Venture scouting – networks-based investing

The Age of Venture Hyper-competition

It’s a tough (but also rewarding) time to be a venture capitalist.

The number of startups looking to raise has increased, but so has the number of investors. As Nicolas Colin wrote in his “European Straits” Substack newsletter, there is a ‘diffraction of venture capital’, where VCs are in fierce competition against family offices and institutional investors (and even hedge funds) that are looking to invest directly. The new era of lightning rounds is very much real.

Investment professionals and venture associates wear many hats – it really isn’t possible for them to maintain hyper-awareness of the early-stage startup scene, and by the time a promising startup has come on the radar, chances are that they have already received funding and closed a substantive round. How does a VC stay at the top of their game? Enter venture scouts.

Six Degrees of Separation

Venture scouts are individuals external to a VC firm, who are able to identify promising startups at the early stage and pass on deal flow to venture firms.

The backgrounds of venture scouts can be quite varied – from founders and serial entrepreneurs to angel investors and professors from MIT and Oxford University. The common thread tying them together is the ability to identify, at the very start, promising entrepreneurs within their network (whether it be professional, academic or personal), at an early-enough stage so as to put the startup in the venture firm’s radar.

Venture scouts are therefore, to put it simply, the eyes and ears of a discerning venture firm.

Exponential Origins

The venture scouting phenomenon was popularised by Sequoia, who have had a long-standing angel scout programme and have also raised main Funds to further incentivise their scouting network. Newer entrants emphasising this approach include Village Global, who brand themselves as a “network-driven venture capital firm”.

Kickstarting the Network

There are two tangible outcomes arising from the adoption of a venture scout programme.

Firstly, venture scout programmes enhance deal flow, allowing venture capital firms insight into companies operating at the early-stage.

Additionally, investments made at such an early stage will generally accrue pro rata rights, which will become incredibly valuable as the startups raise additional funding rounds. These can then be taken up by a Main Fund targeting later-stage investments or syndicated out to the VC’s wider network.

Venture scouting is the intersection of angel investing and traditional venture capital. How it will look like in practice will depend on the VC firm’s preference. There are generally three models.

  1. A Fund (either a Main Fund, or a Scout-only Main Fund) will be used to invest, with the scout being granted a carry arising out of that particular investment.
  2. Alternatively, a more informal arrangement, where the VC firm will fund the venture scout who will make the investment as a private individual, who will in turn pass on their follow-on rights to the VC.
  3. Finally, a SPV or a deal-specific co-investment vehicle may be raised.

Turbocharging Scouting Programmes

The third model – where a SPV will be raised for venture scout investments – is expected to become increasingly used by VCs looking to launch their own scouting programmes. There are three reasons as to why we expect this to be the case.

  1. With a SPV, carry is aligned on a per-portfolio company-level, thereby aligning it with the incentive structure of a venture scouting model.
  2. As the pro rata rights would accrue directly to the SPV (rather than a Fund, which may require pre-emption from existing LPs), this gives the venture capitalist more options.
  3. By placing the investment into a dedicated investment vehicle, the venture firm has greater optionality – secondary transactions can be conducted, and transfers (fund warehousing) can also be made with ease.

Silicon Valley in Europe

As the private markets becomes much more crowded, venture scouting programmes is a tried-and-tested solution for VCs looking to maintain and scale deal flow, and gain an edge at the earlier stages of the investments lifecycle.

In the USA, the US ecosystem continues to lead the market in its sophistication, with more venture firms expected to build (if not, expand) their venture scout network.

Separately to this, in conjunction with US investors expressing their interest in investing in (and establishing investment operations in) the UK and the EU, they are bringing the venture scout phenomenon with them as well. Prominent British and European firms are now looking to build their own equivalent, including raising their own funds, to combat this.