Risk And Startups

Lately I have seen a lot of thematic investing around startups.  Some investors are “Efficient Market Hypothesis”-ing a portfolio.  By this I mean they are writing a lot of checks and figuring portfolio theory will bail them out.  I think this is a huge mistake.

Sure, if you take a universe that is big enough, you can figure on a 27% IRR on invested capital.  But, that universe has to be really big and the investments need to be made within the same time frame to replicate anything like EMH.  The truth is, you cannot diligence companies and invest in them in a timely enough manner to have a portfolio that will resemble diversification like an S&P 500 ETF at Vanguard.

The other piece is not every startup has the same funding trajectory.  Some need more capital to get to the finish line, so some initial investments will get diluted more than others.  If you get diluted on your big winners, and less on your other winners, your return won’t be efficient.

I love what my friend Albert Wenger says about investing in startups.  With every investment, you add more risk.   Brad Feld has said it is impossible to line up a bunch of seed stage startups and decide who the billion dollar company is going to be and who is not.  I like to look at portfolios of venture firms to see what they are investing in.  Even if I wouldn’t personally make the investment I would never criticize another portfolio because you don’t know all the details of that investment.  I try never to tell someone that the company they invested in is a “dog that won’t hunt”.

With crowdfunding going more mainstream, I thought I might pass on a piece of advice.  First, your chances of making money are low.  This is high risk and high reward.  Make sure you can burn the money and you don’t need it.  Who knows what the real ratio of failures/success really are.  Let’s say it’s 50%, or worse.  That’s not wrong.   Second, there is zero liquidity.  You can’t invest at a $4M valuation and sell to a VC at a $10M valuation.  There is no scalping the venture market.  If there is scalping, you probably don’t want out of the deal.  If you sell, you are the person at the card table who doesn’t know who the sucker is.  Third, usually the outcome is binary.  It’s either a winner or a loser.  You make money or lose it.  I don’t like it when people put “exit” or “acquired” on their tombstones when they didn’t make any money.  An exit or acquisition implies that money was made.  I also think exits should be calculated without applying artificial tax credits someone may have gotten.  Tax credits are nice to have but shouldn’t be a part of any calculus on whether to commit capital or not.

People that crowdfund might be better off paying fees to a fund.  Or, they might be better off in syndicates until they get their confidence.  The problem with a syndicate is you never really know why a person is investing, nor do you know the diligence they did to reach a decision to pull the trigger and invest.

The other thing to remember is exits take time. You will feel losses sooner than any exit.  That just makes it more painful, but when you get a winner it makes it sweeter.

  • awaldstein


    your opinion on accuhires?

    • If it’s a win, I think you can count it as a win. If it’s a loss, it’s just an acquihire and a loss like anything else. It’s just less of a loss. I have never had a losing aquihire turn into a “winner” through earnouts or anything like that.

      • awaldstein

        Agree–doing that alot lately it seems.

        Have had a few investments go this way. Loss for me, a soft landing for the team mostly which is a good thing.

        Startups by the number are a brutal game.

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