Lesson 1: Growth & Start Up Investing

Growth and Origin of the Private Equity aka Start-up Investing

Venture capital has its roots back in the 1960s and 1970s. While investing in new companies precedes this era, this is where it became a professional industry. The way was led by technology executives who wanted to stay involved in start-ups and young companies without operating them. They had grown their companies and were looking for something else.

The Rise of Angel Investors

Nowadays, we would call these executives angel investors. The classic angel investor is an entrepreneur who has a successful exit and reinvests capital into their industry and related industries. The term, as it is used nowadays, is anyone who invests in start-ups regardless of background or expertise, so long as they meet the accredited investor rule. 

Equity Crowdfunding

Equity crowdfunding has expanded the definition of who might be called an angel investor to include small-scale retail investors. Entrepreneurs should always conduct basic due diligence on any angel investors to see if they are the investor they are seeking to target. Luckily, the definition of a venture capitalist remains unmuddied.

These executives-turned-angels were good at picking winners, and some managers of large funds noticed. This began with university endowments and corporate financial services, i.e., companies that managed large pools of funds. Pension funds are an example of this, but it was not until some laws were changed that these large sources of capital were accessible to venture capital funds. 

Portfolio Management Theory

This era is also a time when portfolio management theory was becoming the norm. Diversification across asset classes was seen to maximize returns while reducing risk, especially given the chance to invest across uncorrelated asset classes. While the small retail investor can diversify using the readily available asset classes, such as equities and bonds, large pools can move markets and become overexposed with limited asset classes.

This is when they turned to alternative assets, which was coined to include a plethora of other assets. The hunt for alpha, defined as a return over a benchmark, led these successful angels to make large returns. This would be a turning point. Angel investing transformed into a more standardized, corporate, and industrial approach we now know as venture capital.

Dedicated Investments in Start-ups

Suddenly, there was a lot of capital available to invest in start-ups, relative to what was available before. It was also much more organized. Rather than having to reach out to individuals, there were organizations dedicated to the investment of start-ups. As much as the venture space right now is seen as based on networking and relationships, it was more so before the organizations known as venture firms coalesced.

Development of Venture Capital

Over time, venture capital developed and became subject to cycles, as most things do. Law and regulation followed, mostly allowing access for more pools of money to gain access. Missing from this equation was the retail investor who was barred because of a presumed lack of sophistication and knowledge. 

Also, because of the risk of the investment, retail investors were deemed unable to afford significant losses. Equity crowdfunding is the first step in opening this space and potentially abolishing the accredited investor classification.

Venture funds now raise large amounts of capital to be deployed and the term “start-up” has become muddled to include multi-billion-dollar companies. Where at one time raising a $100M fund was large, now funds can raise multiple billions for a single fund. The difficulty in sourcing that many investments means that investments into start-ups have become far larger. 

There is an opportunity earlier in the start-up life cycle for those willing to use capital. Angels filled that in the 2000s and 2010s, but as they increased their wealth, the same thing happened. Equity crowdfunding may not have filled a gap at the earliest part of the start-up life cycle, but because of the limitation of raising around $1M it has filled that gap out of necessity.

Venture Capital Firm Structure and Fees

Venture capital is private equity, and a venture capital fund is essentially a hedge fund. The fee structure for venture capital firms models the hedge fund model almost exactly. A 2% management fee per year is taken and when an investment is liquidated, the capital of the investors into the fund is returned. The venture fund takes 20% of the profits and the rest is divided up to the investors. The main difference with venture firms is that the 2% management fee is generally recycled as that 20% stake comes in as cash. The reason for this is that it leads to better overall returns and a $100M fund invests $100M in companies not $100M minus the 2% management fee. Hedge funds have capital coming in and out all the time; in that way, they are like accredited investor-only mutual funds, and the 2% yearly fee pays for the administrative cost of the hedge fund, which runs higher than venture capital firms.