Expensive Options and Losing Big
How to be Wrong
Early stage venture investing is all about option betting - whether you’re investing as an angel, a fund or a syndicate, returns are generally driven by a small number of very large successes. The conventional wisdom is that in a fund of 20 companies, one should be able to return the whole fund or more, a few others will make a modest return, and the rest go to zero. Of course, going into these investments, the assumption needs to be that any or all of them could be that one big winner, but an understanding that the statistics show that unlucky means you get 0 big winners and lucky means you get 3-5 big winners.
While there are different dynamics for angels, syndicates and funds due to incentive alignment, they all share a critical assumption: every early stage investment is an option bet with massive upside and finite downside. Meaning, if you invest $100,000 into a seed stage company, you could make $10,000,000+, lose the $100,000 or something in between. This is the business of backing disruptive, innovative companies that can grow extremely quickly - it’s pretty amazing, but it’s also challenging and nuanced. When a massive number of people and dollars rush into a market that has shown it’s amazing, there is a tendency to ignore the challenging and nuanced aspects of the market and focus on the big flashy numbers.
The key assumption is that each early startup represents a “cheap option” because of this imbalance between upside and downside - in the industry we call it asymmetric upside. There are two problems with this oversimplified assumption:
These startups are run by people who are putting their career at stake. While an investor may be looking for that elusive 100x, there are many ways for the founders to make meaningful personal money. Sometimes the option-betting approach creates a problematic misalignment between investors (especially large ones that need 100x’s to make a dent in their fund) and founders, for whom a medium sized exit will change their life. (And no, founder secondaries are not the answer.)
As I mentioned before, the assumption is that you can only lose the nominal amount that you invested: whether that is $100,000 or $100,000,000 - that is all you can lose. The problem is that if you lose in the wrong way, the after effects and collateral damage can be more costly than just the invested capital.
With respect to the first problem, it is up to entrepreneurs and investors to be honest with themselves and each other about scenario planning and goal alignment. We’ll see more and more issues arise between entrepreneurs and investors as things go south and these misalignments come to light. It will not be fun for anyone.
The second problem will also continue to come to light as things get a little bit more complicated in the coming months and years. There is more than one way to lose money in a startup investment. I have had a handful of 0s (or close to it) throughout my career, and I can confidently say that each painful process was handled with class, honesty, transparency, effort and alignment. There needs to be an understanding that this is part of the business, and while we all believe we are above the statistics, we are not, and failure is a real part of the game.
While you cannot be a good early stage investor by planning for the failure scenario, I think it’s critical to think through it in order to avoid a situation where you lose more than you invest. When you make a $1M investment and lose that $1M, there is still some potential upside - you’ve developed relationships and learned, which compensates in part for the time spent (in addition to the capital allocated). The result is a 0 - it’s part of the business and 0s don’t make you a bad investor. The issues arise in the cases where people do not act with class, transparency, alignment and honesty. These are the cases that represent a reputational risk to the investor, and result in significantly more downside than just the capital invested.
There are right ways to be wrong and wrong ways to be wrong.
I would go further to say that there are 4 levels: right ways to be wrong, OK ways to be wrong, not great ways to be wrong and catastrophic ways to be wrong.
Right ways to be wrong: You bet on a great team going after an emerging market and that market, due to unforeseen circumstances, has a major shift from which the team and product cannot recover. These are what we call “good mistakes,” or not mistakes at all. In some ways, these hurt the most (highest potential), but if you invest in enough of these sort of companies, you’ll be just fine. Nobody is going to criticize you for this kind of loss.
OK ways to be wrong: You bet on a team that you think is great and later realize that the market and/or the team lacked what it takes to really build a great company at scale. There may be too much competition, execution risk, or other potentially foreseeable challenges involved. There are a lot of OK ways to be wrong.
Not great way to be wrong: You miss something in diligence on the market, competition, product, underlying tech, etc. It happens, sometimes you feel like you really should have caught it - maybe others did. These are the ones where you probably want a mulligan. The business may also have been improperly financed, which hindered its chances of success out of the gate (this is the responsibility of the financier to manage). You might have some explaining to do with your LPs, but they’re not going to come after you with torches and pitchforks.
Catastrophic ways to be wrong. This is where it gets ugly and the cost of a 0 is much greater than the amount invested. Just being associated with a certain company or founder is so toxic to your reputation that other founders want nothing to do with you. LPs are, at the very least, considering pulling out of future funds and, at most, coming after you with torches and pitchforks. These mistakes are deemed unacceptable by the industry and you will feel pain for years to come.
In a market recovering from an intense bout of fomo and hype, it’s important to look at these scenarios with eyes wide open - both in evaluating new investments and honestly assessing your existing portfolio. For existing portfolio companies, try to be honest about which type of mistake it may have been and do everything you can to avoid letting things devolve into catastrophic scenarios that will cause losses far beyond the invested capital.
A great piece of advice I once heard about joining a company I think also applies to investing in them early: Focus on the people - if they are the people that you know you can really trust when things go bad, they are probably also going to be the people ringing the bell at the New York Stock Exchange with you.
In a business where everyone seems to be focusing on the people, remember that charisma sometimes comes along with some other pretty nasty traits that can cost you dearly in the long run.
Great article!