Joe Reilly speaks to David Teten, partner at ff Venture Capital, about how technology will disrupt wealth management, angel investments for family offices and crowdfunding.

Part two: This month, family office consultant Joe Reilly has an in-depth interview with David Teten, partner at venture capital firm ff Venture Capital and founder of the Harvard Business School Alumni Angels of Greater New York, about how technology will disrupt wealth management, angel investments for family offices and crowdfunding. View part one here.

Joe Reilly: You are an investor in Indiegogo.  Do you think crowdfunded start-ups will be seen as viable investments or just fun lottery tickets?

David Teten:  We are really excited to see the impressive growth that Indiegogo has achieved, and we know that this is just the beginning for them.  Before answering that question, let me clarify that there are four types of crowdfunding:

1. Donation-based crowdfunding: Contributions go towards a charitable or artistic cause like a literacy program.  Indiegogo started out as a vehicle for funding artistic projects such as movies, and is still heavily used for that purpose.

2. Reward-based crowdfunding: Investors receive a tangible item or service in return for their funds.  E.g., you could commit some money on Indiegogo and get an early shipment of Interaxon Muse, a brain-sensing headset (another one of our companies).  Rewards-based crowdfunding is a big driver of Indiegogo’s success now.

3. Lending-based crowdfunding: Investors are repaid for their investment over a period of time, e.g., LendingClub or Prosper.  This is not a focus of Indiegogo.

4. Equity-based crowdfunding: Investors receive a stake in the company.  Indiegogo is not currently in this business.  Numerous other companies are, including but not limited to AngelList, SeedInvest, and OurCrowd.

Services like Angel List syndicates are reducing the traditional information costs and access issues that have made angel investing more work.  However, I’m obliged to emphasize that the time people put into angel investing is precisely a driver which helps make it a high-returns asset class.  The jury is out on whether the increasing ease of angel investing will potentially lower returns.  I believe that the highest-potential entrepreneurs will have a strong preference for experienced VCs and angels as investors, such as ffVC, not individual angels they don’t know and who do not have a track record of being value-added investors.

Joe Reilly:  The trend in VC is to raise ever-larger funds on the back of good returns, many in the billions.  Why don’t you get on that bandwagon?

David Teten:  Simon Lack reports in The Hedge Fund Mirage that from 1998 to 2010, hedge fund managers earned $379 billion in fees, while their investors earned only $70 billion in investing gains.   Would you pay a $379 tip for a $70 meal?

There is an inevitable tension between size and returns in asset management, but the compensation structure of the industry encourages raising ever-larger pools of capital. This is like a restaurant, which keeps opening more branches while their profits per customer steadily decline.

VC funds on average earn two-thirds of their compensation from fixed fees, not carry, so the motivation for a larger fund is clear. However, small VC funds earn much higher returns than most other asset classes, let alone the large VCs.  The Kauffman Foundation reports that no VC fund larger than $1 billion returned more than twice the invested capital after fees.

We are optimizing for high returns rather than high assets under management.  We have over 200 investments in over 70 companies.  Our strategy is to be the institutional-quality investor in the Seed/Series A space.

Joe Reilly:  Yes, but given your small fund size, aren’t you going to have a relatively small percentage of the company upon exit?

David Teten:  Sometimes, but that’s a feature not a bug.  Our ownership percentage on exit depends on a number of factors, including how much capital we initially invest, how much capital the company raises in subsequent rounds, and when the company has an exit.  Our goal is to optimize for returns, not ego or percentage of company.  The investors with big percentages of the company at exit are the ones that, on the median, have mediocre returns. In addition, we are optimizing for diversification and risk management.I have frequently heard the expression from other investors, “We can put a lot of money to work here.”  This is the psychology that drives VCs to load up a company with more capital; rationalizing that $5 million at a $20 million pre-money valuation is little different than $10 million at a $40 million pre-money valuation.  By spending more money, investors can justify managing more money, which in turn increases their fees. This is like a chef who likes to buy a whole cow in order to serve a client one hamburger.

This is very different from the way most of us think about investing; in our personal lives and in most operating businesses, investors try to spend as little as possible for the maximum results.  We believe it’s healthier to stage our investments in a series of modest-size checks.  This lowers our risk, increases diversification, and, we believe, creates a healthier corporate culture.  According to CB Insights, there is little to no relationship between financial runway and startup success.

Joe Reilly:  Do you think technology companies currently are overvalued?

David Teten:  Most investors in traditional asset classes value a potential investment based on some variation of a discounted cash flow.  However, I’ve seen many VCs who value companies as an option: the company has a 1 per cent chance of being worth $1 billion, therefore it’s worth $10 million.

This may make sense from the individual perspective of a given VC, but collectively it ensures that early-stage companies are overvalued.  It means that mathematically, 99 investments will go to zero, while one will yield a 100x return.  This is one of the reasons that VC returns are consistently mediocre; what if that one long shot that everyone is hoping for doesn’t actually pan out?  And what happens if you don’t get into the one VC that gets into that company?  We were able to be an angel investor into Cornerstone on Demand, which then grew to one of the 10 largest SaaS companies in the world.  This option-based valuation methodology can also be used to explain the early 2000 internet/telecom bubble in the public markets.

We don’t try to do a Net Present Value valuation on the financial model for a seed-stage startup.  The one fact we know for sure about every financial model we see for early-stage companies: they’re wrong.  However, we do assess if the business has a valid financial model to use an operational tool, and we in fact have one team member who is dedicated to helping portfolio companies build financial models and evaluating financial models of companies under due diligence.  We’re judging each investment as an investment, not a lottery ticket.

Joe Reilly: Do you think a business school degree is a hindrance to a start-up entrepreneur?  Do you only invest in technical founders?

David Teten:  We have invested in founders from a wide range of backgrounds, including Physics PhDs, JDs, MBAs, and high school dropouts.  A top-tier MBA is a hindrance only insofar as it creates a high opportunity cost for a founder to consider before pursuing the high-risk/high-reward path of entrepreneurship.