Potential Conflicts of Interest in Proptech

Unpacking Proptech: A data-driven series on advancing built world innovation

As mentioned in Part 1, an outsized portion of the proptech investor base comes from the real estate community — a reality I would argue is complicating the industry’s growth. Part of the antidote for startups: employing a more prudent approach to raising capital and curating a diverse investor base. To shed additional light on this issue and its ultimate impact on startups, I partnered with the Center for Real Estate Technology & Innovation to ask proptech founders about their capital and strategic partners. Below, I break down the survey results and what they say about the state of the industry.

Capital Sources Matter

In my experience, there has been persistent overcapitalization, mispricing, and loose governance in the proptech space. This is largely driven by large investment flows from strategic and tourist investors. VC firms are not blameless — over 1.8K VC investors wrote checks into proptech deals over the last five years. The remaining 2.8K+ active investors in proptech are mostly asset managers, family offices, corporate venture capital firms, and real estate executives (let’s call this group “strategic” investors).

These strategics have fundamentally different models and objectives for investing in proptech startups compared to a VC that is focused on generating returns through scaling tech companies. Strategics in this space typically have a portfolio of hard assets (i.e., buildings) and are more interested in improving the portfolio’s underlying performance through revenue maximization or cost reduction. They view proptech investments as R&D for their own real estate assets (the goal is not to miss out on an interesting technology) and are typically one-time check-writers. To be clear, there are real estate strategics that have experienced teams and defined, value-add processes that rival some of the best VC firms. However, on average, these groups tend to have limited desire, capacity, or experience in active tech company management, governance, and growth.

So, what does this mean for a proptech founder with a heavy strategic investor base? It can present a risk for future scalability and fundraising. I worked with a founder who raised small amounts of money from a large pool of real estate strategics (nearly 200 investors), but when the company began to experience challenges, few stepped up to invest or offer advice. Bottom line: Founders have to be realistic about the inherent conflicts of interest in proptech (some of which I have outlined below) and build investor bases accordingly.

#1 — Fund Managers and their Real Estate LPs: A VC fund manager taking LP commitments from the real estate community is not inherently problematic — it just needs to be closely managed. Part of the appeal for a potential LP is the insight afforded through outsourced due diligence (assuming the fund backs companies that offer applicable tech solutions for the LP’s portfolio). But this is a slippery slope as portfolio companies feel pressured to put on a dog and pony show for every LP. Additionally, the lack of curation can result in disappointed LPs who believed in the first look advantage, and disappointed founders who are pushed into partnerships that might not be ideal or strategic.

#2 — Real Estate Strategics and their Partner Companies: There is a big difference between a strategic investor supporting an experimental pilot in a couple of buildings and one that is offering a thoughtful, scalable partnership with true buy-in from key internal stakeholders. It does not have to be an either/or situation, but I advise founders to have right-sized expectations and pay careful attention to the strategic dealmaking necessary to derisk these investment and partnership conversations. What enterprise value are you building as a founder if your ultimate buyer:

• Represents the majority of your company’s revenue or ARR,
• Led and mispriced your last round resulting in a failed fundraising effort and early exit; or
• By virtue of being on the cap table, precluded other likely partners or buyers from contemplating a partnership or M&A deal with your company?

These are not hypotheticals — I have seen this play out more than once over the last five years. CEOs need to carefully weigh these considerations to secure thoughtful deals, which solve for the upside and limit the downside of potential conflicts of interest with other customers and investors.

#3 — Double Dipping: Many large institutional real estate organizations have launched their own corporate venture capital arms and innovation groups — some are active check writers, while others focus more on partnerships. In either case, it is hard to see the benefit from a real estate strategic paying a 2% management fee to a fund manager to see the same deal flow their innovation or corporate venture capital arm already captures. It is even more tenuous when the strategic is already an LP in a fund that has exposure to a particular proptech investment, leading to a doubling down through the corporate venture capital or innovation arm (which typically only makes sense if the company truly demonstrates breakout potential/a strong return profile). From the founder’s perspective, it is a missed opportunity to bring an additional third-party investor onto the cap table who can help diversify funding sources and add strategic value.

The Hard Truths

So, what do founders have to say about these issues? Most recognize the challenges above, but have not changed what they are looking for in an investor. So compelling is the promise of a strategic backer that many founders continue to hope the next will be the one to deliver vs. assessing the value of other types of investors. Results from our survey of more than 50 proptech founders revealed:

• Only 13% raised the majority of their capital from institutional generalist VC funds. Even if you exclude proptech funds, 66% of founders raised the majority of capital from real estate strategics (82% including proptech funds). These parties are all generally subject to the conflicts of interest outlined above.

• Of the total capital raised, 87% remains outstanding under convertible notes/SAFEs. These convertible securities have many negative structural and signaling impacts, often making future fundraising harder and more dilutive for the founders (convertible notes and SAFEs are dangerous when thought of as a replacement for priced equity).

• 71% of founders were focused on having real estate strategics invest in their company; yet 64% felt that these strategic partners and investors have failed to deliver value (i.e., live up to the promises of partnership, implementation, portfolio expansion, knowledge share, etc.).

• Worse yet, 85% of founders believe their proptech fund investors (with real estate LPs) have NOT delivered on the promise of more efficient customer introductions and partnership opportunities.

• Despite the above, 43% of founders would prefer a proptech fund lead their next round. Another 33% of founders would prefer that lead be a strategic real estate investor.

These findings highlight the systemic issues and misinformation in proptech, but breaking the pattern has proven difficult — founders still place a premium on generally higher valuations, ease of raising convertible notes/SAFEs vs. priced institutional equity, less governance, and customer relationships — all characteristics of working with strategics. But that short-term gain and convenience often results in long-term stagnation and limited exit opportunities.

Building the right investor syndicate takes time and effort. I recommend careful due diligence on potential investors to ensure you are bringing on true value-add partners. And do not discount the value of a quality generalist institutional VC — there is something to be said for a proven track record of helping companies get to scale.