Introduction to Venture Capital
Venture capital is a form of private equity (PE) which focuses on investing in start-up companies and entrepreneurs with high and long-term growth potential.
VC financing often involves early and seed round funding and understanding the net promoter score. According to Teoh Capital Private Equity, depending on the stage of the company, how much is being invested, the company’s prospects, and the relationship between the founders and investors, VC will typically take 25-50 percent of new company ownership.
VC firms are managed by investment professionals (normally referred to as general partners or venture capitalists) who make the investment decisions for the company.
As the legal owners of the VC firm, the venture capitalists thus bear unlimited liability. And while they typically participate in the VC funds, their capital commitment rarely exceeds more than 1% of the overall capital.
Limited partners (LPs) are the investors that provide the lion’s share of capital for the fund. They are mainly wealthy individuals and institutional investors, such as banks, insurance companies, and state and private pension funds.
Most funds have a finite, fixed life of around 10 years, with the possibility of an extension of 1-3 years to accommodate companies looking for follow-up funding.
After the fund is dissolved, the proceeds are distributed to the GP (i.e., the VC firm) and the LPs according to the terms set in the venture capital limited partnership (VCLP).
A Little History of VCs
Venture capital was developed as an industry after WW2 by Georges Doriot, a Harvard Business School professor.
Through the American Research and Development Corporation (ARDC), he raised a $3.5 million fund that he pumped into companies that commercialized technologies created during the war. The success of Doriot’s investments propagated the asset class.
Through the 80s and 90s, venture capital underperformed compared to public markets or other alternative asset classes. Venture deals returning less than the capital invested can be attributed to their notoriously illiquid positions.
However, since the aughts, the VC industry has grown both in popularity and activity.
There are success stories of unicorns and other successful one-off investments all over the internet. In fact, many of today’s industry leaders were backed by VCs. Some prominent examples include Facebook, WhatsApp, Twitter, Google, Alibaba, Snapchat, and Dropbox.
These have pushed venture capital to the forefront, with investors seeking exceptional returns.
As a result, the VC space has witnessed an influx of participants, including first-time fund managers. Corporates are now creating venture arms and getting involved in start-up funding. Even celebrities are dipping a toe into the start-up investing craze.
Out with the Old, In with the New
The problem is that many newcomers in venture capital don’t follow the fundamental principles of VC investing. These newcomers are blind to the fact that the mechanisms to create value and manage risks in VC investing are different from traditional forms of investing.
Venture capital investing is sometimes referred to as an apprenticeship business. This means that you learn by doing it, which can take you years or even decades.
The good news is that you can shorten your learning curve and improve your odds of success if you learn and follow best practices from experts who’ve already mastered key parts of the business.
Dale W. Wood, founder and CEO of Dale Ventures, is one such expert.
The Dubai-based global investment firm was established in 2017 and has helped companies make big strides in their fields.
Like other businesses, Dale Ventures was also affected by the pandemic, but the company still managed to find top-tier start-ups to cultivate and fund.
Wood’s portfolio strategy plays a huge role in his success.
Venture Capital Portfolio Strategy
As with investments in financial markets, VC firms typically don’t invest in a single project but rather combine many investments in a portfolio.
According to Wood, “venture capitalists may intentionally spread investments across different industries to either minimize the industry-specific risk of their portfolios or simply experiment by investing in new industries.”
Understanding the various aspects of venture capital portfolio strategy is something anyone in the VC industry should be familiar with. Portfolio construction impacts nearly every aspect of running a fund, and this includes return performance.
We sat down with the serial investor and alumnus of Texas A&M University to discuss venture capital portfolio strategy.
Tell us about your background
DW: After earning an MBA in international business from Edwin L. Cox School of Business, I secured a position as a market specialist at Texas Industries, a construction materials manufacturer.
I launched the company’s first website, an early tech achievement for the company and me. The concept of the internet dates back to the 50s, but it wasn’t until the mid-90s that it started going mainstream.
I wanted a new challenge, which led me to join KForce Inc., a Florida-based professional recruiting firm where I spent time resume writing, cold calling and scheduling interviews. This was back in 1997, and due to my hard work, I quickly rose to become the team leader.
I saw what they did at the company and was determined to carve out on my own in the quickly evolving world of online business. The entrepreneur in me needed to break away from the structured, traditional office environment and venture into different global markets.
I quit my job in 1999 and used the contacts I made in the staffing business to find, lead, invest and manage multiple internet-based businesses. This phase of my life gave me valuable experience in identifying talent and growth potential on a sustainable basis.
My real-world exposure showed me that it was finally time to explore other industries as the IT industry was becoming over-saturated. Real estate, finance, media, healthcare, and technology were on the brink of huge transformations.
Using the same know-how that led me to decades of work with start-ups and industry innovators, I embarked on a new path and founded Dale Ventures in early 2017.
I have helped many forward-thinking innovators turn ideas into successful companies by focusing on a value-added investment approach. Notable mentions include TechMet, Huma, Instanda, Arcadier, and Rayo Credit.
My company’s portfolio includes start-ups, turnarounds and carve-outs from bigger corporations.
You seem to have a lot of passion for start-ups? Any particular reason?
DW: Start-ups are the most important vehicle for spurring technological innovations.
These young and small-sized companies face the challenge of operating in always-evolving and highly volatile industries.
My view is that as VC, I can help these start-ups realize their potential by providing financial support, market expertise, and industry contacts.
Many studies have shown that venture capital-backed start-ups are, on average, significantly more successful than non-venture capital-backed start-ups in terms of profitability, innovativeness, and share price performance upon going public.
What does portfolio management entail in your book? And what’s its significance?
DW: As it relates to venture capital, portfolio management is a strategy that VC investors use to safeguard and increase the value of their investments.
Proper portfolio management encompasses information analysis, intelligent decision-making, and resource commitments, all intended to accomplish the value increase and stability of the investments range.
Portfolio management consists of 3 key areas:
Market research and oversight – As a VC, you need to be savvy and updated with the most relevant and real-time news about the industries that your investments sit in. Sometimes, venture capital firms focus on a type of investment (seed, stage, later stage), and other times they’re industry-specific.
But more often than not, VC firms are industry agnostic, meaning their portfolios may be made of many different industries. Being on top of market and industry performance will help VC managers make smart investment decisions at all stages.
Risk profiling – It goes without saying that venture capital investing as a whole is a risky business. But having a clear understanding of the period it will take to gain an ROI is vital. This also goes hand in hand with market research when choosing your portfolio management strategy.
VCs should profile how high of a risk every investment will be by knowing the approximate time it will take to recoup their investment back and the probability of doubling or tripling their investment. When managing new investments for a portfolio, it’s critical to consider the balance of quick return with high potential.
Exit strategies – Many newly minted VC managers typically outline how they hope to exit the business eventually. This plan includes pinpointing exit targets and proper negotiation engagement in best- and worst-case scenarios.
Exit strategies may include acquisitions, mergers, buyouts, or public offerings. It’s vital to outline an ideal exit plan in your portfolio management strategy. This will help you better moderate risk and recognize the potential results and value of your portfolio.
How did you create a winning strategy?
DW: Generating a well-thought-out investment strategy is critical if you want to build a high-performing portfolio of early-stage companies. This is especially true if you want the portfolio to generate acceptable returns.
The problem with most new venture capital managers is that they put all their focus on “discovering great companies, funding them and waiting for big financial returns.”
While having the connections, skill and foresight to invest in big winners are important for the success of an early-stage fund, there’s so much more to running a VC firm than leaping in, finding companies and slinging cash around.
And while this strategy is directionally correct, in reality, it’s extremely rare to come across that type of successful investment. Fund managers shouldn’t set out to build their portfolio by assuming they’ll invest in one of these 1000x return deals as the core part of their investment strategy.
So, here’s how I created a winning strategy:
- As an experienced venture capitalist, I invest in people, not ideas. Since ideas are more malleable, I apply more emphasis to assessing the team behind them.
- I pick a company with a significant addressable market size. You can either make many bets to better your chances of finding good companies or select fewer investments but commit yourself to help these companies to succeed. The vast majority of your fund’s return will be generated by a small number of companies in your portfolio.
- I look for scalable start-ups. Founders of a scalable start-up believe that they can make obscene returns by either creating a new market or disrupting an existing market and winning customers from existing companies.
- Timing is everything, which is especially true when it comes to VC investing. Even with a good idea, business model, and execution, chances of success decrease drastically if the timing is not right.
- I also use my past experiences in determining patterns in investment strategies and the most effective method to interpret various potential investment outcome scenarios.
So, ultimately, VC portfolio management boils down to understanding the delicate balance of quantitative and qualitative information regarding the investments in your portfolio.
What portfolio management metrics can VCs use to track their portfolio performance?
DW: The first metric is financials and cash position. As a VC, you want the truth about how a company is positioned financially. You will want to know details such as their monthly and annual operating budgets, how much money they’ve previously raised, any profits to date, and the amount of runway they have left from current investments.
This info will help you determine if an investment fits into your company’s portfolio, how big of an investment you should consider and what a potential exit strategy might look like.
Another metric to track your portfolio performance is true north KPIs. This metric should be considered a key performance indicator that guides a business daily. Beyond revenue goals, other KPIs can include active users/customers, a customer net promoter score, or average contract value.
The third metric is ownership and cap data table. If you’re looking to make a new investment, how much ownership you will have in the company is a key component you will consider for your portfolio management.
Ask for information like the percentage of the company that’s available in exchange for investment as well as how much is already taken. Besides clear ownership break-down, ask for info about the company’s securities.
How do you handle decision-making?
DW: VC investing is as much about the deals you choose to be involved on as it is about the deals you choose not to participate in.
I always ask the right questions and ensure I have clarified who gets to vote on investments, whether any single partner can make or kill a deal, etc. I also see that the rules of engagement are established upfront. This gives me decision clarity.
This is how I see it. 14 years is the life of an average VC fund. You’re likely to invest through at least one major global crisis within this period. Having a clear guideline in place will help you make crucial, difficult decisions quickly in such tough times.
How often do you change your investment strategies?
DW: As a VC, you have to be proactive. That means being ready to change your strategy if the target market around you changes.
But remember that potential investors of tomorrow will scrutinize your results today. They will assess whether you accomplished what you set out to do and how well you performed relative to those objectives.
There’s no problem if you change your investment strategies when the need arises. Just remember to communicate and explain any changes. Your partners will appreciate consistency in your strategy.
Can you please share one simple but priceless portfolio strategy that most VCs ignore?
DW: VCs should consider assigning one partner whose duty will be to oversee the whole portfolio.
Many VCs make the mistake of viewing their portfolio as a collection of individual companies rather than a capital pool expected to produce aggregate returns over a five to ten-year period.
In light of the above, letting one partner worry about the total portfolio while others handle individual companies could help your team move past your deal/my deal level.
What are some of the things to avoid when creating a portfolio strategy?
DW: One thing that comes to mind right now is not having capital reserves for follow-on investments.
I’ll tell you this from experience. There’s no worse feeling than losing out on the benefits of a deal just because you lack the funds for follow-up capital.
Many of these emerging VC managers put too many companies into a portfolio to a point where they run out of funds and can’t participate in follow-on rounds.
Reserving capital for follow-on is, how do I put it, your portfolio’s lifeblood. The best VC firms follow this tip religiously and benefit immensely from it.
So, clearly establish your reserve policy, suggest reserve amounts and review them often with all partners, and be prepared to shift reserves accordingly when the need arises.
What advice can you give emerging start-ups?
DW: VCs take portfolio management seriously because they want to see their investments succeed and make money.
Because of this, VCs normally incorporate many other opportunities and touch-points besides putting down the initial investments. This can include making hiring decisions, acting on metrics, and making strategic product decisions. By helping their portfolio companies, they’re also helping themselves.
As a start-up, fostering a close working relationship with your VCs and investors can be a competitive advantage that will make or break your company.
These competitive advantage points are also part and parcel of a successful portfolio management strategy.
What’s your prediction for VCs in 2022 and beyond?
DW: Amid an economic recovery rife with geopolitical tension and market volatility, global markets are gradually finding their way toward normalcy.
We’ve just come from the first quarter of 2022, and nobody knows what the rest of the year has in store. Still, if 2021 is anything to go by, we could witness another wildly successful year as venture capitalists look to establish dominance among their global counterparts.
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