In the alternative investments space, attorneys have long been able to play an important role. Whether the investment in question is senior bank loans, non-recourse litigation finance liabilities, venture capital investments, or hedge fund vehicles, attorneys play a crucial role in helping clients to evaluate risk. Given that, there is an exciting new business model in the venture capital space that attorneys should be aware of. This model has the potential to turn the VC space on its head over time given the significant opportunity for returns around it.
Essentially the new model being used by a select number of VCs such as London-based Invoke Capital, involves identifying promising ideas from high-caliber individuals and then working with those individuals to build the company from the ground up. This tactic has some similarities to what angel investors do, but with some important differences. Angel investors generally make early stage investments after family and friends, but their involvement with the company is usually arms-length, and angel investors often lack the resources to build out a professional organization. In contrast, VCs getting involved at the earliest stages have the ability to staff the startup with an experienced executive team they are comfortable with, and to help the startup focus on building a company rather than focusing on looking for funding.
Two recent consulting engagements I worked on illustrate the perils of the traditional VC model and the attractiveness of the new model. In one company, I served as an interim CFO and helped the firm to raise VC money in order to take their product from a patented prototype to full production. Despite the company having letters of intent from four separate major corporate customers on three continents worth hundreds of millions in potential sales, the fundraising process was still difficult. The process of raising VC funds took months, enormous amounts of time from myself and the rest of the company executive team, and required countless meetings with VCs and strategic investors. If it weren’t for the fact that the firm had a stable financial footing from the founder, a promising company with a patented product might have ended up defunct.
In this traditional VC model, a good attorney can help investors with understanding the risks in the process, but the transaction time and cost is significant no matter what the circumstances are.
In contrast, I also currently work with a mid-sized VC firm in the Boston area that follows the new VC model. Rather than investing in later stage firms though, the VC fund instead looks to reduce risk by identifying promising university inventions by professors, and then building a company from the ground up around them. The fund currently has more than a dozen different portfolio companies that they have built this way. (My role as a financial economist and a university professor is to help them vet the inventions and projects with the most financial promise based on data analysis work.)
A research study that I did of the new VC model versus the traditional model based on data gathered from funds across the country suggests the new model has internal rates of return that outperform traditional VCs by more than 10% annually. My results are similar to finding from benchmarks shown in the table below.
The strength of the new VC approach stems not only from the ability of the VC to select their executive team, but also from keeping those executives focused on building a company rather than looking for investment to keep the company afloat as it grows. Getting in at the earliest stages of the company with an idea which is solid also dramatically improves returns.
The university innovations market is particularly attractive for the new model of VC funds because most university professors are generally required to do significant amounts of research and develop new ideas and inventions. That’s true at my university and most other high-quality universities, both public and private.
Virtually every professor in the STEM disciplines, and many in the business disciplines, has an algorithm, piece of software, or novel type of invention that could have merit as the basis for a new company. Universities are terrible at capitalizing on these ideas, and professors are even worse. As a result, the ideas often languish unused on the shelf indefinitely.
This market represents a major opportunity for VCs to tap. Again, attorneys can play a role in helping VCs in the new model by crafting contracts which protect the interests of both the inventor/company visionary and the VC who will professionalize the product.
As the alternative investment market evolves, attorneys should keep in mind the next generation of opportunities like the one described here. Fund managers and investors will need help with a variety of services from risk management and contracting to deal sourcing and evaluation. The attorneys who serve clients best will be the ones looking forward and evolving as the markets evolve.