Venture Capital Guide for RIAs
An Important Asset Class for Investors
In the evolving investment landscape, venture capital (VC) stands out as a unique asset class, offering wealth managers and financial advisers an opportunity to further diversify their clients’ portfolios beyond traditional stocks, bonds, and the growing options for core alternative assets. Venture capital, known for fueling innovative startups and tech advancements, plays a critical role in driving economic growth. It’s distinct from standard market securities, focusing on startups with significant growth potential and balancing high risk with the potential for high rewards.
For wealth management, venture provides clients with access to the burgeoning innovation economy. VC’s low correlation with market movements makes it a strategic tool for portfolio resilience against volatility.
However, the venture capital journey is not without risks, such as startup failures and illiquidity. To navigate these challenges, wealth management must rely on a VC firm that employs disciplined strategies with thorough due diligence, sector diversification, and awareness of market trends. A VC firm’s expertise, like that of Alumni Ventures, is crucial in guiding RIAs through this landscape, leveraging their experience in identifying and nurturing promising startups. By embracing the nuances of VC, RIAs can unlock new growth avenues and portfolio diversification.
And, if you want to explore this topic further, register for our next wealth manager webinar on April 11.
First, let’s review some of the common items in venture to help demystify this asset class.
DEFINING VENTURE CAPITAL
Venture capital invests in startups and early-stage companies with high growth potential. Successful venture investments have been pivotal in birthing industries and transforming society. For instance, VC has been instrumental in the rise of significant tech companies — among them, Amazon, Facebook, Google, and Uber — contributing to job creation and tech advancements. The Wall Street Journal reported how an early investor in Uber, Garrett Camp, may have turned his $220K investment in Uber into $1.0B if he held the stock at the time of the report (2019).
While this kind of return is not common, outsized returns are what drive venture capital returns.
Venture capital invests in startups and early-stage companies with high growth potential. Unlike traditional investments in stocks or bonds, VC is distinct in its high-risk, high-reward nature. Did you know that, historically, VC investments have shown the potential to offer significantly higher returns than traditional equity markets? For instance, data from the National Venture Capital Association indicates that VC returns have outperformed the S&P 500 by a substantial margin over the last 20 years.
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How Venture Capital Differs from Other Asset Classes
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- Risk and Return Profile: VC is characterized by a higher risk-return profile compared to traditional asset classes — but with significantly higher return potential.
- Illiquidity: Unlike publicly traded stocks or bonds, VC investments are highly illiquid. Investors typically commit their capital for a period of 5-10 years or more, with no guarantee of returns or the ability to exit the investment prematurely.
- Direct Impact on Innovation: VC investments are directly tied to innovation and the growth of new industries. VCs fund startups that are working on cutting-edge technologies or disruptive business models, often filling a gap that other financing sources like banks or public markets may not serve.
THE VENTURE CAPITAL ECOSYSTEM
A VC fund operates on a simple yet profound principle: invest in innovation, nurture it, and reap the benefits of its growth. Take Zoom, for example. It started as a simple idea pitched by Eric Yuan and, through VC funding, transformed into a company valued at approximately $9.2 billion at IPO. This example underscores the journey from an innovative idea to a successful exit, highlighting the role of VC in turning visionary ideas into reality.
Venture capital (VC) is a unique asset class that plays a pivotal role in the broader investment ecosystem, differing significantly from traditional investments like stocks, bonds, or real estate. Here’s an overview highlighting its distinct characteristics, role, and the key players and stages in the VC ecosystem:
Players in the VC Ecosystem
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- VC Firms: These are the entities that manage venture capital funds. They raise capital from Limited Partners (LPs) and invest it in startups, taking an active role in the management and growth of these companies.
- Limited Partners (LPs): LPs are the investors in a venture fund conventionally structured as a limited partnership. They can be institutional investors like pension funds, endowments, and insurance companies, or high-net-worth individuals.
- Entrepreneurs and Startups: The recipients of VC funding, these are typically early-stage companies with high growth potential.
- Angel Investors: High-net-worth individuals who provide capital for startups, often in the very early stages or even pre-seed stages.
Stages/Series in Venture Capital
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- Pre-Seed and Seed Stage: This is the earliest investment stage, where capital is used for product development, market research, and building a management team.
- Series A: Often the first round of venture funding after seed capital. The focus here is on further developing the product and market fit.
- Series B and Beyond: These funding rounds are about scaling the company, expanding into new markets, and possibly working towards profitability.
- Late Stage or Growth Stage: Investments at this stage are made in more mature startups that are looking to expand significantly or prepare for an exit, such as an IPO or acquisition.
THE MECHANICS OF VENTURE CAPITAL
Below is the process that AV and other VCs follow in building a portfolio.
Thesis Development
The first step is Thesis Development, where we lay the groundwork for our investment strategy. We seek to thoroughly analyze market trends, emerging technologies, consumer behavior shifts, and economic forecasts. Our team collaborates to identify sectors and niches where we believe the next wave of innovation and growth will occur. This could be anything from fintech advancements to healthcare tech breakthroughs. This thesis not only guides our search for potential investments but also ensures that we’re looking in areas with the highest potential for disruptive success.
Sourcing Deals
Armed with a well-defined investment thesis, we then actively scout for deals. This is a dynamic process where we leverage technology and human insights, utilizing databases, attending pitch events, and drawing on our entrepreneurial networks. Our objective is to uncover startups that fit our investment thesis and show potential for exceptional growth.
Evaluating and Winning Deals
Once a promising startup is on our radar, we move to rigorous evaluation. Here, we assess the startup’s market potential, team strength, product uniqueness, and deal structure. Given the competitive nature of the venture landscape, we also strategize on how to win the deal by convincing the founders that we are the right partners for their growth journey. This involves demonstrating our value beyond capital through our industry connections, expertise in scaling businesses, or our hands-on approach to guiding startups.
Adding Value and Managing Exits
After successfully securing an investment, our focus shifts to adding value to the startup. This includes providing strategic advice, facilitating key industry connections, and providing exposure to pertinent people in our 650k person network. We maintain a close partnership with the company to help navigate growth challenges and seize market opportunities. VCs also help companies plan for exits, whether through an IPO or a strategic acquisition, their goal is to ensure a lucrative exit for all stakeholders, reflecting the value that has been built over the course of a VC’s involvement.
RISK AND RISK-MITIGATION IN VENTURE CAPITAL
Venture capital investments while promising substantial gains also involve inherent challenges such as the significant risk of startup failure and the illiquid nature of the assets. Additionally, the unpredictability of market trends and limited control over these investments add layers of complexity.
However, experienced VCs have developed strategies to cope with these risks. Here’s how the risk-reward equation can play out.
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High Risk of Failure:
Startups and early-stage companies often face a high risk of failure due to various factors like competitive markets, evolving technology, and consumer preferences. This risk is inherent in venture capital, as these companies are in their nascent stages, trying to establish a foothold in often untested markets. However, this high risk is counterbalanced by the potential for high rewards. A single successful investment in a 'unicorn' startup can yield returns that far exceed the losses from several failed investments. In the case of Uber, First Round Capital’s $510K investment in 2010 was worth $2.5B in 2019, in other words “a fund returner.” Moreover, experienced VCs mitigate risk through diversified portfolios and rigorous due diligence, increasing the likelihood of identifying and investing in successful startups. - Home
Illiquidity:
Venture capital investments are typically locked in for long periods, ranging from 5-years or more, meaning investors cannot quickly liquidate these assets in response to market changes or personal financial needs. The illiquid nature of venture capital is often offset by the higher return potential compared to more liquid assets. Furthermore, the long investment horizon allows startups to mature and potentially deliver substantial returns. Some investors, knowing these facts, often find that retirement investments are a good match for venture investing. - Home
Market and Technological Uncertainties:
The performance of venture capital investments heavily relies on how well the market accepts new products and the pace of technological progress — both of which can be unpredictable. This uncertainty often leads to fluctuating investment outcomes. However, experienced VCs draw on their deep knowledge, extensive networks, and eye for spotting emerging trends to invest in companies that might benefit from these shifts, which can result in significant returns. Don Butler, Managing Director of Thomvest Ventures, made a related observation about AI trends in TechCrunch: “I think 2024 will be one of the most promising years for AI investing. While there has been a bubble building in this space, 2024 and 2025 will be when some of the most interesting companies of the next generation will be started. If we look back at prior shifts in technology, such as the introduction of the iPhone, we’ve seen a pattern that has repeated: The most interesting companies that take advantage of such The most interesting companies that take advantage of such shifts are typically started one to three years after such technologies are introduced.” - Home
Inherent Unpredictability in Venture Capital Exits (J-curve):
The J-curve in venture capital typically involves an initial decrease in fund value, followed by growth as investments mature. This curve's unpredictability, especially regarding the timing and success of exits like IPOs or acquisitions, presents an additional risk. Experienced VCs manage this through diversified investments and staggered timing, aligning with market trends and strategic exit planning. These methods aim to maximize successful outcomes, enhancing the potential for significant long-term returns. In the case of Alumni Ventures’ performance, a meaningful uptick in MOIC is seen in vintages in 2019 and prior, where companies have had ~3+ years since the vintage of the fund to grow into a new valuation.
TRENDS IN VENTURE CAPITAL
Below are a set of high-level observations for venture capital in 2023 and forecasts for 2024. These examples give support to realistic optimism for the asset class.
2023 Review: Investments and Trends
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Healthy levels:
Startup funding in 2023 was healthy at an estimated 11.9k deals (to Q323) versus 12.5k-13.6k between 2018-2020. — PitchBook - Home
Early stage continues to attract interest:
"Two stages saw deal count growth in Q2, though for different reasons ...early stage had the fourth-most-active quarter ever. ...Venture growth also saw a deal count increase...more likely rescue funding than simply new growth investments." — NVCA - Home
"Investor-friendly" period:
“There was a sharp change in 2022 that is continuing today. We are in a time of higher indicator values and a much more investor-friendly environment.” — Foley & Lardner, LLP - Home
Flight to quality, high bar:
“Many companies are successfully raising venture capital at attractive valuations. But investors are still playing offense in most deal negotiations, and the bar for writing a check remains high.”— Carta - Home
Vertical AI opportunities:
“2024 could see the beginning of a second wave of AI startups that are more verticalized, that are focused on specific sectors, and that move away from building layers on top of technologies from companies like OpenAI and Google.” — TechCrunch
2024 Forecast: Investment and Operating Strategies
Below are observations and predictions about the venture ecosystem from a recent article in TechCrunch.
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Economic climate requires capital efficiency:
“We’re adopting a more selective approach, focusing on capital efficiency (18-24 months of runway versus 12-18 months back in 2021) as the metrics to raise the next follow-on round keep moving higher for non-AI companies (B2B SaaS).“ — Matt Cohen, founder and managing partner, Ripple Ventures - Home
Late-stage tightening belts:
“Many of our existing portfolio companies cut expenses and have now either reached breakeven (at the later stages) or have the runway needed to continue to grow well into 2025 and beyond.” — Don Butler, Managing Director, Thomvest Ventures - Home
Startup valuations adjusting:
“We will see many more recapitalizations and down-rounds in 2024. Startups that have inefficient business models and lack investors willing to support them will shut down or be sold for pennies on the dollar.” — Jai Das, President & Co-Founder, Sapphire Ventures - Home
Valuation repricing and quality:
“Our team has seen many Series B and C deals closing at nearly the same pricing as Series A. But these companies have typically accomplished significant de-risking milestones, particularly from a commercial perspective. The seed stage remains highly competitive, and valuations are still relatively elevated.” —Sophie Bakalar, Partner, Collab Fund
WHY VENTURE CAPITAL MATTERS FOR RIAS
Venture capital (VC) is a dynamic asset class for Registered Investment Advisors (RIAs), offering portfolio diversification and exposure to high-growth potential. VC’s low correlation with traditional assets like stocks and bonds provides a buffer against market volatility, while its focus on innovative startups offers investment opportunities with significant growth prospects. VC stands out in an inflation-prone economy, as startups’ potential to rapidly scale and generate revenue can effectively outpace inflation.
This investment strategy empowers RIAs and their clients to directly contribute to economic growth and technological advancement, beyond mere financial returns. Incorporating VC into investment portfolios enhances their appeal, giving clients the chance to be part of transformative success stories. For RIAs, offering VC options solidifies their role as comprehensive advisors in the evolving investment landscape.
Partnering with Alumni Ventures
If you’re an RIA seeking a partner to bring venture capital to your clients, consider Alumni Ventures. Here’s what sets AV apart:
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#1 most active VC in the U.S.*
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Top-quartile and near top-quartile DPI for our fund vintages from 2016-2020**
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Focus on individual investors, from our products, platforms, people, and services
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Network-powered community of 625K+ entrepreneurs, venture capitalists, and innovation enthusiasts
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Co-investing strategy, investing alongside established VCs such as a16z, Sequoia, Accel, and others
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Diverse portfolios, covering a wide range of sectors, stages, and geographies
*PitchBook Global League Tables: 2023 Annual and 2022 Annual
**Top quartile according to comparison to Cambridge Associates’ peer group. Performance is net of management fees and incentive allocations.
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Venture capital is a dynamic and potentially rewarding asset class. At Alumni Ventures, we strive to make this class accessible, understandable, and attractive to RIAs and their clients. Register here.
This communication is from Alumni Ventures, a for-profit venture capital company that is not affiliated with or endorsed by any school. It is not personalized advice, and AV only provides advice to its client funds. This communication is neither an offer to sell, nor a solicitation of an offer to purchase, any security. Such offers are made only pursuant to the formal offering documents for the fund(s) concerned, and describe significant risks and other material information that should be carefully considered before investing. For additional information, please see here. This communication includes forward-looking statements, generally consisting of any statement pertaining to any issue other than historical fact, including without limitation predictions, financial projections, the anticipated results of the execution of any plan or strategy, the expectation or belief of the speaker, or other events or circumstances to exist in the future. Forward-looking statements are not representations of actual fact, depend on certain assumptions that may not be realized, and are not guaranteed to occur. Any forward-looking statements included in this communication speak only as of the date of the communication. AV and its affiliates disclaim any obligation to update, amend, or alter such forward-looking statements, whether due to subsequent events, new information, or otherwise.