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Where’s my unicorn: Are ordinary investors missing out on venture capital returns?

Note: While as ever this article is not personal investment advice, know that do I own a few shares in Seedrs [1]. Also if you follow my links to Seedrs and try their platform, you can get a £50 investment credit and I may receive a small marketing fee.

Over the past 15 years, advances in technology – smartphones, Cloud-based storage and processing, and low-cost software development – have enabled entrepreneurs to scale up massive companies with little outside capital.

In 2014 Facebook paid almost $20 billion for WhatsApp, a messaging service only five-years old.

WhatsApp had just 55 employees at that time, and most of the momentum that took it to 400 million users came from seed capital1 [2], and some later venture capital (VC) funding.

That was enough to grow it to a valuation of c. $20 billion!

WhatsApp is not unique. The current implied valuations of unlisted start-ups like Uber and AirBnB make the billions Facebook paid for WhatsApp seem stingy. These disruptive giants – again just a few years old – have made their early seed investors rich and delivered stellar returns for VC firms.

Previously it would have taken a couple of decades for a new industry to grow into the $20-billion deal bracket.

Along the way, at least some of the leading companies would probably have floated on the stock market.

But these new behemoths achieved scale without us ordinary stock market investors getting a look in.

It’s not unprecedented, but it is a conundrum.

When capitalists don’t need capital

Of course the initial money for startups has always come from friends, family, and angels [3] (wealthy individuals).

Later and more substantial financing comes from VC funds (especially in the US tech sector) and strategic partners such as big firms in adjacent sectors.

But most founders with global ambitions previously had to tap the public stock markets for the booster fuel needed to achieve multinational escape velocity.

A wider range of funds – and even ordinary punters – could then buy into these still relatively small firms when they floated on the stock market, via an IPO [4].

And after that, anyone could buy their shares.

In today’s low-capital startup world, however – where it takes takes barely a Love Island villa’s worth of talent to create companies worth billions – we might wonder whether we’re missing out on growth that has previously made up part of the reassuring historical returns [5] seen from owning equities.

Most startups amount to nothing, but the best become the giants of tomorrow. They grow from small winners into middle-sized companies, and some into stock market titans.

True, Uber and AirBnB will probably float some day. (If only so their employees can easily offload the shares they’ve earned.)

But given the vast scale they’ve already achieved as private companies, how much growth will be left for ordinary folk when they do?

I don’t know the answer, but I think it’s worth asking – especially given how important the tech sector has been in driving global market returns.

Imagine if the next wave of Amazons, Googles, Microsofts, Apples, and Netflixes all came to the market years later – and far bigger – than they did?

Trillions in valuation growth might never be seen by stock market investors.

The best VC funds don’t want our money, either

If you think this is a problem – I’m undecided, but wary – then the obvious answer is to invest in private (i.e. unlisted) companies for yourself.

This has long been possible, but it’s not a straightforwardly good decision.

Studies paint a mixed picture about the returns from venture capital as an asset class, and it’s hard to get clear data.

Industry promotional material – such as this overview [6] from Barclays – tends to be short on return information.

The picture is complicated by how venture capital goes through feast and famine, wildly influencing the performance of funds of different vintages that raised money at different times.

For instance the FT reported [7] in 2017 that a representative subset of European VC funds that took money at the height of the dotcom boom in 2000 on average paid back just 39% of the money put into them!

Some did much better. But this only raises the perennial question of knowing which funds to put money into.

And while the UK and European VC sector is becoming more established, the biggest and best funds are still based on the West Coast of the US.

These US funds get the pick of company founders and ideas. In the hit-driven game of venture capital, that’s crucial.

US funds would also argue they’re best-placed to help the startups they invest in via their own long-established networks – by introducing them to managerial talent, other investors, potential acquisitions and so on – and so creating a virtuous circle.

You might decide the solution is to invest in these US funds, but the elite ones are usually closed to all but the richest investors and institutions – and some even to them.

Yet the return from these top outfits will skew higher any return figures you see from the VC asset class – even though oiks like us can’t buy into them!

Ways to invest in venture capital

For these reasons and others (notably a lack of liquidity [8] and high fees) most of the writers we rate – Hale [9], Kroijer [10], Swensen, and the lazy portfolio [11] creators – do not see a place for VC in everyday investor portfolios.

But what if you disagree?

There are ways to put money to work in private companies if you’re keen. You don’t even have to move to San Fransisco and fill your wardrobe with chinos.

However all come with challenges – and you’ll need to do a lot of research.

Here’s a summary of the main routes you could explore.

Invest via venture capital funds

The venture capital firms are out there – there’s even a growing seed investing scene in London [12] – but whether you can judge the best funds in advance – or as I say put money into them – is extremely debatable. VC investing is brutal [13], at least for the investors. (The managers enjoy some fees either way.) If you’re a high net wealth type, you’ll find private banks may include VC (or at least private equity) funds in their managed portfolios. Such a relationship might get you access into better funds that would otherwise be unavailable – but you’ll need to don your shark-proof armour!

Investment trusts

There are a bunch of investment trusts [14] that operate in the unlisted space. The majority are private equity rather than VC-focussed. This means your money will be funding things like management buy-outs, expansion at more established companies (including debt raises), and perhaps buying into a portfolio of companies that your trust owns outright. You’ll need to dig deeply to look for trusts with a growth perspective, if that’s your bag. You could even look at something like Neil Woodford’s Patient Capital Trust, or other idiosyncratic trusts that have a relatively high allocation in unlisted firms. Expect a rocky ride – with market conditions and the business cycle playing a big role – and understand that failures happen early in VC investing, so it can look pretty dark before any dawn.

Venture Capital Trusts (VCTs)

Going by the label on the tin, you’d think your hunt would stop here. VCTs [15] come with tax breaks (albeit watered down in recent years) and many do put significant sums into start-up firms. However as a class they are definitely not all focused on high-growth minnows.2 [16] VCTs mostly aim to return money to shareholders via relatively high (and tax-free) dividends rather than in multi-bagging your initial investment. Their high fees make are also a big problem, as I’ve discussed before [17]. I’ve wealthy chums who’ve maxed out their SIPPs and ISAs who love VCTs for the tax-free dividends, but for most of us these probably aren’t the venture capital vehicles we’re looking for.

Angel investing

It’s hard to get closer to the coal face of backing unlisted companies than to do a bank transfer to the founder of a start-up in exchange for a chunk of their shares. Perhaps you’ll even get a say in how the business develops. Results from angel investing will vary extravagantly, and cause your typical Monte Carlo simulator [18] to reconsider its life choices before having a melt down. Angel investors run the gamut from the founders of hit companies like Skype to big fish in small provincial ponds who fancy co-owning a restaurant. Clearly, if you’re looking for the next globe-conquering Tinder or WhatsApp, don’t give money to your mate who wants to open a craft beer shop. The best book I’ve read on hunting for tech companies that might return 100x your money is Angel [19] by Jason Calacanis.

Equity crowd funding

Not many of us can write the chunky cheques required to be an angel investor without jeapordising our future wealth. If you’ve got £5m to your name then perhaps it’s fine to stick £50,000 into several exciting moonshots to hang around with clever 20-something hipster coders. If you’ve only £50,000 in your ISAs and SIPPS, not so much.

Over the past few years, however, platforms such as Seedrs [1], Crowdcube [20], and Syndicate Room [21] have addressed this issue by pooling often very small amounts of money from thousands of individual investors to put money into startups as a bloc.

It works, but there are issues.

In theory these platforms are democratizing venture capital and I applaud that on principle. (I even invested a little in Seedrs).

But in my experience the quality of both the companies listed on these platforms and the investors putting money into them is extraordinarily variable, to put it mildly. This is hugely risky investing, and as the space is so new there’s not return figures available that take into account all the future failures – or at least not figures I find thoroughly convincing.

For the record, Seedrs for instance has claimed [22] a 12% internal rate of return across all-fundraisings on its platform – jumping to over 26% if potential tax breaks are taken into account.

I do judge Seedrs puts a superior cut of companies onto its platform, for what my observations are worth.

But the truth is we’ve not got a long-term to look at with these platforms yet, and barely a medium-term.

Worse, most individuals will likely discover they have a negative edge in assessing small startups. Crowd funding raises are invariably supported by scanty financial details and in a handful of cases what have seemed to me borderline fraudulent business plans. People still back them.

‘Adverse selection’ also looms large. Why are the founders coming to the great unwashed if they could get money from traditional VC funders? Perhaps because they’ve been turned down elsewhere?

On a brighter note you can often meet the founders in person (at least in London) which I believe is far more important with this kind of investing.

I also think there are companies for whom crowdfunding actually makes more sense than traditional fund raising, at least early on. I’m thinking of consumer-facing companies that may benefit from an army of shareholder-promoters.

There are also compelling tax breaks [23] for investors putting money into firms that qualify for EIS and SEIS relief. Most of the tiny startups you’ll come across via fund raising do qualify.

Just remember that however good you are, many or maybe even most of these companies will eventually fail or near enough fail and you’ll lose the money you put into them. Much of that money can be offset by the tax reliefs, but not all of it.

The following graph is typical of the distributions of winners to losers you’ll see quoted:

[24]

(It’s based on [25] US returns from professional VC investors, so if anything it is over-stating the chances of amateur angels striking it big.)

The aim of the game is to be in one or two of the few companies that may eventually break out of the crowdfunding morass to achieve ginormous scale. If you manage this it could make up for all your losers and then some.

Financial firms Monzo and Revolut and the brewer BrewDog have all delivered handsomely for early crowd funding investors. There will be others, but they’ll shine beyond a meteor storm of burnouts and crashes. (One irreverent blog [26] specialises in tallying the frequent failures).

Investing in lots of companies rather than betting on half a dozen is probably the best strategy for trying to get a sliver of a future giant.

But I wouldn’t invest so much that it will make a big difference if you never strike gold. This is lottery ticket investing at its riskiest.

Innovation in venture capital investing

For all the downsides, I have put about 3.5% of my net worth into unlisted companies via crowdfunding platforms.

However I have several diverse reasons to get involved, beyond any returns. (Improving my investing chops, for example.)

I’d urge caution in allocating anything more than play money-sized allocations for even most active investors, let alone passive players.

Indeed there seems to be gap in enabling everyday investors to get exposure to venture capital – and to enjoying those generous tax reliefs – without digging through the business plans of hundreds of mostly doomed start-ups.

The Seedrs [1] platform has recently made some interesting moves in this direction, though I do think its solutions raise new issues even as they address others.

Will they offer a way for passive investors to easily get exposure to start-up companies?

More on that next week – subscribe [27] to ensure you see it!

  1. Seed capital is the first money that goes into starting a new business. [ [31]]
  2. In the past some VCTs even actively avoided VC-type investments as much as was possible within the rules, in order to offer limited life capital preservation vehicles that milked the tax breaks, though this has now been curbed. [ [32]]