How One Venture Capitalist Thinks About Capital Allocation

Picking the right companies to invest in is probably the biggest challenge to being a successful investor, but there's more to it than that. You also have consider things like position sizing, or how much to invest in each company.

In this Backstage Pass interview aired on Jan. 5, Fool contributor Jeremy Bowman talked with Prince Khaled bin Alwaleed bin Talal al Saud, the CEO and founder of venture capital firm KBW Ventures, about how he thinks about capital allocation.

Jeremy Bowman: Hello, Fools. I'm very excited today to have with us Prince Khaled bin Alwaleed. He is a global investor and advocate for the adoption of green technologies and climate change awareness, and a proponent of healthy living. As the founder and CEO of KBW Ventures, a venture capital firm that has invested across a variety of tech sectors, including headline-making foodtech and fintech start-ups, Prince Khaled believes that today's entrepreneurs can solve much of the world's problems around food security and preservation of the earth's finite natural resources. Khaled, thanks so much for coming on the show today.

Prince Khaled bin Alwaleed: Hello. Thank you so much for having me. An absolute pleasure being on. I must say I'm a very avid reader of your website, so thank you much for having me. It's a real pleasure.

Jeremy Bowman: Thank you so much for saying that. I'm flattered. [laughs] We're big fans of mission-driven investing here at the Fool. I can tell from your bio and your investment portfolio that you are, too. To start, I was just hoping you could tell us a little more about KBW. If you could describe the investment process for us. What criteria do you use to decide what to invest in and where do you start with your process?

Prince Khaled bin Alwaleed bin Talal: Really good question. Basically, what we start with really is just that we invest really through our networks. I've been lucky enough to meet some very prominent figures in the venture capital world throughout my trips and visits in Silicon Valley. One of the most important ones I must say is a meeting that I had about six years ago or so with two gentlemen, John Backus and John Burke [co-founders of PROOF, or Pro-Rata Opportunity Fund]. Obviously, there's a third partner, but I've met with those two gentlemen. They pitched me an idea of a new structure of how to invest in venture capital and how to raise a fund to invest in venture capital, early-stage investing. The idea is rather that they have about 25, 30 years each of investing in the venture capital world. And what they've learned is that there's the 80-20 rule, if you will: 80 percent of your returns are really wiped off if you're really in venture capital, 20 percent really drives all the return. One or two of those really gives you the most out of your buck when you're investing in venture capital.

What we've done -- or what they've done then and I've since partnered with them -- is partner with early-stage funds, smaller funds, so that they would eventually run out of money or run out of resources or their LPs [limited partners] would run out of resources, or they would overexpose into the companies that they want to keep investing in, their winners, so to speak. They have a pro rata, as you know, to keep investing in these winners. What we do is, they would bring us these opportunities. We would obviously do our due diligence and then we would invest on their behalf into these companies, retaining their ownership or their pro rata in each of these companies that they want to keep investing in. We give them 10 out of the 28 points of carry that we get from investing in these companies, incentivizing them to really bring us their deals or their best companies.

That really flips the 80-20 rule upside down, really. We had one write-off, tiny write-off, $57,000 write-off, and everything else has been in the green. We've been really excited with the progress and we've raised Fund 1. We closed Fund 1. We already closed Fund 2, and we are raising right now Fund 3. Going back to KBW Ventures, that's the philosophy that I really wanted take on in terms of investing in venture capital, is really invest in companies that the big VC [venture capital] firms that we all know and want to invest in next to -- but don't really get to because they're really hard-to-access deals -- are accessible. That's really the philosophy of the majority of the investments that we do in KBW Ventures.

Now, obviously, there are a few strays. We've invested in TurtleTree Labs, we've invested in Memphis Meats, which is now Upside Foods, and other companies like that, for example Square (NYSE:SQ), or other companies. Anyway, we've invested in companies that we did not necessarily follow that same criteria, but these are companies that I feel really are dear to my heart because they are companies that tackle a serious issue that we have in this world, which is food sustainability. That's one of the criteria that we really focus on.

Jeremy Bowman: That 80-20 rule reminds me, it sounds like growth investing on drugs or something. [laughs] I think one of the tenets at the Fool is you expect to lose some money on your growth stocks, but you're going to make it up over the long run with your big winners like the Amazons and the Netflixes of the world.