A Disciplined Approach to Single Family Office Venture Capital Investing
Here is a familiar story for family office investment teams: an email arrives, perhaps from a principle looking to learn more about an opportunity; or a deal comes through trusted advisors or the CIO. A family office management team wants to make sure they thoroughly investigate the opportunity in order to provide value to the family. Resources are allocated, introductory phone calls are made, and before long a young analyst is writing up reports on an industry she’s not familiar with, while trying to model an aspirational J-Curve into something that approximates reality. Weeks might be dedicated to such an opportunity before it becomes clear this is not a good fit for the family office. Now imagine emails like that coming in on a daily basis.
According to PitchBook-NVCA Venture Monitor, 2019 saw a record-setting decade in venture, with a 5x increase in deal value to roughly $140 billion.1 It’s an exciting space filled with the promise of tomorrow, but it is also uncertain, filled with risks, and for many marked with embarrassing failures. A disciplined, proactive approach allows a team to mitigate the risks and maximize their upside, while also providing a singular opportunity for learning and leadership development. Despite all of the bad experiences we’ve all had with early stage investments, there is a real opportunity to bring value to the family office by creating a disciplined approach that fosters exceptional returns, as well as internal learning and skills development.
A reactionary approach to venture capital investing creates more problems than just time management. First, there’s the problem of deal quality. In Texas, many of us are familiar with the major features of a “good” oil and gas deal. We know the structural red flags, how to read a reserve report, and how to evaluate a drill plan. Furthermore, many of us have good contacts in the industry who can provide invaluable insight as we make our initial assessment. Our family office friends and partners outside of Texas are not so lucky. Having worked with family offices in Texas and outside of Texas, we can anecdotally report that the quality of oil and gas deals tends to diminish outside of the state. What’s true for oil and gas in Texas is also true of the tech world outside of Silicon Valley. The comparison is not one-to-one, but the general principle stands. As family offices grow and the sources of their deal flow expands, there is an increased exposure to new industries and new kinds of opportunities. Evaluating the quality of these opportunities becomes increasingly difficult, but not impossible.
Second, it is often difficult to properly analyze the relative risks and rewards. Every venture capital pitch book makes strong claims about their path toward profitability, the stability of their future recurring revenues, and their potential valuation once they hit a benchmark that is (always) only 18 months away. All of these claims rely on a solid understanding of the business, the team, their story, and their projected financials. In lieu of historical financials, analysts must make reads on the teams themselves, conduct research into the industry, weigh the various business risks, and proceed with great care. Even in the best of circumstances the likelihood of a profitable outcome is low. SoftBank’s vision fund has made a satire out of this in their recent investor relations materials. Slide 51 of their Q1 2020 financials features a graphic of a winged unicorn, this time soaring over the V-shaped valley of Covid-19 recovery.2 Jack Ma resigned from the board of SoftBank’s vision fund a few hours before this presentation was released to investors.
Third, capital stack and equity considerations often get in the way of a good idea. Promising early stage businesses are sometimes hamstrung by messy capital stacks, convertible notes, and previous investment rounds. All of this adds up to a situation where the price at which one can come into the business is not commensurate with how the business should be valued. Many deals fall through simply because the family office investment team can’t get comfortable with the price at which they are coming into the investment.
While the challenges loom large, there is still much to gain from early stage investing. Early stage investing allows one to learn about and enter into industries in a position to make exceptionally outsized returns. Furthermore, the uncertainties of the space means teams need to do their homework and learn about these industries and businesses from the ground up. This earned knowledge is invaluable and can benefit the team and the family office for years to come. Early stage investment analysis is also a great tool to engage second generation family members that are interested in learning more about capital management. Within investment teams themselves, these opportunities are a great way for younger analysts to develop new knowledge and take ownership of projects without having to be aggressively managed by their managing directors.
The potential benefits from engaging in venture capital investing don’t in and of themselves immediately overcome the challenges presented above. One must develop a clear plan in order to get the most from early stage investing. The general principle of this strategy should seek to move away from a reactionary mode, where a team is running in multiple directions trying to catch every pitch that comes through the door, toward a more disciplined and proactive approach, where team members are empowered to go out and seek opportunities that fit specific criteria.
Most important, the investment team should work with the family to develop clear venture capital and early stage investment objectives. Sector identification and investment thesis can come from the team, the family, or a mix of both. Important considerations include the business sector/industry, average deal size, ideal equity stake, and the size of the committed capital allocation. Ultimately, successful early stage investing is a numbers game. Ideally one would invest a small amount in a number of companies and over time lean into the companies that continue to demonstrate success. Having clear metrics also makes you a good partner to companies that you interact with. Having listened to countless pitches from early stage companies, there is nothing that they want more than clear parameters for what kinds of early stage companies you’re willing to invest in.
Once the team establishes the overall objectives with the family, they can develop a more specific strategy. On the research side, the team can make contact with industry experts and begin to develop an internal working knowledge of the sector. Strategically, investment teams should endeavor to secure as many co-investment rights and other upside options, while mitigating as much downside risk as possible. This asymmetric risk to the upside is best achieved when many small investments (all with their own upside risk potential) are made across a single sector. The proactive time spent in sector research can also be spent researching the various term-sheets and capital stack structures and mechanisms that exist in that space. Venture is an industry that has adopted a fairly open-source approach to documentation, to the benefit of all.
A disciplined and proactive approach to venture capital allows teams to more efficiently process deal flow, source higher quality deals by building deeper relationships within a given sector, fulfill investment policy statement objectives and allocations, and engage family office principles and family members with opportunities that they care about. When done this way, a suitable allocation to venture capital in a broadly diversified portfolio can deliver quantitative and qualitative value to the portfolio and to the family office team.
Notes
- Venture Monitor, 2019
- Softbank, “ for the Fiscal Year ended March 31, 2020” , 2020
Frequently Asked Questions
How should a single family office approach venture capital investing?
A single family office should take a disciplined, proactive approach to venture capital instead of just reacting to deals. Rather than chasing every pitch that lands in the inbox, the team should work with the family to set clear goals, pick target sectors and a strategy, and let members hunt for deals that fit set criteria. This lowers risk while keeping the upside.
What are the main problems with a reactionary approach to venture capital in a family office?
Reacting to deals creates three big problems beyond just wasted time: poor deal quality, trouble weighing risks against rewards, and messy ownership structures. Without a sector focus, analysts spend weeks studying industries they do not know, while tangled convertible notes and earlier funding rounds often leave the entry price out of step with what the business is really worth.
Why is venture capital considered both an opportunity and a risk for family offices?
Venture capital can give family offices unusually large returns and access to new industries, but it is uncertain, risky, and often ends in failure. Even at its best, the chance of making money is low, so a disciplined approach is needed to limit losses while still gaining the learning and leadership-building benefits that early-stage investing offers.
How large did the venture capital market become according to TFOA?
Venture capital hit record highs, with 2019 ending a record-setting decade in which deal value rose roughly 5x to about $140 billion, according to the PitchBook-NVCA Venture Monitor. TFOA points to this growth to show that venture is an exciting but uncertain space, full of both promise and real risk.
What investment criteria should a family office define before making venture capital investments?
Before investing in venture capital, a family office should decide on its industry focus, average deal size, the ownership stake it wants, and how much money it will set aside. The investment team should work with the family to set clear early-stage goals and a strategy, which can come from the team, the family, or a mix of both.
Why is venture capital described as a numbers game for family offices?
Early-stage investing is really a numbers game because outcomes are uncertain and most bets do not pay off. The best approach is to invest small amounts across several companies in one sector, then put more money into the ones that keep succeeding. This tilts the odds toward big gains while keeping losses small.
How can venture capital investing benefit a family office beyond financial returns?
Venture capital adds value beyond money by building learning, skills, and leadership inside a family office. Early-stage analysis is a great way to engage second-generation family members interested in managing capital, and it lets younger analysts gain new knowledge and take ownership of projects without heavy oversight from managing directors.
What is the difference between a good oil and gas deal and evaluating a venture capital deal for a family office?
A family office often has deep expertise, contacts, and warning signs for familiar sectors like Texas oil and gas, but lacks that footing when judging venture deals in unfamiliar industries. As deal flow spreads into new sectors, sizing up quality gets harder, which is why TFOA suggests building deep relationships and real know-how within a chosen sector.
About the Authors
Marc J. Sharpe is the founder and Chairman of TFOA, an organization formed in 2007 to provide a forum for education and networking and to serve as a resource for single family office principals and professionals to share ideas and best practices, pool buying power, leverage talent and conduct due diligence. Mr. Sharpe also teaches an MBA class on “The Entrepreneurial Family Office” as an Adjunct Professor at SMU Cox School of Business. Contact: marc@tfoa.me
Seth Morton, Ph.D. has served family offices in areas of investment diligence, execution, and management; governance; research; communications; and multi-generational, sustainable legacy planning. He seeks to improve team performance by cultivating learning-focused and communications-driven processes that deliver exceptional results. He and his family are currently based in Texas.
About TFOA
The Family Office Association (“TFOA”) is a global peer network that serves as the world’s leading single family office community. Our group is for education, networking, selective co-investment, and a resource for single family offices to share ideas, deal flow and best practices. Members are not actively marketing products or services to other members and no contact information or email lists will ever be shared. Since our founding in 2007, TFOA has led the global single family office community by delivering world-class educational content, unique networking opportunities, and exceptional thought leadership to our highly curated network of the world’s largest and wealthiest families: www.tfoa.info
Disclosures
The Family Office Association (“TFOA”) is a peer network of single family offices. Our community is intended to provide members with educational information and a forum in which to exchange information of mutual interest. TFOA does not participate in the offer, sale or distribution of any securities nor does it provide investment advice. Further, TFOA does not provide tax, legal or financial advice. Materials distributed by TFOA are provided for informational purposes only and shall not be construed to be a recommendation to buy or sell securities or a recommendation to retain the services of any investment adviser or other professional adviser. The identification or listing of products, services, links, or other information does not constitute or imply any warranty, endorsement, guaranty, sponsorship, affiliation, or recommendation by TFOA. Any investment decisions you may make based on any information provided by TFOA is your sole responsibility. The TFOA logo and all related product and service names, designs, and slogans are the trademarks or service marks of The Family Office Association. All other product and service marks on materials provided by TFOA are the trademarks of their respective owners. All of the intellectual property rights of TFOA or its contributors remain the property of TFOA or such contributor, as the case may be, such rights may be protected by United States and international laws and none of such rights are transferred to you as a result of such material appearing on the TFOA web site. The information presented by TFOA has been obtained by TFOA from sources it believes are reliable. However, TFOA does not guarantee the accuracy or completeness of any such information. All such information has been prepared and provided solely for general informational purposes and is not intended as user specific advice.
Frequently Asked Questions
How do family offices invest in venture capital?
Family offices invest in venture capital through three primary channels: direct investments into startups, LP commitments to established VC funds, and co-investments alongside lead investors on specific deals. Many SFOs start with fund commitments to build deal flow access and market knowledge before moving to direct investments.
What are the advantages of venture capital for family offices over institutional investors?
Family offices have structural advantages in venture capital: patient capital that doesn't require forced exits on a fund timeline, the ability to make follow-on investments over many years, and the flexibility to invest in sectors aligned with the family's domain expertise or values. They can also maintain confidentiality in ways that institutional investors cannot.
What allocation do family offices typically make to venture capital?
Most family offices allocate 5% to 15% of their total portfolio to venture capital, though this varies widely based on the family's risk tolerance, liquidity needs, and prior experience in the asset class. Direct venture investing programs at larger SFOs may be significantly more concentrated.
What are the key risks of venture capital investing for family offices?
The primary risks are illiquidity (most VC investments take 7 to 10 years to reach liquidity), high failure rates (most startups fail), valuation uncertainty, and the difficulty of selecting top-performing managers. Families new to VC often underestimate the time and expertise required to manage a direct venture program effectively.
