Family offices (FOs) control and manage substantial fortunes of private individuals. These individuals either run large family businesses or were part of a liquidity event resulting in significant magnification of wealth. The vision of a FO is to secure finances by building, preserving, and finally transferring family wealth and legacy for generations.
FOs have been successful with investments in asset classes like real estate, equities, fixed income, commodities. These options are well advised to FOs by private banks or family office experts managing broad range of financial products. For FOs, there are many reasons to be paying attention right now. So much is going on in the startup space that I find very interesting opportunities for wealth creation.
Knowing many of these FOs personally, they have appetite & desire to invest in booming startups space. But most of them end up being passive limited partners (LP) to venture funds.
Startup investment strategy requires different talent, insights & skill sets. Starting from discovering seed stage startups, working with founders, building a diversified portfolio and finally securing exits, requires different experience but it’s not rocket science. I’m always pushing FOs to get directly involved with founders, get educated about startups, and to talk to other FO’s and build the portfolio together.
Family Offices Are Doing Direct Investment In Startups
Family offices are no longer considered tourist investors in startup space. They find direct investment in startups attractive as small bets can create big winners. It’s exciting to fund future and engage with founders directly. FOs no longer want to invest in blind pools but rather take selective bets with deal to deal in depth understanding.
FOs now want to leverage their core expertise & network of connections by investing in startup which are directly or indirectly strategic to their business. Founders know that raising equity capital is tough with VCs because of their short term financial expectations whereas they look at FOs as business mentors & their investments as long term, patient capital.
Today FOs clearly understand that their direct involvement with startups can result in potentially higher returns.
Three Questions To Be Asked By Family Office For Every Deal Opportunity
Is there money to be made?
The first question to begin, when you get a pitch for review. Evaluate what’s that unmet need that these founders are solving, the key value proposition, total addressable market size, market validation, solution offered, business entry barriers & finally the most important a does it have a wow product with IP.
Are these the people (founders) who will make me money?
The second question to follow up with is – assessment for the integrity of the said rock star team, execution plan, go to market strategy, financial assumptions & finally the most important understanding of the founder’s passion & hunger for investments to grow.
How much money can we make?
Final question is to assess the IP unfair advantage to make profits, current traction, deal mechanics, funding requirement, co-investors on the cap table, terms of investment, valuations & finally the most important what are the rights offered in the SHA.
Portfolio Strategy For Direct Startup Investments By Family Office
- Invest in a minimum of 10 startup deals (lifetime objective).
- All deals must at least have a potential for 20X.
- Plan for 2 rounds investment in each startups.
- 2-5% of total assets should be invested in startup.
- Divide total financial commitment by a minimum of 20 startup investments.
It’s not necessary to do extraordinary investments to get extraordinary exits
Typical Exit Triggers For Family Offices
Family offices are not seen getting into early-stage, seed investment but they tend to get involved later with Series A or B onward. FOs should not lose patience and expect high yields within 3 year of investing.
- 1X returns typically to be expected with acqui-hire type exits within 2 to 3 years from the date of investment.
- 10X returns is expected with corporate acquisition exit to take 4 to 5 years from the date of investment.
- 30X return can be expected with VC, PE exit & can take 8 years or more from the date of investment.
- Unicorn with a blockbuster IPO exit to happen will take at least 10-15 years from the date of investment.
Family Office Investment Thesis
- Do small bets early with Series A investment rounds – if it’s FO’s lead investment then acquire 10% to 20% equity stake. With co-lead investments take minimum of 5% equity to max 10% & then follow up the high growth companies till Series C.
- If the required equity thresholds are not met via primary investments then look at acquiring secondary equity stake (at discount) from existing investor. Secondary equity stake acquired will have lesser or no SHA rights in comparison to the equity stake acquired through primary.
- Maintain a healthy balance with 80% new investments & 20% with follow-on investments. For investment selection give 80% preference to founders & 20% market size, business plans are only 20% of the success, balance 80% is all about execution. Invest 80% of the family office time to hack exits & 20% of the time for due diligence, favour early exit in 80% of portfolio & stay put long-term in 20% of portfolio, 20% of the portfolio will generate 80% of the wealth.
- Focus on investing in startups working on future endeavours because it’s easier to look at existing cheaper & better value propositions than to back startup focusing on new businesses created due to an abundance of technology, power, sensors, storage.
- Don’t get hung up on mechanics or deal terms. Invest time on whether the startup is good or not. When FO’s get bumper exits from a deal, it’s because the company was really successfully disruptive & not because valuations were attractively low.
- Invest in companies with clean capital structures & with zero tolerance to innovations in finance & legal. While investing in right opportunities is important but equally important is legal documentation that protects FO’s rights. Be direct in engaging with the entrepreneurs, Be challenging on milestone deliverable, but not destructive.
Founders To Be Avoided
- Boy In Costume: Founders with elite college degree aiming to be a corporate strategist with his freshly printed business cards with the tag “CEO.”
- Paranoid Founders: These suspicious secretive geniuses want to develop business at scale without talking to anyone including investors.
- Flawed Egotists: On getting funded, founders get a tremendous boost to their confidence. It’s good but when they start thinking that they are smartest people on earth, the problems start.
- Superman Founders: They think themselves as super human with infinite strength and capabilities to solve everything and anything.
- Over-hyped Founders: Media has made startup founders part of gossip pages. Founders love to see themselves in media glamour. They believe in self-aggrandising promotions.
- Gold digger: These founders dream of becoming rich by following trends, attract investors and build companies like playing a poker game with investors’ money. These gold diggers believe money is the solution to everything.
- Perfectionist Founders: These founders struggle with issues of hiring team, product release, and invariably delays & costs business at every juncture.
- Copycat Founders: They portray themselves as excellent copycats and are proud being successful in doing it so well. These founders are looking for instant gratification. The Internet has produced an accelerated pace of business cloning. These founders are short on ideas & will typically quit early in the game.
Family Office Deal Evaluation Sheet Scores
- Management Team 0-30%
- Size of Opportunity 0-25%
- Product & technology 0-15%
- Marketing/Sales channels 0-10%
- Competitive Environment 0-10%
- Other 0-10%
Engaging With The Startup Expert
The right selection or partnering with a trustworthy confidant can help FOs identify direct startup investment opportunities. There’s no substitute for the knowledge and insights gathered from hands-on work done by these successful confidants. The turnaround times required with startup investment deals is 5X faster.
Private banks and venture funds have lengthy chains of command, filled with bureaucratic policies, hence, they are not preferred by FOs to engage with startups. FOs trust the startup expert confidant more as they offer transparency with sincere personal attention. FOs should work with selected confidant who either is a technology evangelist or has an established network of specialists to call upon to evaluate the unique deals.
Most of the confidants would have comprehensive profiles of the wealthy people with whom they work with. FO’s can maximise opportunity and minimise risk exposure by being part of these syndicated deals along with a like-minded group of investors sharing common investment thesis. FOs see these confidants as specialists – a trusted partner despite their size & value their ability to discover winners.
Until we enjoy an exit, we investors are just donors.
[This post by Sanjay Mehta first appeared on LinkedIn and has been reproduced with permission.]
[Note: This article is part of The Junction Series. Sanjay Mehta will be speaking at “The Junction” in Jaipur in January 2017. Get a deep dive into angel investing, the metrics of funding and more with him. Learn more about The Junction here!]
