes and potential returns in the deals that you find most interesting and attractive.
Patience is a virtue
Finally, venture capital isn’t called patient capital for nothing, so family offices need to be prepared to stick with their funds for the long term. That means five or even more years before you’ll start to see exits and returns coming through. Startups, particularly at the early stage, can be unpredictable, and may go through a couple of pivots on their journey to success. Others may never make it, which is also par for the course; bear in mind that VC funds often make the majority of their returns from just 20% of their deals. But good VCs will have diversified their portfolio to allow for this uncertainty, while also taking an active approach to guiding and nurturing companies, to maximise their chances of overcoming the many obstacles along the way. They should also be fully transparent with the family office and give you an early heads up about any issues, so you don’t get any nasty surprises.
The European startup sector has come on leaps and bounds in recent years, to a point where we are increasingly challenging the US and Asia for building innovative tech companies. Collaboration between venture capital funds and family offices has been key to this success, bringing the ideal combination of funds, networks, and experience, to select, nurture, and scale the next generation of founders. And with the future of startups looking brighter than ever, this relationship only looks set to be even more vital in the years to come.