New Club Enables Angels to Enjoy Top Decile Performance of VC Funds. How Risky Are VC Investments and How Can You Support Startups at the Beginning and Still Expect a High Return in Any Market Situation.

Investing in startups is exhilarating. Many angels enjoy supporting entrepreneurs who create something out of nothing, joining the journey — riding this roller coaster even if they’re not driving it themselves, assisting with funding, and sometimes even guidance. Such investments are inherently risky, and our motivation as investors, aside from perhaps spicing up living room conversations, is the remarkable returns achievable — the greater the risk, the greater the reward, they say, primarily when investing in early-stage startups.

Indeed, according to PitchBook Data, Inc., as of 2022 the median of venture capital funds raised  between 2017 and 2021 enjoyed an IRR of over 20%, while the average IRR of the S&P index over the previous decade stood at just 10.4%.

However, venture capital investment demands considerable patience, as IRR estimations are based on valuations of VC funds assigned to startup equities. Still, most of these investments are “on paper” and not liquid. Investments can take many years to materialize, and the question is whether the anticipated return justifies the risk and illiquidity. When looking at the top decile performance of venture capital funds from2014 vintage onwards, the IRR ranged between 35% and 55%, so if investors choose startups wisely, the reward is highly worthwhile (according to PitchBook Data, Inc., as of 2022).

We note that at the macro level in recent years, the multiples of traded high-tech companies have been getting smaller and smaller, and interest rates have risen, so many investors have preferred to sit on the fence.  As a result, many companies in the private market lost their estimated valuation. Therefore, we have observed a decline in the performance of venture capital funds in the last year. Due to the current situation, we are seeing more and more investment opportunities with reasonable valuations for their risk levels. In addition, due to the monetary expansion trend, we expect excess growth potential for those new startups created today.

We see a correlation between the valuations of traded companies and the valuations of startups in the private market that  are backward derived. That is why professional VC managers in the top decile always know how to provide an attractive excess return, compared to the S&P 500 index, even in challenging market conditions, especially if they did not participate in transactions with inflated valuations.

So, how do you start or improve investing in startups?

Many private investors approach me and ask how to enter this world. I always respond with the advice that every investor needs to ask themselves honestly: If they lose all the money they invested, how much would it hurt them, and how much would it affect their quality of life? If you answer that the sky will fall if you lose the money, simply don’t enter this field.

Therefore, allocating only a portion of the capital to startup investments is always advisable, each allocating a certain percentage according to risk preferences. Full disclosure – I have put all my savings into startup investments, but that’s because I’m a professional in the field :).

The second piece of advice, and no less noteworthy, is never to put all your eggs in one basket. If you invest in this asset class, diversify your allocation across several startups to better manage risk. Even startup investments with great promise may end in disappointment, so be cautious and manage a portfolio of startup investments within this risky capital segment.

Another guiding principle is that success in venture capital investment requires expertise. It may sound obvious, but in practice, it’s something many angels fail to grasp, especially at the beginning.

So why not invest in a VC fund, and that’s it?

Many private investors prefer to invest directly in startups rather than entrust their money to a VC fund to manage their portfolios. There are various reasons, such as angels’ satisfaction in choosing startups themselves, working closely with the entrepreneurs, avoiding fee payment, or sometimes, I would claim naively, the feeling that they could achieve high returns if acting independently.

I often encounter family offices or private investors who have tried to invest in startups in the past and, after being burned and losing their money, reached the “inevitable” conclusion that investments in startups are a problematic field not worth entering. There is some mistaken conception that investments in startups are a commodity. However, the truth is the same way you wouldn’t hire a random person to build you a kitchen with zero understanding and experience in carpentry – it is a mistake to think it’s worthwhile to invest in startups without genuinely understanding and specializing in this field. Despite the inherent risk, startup investments are far from being a roulette!

Even if a private investor concludes that it’s right for them to invest in a VC fund, here, too, there are challenges, as many funds fail to fulfill their promise of decent returns, and one needs to know how to choose the better funds. There isn’t necessarily a correlation in this field between the fund’s ability to raise from investors and the fund’s professional ability to make suitable investments. From personal acquaintance, I would even say there might be an inverse relationship, as evidenced by the findings of a 2021 report by a committee appointed by the Israeli Capital Market Authority, which indicated that “investments by Israeli institutional bodies in private equity (PE) funds in the past decade… yielded lower returns than could have been achieved in major US stock indices such as the S&P 500 and the NASDAQ… VC funds in which Israeli institutional bodies invested lagged significantly behind these indices.”

Moreover, unlike institutional bodies, many angels usually have limited resources. They cannot, or do not want to, commit years ahead to put up the high capital required to invest in leading VC funds.

The challenges in direct investments and the ultimate answer that is more accessible than ever

The reason for the high risk in direct investments by angels is that most of them do not work in this field, and often, the opportunities that come their way are random and based on sporadic mutual acquaintances. If an angel is not a guru in a specific area whose advice entrepreneurs crave or has some exceptional networking, the odds may not be in their favor. Even if an angel succeeds in one or two investments, gaining a reputation or developing special access, investments in startups are still not their primary profession. It requires meticulous work to create access to a quality range of startups and expertise to evaluate and decide where it is worth taking the risk.

Other challenges that angels face are their ability to take care of their interests as minority shareholders, the time required to support and mentor entrepreneurs, and, of course, how to make the investment round happen – not all private investors enjoy negotiating with entrepreneurs or can lead a deal with a relatively small amount.

The M-Fund Club I founded over four years ago aims to address all the challenges private investors face. Thanks to the club, we support the Israeli economy and manage to create category-leading companies. We take pride in making top-tier venture capital performances accessible and affordable to angels.

* The writer, Lior Elkan, manages the M-Fund Club, an experienced venture capitalist who provides breakthrough startup investments to angels and accredited investors. For more information: info@mfundvc.com