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Venture Capital

Partnering With Early Stage Experts Can Offer “Mega Funds” Better Chances of Success

The news of Softbank’s $23bn loss on recent tech investments has been the source of widespread discourse, largely as part of an ongoing narrative around the tech bubble ‘bursting’. Indeed, the company itself has put the loss down to the “global downward trend in share prices”, “concerns over economic recession” and “the decline in the fair value of private portfolio companies.”

The reality, though, is that while those factors will have played their part, the issue is strategic at its heart. The “mega fund” allocation strategy is principally a ‘two headed monster’ with the key driver being the need to allocate lots of money to start-ups fast. The mega fund typically comes in late and at high valuations. This strategy only works in the bull market, leaving the mega funds exposed to good old market volatility. The Digital Horizon Launchbay Index of pre-IPO companies from various industries fell by 20.8% year-on-year, compared to -21.7% for the Nasdaq-100. Looking in particular at private/public gives a sense of correlation. For example, the cost of private company Klarna’s stakes fell by 87% between June 21 and now, compared to 86% for Affirm, which is public, over the same time period. Revolut and Chime's shares fell by 48% and 53%, respectively – both private – compared to 60% for the public NuBank.

The second common strategy is to come in with large ‘spray and pray’ tickets at the early stage, which presents enormous business risk. We believe both of these approaches are flawed and an alternative approach could offer more success in the longer run.

Early-Stage Investing Requires Specific Skillset

The critical factor to bear in mind is that successfully investing in early stage start-ups requires a very distinctive set of expertise, which are different to pure ‘investment types’ typically found in the so-called mega funds. Deep product, industry, operational and technology knowledge are all required, in order to add real value in those initial rounds, in addition to, importantly, senior partners’ time!

For example, you need to spend an absolute minimum of a day a month on a startup to add real value. In one month that equates to a maximum of 20 startups at seed or series A stage with an average ticket of £5-7m. That means that the partner can realistically look after a maximum portfolio of £140m at one time – which is a generous estimation, as a partner’s time is also allocated to fund raising, sourcing and operational issues. That means that on average, a team of four experienced partners could manage up to £600m, not billions. Following that logic, “mega funds” need to partner with  5-10 early stage feeder funds.

Early stage specialists should offer start-ups hands-on advice on the plethora of issues a rapidly scaling business will face. That could include legal or regulatory issues as they expand into new markets, making decisions about where to prioritise limited investment funds (in the face of multiple options for product/service/backroom infrastructure upgrades), or how best to balance retaining customers and winning new ones. The list goes on. That demands operational, industry  as well as investment experience, each and every time. The support needed goes far beyond pouring large sums into growth marketing and sitting in on board meetings.

With that in mind, it’s arguable that the ‘feeder model’ approach is the most appropriate investment strategy for mega funds. But what does this look like? Put simply, the feeder model works on the basis that industry specialist early-stage funds work with mega funds to develop start-ups in the earliest stages, building them up to the point where they can maximise the benefits of later stage funding. The mega fund invests into the earlier stage funds, while securing pro rata and extended co-investment rights for itself.

Partnering with an early stage ‘feeder fund’ expert can offer mega funds looking for investment opportunities huge advantages. While some funds do have such programs, most still don’t.

Firstly, the feeder fund will have skin in the game. They won’t act like traditional scouts, who are often motivated purely by closing the deal and moving on. As a result, they will invest time and funds into building strong and long-term relationships with founders, which helps to secure larger allocations in future rounds.

We also find that founders are more open to receiving investment from a feeder fund than from a scout program. They can often be concerned that the scout program’s main fund won’t invest in future rounds, which can reflect badly on the start-up and impact investment opportunities. By entering into a partnership with an early stage specialist, mega funds can add rigour to their investment strategy and, ultimately, increase their chances of better returns.

Opportunities Remain, Despite the Economic Gloom

Despite the looming economic downturn, early stage opportunities remain while tech progress and innovation continues.

Start-up investment will be driven by genuine problem solving in the coming months. The question for investors is “what is going to make people’s lives easier?”. It could mean smoothing income for gig economy workers, helping SMEs unlock valuable funds more quickly, or helping brands invest in marketing as cost effectively as possible. Time will tell.

One silver lining from the cloud of a looming economic downturn is that it highlights where the need for innovation is greatest, and this helps us focus on the right investments.

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Alan Vaskman is Founder and Managing Partner at Digital Horizon

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The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group

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