How to Scale Early-Stage Investing

English: Diagram of venture capital fund struc...

Before making the decision to join ff Venture Capital, I did some research on early-stage tech investing as an asset class and how it’s evolving. What was striking was what an attractive asset class it was. Although any given early-stage company is quite risky, when aggregated across a large portfolio, returns are very attractive. There is low exposure to many risks that investors inherently have in most of their other investments, e.g., interest rate volatility, exchange rates, macro factors such as unrest in the Middle East, commodity fluctuations, unfunded pensions, etc. In addition, angel investments historically have a low correlation level with other asset classes, given the nimbleness with which small companies can adjust to changes in the economy, and the great diversity of companies in the typical early-stage portfolio. They’re also inflation-hedged.  As a result, various analyses have shown annualized median returns for the industry of 18-37%27%, and 30%.

From the point of view of a limited partner, the great challenge is scaling the business.  I’ve seen an estimate that the total amount of money in all micro-VCs combined is $400m, which is smaller than many individual positions a large hedge fund would put on.  Countless pension funds and other LPs need to get returns on billions in assets, and early-stage VC is inadequately large from their perspective.

We think there are a number of ways to scale the early-stage investing business:

–       Templatizing the entrepreneurial process, by providing checklists, standardized agreements and other reuseable code.  We’re already doing this; see some samples.  All of the accelerators are doing the same, to greater or lesser extents.  This enhances our ability to work with more companies, thereby increasing the amount of capital we can put to work.  This also should lower the failure rate of our companies.

–       Providing standardized operational support for portfolio companies.  We have eight full-time employees and 5,000 square feet of office space to help our portfolio companies.  We provide hands-on support through our in-house operating team, plus a proprietary network of outside mentors who work with portfolio companies on an as-needed basis.  Our finance team acts as an outsourced CFO.   We particularly help companies in raising capital for subsequent rounds from top-tier late-stage investors.  We see other VCs pursuing a similar strategy.  I am now leading a team of 3 Columbia MBAs (ex-McKinsey & BCG) on a research study on “Best Practices in How Venture Capitalists and Angels Add Operational Value to Portfolio Companies”, which we plan to publish (details soon).  We’ll likely expand our efforts in this area over time, e.g., by adding recruiting support.

–       Semi-automating the investing decision, by using internet tools to generate idea flow, and ideally by leveraging the data from these online platforms.  There are at least 100 online communities for small companies to connect with investors but in my experience most attract the lowest-quality companies.  There are two resources that I’d highlight as particularly attracting higher-quality early-stage companies: Gust (formerly Angelsoft) and AngelList.  A number of other companies are trying to create online markets for private companies, but focused more on the private equity mid-market and/or other asset classes which are not really our space, including but not limited to AxialMarket, BizBuySell, CapitalSphere,  DealMarket, PEGBASE, PE-Nexus, SecondMarket, and MergerID.  Gust and AngelList have a clear opportunity to build analytics products on top of their platform, similar to Quid and Navon Partners, and similar to what YouNoodle was working on prior to pivoting.

–       Keeping the ratio of value of dollars under management to partners low. First Round Capital is an example of this.  If you calculate the dollars under management and divide by the number of Partners, they have one of the lowest ratios of any VC in the US with over $100m in assets.

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