Should universities have venture funds?
Posted on October 21, 2014
With the renewed focus on entrepreneurship at many universities and colleges, the question of whether universities should be operating their own venture fund is being opened. The reasons for doing so range from the admirable (startups at our institution struggle to raise so let’s help) to the supportive (let’s put our pension dollars where our mouth is) to the money making (we should fund our programs off the success of our alumni).
However, few are asking the big questions. Should universities be building venture funds in the first place? Are universities well suited to running an investment firm with a core focus of investing into its own alumni? What downsides should universities be considering when thinking through whether to start a fund? My overall belief is that universities and colleges should not run their own funds. I believe they will lose money and cause more harm than good for the following reasons:
1. Geographic focus – most universities and colleges are located in a single city or region. Studies highlight that geographically focused funds do not outperform their competitors. For example, here is a Harvard Business School paper talking about the performance of investments comparing geographies. Funds that focus based on stage or sector tend to perform better than funds based on geography. And isn’t the primary focus behind a venture fund to achieve monetary success?
2. Signalling bias – when a university runs a fund then it would be an obvious choice for entrepreneurs of that school especially if the purpose is to help bridge the initial funding gap. If the university fund passes on a company, especially one that participates in its own programs, then it would be a signal to outside investors that the company is not worth investing in. This causes significant challenges for entrepreneurs who now need to show justification for why the university fund didn’t invest.
3. No sector focus – the best funds tend to have a focus in a specific market or area where the partners have networks they can leverage along with significant lessons learned that can be applied to all future companies in the portfolio. Investing in the broad set of university alumni companies (eg. everything from apps to nanotechnology startups) creates a situation where the investors don’t have the expertise to help manage the winners.
4. Competition – in a world where entrepreneurs are always looking for great investment partners, the university creates tension and competition between its own fund and existing investors. This is particularly troublesome for university programs because one of their competitive advantages is the ability to catch many companies at an early stage before they are visible to outside investors.
5. Conflict of Interest – the university will be seen as having a dual mandate which is both to invest in companies and to educate them on the fundraising process. This can turn into a conflict of interest between the roles or even worse can leave entrepreneurs with the feeling they were taken advantage of.
6. Internal misalignment – when building the fund, the university should hire a separate team to manage the fund from the existing teams responsible for the entrepreneurship programs. This can create internal alignment challenges if the entrepreneurship program teams and the investment fund team do not have the same vision. If the entrepreneurship program actively discouraging companies from taking their investments, it would create additional challenges for the fund to generate high returns.
7. Risk aversion – universities tend to be risk averse places, which is the opposite mindset for running a very early stage venture fund. Using the traditional power law curve for investments, 1 or 2 out of 10 will be successful and provide the largest returns to the portfolio. While it sounds great upfront to create a fund to support entrepreneurs at the university, it will become untenable over time for the university to publicly and actively promote that they had 80-90% of their investments fail. The pressure from the losing companies (and their supporters) along with pressure from funding sources for the university (alumni, government, etc) would be difficult to manage with such a public loss ratio.
With so many potential reasons for why you shouldn’t build a fund, why would anyone do it? The biggest counter argument for universities to create their own fund is to help companies get that first round of financing. The angel round can be difficult to pull together especially if the angel investing community in the region is small or non-existent. By pulling together a fund, using alumni and endowments as the funding source, the university reduces friction for a very common step in the funding cycle for their teams. At Velocity, we solve this problem by offering that initial funding source through grants rather than equity investments and only through a competitive program that runs three times per year.
I believe that the entrepreneurship programs can make that angel investment round easier to get without building their own fund and will discuss that strategy in a future blog post. What do you think? Are there any reasons that I missed on either side of the debate?