Venture Capital
Venture Capital

From Hedge Fund to Psychedelic VC: How I Used the 506(c) Rule to Invest in My Passion

Raising capital for a venture fund is now more attainable with the SEC's 506(c) rule. Here's how Brom Rector grew his personal brand in a niche space and raised a fund to invest in psychedelics.
Brom Rector Empath Ventures Psychadelic investments

Before becoming a VC, I had set my sights on doing quantitative work at a hedge fund. For more than 7 years, I worked at two different hedge funds, but like many people in the hedge fund space do, I eventually became disillusioned and burnt out. I wanted to look for work that I found more meaningful and ended up leaving my hedge fund job a month before my thirtieth birthday. The problem was that I didn’t have a plan for what was going to happen next.

I made a list of about 10 things that I could see myself doing, and working with psychedelics was one of them. I had been interested in psychedelics for over 10 years, used them personally, and was aware of the mental health benefits that they can have. I also grew up in a military family and had seen mental health challenges firsthand, especially struggles with PTSD.

The potential of the psychedelics industry
In addition to my deep personal interest in psychedelics, I realized there was significant long-term potential for the psychedelics industry. People often compare the psychedelics and cannabis industries, but I think the shortcomings of cannabis show why psychedelics have such a bright future.

One of the unfortunate things about the cannabis boom is that most of those companies haven’t made any money–the industry is infamous for burning investor capital. I’ve found that people often transfer their negative impressions about the cannabis sector over to psychedelics. But there are a couple big differences between these two industries. First, whereas cannabis companies are interested in recreational use, in the psychedelic field most companies are focused on getting existing or new psychedelic molecules approved by the FDA as a treatment for mental health conditions. (The FDA never approved marijuana as a treatment for anything, despite some states allowing medicinal use.)

There’s also a lot more potential for psychedelics to be a successful long-term pharmaceutical investment. Cannabis companies have had limited success in creating synthetic cannabinoid derivatives – it turns out that cannabis is a super complicated plant. By contrast, psychedelic molecules like psilocybin or LSD are very simple: people have been synthesizing them since the 1940s. This opens the door for pharmaceutical companies to create novel-psychedelic molecules with more pleasant attributes for the average patient: perhaps the trip is shorter and less hallucinogenic, or perhaps there’s no trip at all and only therapeutic benefits.

A third major difference between the two industries is the integration (or lack thereof) into the wider healthcare field. If you want to get the medical benefits of cannabis (like pain relief), all you have to do is smoke the weed–you can do it from your couch and it will work. With psychedelics, the research shows that if you’re actually trying to use them as a tool for changing your mental state, it’s very important to have some sort of psychiatric support during and after the trip. Unlike cannabis, for psychedelics you need to be interfacing with a doctor and creating a formal process of integrating the things you’ve experienced back into your life. This means that there are so many more touchpoints with the healthcare system for psychedelics, and every one of these touchpoints creates an opportunity for business that cannabis just doesn’t have.

Using new media platforms to reach LPs
With all this potential, the timing was right for me to move into psychedelics. 2020 was the first year you could talk about the “psychedelics industry” and be taken seriously. Prior to that, there hadn’t been an industry to speak of: work with psychedelics was happening either underground or in university research. But in 2020 we began seeing publicly traded companies popping up that were focused on psychedelics. I started doing research on these companies, bought some of their shares, and realized that nobody in the podcast or YouTube spheres was talking about these companies from a serious investment perspective.

Once I noticed this gap, I started recording monologues on psychedelic investing, and my content quickly became the number one search result on the topic. I feel lucky that a topic I’ve been interested in for a long time is now becoming a viable career.

Soon after I started putting my monologues online, I began getting interest from investors. People had been following my channel, knew that no one else was talking about psychedelic investing, and wanted advice about what companies to invest in. I was also contacted by startups in the space that were looking to raise money. Between these conversations and discussions I was having with friends who worked in venture capital, I decided that psychedelic venture investing was the right path for me–you can’t exactly make a living as a podcaster on such a niche subject!

Within just a couple weeks of announcing that I was planning to raise my fund, I quickly got to over $1 million in soft commitments. Some of the people interested in the fund are more conventional LPs from Silicon Valley. However, other types of investors have also reached out, such as doctors from Europe who share my interest in psychedelic medicine and even 21 year-old dogecoin millionaires! My fund has revealed a class of investor that most venture capitalists aren’t even talking to. Most of these investors are already sold on the idea of psychedelics, but I’ve also used my YouTube channel to post some broader educational content for people less familiar with the field, like my Psychedelic Therapy FAQ.

In fact, I’m frequently able to educate more traditional investors on the benefits of psychedelics: for example, after I left my hedge fund job, I had to get new health insurance and a new doctor. When I met my new doctor, I told him what I was doing with psychedelic medicine. He had never really heard of psychedelics outside of the recreational context, but asked me to email him the most compelling studies. A few days later he called me, blown away by the studies I had sent, and said he wanted to help me in any way he could with my raise.

Asking the hard questions leads to unique due diligence
Many YouTube stock channels engage in paid promotions, but my videos don’t go that route. This means I’m free to ask the hard questions, which is what my audience really appreciates.

There are a couple different tough questions we need to be asking. For example, one of the interesting things about the psychedelic industry is that many popular companies right now are doing research and trying to get FDA approval for classic, known psychedelic molecules like psilocybin, LSD, or MDMA. This approval is certainly possible, but one of the big challenges is that because these molecules have existed for so long you can’t exactly patent them. What defensible intellectual property do these companies have that might allow a VC to return investors’ capital at a markup? It’s really important to dig into these patent claims.

Another tough question has to do with stock promotions. Many new companies in the psychedelics industry are located in Canada, which has more liberal drug laws but also looser regulations on how companies can promote their own stocks. Investors need to ask how much money a company is spending to promote its stock, or what kind of deals it might have with certain stock promoters.

In addition to these broad and thorny questions, when I interview CEOs I solicit questions from Reddit or Discord chats. This approach allows for some community input into how debates about the psychedelic industry take shape.

My conversations allow for unique kinds of due diligence and access to different companies. In a traditional venture model, a fund manager might reach out to a startup that isn’t raising at the time, only to be ignored. But if I email a company, tell them I have a podcast, and offer to let the CEO talk about the company for an hour, they likely won’t refuse. This integration with new media gets me access to companies on potentially friendlier terms. Even if I don’t end up investing in a given company, this kind of access might give me color on what they’re doing that might affect other kinds of investments.

Raising under the 506(c) rule
With my venture fund, I’m taking advantage of my professional finance background, my longstanding interest in psychedelics, and my new media platform. But what’s unique about my approach is that I’m raising under the 506(c) exemption. With this exemption, I’m actually able to talk about this fund on my podcast or YouTube channel. This has given me a unique advantage, since I’m able to reach LPs that more traditional venture capitalists don’t have in their networks–their investor pools tend to be pretty established and settled.

Traditionally, venture capital funds and hedge funds have raised money under the 506(b) rule, meaning they don’t have to register their securities offerings with the SEC (only fill out Form D). In exchange for this exemption, though, firms raising under 506(b) aren’t allowed to publicly talk about or advertise their funds. So for example, if you’re raising a traditional venture fund you can’t go on a podcast and ask listeners to visit your website to learn more and potentially invest.

But under President Obama, the 506(c) exemption was introduced: this rule says that you are allowed to talk about your fund publicly, but the tradeoff is that the restrictions and vetting of accredited investors are tighter than they would be under the 506(b) rule. In my experience so far, I haven’t found this tighter vetting troublesome for any of my LPs.

What’s neat about the 506(c) exemption is that it opens up a totally new category of investor, because by speaking publicly about your fund you’re reaching people traditional VCs don’t reach. It also gives you access to a different kind of deal flow: startups in the psychedelic space might learn about me from my podcast and proactively get in touch. When I share deals with other venture capitalists in the space, they often ask where I even found the company since they hadn’t heard of them before.

If you’re a VC with an already-established deep network, the 506(c) exemption may not make much sense. But if you’re like me and you have a new media presence, it could be an amazing vehicle for raising a fund.

DocSend and the 506(c): a new investor outreach strategy
One of the cool things about the 506(c) exemption is that I can publicly share a link to my DocSend deck right on my website. When I tell my YouTube or podcast audiences to visit the Empath Ventures website, I know that they’re likely going straight to DocSend where I can capture who has viewed what. In addition to my deck, I use DocSend to host a “What is psychedelic medicine?” primer as well as a fund memo. Going forward, I plan to share deal memos with LPs via DocSend, as well.

I use DocSend almost as an information-gathering form. I ask visitors to enter their email address and when I get notified that someone has visited the deck, I send out a cold email with a link to my Calendly offering to chat more about the fund. I’ve gotten quite a few commitments from this outreach that I wouldn’t have been able to do without DocSend’s insights. If I just had a link to a PDF version of the deck, I certainly wouldn’t be able to run the same proactive and ongoing investor outreach strategy.

Cultivate an authentic interest in your investment space
An overarching piece of advice I have for all VCs, and especially for those getting into nontraditional industries, is to make sure you’re motivated by a genuine interest in your space. A lot of the entrepreneurs working in the psychedelic space are there because they’ve had very profound experiences with psychedelics. These are people who are very passionate about the industry and who are motivated by more than just profits.

But because the industry is growing, we’re starting to see VCs with no prior interest in the space–these could be investors who are personally very anti-drug. They might be interested in emerging spaces and think there’s money to be made, but they don’t necessarily have an abiding interest in psychedelics. I’ve met some VCs that are investing in psychedelic companies, but have never personally used psychedelics and say they never will (they don’t want to “give up control”)! A VC should be someone that adds unique value to the businesses they fund, and founders should make sure that their investors aren’t just following a fad.

To me, this is like being a crypto investor while thinking that Bitcoin is nonsense. Why would you invest in a space when you aren’t fundamentally interested in it for its own sake? Not only would this be strange for you, I think a lot of founders would potentially be very wary of doing business with you. Emerging fund managers need to cultivate an authentic interest in what they’re getting involved with; if they don’t, I think it will be hard to gain acceptance by other operators in the space.

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