Pitfalls LPs Need to Avoid When Co-Investing Directly in Startups

By Ben Casnocha

At Village Global, an early stage venture firm where I am a partner, we have the privilege of working with several of the largest family offices in the world, along with university endowments and other institutions. As LPs, they expect to generate a return on their investment in our fund. Many of these LPs also seek opportunities to invest directly in our underlying portfolio companies in subsequent rounds (Series A and beyond).

For LPs keen on minimizing fees and carry, the appeal of going direct is obvious. Especially if they can leverage a GP’s initial sourcing effort and then cherry-pick the best underlying companies in the portfolio.

LPs directly investing in startups sounds good in theory. But in practice, there are pitfalls.

A key challenge LPs face with co-invests: adverse selection on the quality of deals

Here’s the most important question: Why would a startup that’s breaking out, with plenty of financing options, take money from a family office, endowment, fund of funds, etc. when they could partner with one of the many excellent venture firms who solely focus on supporting startups?

Great VC firms like Accel, NEA, A16Z, and Greylock employ teams of people who help on recruiting, marketing/PR, sales, and more. It’s rare for a family office or endowment to offer anywhere near the same level of portfolio services. It’s rare for the investment staff at an LP office to be filled with ex-entrepreneurs chock full of operational wisdom, as is the case at venture firms.

So the risk for LPs when doing directs is that they access all the startups that were unable to raise money from great VCs. It’s those dreaded words: adverse selection.

That said, plenty of LPs do successfully co-invest in great startups. What are value propositions from LPs that resonate with GPs and founders that would lead to allocations in the best companies? There are at least three.

Three possible value propositions from LPs to startup founders to win better deals

1. The principal of the office is well known and personally engages. If it’s a family office or foundation with a living, high profile CEO who’s involved in investment decisions–this can obviously stand out to founders. For example, if you’re Jeff Bezos’ family office, and Jeff is potentially active with founders, that’s a differentiator to win over venture firms. 95% of LPs will not be able to use this strategy.
2. The LP offers specific, strategic value to startups that are unlikely to be served by traditional VCs. For example, they can open doors in China, or they maintain a huge real estate portfolio and so can be of service to real estate tech companies, or they’re deep in the entertainment/celebrity world and can help consumer social companies, etc. There’s some domain area where the LP has a specific value-add.
3. The LP can move quickly, commit early (i.e. not wait to be last check in), and be low-maintenance post-investment. If an LP is comfortable making a decision in a week or two, and doing so without maximum social proof, their odds of gaining an allocation goes up dramatically.

Value prop #3 is the most common way we see LPs win co-invest opportunities over traditional VCs. Because the LP has already underwritten the GP, when the GP comes recommending a direct opportunity, the LP can move quickly given the presumed good judgment and trust.

It’s important for LPs to make concrete to founders how this value manifests.

• Speed = “We’ll make a decision within a week.”
• Committing Early = “We’re happy to invest before you’ve secured a lead in the round.”
• Low Maintenance = “Call us if you need us. We won’t bother you otherwise.

Committing early is the hardest principle to put into practice. When you wait to commit until Benchmark is known to be leading the Series A, there won’t be room left. You’ve got to commit earlier. Striking the balance between moving quickly and waiting for signal on a deal is difficult for LPs who are not experts in direct venture investing. This may explain why many LPs focus only on true late stage co-invest opportunities, i.e. Series C or later. When the round size is $30M+, it’s more possible to gain allocation – given the larger overall capacity – after a high quality lead is set.

There is one other way LPs co-invest that has nothing to do with their value proposition: The lead VC recommends an LP to the founder (for competitive reasons)

Occasionally LPs successfully directly invest in startups for reasons that have nothing to do with their value-add to founders. Indeed, one of the most successful venture backed companies in history had a somewhat random family office on their cap table next to a Tier 1 VC. How did this happen?

The company needed to round up some more capital but the lead VC didn’t want a competitor (i.e. another brand-name VC) on the cap table who might be a nuisance in later rounds by fighting for greater allocation. So the VC encouraged the founder to bring in a family office as a non-threatening source of “top-off” capital.

Of course, perhaps the founder would have been better served by adding another value-add VC on the cap table. But founders listen to their lead investors perhaps more than they should, and in this case, Tier 1 VC + Family Office was pitched as the fastest way to get the Series A done, and so it was.

How LPs can work with partner funds/GPs to gain better direct flow

To find, select, and win allocation in the best tech startups directly is exceptionally hard. For LPs, it requires either a robust fund portfolio of GP partners who can be your partners and/or  a large direct investment team who do nothing but talk to founders directly. For many family offices and smaller institutions, it will likely cost less to pay management fees to GPs and leverage their portfolio than it would to hire several principals and associates to do direct top-of-the-funnel deal sourcing. Some tips on working with GPs on co-invests:

• Don’t invest the minimum in the fund if you want to be prioritized for co-invests. As GPs, we prioritize LP access for co-invests first based on potential value-add to our founders (founders come first), and second based on the LP’s financial commitment to our fund and the depth of the relationship. I recently had a prospective LP tell me, “Our strategy as an LP is to play at the minimum in terms of our fund investments and then spend as much time as possible looking at directs.” The conversation didn’t last long.
• Be as clear as possible with your fund managers about what you’re looking for. Set specific parameters of interest around stage, sector, and your likely check size. “Send us your best companies” isn’t specific enough. GPs don’t know how to categorize you in their head when they’re thinking of ideal co-invest partners.
• Don’t be overbearing with your fund managers when seeking portfolio intelligence. A GP friend recently told me he declined the overtures of a well known Fund of Funds who wanted to invest in his seed fund. He declined because “the FoF will be calling me every two weeks and pumping me for information on every portfolio company, looking for direct opps. It’ll be exhausting and a huge time sink.”

And of course most importantly, to reiterate the main thrust of this article: Develop a real value-add pitch why founders would benefit from your involvement, even if that value prop is speed and ease. And make sure your GP fund managers know how to articulate that pitch in market!‍

(Thanks to Samir Kaji for his feedback on a draft.)

This piece originally appeared on the Kaufman Fellows site.