Over the past decade quantitative easing has suppressed fixed income yields globally, this has led to a surge in equity investment. With stock markets showing lower returns, venture capital has become increasingly popular amongst private investors, especially with the significant tax incentives available. Here we look at how institutions tend to invest in venture capital to explore what private investors can learn. The huge increase in valuation of major tech companies has also increased private investor appetite wanting a piece of the action.
The amount raised through VC has increased by 18 per cent annually since 2015.
$254 billion in 2018 was invested globally into over 18,000 companies via venture capital financing and $75 billion invested in Q1 2019.
It has long been considered easier for private companies to grow faster than listed competitors assuming they have access to the right level of funding. With the increased levels of investment, VC companies are staying private longer resulting in bigger exits to investors. Global VC exit proceeds have grown from $70 billion in 2010 to $300 billion in 2018.
Specialist investment funds dominate the market, for example 72% of sovereign wealth funds now invest in VC deals directly. So what can private investors learn from the way institutions strategically invest into venture capital?
Investment in venture capital can be broken down into different stages – Seed, Series A and Series B.
Seed investment –also known as the start-up stage. This can range from companies with little more than a concept to those with a finished product that has successfully passed the R&D stage. Crowdfunding and angel investors together with friends and family are the first port of call for seed investment.
Series A – the business acceleration stage. This is where a private company has a market tested product, is revenue generating but pre-profit. Funds are generally utilised to scale up on the company’s existing, proven market strategy. Pre-money valuations will typically be between $6 million and $20 million.
Series B – follow-on investment where the company has accomplished certain milestones in developing the business and has established a significant market position. It is not unusual for companies to raise hundreds of millions of dollars at this stage at a much higher valuation than the Series A round. This is typically the earliest stage that private equity funds will consider taking a stake.
Investing in Series B rounds has a much lower risk profile than investing into start-ups, at the same time the targeted returns will be much lower.
Institutional and corporate investors recognise that investing in early stage VC is a game of the few haves amongst the many have-nots, with a low percentage of winners. For that reason, investors will expect stellar returns from the successful early stage VC investments.
Irrespective of the amount of due diligence you perform on a start-up business, investing at this stage is a clear numbers game. Funds will look to spread the risk across a number of equally sized investments and most importantly will make sure they have first refusal on the next round of funding. This way they will carefully monitor their investments in the start-ups and look to maximise exposure in the best ones.
They will also have clear investment strategies in an attempt to maximise returns.
For example, one fund I know that invests in the most transformational technologies, including Artificial Intelligence and Fintech, has the following strategy:
A maximum of 25% of the fund will be invested in up to one hundred different start-up companies.
75% or more of the fund will be held back for the Series A stage of typically the four or five companies that have shown the most growth.
This means the fund is keeping its powder dry until it has a clear picture on the company’s growth outlook having carefully monitored the performance of the management team, assessed sales and marketing strategies and whether revenue forecasts have been hit.
What about investors who do not have the means or expertise required to follow this institutional investment model?
Our service is designed around the needs of investors – whether that means a short summary, deep analysis or somewhere in between – we have you covered. Between us, CSS Europe and the directors of the investee company, we are confident we can provide the answers to pretty much any questions raised.
At CSS Partners we have moved away from investing in start-ups and prefer to back companies with a market proven product, investing alongside or even after institutional investors. At the same time, we will only consider investment opportunities with considerable growth potential so successful exits can more than make up for the have-nots. Our stringent selection criteria means opportunities are harder to find resulting in typically a maximum of four new investment opportunities a year.
Investors in CSSP backed companies will often use the significant tax breaks of the UK Enterprise Investment Scheme to help mitigate the risks of venture capital and maximise returns.
Private Markets Come of Age McKinsey Global Private Markets Review 2019 – McKinsey & Company
State of the Venture Capital Industry 2019 – Investors and Funding
CSS Partners has raised over £175m for entrepreneurial companies since 2001. To learn more about how we enable private investors seeking higher capital growth to invest with confidence in smaller companies click HERE.
Investments offered by CSS Partners are not appropriate for all investors. Our free client service aims to be of benefit to high net worth and sophisticated investors looking to achieve higher returns.
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Any views or opinions expressed in this blog are those of the author alone, except where specifically stated that they are the views of CSS Partners LLP.