Family offices bet big on startups through direct investments
By AMY GUTTMAN
More family offices have joined hedge funds and private equity in the quest to discover the next "unicorn." Driving this trend is a boom in startups valued at $1 billion over the past decade and the fact that venture capital has outperformed every major asset class in the past three years.
Just this month, billionaire Andrew Forrest announced that his family office, the largest in Australia, had formed a $250 million venture capital fund focusing on investments in medical technology. J. Hunt Holdings, cited by Crunchbase in 2018 as one of the top 10 family offices with the most direct investments, recently participated in a $2 million seed round investing in Spectrohm, an internal-imaging company developing technology to inspect mail and packages.
A recent report produced by Silicon Valley Bank and Campden Wealth found that family offices invested in 5% of global venture deals (direct equity financing to startups and small businesses) in 2021, compared with only 1.9% in 2011. Already, in the first half of this year, family-office direct investment has reached 4.6% of deals. Many still rely on fund managers to access deals, but on average, family offices allocate 54% of their venture portfolio to direct investments versus 46% to funds.
Early-stage funding remains the largest source of investment from single-family offices, making up 41% of venture investing. Nearly a quarter of early-stage direct transactions are from family offices with $50 million to $100 million in assets under management.
Historically, family offices have invested through VC funds or funds of funds. But now they are facing high minimum commitments starting at $1 million for funds and frequently $5 million to $10 million for funds of funds, along with substantial fees. As a result, offices with active, tech-savvy next-generation members or those led by former founders trying to create first-generation wealth are seeking direct deal flow.
LOWER VALUATIONS = MORE OPPORTUNITY
Geopolitical instability and inflation are pushing greater diversification, while market volatility is putting pressure on valuations, creating more opportunities for family-office investors.
“There’s been a readjustment, given the market volatility, that has had a cascading effect on valuations,” said Shailesh Sachdeva, who heads the family-office group at Silicon Valley Bank. Some valuations have dropped as much as 40%, he said.
But some caution that direct investing isn’t for everyone.
Former founder David Neubert is partner and CIO of the multifamily office Eagle Bay Advisors. Neubert uses a hybrid approach, investing with other former founders and through VCs.
“While I have had a couple successful and many not successful exits, the source of my wealth is principally my trading in securities markets,” he said. “I try to outsource my angel investing, as I have a terrible track record. Some of my partners are much better at it.”
Direct investing, Neubert said, requires a more attentive approach — monitoring and tracking each business and subsequent investment rounds, which can be cumbersome. In contrast, VC firms are responsible for managing the investment.
Early-stage investments are attractive to former founders who have had to raise funds and exit. Manuel Ho is building his second fintech startup, INTNT, which provides improved AI-driven chat and voice bots for the banking industry. He received substantial seed-stage funding for both of his startups from a serial fintech entrepreneur with his own family office. It’s a natural fit, Ho said.
“They usually go first and take that risk,” he said. “They see a whole range of skills and assets that typically VCs cannot see. They also feel like they can add value to the project itself.”
Beyond the desire to replicate success, there are practical reasons to pursue direct deal flow. Though Neubert mostly entrusts partners with venture investing, with some exceptions, he said, investing directly offers attractive tax advantages. Section 1202 of the IRS code states that if you invest in a qualified small business that raises under $50 million, then up to $10 million of your profits are tax-free.
“The tax break is the reason a lot of people do these direct deals,” Neubert said. “The other pros are you get in earlier; and you’re not paying the fees to a VC firm, which are really high. Investors feel personally connected with the deals.
“I try to be hands-on. I used to design trading platforms, so I’ve been involved with companies that do that.”
For entrepreneurs, direct deals with family offices also bring benefits. VCs typically require an exit within 10 years. Family-office investment is considered patient capital, since investments are usually held longer.
Due diligence and trust-building can be slower than with VCs. But both parties see the relationship as a marathon, not a sprint, with family offices often investing in subsequent rounds.
There are other incentives, Ho said. “If you want to grow organically, with yourself as founder, then family-office money is better,” he said. “VC money is more expensive, and many times their ideas conflict with a founder.”
Like any other asset, deep sector knowledge is vital, as is due diligence on the team, the idea, the market, customer acquisition and the ability of the team to execute. Delivery is everything — and those who have done it can bring money and wisdom to those who aspire to do it.
Family-office investors with a background in the same sector can help with customer acquisition, recruitment and other aspects of the business.
Sachdeva emphasizes that building networks and performing due diligence are critical to direct investing. Attending conferences to cultivate relevant contacts can provide access.
“It’s the people that have the network that are the great investors,” he said.