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How VCs Structure a Syndicate and Recruit Coinvestors

When I meet with other VCs, family offices, and other institutional investors, the most common question I get is: “What are the highest-potential companies in your portfolio which are raising now?”  I thought it might be helpful to provide transparency on how we and many of our VC peers think about optimizing the cap table for our companies.  

First, a formal definition: According to Capital Dynamics, “Co-investments are direct investments in a company made alongside and on the same terms as a lead [General Partner].  GPs strategically invite trusted [Limited Partners and others] to co-invest, often based on the LP’s ability to add value or when the amount of capital required to complete an attractive transaction is larger than they are able to invest alone.”

We see our potential coinvestors in four primary buckets:

1) HOF Capital’s own limited partners.  Some are very interested in coinvesting, and naturally we prioritize their interest above others.  

2) Investors with very specific value-add.  These firms typically have deep, industry-specific operational expertise which validates the investment, and often have relationships with potential early clients.  The ideal coinvestor in this bucket varies wildly depending on the underlying company’s profile.  The challenge with most such independent investors is that they, quite reasonably, all have their own independent decision-making and due diligence process.  They don’t automatically invest just because we invested; they usually move more slowly than the company’s management team wants.   

Sometimes we’ll reach out to individual angels, not just funds and family offices.  Even if the angel’s check is small, the right angel can be very motivated to help the company.  The average angel’s check is usually a higher percentage of their AUM than the check written by an institutional LP, so the angel is sometimes more motivated than an institutional investor to accelerate the company.  Harvard Business School Alumni Angels of Greater New York Fast Track offers a company quick visibility to serious potential investors, some of whom can be very additive.

3) Other VCs, especially those who specialize in coinvesting.  The purest example of this are VCs whose strategy is almost exclusively to coinvest, e.g., some of the funds managed by Alpha Venture Partners, Connectivity Ventures Fund, Correlation Ventures, Proof.VC, and Service Providers Capital.  Alpha Venture Partners’ and Correlation Ventures’ founders all have strong operational backgrounds; that said, they don’t typically serve on boards and don’t get as involved in company management as many other VCs.  They are comfortable with others taking the lead.  

4) Crowdfunding platforms, e.g., Angel List, Crowdfunder, FamilyOfficeDeals.com, Gust, OurCrowd, and SeedInvest.  These firms can typically target a large pool of individual value-added investors, surfaceable by industry, region, title, and expertise to support the company.  Although EquityZen is primarily an online marketplace for secondary shares in private companies, they also offer syndicated primary investments.  AngelList now runs several institutional “platform funds”, e.g., Maiden Lane ($35M) and CSC Upshot ($400M).    

The firms soliciting coinvestment opportunities offer several motivators to VCs to win these opportunities, which I’ve ranked in very roughly descending order of importance (from the VC’s point of view):

Value-add.  Many VCs and family offices market themselves based on their network, internal resources, and other levers to accelerate value creation.   

Certainty.  Fundraising is burdensome.  If I can reduce a portfolio company’s time burden, I create value for them.  When working with institutional, sole-purposed coinvestment funds, the likelihood of them investing is high (>50%) once a credible fund is already committed.  Similarly, there are roughly 1/3 odds that a firm referred by a VC into Harvard Business School Alumni Angels of NY Fast Track will get money, compared with perhaps 1% odds that any random applicant to an angel group will win capital.  Steve Brotman of Alpha observes, “In general, for any co-investor, the higher the quality of the institutional VC firm lead for the new round and the more reasonable the valuation, the better the odds of a coinvestment.  Hence, if Sequoia is the lead and the valuation is reasonable, it’s near 100% chance.  If the company has an unknown, foreign, non-VC corporation as the new lead investor that is investing primarily for strategic reasons, and the valuation is way above market, it’s near 0%.  There are other factors, like stage of the company, the quality of the team, and the market opportunity, but venture fund lead quality and valuation reasonableness are the primary ones as they signal directionally on these other factors.”

Speed.  From the day that a deal is sent to AngelList’s private funds, the turnaround on a decision is 72 hours.  Alpha, Correlation, and EquityZen promise a decision within two weeks, and are often faster.  Crowdfunder’s VC Index Fund turns around the decision in one week.

Clearly stated screening criteria.  Effective coinvestors have very clearly stated investing criteria on their website, which makes it easier for us to determine which investments to send them.  

Economic benefit.  Potential limited partners sometimes say or hint (but usually do not contract) that offering them coinvestment rights will increase the odds of them recommitting to a direct investment in a fund.  Some limited partners have offered to us to staple their investment, i.e. if we bring them a coinvest opportunity which meets their criteria, they will commit contractually to invest in our next fund.  More directly, Alpha Venture Partners, AngelList, and EquityZen provide some share of the carry earned in their coinvest to the referring party for information services.  I place economic benefit from deal-by-deal carry relatively low on my hierarchy, because it’s so uncertain.  No one can say for sure that the carry on any one investment has value, and in any case it won’t pay off for a long time.  

Liquidity.  Investing through a vehicle (as opposed to directly) facilitates relatively easier transfers of ownership, which may make it easier for the company to fill out a round.  Atish Davda, co-founder of EquityZen, observes, “While there are hundreds of ways to put capital into the ecosystem, taking money out remains harder. Liquidity is often easier to attain for investors who own shares in a syndication vehicle that owns shares in the company, as the change in ownership can be changed at the SPV level, rather than having to involve the company. This is especially true for partial transactions meant for portfolio rebalancing, which may become a distraction for the company.”  This is primarily an advantage for the underlying investor in the company, not the VC leading the syndicate.  

Market Insight.  Correlation Ventures has arranged a recurring scheduled call with me 4-6 times/year to discuss live deals where they may be a fit.   Alpha pursues a similar model.  Alpha organizes about 2 networking events a quarter, including periodic high-end dinners at the James Beard Foundation, opportunities to meet fellow investors (including an exotic sports car tour), and other touchpoints with the VC and entrepreneur community.  These all help to maintain the firms’ brand awareness, and I get a lot of useful market insight from these conversations.

If you are an institutional investor or large family office looking for coinvestment opportunities, I suggest you offer as many of the motivators above as possible.  If you are a high net worth individual, the simplest way to join syndicates is either invest in an institutional VC, and/or join one of the online investment networks or reputable angel groups.

For further reading:

Making Waves: The Cresting Co-Investment Opportunity (Cambridge Associates)

Private Equity Coinvestment: Best Practices Emerging (PWC)

Issues to Think About in Diligencing a Coinvestment Opportunity (Shelly Hod Moyal, founding partner of iAngels).  

Thanks to Jeff Barnett and others for thoughtful input.  Cross-posted on PEHub.

 

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