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Why venture capital funds are better than investing in single companies

by xyonent
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If you want to invest in venture capital, Venture Capital Fund Investing in venture capital funds not only reduces the chances of loss but also increases the chances of earning a positive return.

I’ve been a venture capital investor since 2001, and I definitely don’t recommend angel investing. In most cases, you’ll end up losing. And when you do lose, all Invest half your money in private companies.

Over time, my belief in avoiding investing in individual private companies has only strengthened, primarily due to my experience working as a limited partner in multiple closed-end venture capital funds.

I’ve seen which companies succeed and which fail. The odds are not good for an individual private investor. As a private investor, you have to diversify. And the easiest way to do that is with a venture fund.

The probability of success in venture capital is low

As a limited partner, I recently watched the quarterly update of a small, early-stage venture capital fund. I hadn’t participated in the update in over a year because I prefer to commit once, submit capital, and then stay completely hands-off. Not having to think about how my money is invested is one of the reasons I invest in private funds and am happy to pay the fees.

Venture capital funds invest primarily in seed rounds and some Series A rounds. These funding rounds usually happen within 1-3 years of a company’s founding, so they are riskier. But if the company is successful, the payoffs can be huge. The founders all have impressive resumes, and the problem the company is trying to solve seems promising.

Before investing in anything, know that the marketing materials always make it look promising, but of course, not all investments are successful. That’s why diversification is important.

Venture capitalists know their odds of winning are slim

During the update, I was shown a slide, which I can’t share here due to privacy concerns, that showed a bubble chart of 60 companies the fund had invested in. One small bubble represented the six predicted winners, a medium bubble represented the 30 companies that would survive with only a few exits, and another bubble represented the 24 companies predicted not to succeed.

What surprised me was that even though the fund manager was willing to invest in 60 promising companies, already 40% of companies (24 out of 60) expect to lose 100% of their investment, while 50% (30 out of 60) expect to make little to no profit or even incur a loss. only 10% of companies were expected to make a profit.

As an individual investor, your chances of investing in a successful private company are much lower than the 10% chance that a professional venture capitalist would. Furthermore, your chances of losing all your money in an individual company are much higher than the 40% chance that a professional venture capitalist would invest in a failure.

Professional venture capitalists compete fiercely for access

Most private investors who invest in private companies lack the advantage, expertise, and strong networks of professional venture capitalists who run funds. Therefore, the private companies they invest in are likely to be the ones that all other professional venture capitalists would pass up. This is because Adverse selectionIndividual investors only see companies that no one else wants.

Professional VCs, on the other hand, have much more access to investing in the best private companies. Even the pros often have to fight like crazy just to get allocations to the best companies. Access to the top private companies is the price that limited partners pay.

Going a step further, individuals often compete to gain access to top venture capital funds.

Examples of venture capital investments that were thought to be successful but failed

for example, cameoCameo is an online platform that allows users to book personalized video messages from celebrities, athletes, influencers, and other notable people. Founded in 2017, the company aims to create unique and memorable interactions between fans and their favorite celebrities.

Cameo’s popularity soared during the pandemic as people were stuck at home. Instead of meeting friends for birthday parties or dining out for wedding anniversaries, people found a way to give virtual gifts. And it was a great idea!

I’ve been gifted a number of fun cameos by friends of tennis players I follow, and even had a newsletter reader contact me asking if I would record a one-minute message as a wedding gift for a friend, which I did and was paid a few hundred dollars.

The business model was simple: invite interesting people to sign up to the platform and create video and audio recordings. These individuals would be paid at market rate, and Cameo would take a percentage of the revenue. This business seemed easy to scale; all Cameo had to do was create a marketplace.

Cameo’s previous funding rounds

Below we look at Cameo’s various funding rounds, dates, and investors.

I invested in a venture capital fund that raised $600 million in 2018. In 2019, the fund started allocating capital and one of its investments was in Cameo. The fund invested 4% of its capital, or $24 million, in Cameo in its Series B round. The company was valued at about $250 million after the fundraise.

Two years later, in 2021, Cameo raised $100 million in a Series C round at a post-money valuation of $1 billion. Yay! My venture capital fund made at least 3x its investment in two years, even after dilution.

Then, on March 13, 2024, Cameo raised a $25.1 million funding round (also called Series C for some reason) at a reported valuation of just $100 million! After the terms of the new financing, existing shareholders reportedly saw their valuation drop by up to 99%.

If I had the chance, I would have invested in Cameo.

If my venture capital fund had asked limited partners to co-invest during a Series C round at a post-money valuation of $1 billion, I probably would have agreed and put in $25,000.

It was still COVID-19 time and I was doing something like a Cameo in person, but a billion dollar market cap didn’t seem like much in today’s world, plus I knew some smart, well-connected VCs who were going to vet the company for me.

If I had invested in Cameo, I would have lost it all.

Why did venture capital investments fail?

Remember, 2021 was a boom year: meme stocks crashed, tech stocks soared, and investors just couldn’t afford to lose. Eventually, the 2022 bear market arrived, investors took big losses, and everyone was brought back to reality.

Cameo’s failure to grow its valuation was likely due to a high valuation, raising too much capital, the end of the pandemic, a decline in demand, and the company being overemployed.

Cameo’s 2024 Series C funding is being considered a “clamp-down” funding round. To new investors, Cameo’s post-money valuation of $100 million seems attractive.

But for me and the other limited partners who invested in this venture capital fund, this sucks, right? But not so fast! As I said above, venture capitalists expect about 90% of their investments to not be profitable. Cameo will likely be part of that 90% for this fund.

Winning VC investments made up for losses

The fund that invested in Cameo has made about 50 investments. Of the 50 investments, seven, or 14%, are a grand slam of about $1.5 billion based on investments of about $175 million. About 12 of the fund’s investments have been profitable, totaling about $530 million based on investments of $300 million.

Coincidentally, Cameo is not among them. The $600 million fund, which began deploying capital in 2019, will be worth a total of about $2 billion by the end of 2023. That’s a five-year compound annual growth rate of about 27%. Not bad!

The fund’s main winner was a $25 million investment in Rippling, an HR enterprise software company, valued at $542 million at the end of 2023. Given that Rippling raises another funding round in 2024 at a post-money valuation of $13.4 billion, I would speculate that the fund’s Rippling shares will be worth even more.

As a private investor, would I have invested in Rippling at a lower valuation? Probably not. The founders had fallen out with their previous company, Zenefits, and left. Also, I didn’t understand HR management software and its potential. But the general partners did and knew the founders, which saved me.

Individual investors have no advantage in investing in unlisted companies

Most of us are not professional investors or investment enthusiasts. Despite having an MBA and 13 years of stock investing experience in GS and CS, we only have a limited amount of time we want to devote to stock investing.

With two young children and other hobbies, I don’t have the time to do due diligence on each private company. Plus, if there’s a private company I want to invest in, You will no longer be able to access Unless you invest with an established venture capital firm.

Therefore, I am happy to pay fees and a percentage of profits to private fund managers who spend 40+ hours a week trying to invest in companies I don’t have access to. As I get older, I feel better about outsourcing the responsibility of managing my money to have more time to do what I want.

Not only did I invest in Cameo and not Rippling, I would have passed on the design company Figma when it was valued at $500 million, but it has grown to a $10 billion valuation just three years later. The problem with only investing in things you understand is that you may miss out on a lot of other opportunities.

Leave personal investments

The original $140,000 capital invested in this fund in 2018 would be worth approximately $404,000 as of Q4 2023. If the full $140,000 capital had been called, it would have been worth $462,000. But after all these years, only $123,900 has been called. Typically, it takes 3-5 years for 100% of committed capital to be called.

I’m glad I was able to take capital calls over the years and put money into these private companies, which should continue to grow in value as long as they execute. I’m also glad I didn’t have to experience fluctuations in visibility over the years; all I had to do was keep taking capital calls and I was able to dollar-cost average through the good years and the bad years.

If you want to invest in individual private companies, don’t. Only invest if you are willing to build a portfolio of 20+ companies of similar size. Professional venture capitalists build portfolios of 50+ companies, but expect only 10% of them to make a big profit. For individual investors, that probability drops to less than 5%.

I think it would be much better to invest up to 20% of my investable capital each year in venture capital or other private funds. I would feel much better knowing that I don’t have to invest because professional investors are focusing on profitable investments.

Questions from readers

Have you invested in private companies successfully? What is the track record of individual private company investments? If you have invested in venture capital funds, how has their track record been?

If you are interested in investing in growing private companies, Innovation FundIt’s an open-ended venture capital fund with a minimum investment of just $10. Unlike closed-ended venture capital funds, you can see what the Innovation Fund is investing in and decide how much to invest. You also get liquidity if you need it.

My personal goal is to invest $500,000 in private artificial intelligence companies within a year. I want to invest in AI companies like OpenAI, Anthropic, Databricks, etc., so I am investing partially through the Innovation Fund. The AI ​​revolution is here and I want to be a part of it. Fundrise is also a sponsor of Financial Samurai.

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