Co-Investment As A Stand-Alone Product In The VC Space
Published by Forbes Finance Council
“Never let a good crisis go to waste.”—Sir Winston Churchill
Last year, the industry had arguably one of its worst years in a decade. Global startup investment in 2023 was down by 38% to $285 billion versus the year before, while fundraising by VCs reached a paltry $67 billion across 474 funds compared to $173 billion for 1,340 funds in 2022.
There are many ways investors get exposure to startups. The two most obvious paths involve investing in funds managed by professionals or investing directly in companies themselves. A third way involves co-investing into transactions arranged by the VC managers. It allows the investor to capture the best of both worlds: The deal is essentially done by the VC, so you are benefiting from their expertise and fully outsourcing the transactional work, plus you can cherry-pick a portfolio for yourself as if you were investing directly.
With venture capital going through a rough patch, investors are wary of investing in VCs, while their appetite for startups and tech remains intact. Co-investments are an alternative option to satisfy this demand. The deal-by-deal fundraising required for such transactions is also an attractive way for managers to generate extra revenues in the down cycle.
Structure
The most common way to arrange co-investment transactions is for the VC manager to create a special-purpose vehicle (SPV). The VC uses its main fund to invest in the underlying company through this SPV and opens it up for co-investment at the same time. The SPV’s articles and the co-invest documents become the main documents governing the relationship between the VC and the co-investors. The SPV can be structured as a limited liability company or a partnership, often with investment cells created for each underlying co-investment.
There are three key aspects to take into consideration for co-investors:
1. Fees. The VCs usually take transaction or management fees and carried interest for arranging the transaction. These fees vary significantly and very often depart from the standard structure used in private fund management.
2. Rights. Co-investors want (i) access to ongoing information on the underlying asset’s performance, (ii) exit rights aligned with the VC so that their position is treated in the same way as the main fund investment and (iii) pro-rata rights for further investments into the underlying asset.
3. Liquidity options at the SPV level. A co-investor may decide to exit the position before the underlying asset is liquidated. Understanding how this would work in practice is recommended.
Benefits For Investors And VCs
The benefits of this scheme for co-investors are obvious. They often get to do VC-managed deals with discounted fees. They leave due diligence and negotiating the deal to the VC manager, while, crucially, they keep the investment decision for themselves, providing them with agency in building a portfolio versus a fund investment approach.
The benefits for VCs are more nuanced. Offering co-invest products allows VCs to drive more volume, increasing their total assets under management; however, they can cannibalize demand for the funds they manage in the process. Co-invest products are a much less stable source of revenue and should be used as an addition to a VC’s funds business. They also create complexity and increase the administrative burden on VC managers, taking away time and resources from mainstream fund work.
Probably, the most important benefit for the VCs lies in the flexibility that the co-invest structures provide. A classic win-win example is where the main fund is already at its diversification limit with regard to a well-performing company, and the VC uses the co-invest route to drive further funding from its limited partners into this opportunity.
There are also clear benefits for the underlying companies. They open themselves up to new investment but shift the sales workload onto their existing VCs. The VCs also act as a shield in terms of administration and corporate governance, so the company keeps its own cap table lean.
Productizing Co-Investment
Angel networks and marketplaces for crowdfunding into startups have existed for quite some time. These have focused primarily on small tickets and nonprofessional investors. In the past few years, there has been a significant surge in family-office networks and marketplaces for professional investors.
VCs have taken note and do not want to be left out of the action. Some are creating their own co-investment communities and turning this part of their business into a stand-alone product alongside their main fund business. This involves replacing the ad hoc, deal-by-deal fundraising via emails and investor meetings with a more structured approach, where investors are pre-vetted and then have access to organized information on the available co-investment opportunities through a digital medium.
VCs looking to add this product to their roster should consider the following:
1. Maintaining focus and efficiency in their operations. Deal-by-deal fundraising requires a lot of effort for sales, legal documentation and post-investment administration. The emergence of modern automation tools provides a neat solution to tech-savvy VCs.
2. Allocation between the fund and the co-invest product. They need to develop clear rules on when the co-invest product should be used so that conflicts of interest between the fund and the co-invest are avoided.
3. Participation of limited partners vs. non-LPs in the co-invests. This is potentially the trickiest piece of the puzzle, as achieving breadth of distribution, maintaining exclusiveness and endowing LPs with certain allocation advantages are all important, but contradictory, goals for the VC manager.
Every crisis presents its own unique set of challenges. VCs need to constantly innovate and evolve their business model. They have to prove to their investors that they continue to be an efficient way to allocate capital into the startup world. No industry seems to be immune from the era of disintermediation brought about by the internet, and in an ironic twist, it seems to be catching up with the VC world. The co-invest product is an intriguing response to this crisis. With respect to Churchill, we will do our best not to let it go to waste!