Invest in hot startups without getting burned

Venture-capital funds can provide you with excellent returns, but only if you’re careful—and lucky.

With unicorns—private startup companies worth north of $1 billion, like Uber, Airbnb, and WeWork—thundering past, you may be wondering whether you ought to get in on the venture-capital boom. You can if you’re an accredited investor, meaning you have $200,000 in annual income ($300,000 for a couple) in each of the past two years or a net worth of more than $1 million. Returns can be excellent, but it’s important to do your research before backing a venture-capital fund that invests in young companies.

Money is pouring into startups from these funds, which provided them with $84 billion in 2017, more than in any year since the first internet wave crested in 2000, according to the National Venture Capital Association. The investors behind the funds include university endowments, foundations, and other institutions as well as individuals and family offices. They are seeking returns that beat the S&P 500 index, which historically has yielded 9.8 percent annually. Even after the steep fees that venture-capital funds charge, they could double that figure for you—but only if you’re lucky.

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“Historically, [venture capital] has had better performance than the public markets, especially if you’re with the right managers,” says Michael Chimento, a senior research manager at Ballentine Partners, a Massachusetts-based wealth-management firm.

Picking venture-capital managers carefully can mean a huge difference in performance. Because fees and transaction costs are so high, the returns won’t justify the expenses unless you choose a top-ranked manager, says Carol Schleif, deputy chief investment officer at Abbot Downing, a wealth-management division of Wells Fargo.

Financial advisers typically perform due diligence before offering their funds to clients. Choosing a fund on your own “might limit your sphere to an industry you know well,” Schleif says.

To check managers’ track records, look at their historical performance with several funds, not just the one they’ve most recently overseen, suggests Matt Krna, managing partner of the San Francisco venture-capital firm Princeville Global. Performance figures can be hard to decipher during the life of the fund, while companies are in various stages of investment and sale.

Some fund managers start raising capital for their next fund in the first few years of their current fund’s life. At that point, Krna says, a lot of funds look quite good, “but at the end of their seven- to 10-year tenure, they might look much different.”

To help clients minimize risk, some financial advisers point them to funds of funds. These come with extra fees—often an additional percent of the assets invested, plus 5 to 10 percent of the profits earned above 5 or 6 percent—but they give you diversification across a variety of venture-capital funds, Chimento says.

“We don’t take extra layers of fees lightly, but in this asset class we feel it’s worth it for the access,” he says.

Direct investors in venture-capital funds pay a standard fee of 2 percent of the amount invested, plus 20 percent of the profits. Fund managers occasionally give large shareholders a break on this “2-and-20” structure. A fund can have a 10-year lifespan, with the first three to five years for investing the money and the back half for selling or merging companies, Schleif says.

You won’t have access to your money until the fund finishes selling off its stakes. Because these funds are usually set up as limited partnerships, at the end of their life the managers will return the capital and profits to investors. “If there’s any chance you will need the money before the life of the investment is up, it’s not the right investment for you,” Schleif says.

The minimum amount you can invest depends on the fund’s size. A fund that makes relatively small seed financings might accept $500,000 to $1 million, while a more established fund making larger and later-stage investments might require $10 million commitments, Krna says.

To determine how much of your portfolio you should allocate to venture capital, first decide how much of your equity holdings you wish to put into private investments, which include funds specializing in private equity and buyouts as well as venture, Chimento says. That range could be from 0 to 40 percent of the equities you hold, he notes, depending on your risk tolerance.

Within your venture-capital allocation, it’s important to diversify. Make sure the funds where you put your money invest in different industries and geographical regions, as well as different stages of a business’s lifecycle, from new startups to companies about to go public.

Managers of funds that invest in startups are gambling that just one or two of many investments will boost overall returns. If one proves as successful as Facebook, the rest can go out of business, and the fund’s performance could still be excellent.

One stumbling block: usually only well-connected investors are allowed to invest in the top early-stage funds, Krna says. “If you don’t have a strong set of personal relationships, it’s hard to get access to the best early-stage funds,” he explains.

“If you choose to invest in smaller funds, you may be able to foster a closer relationship with the general partners who manage them,” Krna adds. “Because they know a specific industry well, they can offer advice much as a consultant would.”