With a vast universe of stocks out there, when constructing a portfolio, it’s hard to filter out winners from losers and those stocks that are just a bit ‘meh’. In the world of Venture Capital, that is magnified to the -nth degree, with a lot less data to work with.
Jonny Blausten, founder and CEO of Sprout, a Venture Capital fund platform, explains how VC managers do what they do to try to pick consistent winners and discover that elusive unicorn. Jonny recently guested on The Armchair Trader’s podcast series.
Top performing venture capital (VC) funds have demonstrated returns that far outweigh other asset classes such as the stock market or real estate. And VC funds have played a significant role in the growth of many of the household brands that we know and love, but how have the best funds been able to consistently pick the winners?
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Most established funds screen thousands of businesses each year, making a quick assessment on the vast majority, before conducting more detailed evaluations on those that clear initial hurdles. These businesses are then put through an in-depth due diligence process to establish their competitive positioning, commercial viability, traction and more before a term sheet is offered.
But how does a fund decide which businesses to look at, whether via outbound scouting or when screening inbound leads? Here, we take a deep dive into each of the factors that make up a VC fund’s thesis, and how they can help guide decision making when considering investing in VC.
Specialists vs generalists
Some funds will specialise in a focused set of industries simply because they hold a particular viewpoint on them being high-growth or under-invested. This is typically supported by prior experience having worked, founded or invested in businesses in these sectors, providing them with advanced level insight into the likelihood of success.
Other funds adopt a more generalist approach where they invest in companies across a broader range of sectors.
Whilst specialist funds will often see a greater percentage of their target market, and may be better positioned to understand businesses and their competitive advantage, generalist funds can be more agile with their approach, enabling them to follow fast-moving trends, rather than being tied into a particular area of the market.
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Many private investors will deliberately invest through VC funds to target industries that they like, but don’t understand well enough to invest directly, capitalising on the time that VC funds dedicate to identifying the very best opportunities.
Naturally, companies in different sectors operate across different markets and therefore have variable exit potentials based on client base, scalability, and other market influences. Is it a niche product that has a small addressable market? Can the company introduce new products or services to its offering to stay relevant?
It is also important to consider that certain industries are more cyclical than others, with performance directly impacted by economic changes. For example, consumer spending is affected by inflation whereas biotech and other innovative industries have longer lead times and are therefore less impacted.
When comparing specialist and generalist VC firms, it is not possible to say whether one is better or worse than the other – they simply adopt a different approach with the same common goal of delivering a return on investment across the portfolio.
When to invest?
There is a common misconception that venture capital firms only invest in early-stage, speculative opportunities in search of the high returns that successful growth will bring.
However, much like the sector specialisation, the reality is that a VC fund will invest across a wide range of stages to diversify risk and returns across its portfolio. The typical stages at which a VC fund will look to engage are:
- Pre-seed or seed stage
- Series A
- Series B/C
- Pre-IPO
Investing in early-stage startups is a more high-risk, high reward approach, especially given that statistics show that 90% of startups ultimately fail, with just 0.00006% going on to achieve unicorn status. However, given the lower valuations, those that do succeed see their value increase significantly. Conversely, if a business is at Series B level or further along its journey, it has likely already demonstrated growth with a proven market fit. Whilst this presents a less risky investment, the potential returns are also reduced.
There is no set ‘best time’ to invest in a business which is why we see different funds pursue strategies that suit their strengths when looking to maximise fund performance.
Larger VC funds with greater levels of capital at their disposal will invest across a wide range of stages to diversify the risk and likely return both from a percentage and timescale perspective.
Investing beyond borders
Another factor to consider when assessing investment opportunities is geographical location. If you’re a private investor, your options are likely to be limited to those within your existing network or country of residence due to accessibility, time zones and other factors.
Much like the scalability point made earlier, geographical location of a fund and the businesses they invest in can have a significant impact on growth potential. For example, it is easier to build a large business in the USA than it is in the UK due to the larger population, higher GDP and openness to adopting new technology. We’ve also seen in recent years the rise of innovative firms coming from the likes of Scandinavia and Israel – opportunities that would be difficult to not only identify, but to gain a viable share in as a private investor.
These are just some of the factors that individuals should consider when identifying investment opportunities. VC funds live and breathe investment on a daily basis, developing deep specialism and knowledge of the market, with wide visibility of businesses raising that meet their thesis. This is incredibly hard to replicate as an individual investor, in fact it’s almost impossible.
By allowing VC funds to carry out the depth of research that is required to do so, there is an opportunity for private investors to access greater diversification (across sector, stage, and geography), and professionalisation, that comes from investing in venture capital funds.
Podcast: We chat with Jonny Blausten
The opinions expressed in this article are that of the author. This article does not purport to reflect the opinions or views of Sprout. Nothing contained in this article constitutes investment advice. It is not intended to be relied on to make investment decisions. Eligible investors only. Capital at risk.
