Intro to Venture Capital Investing

By Karl Rogers - Chief Investment Officer at Elkstone & Forbes Councils Member

Venture investing is investment in early-stage and growth private companies.

These venture companies are not publicly available and can pose many risks not generally associated with public companies. These risks include founder(s) working relationship, product execution, product-market fit, business model risk and strategy execution. In addition, as such companies are not publicly available, venture investors tend to have experience, a network and the due diligence infrastructure set up to source, analyze, invest in and help grow venture companies.

A venture investment strategy should be considered high-risk due to the likelihood of any one individual investment resulting in a zero-dollar return. This tends to stem from the above risks inherent in an early-stage company versus mature, public companies.

We can think of a commonly known breakdown within the "early-stage" venture fund space: A venture fund manager expects on average three or four companies out of a portfolio of 10 venture companies to fail, another three or four to return the original investment (i.e., no profit), and one or two produce substantial returns. This means that close to 75% of companies don't return any additional capital (or lose all capital) while the entire fund plus its total return comes from a small percentage of its portfolio. Importantly, when investing so early in a company's life, it is impossible to know which company(ies) will represent that small percentage.

Venture Market Characteristics

High Returning

Venture capital has shown to be one of the higher-performing asset classes over the past few years. As markets are private, data can be hard to come by. However, a good barometer is the Yale Endowment, which has been investing in venture since 1976. It is widely reported that the large 2021 endowment returns were driven by their venture portfolio.

Persistency

Persistence includes continuous refinement of investment selection and due diligence and the fact that venture capitalists are more than passive investors; they are strategic partners. Top venture players get known as being good limited partners (LPs) and typically receive better deal flow on the back of it. Examples of how venture firms help their companies include founder guidance, opening up their network, stepping in to help solve problems and helping to bring investors into future rounds.

Power Law

Diversification is important in every investment strategy. However, based on my experience, in no other asset is it more important. As a rule of thumb, diversification tends to provide both portfolio loss reduction but also portfolio return reduction. However, in venture capital investing, the power law states that the more companies you add to your portfolio, the higher the return expectation. This asset class has a rare characteristic where reducing the risk of your portfolio through diversification can actually increase the return expectation from the portfolio at the same.

Liquidity/Time Horizon

From my perspective, venture investments into early-stage companies should be seen as an investment for 10-plus years. It can be one of the longest investment cycles within an investment portfolio. The trend is also toward longer periods before receiving the end result/liquidity from the investment. Due to the amount of capital within private markets, companies do not need to go public for funding as they can access funding for longer periods of time from the private markets.

Investors should expect the bad news (failing companies) to happen earlier than the news of success stories where funds are being returned. We, as humans, tend to look for instant gratification. However, one must remember what Warren Buffet is often credited with saying: The markets are a device for transferring wealth from the impatient to the patient.

Valuation Vs. Fundamental Health Check

Lessons from professional sports can often translate to other sectors like the business world. I recently spoke with a former Irish rugby player and 6-Nations Grand Slam Champion about complete, unwavering focus on controlling the controllables. From a company founders’ perspective, this reminded me about speaking to a company’s valuation versus the company’s fundamental health check.

Valuation is the multiple the market multiples your revenues by to determine your firm’s valuation. Valuation is based on the market macroeconomic conditions and sector trends. Market conditions cannot be controlled by anybody. Valuations are taken at a specific point in time. Unless that round and that valuation is your liquidity exit, it quite simply is a paper mark at that point in time and begins to change as macro conditions change.

What is most important is the health check of the company during the reporting period. You can ask questions to understand the signals of the true trajectory and health of the underlying company: What is the burn rate? What is the revenue growth rate? What is the client increase? How did all those metrics compare to the forecast or objective over that period?

These are examples of what firms can control and try to execute. The paper valuation has value in relation to funding and dilution, however, as the venture world would say, "you can’t eat it."

Key Takeaways

Venture investing can often be portrayed as an attractive proposition, as we tend to hear only about success stories in the media. But, venture investors will speak to how it often feels like being on a roller coaster. For new or existing venture investors, the main advice I can provide is:

1. Consider starting your venture investing with a firm that has the sourcing, access and top-quartile track record.

2. Build a diversified portfolio over time. Stick to the initial plan despite luck, or lack thereof, at the beginning of strategy implementation. We have seen through our own venture investing that investing over time/across multiple vintages typically produces better overall returns.

4. Size evenly into companies that are at the same stage of their life cycle.

5. Care more about the fundamental health of a company instead of the valuation that one boasts on paper at a particular point in time. During the investment period, you typically want continued fundamental growth. An exit will be timed based on the uncontrollable valuation multiplier.

6. Expect failure to come earlier while you want your successful companies to continue to compound at high growth rates.

Investing in early-stage companies can be an exciting journey—but only if you approach it with a well-prepared strategy.

The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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