This is the third post in a 5 part series. Check out Part 1, Part 2, Part 4 and Part 5
Why Give a Damn:
Investment crowdfunding enables individuals to invest in companies they are passionate about, and in so doing, outperform professional investors.
Let’s recap some relevant historical annualized investment returns:
- Corporate Bonds: 8%
- Public Stocks: 9%
- Venture Capital: 20%
- Warren Buffett: 24%
- Angel Investment: 27%
Before we go any further, it’s important you understand why the above is true.
The biggest factor is that of underlying value. Relatively speaking, small businesses create more value than large companies. Remembering back to Econ 101, we can see that this is an example of diminishing marginal returns. So the earlier you invest in the lifecycle of a business the higher the return you would expect. Public companies are required to be “large”, whereas startups are by definition small. Thus it makes sense that angel returns would be higher than stock market returns.
A secondary factor is that investment returns reflect the shared value created by combining investor resources with the underlying business. The reason Warren Buffett makes more than VCs is not because he’s so much greater at hunting for underlying value propositions, it’s that he adds more value when he invests. Unlike most VCs, Warren Buffett takes a controlling interest in his investments and installs seasoned operational management teams to run them. There are many other ways that he adds value to his investments too, but the point is, capital is the least important resource he provides. As an investor in public stocks or corporate bonds, capital is the only resource you provide.
Harvesting Underlying Value
It goes by many names: super angel strategy, “spray and pray”, black swan farming, and moneyball for startups. But the concept is the same and the trend is undeniable. There’s a data-driven way to make money investing in startups that flies in the face of conventional wisdom. And it’s not how most angels and VCs operate today.
The old way was to spend months searching for, and doing diligence on, just a few investments per year. Because startups are so risky, the conventional wisdom was that you need to make sure everything is perfect before investing. And once you found your golden goose, you were a fool not to squeeze every last ounce of value for yourself — and at the expense of the entrepreneur — in the deal negotiation process.
Here’s the new way: radically reduce the time and money spent trying to pick winners, invest in dozens (if not hundreds) of companies a year, and give the entrepreneur a fair deal.
The reason for this shift is manifold, but it boils down to a startling fact revealed by data mining: nobody can pick winners at the seed stage. It’s simply our hubris and cognitive biases that fool us into thinking otherwise. The data is very clear though. Startup success is correlated with just one factor: the strength of the founding team. There’s so much risk and uncertainty in entrepreneurship that the only thing stopping a startup from flying off the rails is people who are so dedicated they would rather go broke than to see it fail.
And still, nine out of ten startups do fail. The question we must ask, then, is whether it’s possible to reliably earn a living as an angel investor? Is there a way to harvest the underlying value in startup investing without getting lucky?
Several years ago, some friends of mine collected all the known data on angel and VC investing and came up with a quantitative approach to do just that. While 500 Startups, Google Ventures and others were formulating similar strategies, what’s unique about about Right Side Capital is how rigorous and algorithmic their approach is. The key to their strategy is threefold:
1. Be Systematic
Right Side believes that crafting each deal individually is incredibly time consuming and costly. Even worse, it leads to inconsistent investment decisions. It’s not uncommon for an investor to say yes to a deal one day, when they would have said no the day before or after. So Right Side uses a checklist of investment criteria, standardized due diligence steps, and template legal documents to produce a higher quality portfolio, more quickly, and at lower cost.
2. Be Diversified
Each individual startup investment represents a massive risk. But with enough diversification, the risk in an entire portfolio drops dramatically. Based on historical data, Right Side has determined that the minimum desirable portfolio size is around 70 investments. They take it a step further and make 70+ investments per year.
3. Be Data-Driven
It’s hard to quickly make investment decisions if you don’t have good data on startups and founders. Right Side is continually collecting a ton of data about their own portfolio companies, as well as data on the overall angel market and relevant macro trends. This helps them maximize outcomes and also increases the likelihood that they learn and improve over time.
As an angel investor for the past 12 years myself, and having lived through two boom and bust cycles during that time, I believe that some variant of this strategy is the only prayer an individual has of being a professional angel.
Crowdfunding the Black Swan
“We’ll probably never be able to bring ourselves to take risks proportionate to the returns in this business.” (Paul Graham)
That statement was made by the founder of Y Combinator, a legendary seed-stage accelerator which has invested in over 450 startups since 2005. In his blog post about Black Swan Farming, Graham candidly admits:
“I can lay out what I know to be the right thing to do, and still not do it. I can make up all sorts of plausible justifications…. But I know the real reason we’re so conservative is that we just haven’t assimilated the fact of 1000x variation in returns.”
What he means by “1000x variation in returns” is that the best performing investments are 1000x better than the average. For instance, early investors in Facebook realized a 2000x return when it went public. What he means by not being able to “do the right thing” is maximize investment returns by sticking to a data-driven strategy. In other words, Paul Graham is saying that even the professionals are not so professional. To paraphrase Peter Brand’s character in Moneyball:
“There is an epidemic failure within the game to understand what is really happening. And this leads people who run [it] to misjudge… and mismanage.”
There are many variants Right Side’s moneyball being tested in the marketplace right now. But they all involve (either explicitly or implicitly) surrendering to the fact that nobody can see the black swans coming ahead of time. Any attempt to do so will reduce your expected return on investment.
So what’s the lesson in all this for someone who eyes the 27% returns of the angel market? To me it’s very simple. Embrace the risk, and trust the math.
Back in the day, I would do a few angel investments per year at an average of $50K a pop. This was way above my bankroll and I went broke doing it. Moreover, I was focused on the wrong things. I was investing in ideas and business models I was in love with. What I should have been focused on was the people I was entrusting with my hard-earned cash, and let them focus on the ideas and business models. After all, the data shows that successful startups change their idea and business model (sometimes more than once). So unless I trust the founders to exercise good judgment, I shouldn’t be investing, regardless of whether I love what they are doing.
Today I am smarter about choosing the right people, but even when I was full-time investing, I was maxed out at about a dozen deals a year. Without a way to scale, I risk going broke again. And since the minimum investment these days is about $10K, Right Side predicts I would need to invest $2M per year to play proper moneyball. Even if I could somehow magically get 100 deals a year done, how could I possibly manage my portfolio without a full-time support staff?
Once the JOBS Act is fully implemented, I will set aside $10K per year for my black swan portfolio fund and invest $100 into 100 startups via a crowdfunding portal that will handle the mechanics. And even if I lose all $10K in a given year, I’m prepared to do so. It’s my willingness to do so gives me an advantage over the professionals, like Paul Graham, who are not.
Creating Shared Value Through Friendship
Here’s the thing though. Beating Wall Street by 3x or 4x is not hard if you know what you’re doing (and don’t fall prey to irrational decision making). Crowdfunding is going to make moneyball investing an accessible game to millions of average citizens who are smarter and more deserving than the wizards of Wall Street. The oligarchy — some would say the kleptocracy — is ending. Eighty percent of the new wealth in America is generated by average citizen entrepreneurs, and soon their neighbors will be able to come along for the ride as investors. With five hundred startups and 27% inherent returns, $50K becomes $50 Million in under 30 years.
But that’s not what excites me most about crowdfunding as an investor. What excites me is that right now, I have a friend a week who says to me, “I have this idea to change the world and I think it could make a lot of money too…” And soon I will be able to tell them in response, without a moment’s hesitation: “Turn it into a business plan, put it on Crowdfunder.com and I will pledge the first $100 of investment.”
What also excites me about crowdfunding as an investor is no more “portfolio management”, and no more hounding companies for investor updates. I’m only going to be investing in companies run by people I already know and trust; they will look after my financial interests, whether I check up on the company every month or never again. Which frees up time for us catch up naturally, as friends generally do. If there’s important business to discuss, one or the other of us will bring it up in the flow of conversation, or we’ll schedule a business meeting as necessary.
The professionals will scoff at me and say I’m not adding maximum value as a strategic investor. If there’s one thing I’ve learned as an entrepreneur and an angel it’s that entrepreneurs don’t need somebody else’s advice on how to run their business. They need value-aligned partners who will take their lead, not lead them. They need investors to offer wisdom and emotional support, but only when asked. In short, they need a friend. And preferably someone who will introduce them to other friends who are similarly aligned and provide things the investor can’t.
Unreasonable Challenge
What’s your personal long-term investment strategy? Share it with us in the comments below.
I am Senior Vice President of Business Development at Crowdfunder, a leading investment crowdfunding portal. I’m also an angel investor, advisor and friend to many of the people and companies I mention by name. If you’re interested in learning more about my world or want to connect, please visit http://www.rafefurst.com