Every year, thousands of startup founders set out in search of funding for their business ideas, offering the promise of substantial returns for family offices. Yet, the truth is that in another year’s time, only a fraction of those entrepreneurs will still be in business, while an even smaller number will ever make it big. Investing in these ventures is a risky and time-consuming business. So, it’s vital to do your homework before diving in.
Family offices who want to invest in startups effectively have three options; they can invest directly, through a venture capital partner, or they can opt for a combination of the two, often known as a hybrid approach. Every family office is different, and the approach taken will depend on their background, the skills and expertise within the team, and the time and resources available to assess and manage investments. So, how do you know which is the best approach?
Direct investment is growing in popularity amongst family offices, with figures showing that the amount of private wealth invested directly into European startups has grown almost five-fold over the past five years. Family offices are frequently attracted by the upfront cost savings, with no fund management fees to pay, as well as the full transparency they gain into the performance of underlying investments. Direct funding is also particularly popular amongst more entrepreneurially minded offices, who like the idea of personally choosing who they back and building direct relationships with founders, rather than going through an intermediary.
Patrick Aisher, serial entrepreneur and Chairman of family office, Kinled Holding, is a case in point. “My family has always been entrepreneurial in nature, and as a fifth-generation entrepreneur, my background is much more aligned with VC investment,” he explains. “What families appreciate about direct investment is the ability to back people as well as ideas. We have a portfolio of over 50 companies we’ve supported in this way, so in a sense, our office serves as a VC organization in its own right.”
While Kinled Holding is an established office, direct investors are frequently younger, first-generation firms, created by former tech entrepreneurs who have the contacts and expertise to spot the best opportunities. In fact, research shows that two-thirds of newer family offices (created post-2015) now make direct investments in private companies, compared with only just over 50% of those founded between 2006 and 2010.
But while there is no doubt that direct investment can work well for some, it also comes with its challenges. Getting it right requires a certain set of skills, many of which may prove difficult and/or expensive for family offices to develop internally. Not only do they need to understand the latest tech, but also assess market opportunity, identify gaps might exist within founding teams, and know-how to structure deals to achieve optimum outcomes. There is also a strategic element to consider, around maintaining a balanced portfolio and focus, so as to mitigate any uncertainty.
Without this expertise and experience, along with established networks in the sector, making venture deals and decisions can be extremely risky. There are hundreds of thousands of young tech businesses battling it out for investment, so sifting through the detail to find the most promising opportunities isn’t realistic for many. In contrast, investing via a fund enables a family office to hand over vetting responsibilities to a dedicated and trusted third-party while enabling them to support a wider range of businesses than they might via direct investment.
“Early-stage venture is a high-risk environment,” says Ha Duong, investment principal at Ocean Investment. “Specialist VCs with a native understanding of the technology, the business model and the industry should have a much stronger ability to price both risk and upside.”
Investing via a venture capital fund
As well as providing the skills and experience to pick investments, partnering with a venture capital firm enables family offices to tap into well-defined processes and strategies, informed by years of in-market experience and access to extensive on-the-ground networks. This makes VCs better suited to picking the right early-stage companies at the right time, building out a balanced portfolio, and assigning dedicated personnel to focus on managing deal flow. The stronger the investor’s reputation, the more likely they are to access the best deals – to the disadvantage of family offices with no prior record in VC investment.
The best venture firms are also focused heavily on working in a hands-on way with startups, taking an approach that we at Concentric call activist venture investing. In the early days, startups need a lot of support across numerous areas, from recruitment to business development, product positioning, and fundraising to HR, operational setup, and more. The job of managing venture assets in post-seed stages requires total active focus, with little room for other activities. It’s often a step too far for a family office, particularly if venture capital is not core to the office’s overall asset allocation. This additional support should more than justify the management fees, plus pooling capital is economically more attractive in the long-term than investing deal-by-deal, providing an increased level of returns with a portfolio approach.
Of course, opting for a fully outsourced approach to VC investment can also pose issues. Selecting funds is not always straightforward as the established brand name funds are often closed to new investors, and many prefer an institutional investor base. It’s a complex landscape to navigate, however, new ambitious funds are emerging all the time, which offer fantastic opportunities for family offices to start building these partnerships early, with no detrimental impact on performance.
According to Aisher: “The key for a family office is to identify a VC with a modest fund and a small, focused team of people, so you can have a personal relationship – no bureaucracy and direct access to the fund partners. That way, you’re still investing in people, as well as great ideas.”
The advantages of a hybrid approach
It doesn’t have to be an ‘either-or’ approach however, as for many family offices, a hybrid investment model may be the best way forward. This approach involves deeper relationships with two to three complimentary venture fund teams, outsourcing deal flow generation, vetting, and investment management as well as creating balanced diversification. But in parallel, a family office will maintain a small number of direct investments to build its own investing brand within their preferred sector or vertical of expertise.
There is even the potential for family offices to invest into venture funds as well as co-investing directly into selected portfolio companies. This enables the office to gain exposure to different strategies, investment stages, and risk levels in a proactively managed manner, but without the need to hire a full-fledged operating venture team.
“Combining direct investment with a third-party fund-based strategy helps to diversify our risk,” notes Aisher. “Our VC partner won’t necessarily like the same deals that I like, but I trust them to make the right judgment calls. Further, if I really like the look of a business that the fund has invested in, our fund manager is always happy to set up an introduction and allow me to get involved directly.”
As with all VC relationships, the hybrid model requires genuine alignment between the LP and venture team, with the latter able to demonstrate its willingness and ability to support the portfolio companies and keep the family office firmly in the loop on fund developments. Alan Merriman, Executive Chairman at multi-family office Elkstone Partners, suggests that the VC industry could also do more to improve the scope for more co-investment opportunities, so this is an area for potential growth in the future.
“If VC funds found a way to provide more optionality for family offices around each individual portfolio investment, this could be a real win-win,” he says. “This would deepen and increase the pool of money being allocated by offices.”
There has never been a better time to invest in startups, with demand for new digital solutions greater than ever, and some seriously talented founders putting new tech and funds to good use. It is also becoming easier for family offices to get involved, thanks to a maturing venture sector offering a range of specialist expertise, entry points, and ways of working. However, there will always be offices that wish to take a more entrepreneurial approach and more power to them. But whatever strategy is adopted, it is important to remember that venture investing is a hands-on activity, not unlike building a business. To avoid the pitfalls, it requires a diligent and considered approach, but get it right and it can be an exciting and rewarding activity– in more ways than one.