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Shoot For The Stars

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This post on VC returns is sort of obvious in some ways.    Venture capital doesn’t work with normal statistical distributions.  There are no portfolio effects from VC like there would be if I put my money into a diversified basket of stocks.  VC is individually and identically distributed, or iid.  The only thing you do when you invest in one more company is increase the amount of risk you are taking.

At the same time, if you don’t invest in enough companies and take the risk, you give yourself practically no chance of making any return at all.

You never know which company will be the one that returns money to you.  At the first date you invest, you are full of hope.  You wouldn’t make the investment if you didn’t think you’d get a lot of cashback.

I know investors that try to invest at low valuations and then sell when the company gets to 10x or more.  Invest at a $7MM and if the company hits $70MM with new investors willing to buy you out, sell.  Occasionally, an entrepreneur will ask me to sell if I have a small stake to clean up the cap table and I will.  But, the reason I invested early is to sell when the company hit a triple-digit valuation.

I know angel groups where their entire startegy is predicated about being the only money at the table for the entire life of the company and selling at low valuations.  Singles and doubles.   I don’t like that strategy.  Before we invested in one company, we had a long chat about getting alignment on what kind of exit and company they were looking to build.  If it wasn’t a shoot for the stars type company, we weren’t investing.   Their impression from other investors was to think small.  They liked our idea better.

If you are going to take the risk of being an entrepreneur and put your butt on the line, it does you no good to think small.

If you invest for a short term gain, what we used to call scalping in the trading world, you will lose money.  You have to invest in companies that are shooting for the stars.  Home runs.  Big Swings.  Unicorns.  Thing is, when they do that, there are a lot of strike outs.  Home run hitters are also the easiest to strike out.

This graphic was pretty interesting to me.  Only 2% of all venture backed financings returned 20x. When we think about “angel math” or venture math, the breakdown over the last ten years fits in line with what I knew from before then.  VC math is percentage you own * how large the exit is / amount invested.  Hence, you should never write teeny checks in VC.

Essentially, 50-60% of everything you invest in will fail.  Talking to a big family office from Southern California a few years ago confirmed that.  They had been investing directly into startups and some funds since the 80s.  50% failure rate.

The problem gets harder when I think about David Rose illustration of angel math.  You need 1 investment out of 10 to hit 30x to return a 27% IRR.  That assumes 50% fail and 2-4 return 1x-4x.  It also assumes a holding period of only five years and the holding period is more like 8-15 years.

If I look at my angel portfolio, I have some failures.  The problem is, I didn’t write the same size check for every deal so it impacts the returns.  If I wrote a big check and the company goes under and the little check returns 30x I didn’t get a return.  It took me a while to learn that.  So far so good and it looks like I should 3x to 4x my investment dollars but you can’t count your chickens before they hatch.  Just because a company raises at a high valuation doesn’t mean it will be a success.  Bankers don’t cash checks on high valuation and you can’t eat IRR.

In our venture portfolio, we have done a good job trying to get percentage ownership of companies we invest in.  We are a small fund, but we write big checks.  $500k is the smallest check we will write.  I always figure a 60-70% dilution rate from seed to exit.  We try to get enough ownership so that a single check returns the fund.  Doing some general math, 5%*$300MM/$500k=$30MM which would be a super great return.

That means we have to find great teams at seed who are willing to shoot for the stars.  So far, we feel like we have done that.  We have a couple more checks to write and it actually gets harder to write them as the fund progresses, not easier.


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