Historically, venture capital-investing in the startup or early-stage entrepreneurial enterprises-has been one of the most profitable long-term investment vehicles. Amazon, Google, Facebook, Airbnb, and Uber were all startups at one point.
Indeed, every big company was once small-usually very small, generally with one or two people in a room or the proverbial garage with an idea and a phone.
Growing small startups into big companies are never easy, and while the Amazons and Apples of the world were all funded by venture capital, venture-capital funds have also invested in many startups that failed. In fact, they have invested in more failures than successes.
Only 25 percent of investments return investors’ capital, with yet fewer portfolio companies returning the bulk of portfolio return.
Individual startups are far more likely to fail than to succeed, making venture-capital investments seem risky. Yet, as an asset class, venture capital consistently outperforms other asset classes. Why is that the case? Why should you still invest your hard-earned cash in companies that are bound to fail?
Because of three unexpected allies: illiquidity, risk, and surprise.
The Benefits of Illiquidity
When choosing where they should put their money, most investors have a strong tendency to put liquidity first. “What if I need cash in six months, twelve months, or two years?” What if, indeed! As Michael Milken has said, “Liquidity is an illusion…It’s always there when you don’t need it, and rarely there when you do.” That’s why it’s probably best to have some mixture of both liquid and illiquid assets.
Illiquid investments can actually have more solid returns because they aren’t as subject to the ups-and-downs of the market. Sure, with stocks and bonds, you might have more flexibility to buy high and sell low, but the opposite often happens too, and many people have been forced to sell at a loss because of the roller coaster ride of the market.
New ventures have ups and downs, but, because the investment is private, the entrepreneur, rather than worrying about an enterprise’s quarterly stock price, stays focused on understanding customers and building the company. And because the company is illiquid, the entrepreneur is compelled to discount their stock price when venture capitalists make their initial investment.
Venture capitalists are experts at negotiating for lower up-front prices based on illiquidity. With a startup, the entrepreneur needs to raise capital and offers a business plan showing future value. The venture capitalist listens to the entrepreneur’s story and responds, “I love your business model, but it will take you eight years to realize its full value. I will invest, but you need to lower the stock price to protect me and my investors from the illiquidity risk.”
Startups’ illiquidity can be an asset, rather than a risk, particularly if you have the right venture capitalist at the helm.
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Risk and the Rounds
But aren’t startups risky ventures almost by definition? Didn’t we just say that far more startups fail than succeed? So why is it a crucial investment strategy, even if it’s only a small percentage of your overall portfolio?
Venture capital is extraordinarily risky if you don’t do due diligence or diversify correctly. What best-of-breed venture capitalists do to mitigate risk is to look at upward of a thousand companies to find reasons not to invest.
This is due diligence with a vengeance, which is absolutely necessary if you’re going to invest in startups and early-stage companies. You need to know a lot about the company, the idea, and the people you are investing in. Venture capitalists look at thousands of companies and invest in only a few-those that will have a big impact if they succeed, led by entrepreneurs who, at times when the rest of us would run away, only work harder.
Entrepreneurship is such an important topic these days that most people know there are usually several rounds of investment in new, growing companies. The first round is generally called “seed” funding, with a second and third round to follow as the company requires more capital.
As one round succeeds another, you continue to pay close attention. Most of the companies that you’ve made a seed or first-round investment in will fall by the wayside. A few will keep charging forward, and you put more of your second- and third-round chips on these.
Why not just wait until the second or third round to invest in later-stage startups that are more likely to succeed? Because, by investing in a startup’s seed or first round, you also buy a greater opportunity to invest in the subsequent rounds of companies that thrive. Seed-round investors have first dibs on investing in later rounds of companies that look like they’re really going to take off. This creates “optionality”-the right but not the obligation to invest.
Basically, due diligence goes a long way to mitigating risk, but with startups, that remaining risk-and an investor’s bravery in embracing it-is what paves the way for future profit.
The Element of Surprise
Simply put, a good venture capitalist discovers opportunities that surprise conventional wisdom.
To start thinking like a venture capitalist, ask yourself this: what if you’d had the option to invest in Apple just before the iPhone was announced? Of course, Apple had gone public long before. If you’d bought Apple stock on receiving information, well before the market, about a new product that would transform the world, you’d be breaking insider-trading laws.
Now let’s apply this example to the world of non-publicly traded startups. Many people would have done many things differently if they’d known then what they know now. While venture capitalists don’t have crystal balls, they do know what others don’t. Public companies have analysts who write reports. Private companies don’t. The venture capitalist is both early-stage companies’ key investors and key analysts. And since venture capitalists invest in technologies long before they go public, they have special knowledge about what’s happening well before the public markets do.
When you invest in a startup or other private company, you have greater access to information about the products and services the company is planning to launch and the people on the management team. This knowledge leads to the asymmetry between insiders, such as yourself, and outsiders.
To return to our example: if you had known about the iPhone ahead of time, you could have invested in Pandora or the gaming company Zynga, understanding that once Apple’s new product hit the stores, a lot of new content would be needed.
What is a surprise to everybody else is, in fact, not a surprise to the venture capitalist. It’s routine. Venture capitalists spend their time gleefully using the knowledge and “the element of surprise” in private markets. Their information and knowledge about the companies they invest in are so deep that they almost have an unfair advantage.
Find Your Unicorns
The right combination of illiquidity, risk, and surprise can make for seemingly magical returns. But none of this is magical. Most of it is really down-to-earth. Data from the Kauffman Foundation, which has done extensive research on entrepreneurship, indicates that what matters most to a venture capital fund is diversification, and what matters most to the startups it invests in is a really strong management team.
Startups are a key part of investing because they offer such potentially high returns on investments. But you don’ t have to find the next high-tech unicorn, like Apple or Amazon in order to make a profit. There are startups in industries of all kinds-health, agriculture, financial services-and in all areas of the country, and there are thousands of companies that can be considered successful, as long as they’re part of a venture portfolio that delivers a 15 or 20 percent return.
When investing, the only guarantee is that there are no iron-clad guarantees, but properly diversified venture-capital assets have outperformed all other asset classes in the long term. Even if you take the failure of individual startups into account, with a good mixture of illiquidity, due diligence, and a diversified portfolio, you will be well on your way to a successful investment.