Any regular reader of The Constant Investor probably has a pretty good idea of what Venture Capital is. It’s the stage of capital funding for an enterprise before an initial public offering (IPO). The term can be generally used to mean anything from the initial tranche of funding for an idea that’s still germinating in someone’s garage, long before that enterprise ever sees a profit; to final stages of growth requiring capital before an initial public offering.
Generally speaking, venture capitalists are high net worth individuals or institutions looking to access the growth potential of developing start-ups. There are a few strategies venture capitalists can employ: from the “throw a bunch of darts at the board and see what hits” approach, where the investor makes many smaller, early-stage investments in the hope that one makes it big; to a more focussed approach that seeks out well-developed businesses and makes larger, targeted investments at later stages. Everything in between is also an option.
A venture capitalist can make an investment at any point in an enterprise’s lifecycle, but generally investments can be placed at three stages:
- Seed stage investing: very early in an enterprise’s lifecycle. It can be highly speculative and funding may be in relatively small tranches for an as-yet unproven concept.
- Early stage investing: the enterprise may be up and running, but yet to turn a profit. The team has a proven concept, a well-developed business plan and needs capital to get to the next stage.
- Late stage investing: the business may be turning a profit or have a reasonable expectation of doing so in the short term. They may have a proven concept, a developing market and may be ready to move towards an IPO.
Not all businesses choose to move towards an IPO, but for many this is a long term aim. You can find a good rundown of the different stages here.
Venture Capital is receiving a lot of attention and a certain amount of hype this year, especially as Australian Venture Capital is experiencing a strong resurgence. It’s important to remember that this asset class is high-risk: returns are extremely variable and by no means guaranteed.
A lot of start-ups are focussed on the tech and digital industries. Andrey Shirben from SydVentures remarked that the healthiest approach to tech investments is “say goodbye to your money”. Since he’s running a start-up that invests in start-ups, we’ll assume that’s tongue in cheek. However, he does have a point. Long before streaming video, social media or private cars acting as taxis were everywhere, Netflix, Facebook and Uber were speculative with nothing more than great ideas to recommend them. Under any other circumstances, we wouldn’t consider this a great investment opportunity.
Whilst Venture Capital gives the investor a chance to get in on the ground floor with a huge success story (and returns to match), the lack of data, the speculation required and the sometimes closed nature of the companies being invested in are all substantial sources of risk. Venture Capital, even at the late stages, can go drastically wrong. One example is Theranos, a company that had a nine billion dollar valuation revised down to $800 million in June this year. The company raised capital on the basis of technological advancements in blood testing that did not work. The company is being sued for fraud and many investors stand to take substantial losses. Theranos is clearly an extreme case, but it’s a good example of the fact that even experienced, cautious financiers can get caught out with Venture Capital.
So where does this leave the individual investor who doesn’t have millions to lavish on promising start-ups? There are a number of vehicles allowing smaller investors to access venture capital in Australia. These include listed investment companies and early stage venture capital limited partnerships (ESVCLP). We’ll profile a number of different investment vehicles in turn. We’ll discuss the Australian venture capital landscape specifically and talk about some promising developments in the space.
As always, this analysis isn’t financial advice. It’s an economic analysis of this investment type intended to help you start your own research. We’re aiming to show you what’s possible in this field so that you can start exploring other products that are suitable for your own needs.
There are some things to think about if you’re going to start exploring venture capital:
What’s the best vehicle(s) for you? There are a few options here:
- You can seek out opportunities to invest directly and take an Angel Investor role, investing in one or two start-ups that are still seeking out small amounts of capital. This is probably the highest-risk route you could take. A brief run down on the differences between classic Venture Capital and Angel investing is here.
- You can invest in an ESVCLP. These have some specific tax advantages that you can read about here. However, while there may be advantages to investing with an eye to taxation, remember that the fundamentals of the investment matter more than tax. If the fundamentals aren’t sound and the investment fails to make a return (or produces a loss), tax on a non-existent return is irrelevant. This is an unlisted vehicle and we’ll profile a number of these.
- You can invest in a Listed Investment Company that specialises in Venture Capital. There are a couple of advantages to the LIC structure, including the possibility of returns being fully franked. We’ll profile a LIC specialising in VC in the coming weeks and discuss a few of the things you want to be aware of prior to investing.
What’s the quality of the management like? This is a critical point for Venture Capital investments. As most ventures will be relatively young, available data will be limited and the track record of the new enterprise by definition brief. The managers of your investment will be responsible for developing and maintaining the pipeline of investments (and therefore returns). In many cases, they intend to add value by taking seats on boards and mentoring fledgling businesses. Do they have experience and skills that make this a good prospect? Is the fund or investment you’re considering easily contactable and responsive? Can you get your questions answered?
What’s the strategy of this investment? Are they taking a scattershot approach? Are they focussed on later-stage enterprises that are developed and seeking higher levels of funding? Both of these have risk attached to them: the scattershot “fund a lot of early stage enterprises for small amounts” approach may have a high failure rate by enterprise, but it’s risking less on each start-up funded. On the other hand, focussing on later-stage enterprises may be less risky as the enterprise is established and has a proven (albeit developing) track record. However, the investments made in each enterprise tend to be larger and failure will cost more. Does the fund’s strategy align with your own? Do you understand the fund’s strategy, or is it unclear?
How diverse is this investment? Does the partnership or LIC have thematic or sectoral-focus? Is it broader and more general? There are advantages and disadvantages for both. Fintech, for example is a hotly contested and often overhyped sector. Does the individual business case for the fund or LIC’s investment make good business sense? How many individual enterprises are in the portfolio? How diverse are they? This isn’t a case where more is necessarily better. If the fund’s strategy is to add value through board and management support and guidance, then less may be a more effective strategy. Be aware of what the diversity of the investment is and how that might fit into your broader portfolio. If you’re heavily invested in listed tech equities, is a tech-focussed venture capital fund for you? The answer might be yes- but make that decision consciously.
What are your liquidity options? Bear in mind, these types of investments have a tendency to be very illiquid: once you’re in, you’re seeing it through to the end. Also be aware of the time frames to returns. These aren’t the sort of investment where you can expect a regular income. Realisations may be scattered and impossible to predict the timing and magnitude of early in the piece.
Tax- how much does it matter here? Remember that while tax can be an attractive reason to invest, these are often very long term investments with little or no liquidity: if there is a change in government policy, is the investment still a fundamentally positive one in your circumstances?
Does VC have the right risk profile for you? These are investments that require a lot of capital for a long time and have a much higher level of risk than some other investments. If you’re unsure, speaking to a financial planner is a good idea.
To get us started, our first profile is the Ellerston Ventures Partnership. It’s one of a couple of EVSCLPs we’ll be profiling to give you an idea of what’s possible, the structure they may take and what you can expect from them.