Business

Yes, the venture boom continues, but family offices need to be wary of the pitfalls

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The number of unicorns stampeding round the world will surge beyond 500 this year, as tech-driven ventures continue to disrupt their chosen sectors.

November data from Hurun Research Institute put the number of unicorns at 494, defined as private start-ups worth $1 billion or more, based on funding values.

The pressure is taking its toll on entrepreneurs, leading to disputes and personal problems.  Participants say it is vital for family offices to nail down strong working relationships – plus a disputes procedure – from the start

There are plenty of opportunities out there, still. But family offices keen to enter the sector need to tough due diligence to deal with the tricks of a lucrative trade.

The gains for backers are staggering. Creandum’s stake of $4.5 million in Spotify turned into $370 million when it floated in 2018. Sequoia Capital made $2 billion out of Dropbox and $3 billion from Whatsapp. 

Venture capital funds have gorged on new money, charging fees of 2% or 2.5% and taking 15% to 30% profit shares.

Private equity capital raisings are hitting new records: nearly $250 billion in the first 11 months in US private equity alone, according to Pitchbook. 

Family offices are increasingly reluctant to pay the fees levied by managers, as they see the money they are managing to cream off.  They are keen to hire staff to fly solo and pursue co-investment with their peers. They include a number of family offices serving newly-enriched tech billionaires. For their part, entrepreneurs are keen to woo family offices, not least because they can take a longer-term approach than venture capital. 

Family offices are viewed as relatively flexible in negotiating terms, and executive pay, although it would be wrong to view them as a soft touch. 

But stresses and strains are developing. Corporate ventures are being launched into crowded markets which are flawed in terms of detail and over-ambitious in terms of strategy. 

Marketers are arguing that investors need to jump on board before someone else scoops up an allocation. Information in private markets can be scarce, and lacks third-party analysis. There is excessive reliance on unrated private debt.

Competition in a few sectors, such as car ride-hailing and sharing, is leading to redundancies.  The implosion of an IPO for over-ambitious office space provider WeWork led to significant cutbacks. 

The pressure is taking its toll on entrepreneurs, leading to disputes and personal problems.  Participants say it is vital for family offices to nail down strong working relationships – plus a disputes procedure – from the start. 

One family office executive said dealing with personal issues, like drug-taking and divorce, at stressed portfolio companies was his greatest challenge: “It’s exceptionally time-consuming,” he said.   

Mitchell Kapor’s Kapor Capital has invested in a portfolio of 150 impact investments  – unusually large for a family office. It understands the importance of honesty: “Impact investing shouldn’t be the outlier. Greed-based investing should be the category getting scrutinised.”

Christopher Cork, director at London-based accountants haysmacintyre, says family offices need to dive deep when assessing potential ventures with trusted advisers. 

He warns that disruptors do not always find themselves as free of the old economy as they pretend: “Many of the underlying considerations that investors should weigh remain in line with those of traditional businesses.” 

Justin Kan has backed a string of US tech businesses over the years. He has seen the problems they face with their plumbing and has launched Atrium to deal with their legal and administrative issues, as featured in Family Capital on 19 December.

Trade disputes are an old-fashioned issue rising up the agenda, along with armed conflict in the Middle East. Brexit will change the way UK ventures do business. Gritty factors like these could make global conquest harder to achieve.

As well as more familiar business issues, haysmacintyre points out problems can get buried in tax and legal details, often overlooked by ambitious entrepreneurs, but ready to cause problems down the line.

Cork has drawn up a checklist for family offices to kick off their due diligence discussions, these are:   

  • Entrepreneurs often promote businesses where they are selling equity in an entity which licences, rather than owns, intellectual property. This would make their company a distributor, rather than an owner of assets. This might reduce its profits, if licences are owned by others. The business could lose a competitive advantage when licenses expire. Intellectual property rights relating to products also need to be closely explored.
  • Key contracts need to be considered. Is a business too reliant on too few customers? Have exclusive terms been offered to woo customers, which could limit future growth? Growth projections often fail to take account of these limitations to maximise their funding. Businesses can fail to pay attention to the risk that they could lose clients as contracts evolve.
  • Tax registration needs to be considered.   If, for example, schemes are “unapproved” by the UK tax authorities, there is a risk that a change in status would lead to a hefty tax bill for individuals and the company for which they work. This could cause stress, as well as a hole in cash flow.
  • There is an issue relating to the status of contractors and employees, following cases around the likes of Uber and Deliveroo. The tax authorities have been putting pressure on the use of contractors, leading to demands for income and social security taxes which can be backdated.
  • Tech ventures can fail to pay enough attention to the tax regimes of different countries, and how to comply with them. In the US, for example, the Wayfair case has established that online retailers, previously exempt from sales taxes, are now liable despite lacking a physical presence in relevant states.

One Comment

  1. That is a good list of pitfalls.
    As the founder of both a venture firm, Polaris Partners, and a family office, Polaris Founders Capital, I can comment on several other landmines. In addition to those mentioned in the article, family offices should also consider the following issues in the tech sector of venture ingesting: over funding; inflated valuations; and, inexperienced/under-attentive Boards.

    Venture funds are now managing so much money that they are forcing entrepreneurs to take more money than they need to get to the next stage. As a result, valuations are inflated, making it harder to get venture returns…and, many companies are developing business models that make profitability difficult to achieve. Moreover, the hyper growth in VC funds and their team has resulted inexperienced VC’s on Boards, or Boards that have experienced VC’s who, themselves, are on too many Boards to properly pay attention to the needs of their portfolio companies. Accordingly, it would be prudent for family offices to perform thorough due dilligence on the lead VC investors as well as on the target company.

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