The Future of Family Office Investing: I

Practical lessons from 3 years of putting capital to work

Part I: Venture Capital & Early Stage Equity

Hello there, I’m Mesh. I’m in year three of managing our personal family office.

It’s a small operation, mainly just myself, but we have created a pretty robust investing ecosystem. Our allocations consist of both public and private investments. Our private investments are the result of the network we continue to build, and the value we can provide. This has given us access to high quality equity and debt opportunities. See here for Part II: Investing in Tech & Private Credit.

A Brief Background

I spent 2008–2014 at a long/short equity/equity derivatives family fund. I took over our current family assets in 2014. The stock market was reaching peak valuations and interest rates were near zero. We had liquidity with our public equity portfolio, but we lacked income and growth without the volatility of the overall markets. I looked to venture for access to growth, and alternative debt as a means to find income.

We’ll discuss equity now, but I’ll dive deeper into alternative debt in a later post.

Portfolio Allocation

Growth: Venture Capital

The interest in investing in VC has grown rapidly in the last 5 years. The lack of growth in the public markets mixed with the emergence of successful companies like Facebook, Twitter, Uber etc. have driven dollars into venture funds.

Basic VC Facts:

  • It takes 7–10 years for a VC fund to make a return on your investment (if). That’s how long it takes on average for a company to reach a potential exit.
  • A VC portfolio consists of several companies, typically around 30 companies for Seed Stage Funds (early) and less for Later/Growth Stage Funds.
  • Fees are 2/20%, with about a 3 year investment period for Seed Stage funds.
  • A majority of the companies in a 30 company portfolio will fail, and the fund is dependent on its “winners” to return the fund + profit.
  • A top quartile VC return is around 3X your investments in that 7–10 years. That’s a compounded 12% annualized return for 10 years.
  • Most VCs won’t return 3X, let alone 2X. There are only so many successful companies and there’s only so much room in each deal. Access is everything.
  • The average public market return is a 7% annualized return over 10 years. The added risk of a VC portfolio, lack of liquidity and uncertainty equates to the need to receive 3X + in order to make it worth the investment.
  • High risk= lower allocation in the overall investment portfolio. Typically 1–10%.

Given returns take 7–10 years, it’s hard to know whether a newer VC fund has what it takes to provide returns. You’re generally looking for whether they have access to good deals, and if their previous experience provides enough:

  • Experience on what makes a good deal.
  • Value to the company to be allowed in the deal.

Funds that have previous success (USV, First Round, Lowercase, Accel, Benchmark & Sequoia) are usually oversubscribed and are hard to get into.

  • This can sometimes be hard to understand for people coming from public equity or PE backgrounds. Access is a very important factor in venture investing.
  • Most times a deal has been subscribed or over subscribed before you’ve even heard about it. Founders choose who they want in their deals. I’ve seen companies not allow certain investors to participate.
  • Your capital has no clout. If it does simply by the amount you’re investing, then I would be concerned about the deal. Value is your understanding of the market the company is competing, the ability to make strategic introductions, assist with hiring needs, and general guidance on execution.
  • Access can be built over time. However this is a very competitive industry with limited room, and it’s already oversaturated.

Our Approach to Early Stage Venture

I was involved with startups and tech for a couple of years prior to taking over our family office. I was already aware of how the industry was shaped and who were some of the mainstream players.

Being familiar on the surface is helpful in the beginning, but as you dive in you will realize it’s a very closed group of people. Relationships matter a lot, and building those relationships take time.

VC Portfolio

Red Swan VC

My first investment was becoming an LP in Red Swan VC (Red Swan III), a seed stage fund based in NYC. Finding funds that are raising capital is dependent on your network. I heard about Red Swan because the founding partners had a good reputation with their angel (personal) investments. Through my network, I knew they were raising a larger fund, and I asked for an intro. The introduction came from a friend of mine that was deeply involved with the tech community in NYC.

My Criteria:

  • Deal flow: The partners at Red Swan III previously invested in companies like Warby Parker, Coinbase, and Oscar to name a few.
  • Domain Knowledge: The partners consisted of Founder/CEO roles at venture backed companies: Bonobos, Floored; product building roles: Hot Potato & Drop.io (both acquired by Facebook).
  • Fund Size: The size of the fund met our sweet spot. They were large enough to get decent allocations into seed rounds, but small enough where our check size would matter and meet the minimum requirements.

My thought process was how do I get access to deals being led by the top tier VCs? Red Swan was nicely situated because they were a feeder fund. They received allocations into great deals because of the value they provided to the founders, relationships with other VCs and general deal flow.

  • There are only so many great founders out there. Of those founders, only so many can build a team to create a great company.
  • Great companies want the best investors, so investors who’ve built a name for themselves by providing value and making previous successful investments get access. Those investors have a network of other investors, founders and operators sending them deal flow.
  • Good investors have the ability to negotiate pro rata to get the right to invest in future rounds. Those same investors are also sending positive signal for participating in the deal or leading the deal (they set the terms). Pro rata is the right to invest in future rounds and maintain your ownership %. An investor will use their pro rata when they want to continue to invest in a company they believe have the growth and milestones needed to have a potential “exit.”

Red Swan III:

  • 20+ Investments: Bond Street, MIC, AltSchool, Hightower, among others.
  • Investments alongside: Accel Partners, Spark Capital, Union Square Ventures, Lerer Hippeau Ventures, Collaborative Fund

My second investment as an LP was Notation Capital I, a Pre-Seed Fund based in NYC. Investing in a fund is similar to investing into an early stage company. You’re betting on the team and people. Nick Chirls and Alex Lines are a great team. Previously, both Alex and Nick worked at Betaworks, a startup studio that spun out companies like Chartbeat, Giphy and Digg; and invested in companies including Kickstarter, Medium and OMGPOP. Nick ran seed investments at Betaworks (previously run by Andy Weissman, now a partner at Union Square Ventures), and Alex was a key architect in helping build and scale several of their companies.

Notation Capital invests in highly technical teams that can scale their companies, but don’t need a large amount of capital to get started. They are the first check into a company before institutional money comes in. Their experience, expertise and network provide provide unique deal flow and the ability to invest in valuations between $1M-5M.

Notation Capital I:

  • Access to great dealflow: Notation’s network include investors, founders and operators like Naval Ravikant (AngelList), Amanda Peyton (Product Director, Google), Alex Chung (CEO, Giphy), among many others.
  • Invested alongside: Y Combinator, SV Angel, Lux Capital, Collaborative Fund & Spark Capital.

Angel Portfolio + Direct Investing

I understand that a lot of family offices and individuals want access to direct investing and avoid fees. I think the money paid in carry, is much less than one would lose doing direct investing themselves. At least in the beginning. You can invest on a deal by deal basis and pay carry vs investing in a fund and pay carry. This is called investing in a syndicate. Where you’re paying the syndicate lead a carry % if the deal exits. The benefits are:

  • Being able to review multiple deals which will always build experience.
  • Seeing where you’re able to provide the most value so you can eventually get into a deal directly.
  • Review multiple syndicate leads on a deal by deal basis to find which one is a good fit for you.

This is an alternative to investing in a fund. I’ll talk about how you can do this on AngelList later on. For now, let me share why I suggest this based on my own experience.

Our overall exposure to early stage equity is about 15% of our portfolio. Early mistakes account for the larger allocation into Venture. Those mistakes were centered around a misunderstanding of: access & deal sourcing, valuation & check sizes.

Early Errors:

  • Valuation: High valuations are just represented by a large number. You need to get an understanding of the market cycle, industry, early metrics (users/revenue), team, previous funding & risk. You have to see several deals, let alone invest in them, to really develop a solid understanding of whether a company’s valuation is high or not.
  • Check Size: I made this mistake several times. I wasn’t consistent with my check sizes. I made $10K, $25K, $50k bets in Seed stage companies. Both the $25K + $50K checks have gone to zero, but several of the $10K have gone one to raise multiple rounds of financing. Be consistent. If you’re investing in Pre-Seed/Seed deals ranging from $3M-25M, stay with ONE check size. If you’re then investing in later stage deals ranging from $50M+, understand that risk is taken out and upside lowers, so you can increase your check size. Have a system.
  • Deal Sourcing + Access: This comes out of experience. Just because a founder has a “name” doesn’t mean they’re a good bet. Also, be wary of good marketers. A person’s track record and expertise sell… not how loud their mouth is. Also, when a founder isn’t the one pitching you and it’s a capital markets person or fundraiser, i’d be skeptical.
  • Pro Rata: You don’t make money by investing in a successful company early. You make money by having a solid ownership stake in a company. Pro rata is the right to invest in subsequent financing rounds of a company in order to keep you ownership %, and not get diluted. More on this later. It’s hard to get pro rata rights, and it’s harder to make the decision on which companies to “double down” on.

I adapted quickly and I chose to only co invest along side notable seed investors and pay them carry. Majority of this was done through AngelList, but I also did offline syndicates as well. Remember, carry is the percentage paid on profits of an exited deal to the investor who syndicated the deal.

Example: I invest $10,000 into a syndicated deal. 
Carry is 20%. The deal exits at 10X. 
$100,000-$10,000= $90,000 in profit. 
$90,000-$18,000 (20% carry)= $72,000.

What’s hard about this approach:

  • Model Portfolio: If you’re cherry picking one off deals from different sources, it’s hard to create an actual portfolio. Successful VC funds model their portfolio. How many deals they want to invest, at what stage/valuation, for how much % of a company, while making sure to leave $ for pro rata (invest in future rounds to keep their ownership stake).
  • Thesis: Most funds have a thesis in the types of companies they approach. For example, Union Square Ventures (one of the most successful VC funds in the industry) will invest in companies they believe can become defensible because of network effects.
  • Management: When you’re investing in companies on a deal by deal basis, you’re not getting the entire flow of one syndicate leads deal flow, nor are you getting their management on when and how much to deploy for pro rata. Part of that is knowing what the insiders are saying about current or future fundraising rounds, what the competitors are doing, how hiring (or turnover) is going within the company and having a relationship with the founding team.
  • Ownership: It really ends up becoming about ownership. As mentioned before, VC funds make their money because of their ownership stake in a company that has a massive exit. So the question is, can you or your syndicate lead obtain pro rata rights? If so, will they be able to do so in subsequent rounds and make sure you’re not pushed out by the next lead equity investor, or another investor that brings more value. When a company is hot, elbows get sharp, and investors will make sure they take their allocations in future rounds.

Investors like Fred Wilson from Union Square Ventures generate large returns because of the ability to continuously invest in companies where he has conviction. Below are two examples of IPO’d companies USV invested in: Twitter & Etsy.

USV’s Investment in Twitter (taken from Crunchbase)
USV’s Investment in Etsy (taken from Crunchbase)

AngelList:

I’ve used AngelList to invest in several early stage deals. There are several private deals that get syndicated on the platforms, and they’re 100% private. Investors that receive allocations into deals led by top tier VCs may syndicate them on the platform and charge carry. It’s a great option for getting the “access” that I’ve mentioned several times in this post.

One still has to be cautious about you build a portfolio here. If you understand how you want to build a portfolio (thesis, concentration, ownership), then make sure you’re investing with leads who are not only getting access, but are getting pro rata rights as well. I’ve seen tons of “high quality” deals get syndicated through the platform.

AngelList does offer no-fee, carry only funds for portfolio construction and diversification. More information on these funds, you can visit https://angel.co/access-fund/fund.

Both Dave Eisenberg (Red Swan Ventures), Notation Capital & many notable investors/funds leverage AngelList to syndicate deals on a deal by deal basis. Many syndicate deals offline as well.

Expect to see following posts on investing in alternative debt (our specialty), and more. Email me at mesh(at)mk2c.com

Delayed, but many thanks to: Alex Pack, Dave Eisenberg, Kalsoom Lakhani, Naval Ravikant, Nicholas Chirls & Rennick Palley for reviewing drafts.