General wisdom about investing in early stage companies suggests that for every 10 investments, only two companies do well. Let us assume that four of the ten return the money invested and four return nothing. If we invested a million dollars in each we will have invested ten million dollars in total. If two of the investments return 10 times in five years and the remaining return nothing – than the average return would be 15%. But most VC firms do not do that well. The annual return for all VC firms has been 8.1% per year. The top quartile does a lot better with returns of approx. 23%. And the top 20 firms do extremely well – but that is a “hits business” to some extent.
We are better than most. We invest in ten startups. Two of these startups return 10 times the investment, 4 firms just return the money invested and four go under. In that case, we would have a gross return of a bit more than 25% a year. Investors do not get this because of carried interest and management fees (VC’s get 20% of the gains and 2% of the money invested as a fee which is about 10% in five years).
So what does this mean to the different parties?
First of all, remember that only 20% of companies ever really succeed. While 40% will return the capital invested – because of the difference between Preferred Shares (which is what investors get and Common shares which are what founders, employees, directors and advisors) only investors get money from the 40% that return the capital invested. That means 80% of company founders get nothing.
Yes, the entrepreneurs have the same statistical expected value but since they do not have a portfolio, they are only able to make one bet and the chances are very high that this will not be a good bet. Most founders don’t understand this. And even when you explain it to them, they don’t care because they believe that it does not apply to them because their idea is so wonderful, their talent is so great that they are going to be a success, no matter what.
Normally, you can only have one job at a time. It is easier for employees to jump ship than founders – so their odds of getting some payoff might actually be higher although the amount of payoff would be much smaller. Most employees get stock options that have provisions in them that can easily result in the employee working for years and then getting fired or leaving without the ability to exercise their options. When an employee takes a salary cut to get stock in a company, they too are making an investment but on terms far worse than the VCs.
Generally, employees don’t understand stock options. Smart companies create large amounts of stock with low value so they can give employees big numbers. For example, I start a company and set its value at ten million dollars and create ten million shares. Each share has a value of one dollar. Now the company wants to issue an employee a stock option for 0.1% of the company. That employee is offered 10,000 options. However, if I set up the company with 100 million shares at $0.10 per share I could offer the employee 100,000 shares. Many times employees with go with the higher number of options if they are considering two competing offers even though they are worth the same. Often, companies will not tell employees how many shares are outstanding or the value of the preferred shares that investors are getting. These are critical pieces of information in evaluating the value of the offer. For instance, an employee is being given the option to buying 0.1% of a company worth $10 million dollars. Investors were able to buy the same number of shares for $100,000. The employee may have taken a salary cut of $20,000 over five years or $100,000 for a 20% chance that he will get $100,000 which has an expected value of $20,000. None of this takes into consideration the kind of dilutions that result from the company raising additional money along the way.
Board Members and Advisors
This is more complicated because it really depends on how much time one has to put in. If a board member gets 0.5% of a company worth $10 million, the member is getting the value of $50,000. If if it vests of 4 years, that is $12,500 a year. In other words, the board member could have bought that stock for $50,000 and never had to show up at a meeting. There is, of course, a big range of values for companies. Things look a lot different if the company is worth $100 million when the options are granted, but the amount of stock as a percentage typically declines as the value of the company increases.
Advisors to companies get very small amounts of stock ranging from 0.2% to 0.05%. But if all one is doing is lending their name to the company as kind of an endorsement, taking a call every now and then and answering a few email or making a few introductions, it might be ok.
However, we have got to get back to the issue of having a portfolio. It is hard to be a board member of ten companies or even to be an advisor for ten companies. So keep in mind, you only have a 20% chance of getting anything. Also, the is, of course, a variation in the returns so even if you were in ten companies, you might get nothing or get more than projected.
Preferred Stock Versus Common Stock
I am treating all the stock the same in this discussion, but it is really not. Common Stock may start out having a value that is about 10% of the value of the preferred shares issued to investors. Eventually, they are worth the same in a successful liquidity.
Angel Investors usually invest at an earlier stage than Venture Capitalists. In doing so, they are taking more risk for potentially more reward. Since they are investing directly, they do not have to pay carried interest or management fees. Returns for Angel Investors are better on average than VCs which I personally find surprising since I think most angle investors don’t know what they are doing. However, it is important to have a portfolio because otherwise, the probably of any one investment paying off is small. It appears that Angel Investors have to have at least six investments to have a reasonable probably of getting their money back.
So What About Me
I try not to invest in early-stage companies. I like to say “that I made my money in tech and I don’t want to lose it there” but it is really how I feel. When I left Intel in April of 1999, I started making angel investments (I could not do that when I was one of the leaders of Intel Capital). I made about 20 investments in about a year before the bubble burst. Of all those investments everyone failed with the exception of one that managed to go public. Fortunately, I sold all my stock in that company as soon as I could and it more than made up for the other 19 failures.
I only invest in early stage companies when I am either an advisor or a board member. There are only a few exceptions when I found the opportunity extremely compelling both in terms of the company’s prospects and the valuation and terms of the investment. I also have to feel that my own efforts will result in a major increase in the value of the business.
My “ask” as an advisor or board member is about ten times the normal amount But that is because I am in demand so I keep raising my prices. It is also what I think makes sense considering the financial calculation I use to determine the value of the offer. I always ask myself, how much would I have to pay to own these shares.
In thinking about the investments of time and money, I also have to take into consideration that I can not have a large portfolio of angel investments, advisor-ships, and board positions. Therefore, I want to target a much high return.
Finally, I will not take stock options. I want the stock to be granted, but it can be subject to a forfeiture schedule similar to vesting. This has to do with a number of factors including tax considerations (Capital Gains or even better QSBS exclusions). This also increases the expected return.
There are better ways to invest money and time than venture investment unless you are very skilled (or, of course, lucky). I only get involved in early-stage companies for three reasons: I like the people, I think the business proposition is compelling and I feel that I can make a difference. If these things are true, I use my financial analyst to decide how much time and money would make sense. I never invest money I could not afford to lose. And I never count unrealized gains when considering my net worth.
The Bottom Line
Probability theory is very important when investing your money and time. If you do not understand probability distributions, you might want to. There are better ways to make money than investing time and your own money in early stage companies. But some amount of it makes sense – just don’t count on the returns.
I personally would never be a founder of an early stage company. Thankfully, not everyone feels like I do.
At some point, I will also explain why I am not a Venture Capitalist.
I apologize for spelling/grammar mistakes. Hopefully, I did not make any math mistakes either. I am sure I will hear from someone if I did.