Business

Venture, due diligence, and family offices

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An unprecedented $1.2 trillion has been invested in venture capital over the last five years, according to Crunchbase, leading to fears the sector will struggle to digest it. 

The 2019 total of $295 billion, based on a Crunchbase projection, slightly below the previous year’s $322 billion but way ahead of the paltry $48 billion of ten years ago.

You get three to four times [more] interest from venture capitalists and investors if you claim that you have AI, or your solution is AI-driven

The number of deals hit a record 32,800, against 32,000 in 2018. In 2010 the total was 8,200. VC-backed IPOs raised a record $256 billion, according to PitchBook, against $130 billion in 2018.    

Family offices are increasingly involved, pulling off a series of impressive deals. One of the latest to emerge saw US politician Jeb Bush through an investment group called Finback Investment Partners, and Bill Gates teaming up to help raise $30 million for Evolv Technology, which scans crowds for concealed weapons at speed.

US family offices are in the lead in backing tech-driven disruption followed by Asia. After a slow start, European families are stepping up. Few are convinced VC has entered bubble territory, although a few sectors like AI and healthcare are relatively exuberant. 

Bob and Rohini Finch built Vitol Group into a large energy trader over thirty years. Their family office backs London-based Talis Capital, a backer of technology ventures. 

Talis has carried out a survey which found that less than half of the privately wealthy invested in tech-driven opportunities a decade ago. Around 92% of them are now committing. The number of respondents investing more than 20% of their capital in VC has quintupled compared to ten years ago, as the average age of investors drops.

Last week, Family Capital pointed to the importance of bottom-up due diligence in a competitive market.

Following the publication of the article, we are receiving top-down concerns, relating to an excessive flow of funds. According to Jon Flint, founder of Polaris Partners, venture funds are handling so much money that they are forcing companies into taking more than they need to get to the next stage of their development. 

As a result, VC companies have to change their business models in ways which may make profits harder to achieve. There is a risk of over-boarding and directors can also be inexperienced, which suggests family offices may do well to carry out due diligence on lead VC investors, as well as their targets. 

Adviser Stephen Martiros concedes the weight of money may stress some large VC firms. “The dynamic, however, opens the door for smaller/newer VC firms with niche strategies.”

Family office adviser Matteo Dante Perruccio, partner at Wave Financial, and ex-chairman of multi-family office Secofind. He says investors are in a rush. 

“VC investors are overly excited about new disruptive ideas and business models without doing basic homework and due diligence on entry. And, more importantly, on the track record of people running the company. That’s worrying. My experience suggests that success of early-stage ventures is at least 60% due to the people implementing them.”

AI may be one of the hottest areas in the VC world, raising $18.5 billion in 2019, but its complexity can provide cover for poor management. All too few are being picked up, although, in a recent investigation, the Wall Street Journal identified companies attracting more money than they ought to despite their failure to use the AI expertise they claimed.

Vasile Foca, managing partner at Talis Capital, explains: “You get three to four times [more] interest from venture capitalists and investors if you claim that you have AI, or your solution is AI-driven.”

UK-based MMC Ventures has carried out research which suggests that 40% of European startups categorised as AI companies do not use it in a meaningful way.

It is equally hard to form an unbiased opinion of sector prospects, due to a lack of third-party analysis. Data tends to be backward, rather than forward-looking. There were reports last year that drone VCs were facing a serious setback, due to competition from a raft of new entrants. But other reports produced evidence to suggest the downturn was just a blip. 

On the macro front, a tightening of the money supply in China last year saw the value of VC investment fall 77% to $9.7 billion in the second quarter of 2019 from the $41.3 billion invested a year earlier. The number of deals halved to 692. Monetary easing in China helped the situation later, but it is hard to find thoughtful analysis of what happens next.

Investors sometimes put a marker down via seed or early-stage investments, which they expect to sell at a profit, on the back of price trends, rather than bothering with analysis of their operations.

But Mario Giovanni, chief executive of alternatives advisor Hamilton Lane has argued it is important for investors to carry out operational due diligence because the provision of information tends to be a low priority for promoters. 

He added: “If conditions get tougher, do you really want to be in a set of illiquid investments with boards and trustees and constituents questioning the basic operational soundness and integrity of those investments?”

Christopher Cork director of London-based accountant haysmacintyre, agrees investors need to look carefully at the quality of VC forecasts: “Valuations are based on projected EBITDA or recurring revenues. Investors should drill in detail into these projections. Transactions often feature earn-out clauses where a valuation includes an element conditional on future events or performance conditions being met. These can be a risk to both parties if the criteria are poorly defined, leading to disputes further down the line.”

There are also questions about whether stock markets will always welcome VCs whose operational skills disappoint investors.

Uber, Lyft and Slack, three of last year’s biggest floats, received a dismal reception. WeWork had to scrap its IPO altogether and retrench. 

Peter Thiel, co-founder of PayPal, has in many VC opportunities. Earlier in the boom, he warned that investors need to be braced for sudden changes in VC valuations because they are stuck on discounted cash flow calculations spread over many years, which change sharply when changes in expectations compound up.

This potential volatility provides all the more reason for family offices to carry out operational due diligence, to avoid lasting embarrassment further down the line. 

 

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