Liquidity and Startup Investing

One thing that people don’t understand about angel investing are opportunity costs.  There are opportunity costs when you are faced with a choice between investing in a startup, investing in the stock market, investing in treasuries, investing in real estate, or just staying in cash and letting it sit in the bank.

But there are more opportunity costs that I think are discounted by early stage investors, or not even thought about.  Liquidity is a cost.  One of the downsides to early stage investing is the money that you invest in the startup doesn’t come back to you for a long time.  Most people will say that investments last 4-7 years.  But, I don’t think that is true anymore.  It’s more like 7-10.

One of the dangers of the increase in valuations is the opportunity cost of liquidity.  When you first put money in a company, you need to analyze the risk versus the reward, and the anticipated time to exit.  It might not seem important today, but I have been through several times when liquidity was everything.  I recall 2008 vividly.  There wasn’t liquidity in anything.  Commodities that were totally unrelated to interest rates or the S&P crashed in value.  When the Fed pursued it’s initial QE policy, those same commodities rallied.  Normal supply and demand relationships were meaningless on the way up and down.

When startups fail, they become roach motels.  When they are going great, everyone wants to buy your equity. At the same time, when stock markets tumble, and when other asset classes are at highs, startups can be a good place to put money because they can grow quickly.  If there is inflation, they are about the only asset class that can grow faster than inflation.

Liquidity is why startups should always look to raise money when times are good.  When you absolutely need the money, it’s going to be a lot harder to raise and much more stressful.  When you don’t need the money you can relax and actually negotiate a win/win valuation with investors.

When I traded, I always kept a very close watch on liquidity.  It’s sort of ingrained in my DNA.  I watched the size of orders in the market, making sure there was an out door if I was in trouble.  I watched the liquidity in my account too.  When you have too much in your trading account, you can make mistakes by trading sloppily.  The same goes for startups.  When they have too much money they lose discipline-and when you carelessly and fearlessly put money in startups-you have lost your discipline too.

The stock market cannot go up forever.  It’s not going to crash, but it will correct.  Yesterday, it lost all its gains for the year.  The option market has priced a 44% probability of touching $190 (or 19000) by the end of the year. The December 190 calls are worth $1.70.  There’s a 62% probability of touching $165 (or 16500), and those 165 puts are worth $4.70.  That’s the market’s way of saying it’ll pay almost 3x as much for a -7% bet than a +7% bet.  I think that pretty soon, we are going to see who needs liquidity and who doesn’t.  Just remember, when you need liquidity, the price is a lot higher.

^DJI data by YCharts