This is a very brief post on why understanding investment portfolio theory, at least in a basic way, is critical to you not losing money investing in seed stage startup companies. Actually, even later stage companies can fail … just ask the folks who’ve put a ton of money in to Juicero! The thing is, you need to be in a lot of companies to be reasonably certain you aren’t likely to lose your money and even more if you want to be reasonably certain you are going to make money.
We’ve mentioned before that some analysis we’re aware of analysis that said 25 investments was the number you’d need to make for you to be reasonably sure you wouldn’t lose any money. Smarter people than us have done the maths, so we aren’t going to go through it all again here. This recent article on medium.com says 100 companies will give you a good change at 3x. So, the 25 could be a reasonable approximation.
“With the failure rate of early stage companies so high, why does anyone invest?”, we hear you ask. There are a few reasons.
- Naivety – this comes in many forms. It’s not just the naivety of your average Joe investor. Logic says that professional investors with small portfolios are probably losing money too. People love talking about their wins, not so quick with the fails … you decide.
- Bored with the realestate and financial markets … addiction (it’s cool) – there are a lot of people around the space who enjoy the excitement of change. The standard markets aren’t enough to keep them engaged. The 5-10% per year on their money is not interesting … they see people getting 100x in the well publicised exceptions and they want some!
- It’s a business. Actually know what they are doing – not a big group. There are a few VCs and a very small number of angels that make money investing in early stage companies.
- The 3 Fs … (Friend, Family or a close fool) … There is an occasional lucky friend or relative who’ll tell you how clever they were seeing the opportunity. Nope, they were lucky enough to invest their one amount into one company that happened to be the one in a hundred. Good for them! Mostly though, this money is going to disappear. Don’t take this money and don’t give it. The risk of permanent damage to these relationships and loss of their money is not worth it. The 3Fs cannot understand what they are doing, but at the same time the investee doesn’t really understand either as they are blinded by belief.
- No way out … this refers to the entrepreneurs (and inventors) themselves who end up on the hook. Too much invested to walk away, still a faint hope, so they keep pouring it in until there’s nothing left.
- Wealthy folk just ‘Wanting to ‘give back’ … not sure that the love exists without a profit (eventually) … so …
- Companies and people that actually understand the target markets and can provide more than money and generic advice. This is the holy grail of early stage funds.
If you are considering investing in startups, have 50-100 times your first investment handy and double it for follow-on rounds. Eg: I’m going to invest $25,000 into seed stage companies. You’ll need $5m to have a good chance at 3x your investments.
There’s no bad news here. Investing in these companies is a business. You don’t get 2,3,4 or more times your money for no risk.
You can increase your chances of making money by understanding the risks and how to mitigate them.
You almost guarantee losing your money if you don’t.