Venture Returns

Returns to venture capital have outpaced the S+P 500 over the past decade. Here is the growth of $10,000 over the past decade courtesy of Ycharts.

SPY data by YCharts

Very very good return when you look at historical numbers.

But venture has been better. Chicago Booth professor Steven Kaplan has studied venture returns over time and I linked to his 2017 study. That trend has persisted through today.  Venture returns are outpacing S+P returns.

I think it’s important to understand venture returns vs stock returns because with Covid, capital will get democratized more and new entrepreneurial ecosystems might jumpstart.  We might see new investors enter into venture investing that didn’t do it before.

The next twenty years will bring new technology to the market that will be powerful and some outsized returns will be gained by savvy investors.

High net worth individuals and family offices that might not have considered venture investing before might want to take a stab at it.  They need to understand what they are getting into, establish some systems and rubrics, and then have at it if they want to assume the risk.  Personally, I think it would behoove them and society if they did.

Here is the thing.  In Venture, returns happen in certain companies, and the others fail.  My friend Brian Lund wrote about two different kinds of traders in his weekly blog. 

Time works for long-term investors in a different way. It relieves themselves of the burden of themselves.  

All they need is a drawer to put their stocks in and they are good to go.

The above is the way to invest in the stock market and it’s been proven over and over again.  Stick your money in an S+P 500 fund with no fees/low fees and forget about it.  Eugene Fama showed it in 1962 and wealth managers have been fighting with him ever since.

Venture investing is not the stock market.  Returns are uneven and unpredictable.  Remember a story Bob Okabe told me about an angel investor that lost money on the first 19 companies they invested in.  They should have kept investing….

There also is a liquidity premium in venture vs stocks which demands a higher return.  Venture investing is a roach motel.  You can get in, but you can’t get out.

One of the reasons that putting your stocks in a drawer and forgetting about them works is it takes away “variance”.  You aren’t subjecting yourself to the daily gyrations of the market.  As long as the market goes up, and so far over the course of time it has despite hiccups, you are okay.  Behavioral economics would tell you why people overweight hiccups.  If you need the money, you can get the money.

Day traders want variance.  They are in and out, in and out.  Without variance, they don’t have opportunity.  But, day trading is not investing.  If you day trade and aren’t earning more than a minimum 25% on your capital, you probably won’t be doing it a sustainable period of time.  That day when you take a big loss will wipe you out.  It’s gonna happen.

Venture investing means accepting A LOT of risk, or variance. So by definition, returns should be outsized.  One thing that would be tough to execute, but I believe the time has come, is a fund to raise a huge pool of capital and become an LP in many many venture funds.  That won’t mitigate risk, but improve your chances of finding the outsize return if the manager of that fund chooses funds correctly.  The problem is getting access to the funds.

When you look at the universe of funds that return 3x after fees, it’s very small.  Venture is a tougher business than stock picking.

I have seen people try to execute on this portfolio idea by raising money and putting the same check inside lots and lots of startup firms, but that doesn’t work.  You are only adding more risk with every investment and your expected outcome isn’t any better.  There is no “diversification” in the classic finance sense.

The trick in VC is who is managing the money, or in finding the best deals.  Deal flow is the life blood of a VC because it gives them enough looks so that when they decide to invest they feel like they have an edge over the market.  The only way to make money in VC is to go against the herd.  You see something that the market doesn’t.

The other hard thing in VC is putting enough money in a company to own a big enough chunk of equity so that if it pays, it pays big.  This is why if you are an angel, be disciplined.  Put similar amounts in every company on initial check sizes so that the check sizes combined with the amount of equity you own are replicated across your entire portfolio.  That way, when one pays you probably will pay for your entire portfolio.  Rule of thumb angel math is 50% of your investments will fail.  20%-40% will return 1x-4x.  That means you need 10% of them hit 30x to realize a 27% IRR.

Over the past few years I had some angel investments pay off.  They had been in my portfolio over 10 years.  The internal rate of return was well over 20%.  It beat the same return on the SPY over the same period by quite a bit.  What I mean by this is if I invested $1 in the SPY, or $1 in this company, I was far better off accepting the risk, lack of liquidity, and being in the company.  I also had some companies fail over that same time period.  Your failures happen early.  That’s the thing about venture investing, your choices are highly dependent and the outcomes highly variable.

By the way, I co-founded Hyde Park Angels in April of 2007.  4 out of the first 5 investments paid off and the other company is still a going concern.  That’s an amazing track record.

Risk is severely misunderstood in America and not taught well.  Conditional probability is not understood, and not taught well either.  That’s apparent in how we have dealt with Covid.

I will post tomorrow on what I see for the future of VC and the stock market.

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