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September 10, 2020

Common Mistakes in Early-Stage Investing – Part 4

 

Note: this is the last of four articles on best practices in early-stage investing.

Links to the rest of the series: Part I, Part II, and Part III.

 

We’ve finally reached the fourth and final article in our series on common mistakes that investors can make as they begin to invest in early-stage companies.

Before diving into this final entry in the series, readers might care to start with a review of Part I, Part II, and Part III — which address Conceptual Approaches, Deal Flow Sourcing, and Execution of Investments, respectively.


Introduction

Congratulations, investor! 

If you’ve managed to do all of the following steps: develop an initial understanding of the world of early-stage companies; review a bunch of deals; and actually make some startup investments — then you’re already way ahead of the average investor. There are many people who might be familiar with investing in stocks or real estate, but far fewer who have knowledge of startup investing.

Once you’ve gotten your feet wet with a few initial investments, the final area of critical skill-building for early-stage investors is Portfolio Management. Investors can sometimes feel unsure whether they are even on the right track as they try to develop their startup portfolios. And that uncertainty can lead them to make some (or all) of the following mistakes as they enter the portfolio management phase of their investing journey.


Mistake 1 – Distracting Founders

Early-stage investors tend to be smart, successful, inquisitive, dynamic people. 

As such, they are eager to offer strategic advice, coaching, and operations assistance to each shiny new company that they’ve added to their portfolio. But this instinct — while usually well-intentioned — is also highly misguided. 

Once a founding team has received the capital that they need the most important thing is to give them plenty of breathing room. Let them actually put that capital to use, as they run and grow the company!

Unfortunately, angels and even institutional investors systematically overestimate their own helpfulness. As prominent VC Vinod Khosla notes, the vast majority of investors add zero value — and a majority of THOSE end up contributing negative value. In the most detrimental cases, this negative value takes the form of heavy-handed intrusion into the company’s management activities. But the more mundane version is simply investors who create distractions for founders at a time when those founders should be focusing on developing their business (and thereby ensuring that your investment will actually be worth something). 

If the Hippocratic Oath commands physicians to do no harm, then perhaps the world of startup investing requires its own version: “Do No Distracting.” If you must contact a founder after you’ve made an investment, consider sending them a single email, thanking them for the opportunity to invest, and (if you’re so inclined) offering to help anytime they need it. If you have truly remarkable industry connections or recognized expertise in a field that’s relevant to their business, this email would be a good time to bring that capability to the founders’ attention. But once you’ve hit Send on the message, give the founders some space. Don’t send a barrage of pestering emails, or interrupt their workday with phone calls, or maneuver your way into their calendars. 

It’s fine to keep an eye out for any investor update emails that include a request for investors’ help — and respond to any such asks, if you’re confident that you can truly deliver value. But outside of that, you should mainly just keep a respectful distance. As an investor, you’ve done your job. You found an intriguing company, assessed their prospects, and equipped them with capital. Now it’s time to let the founders do their part.


Mistake 2 – Not Knowing How to Assess Follow-Ons

It’s a great experience when one of your portfolio companies — after tirelessly executing their go-to-market plan — finally raises a new funding round at a solid markup over your entry valuation. Although savvy investors will remind themselves that (to quote an LP from a famous VC firm) you “can’t spend unrealized gains”, it’s still undeniably gratifying to learn that one’s position has jumped up in value… at least on paper. 

However, the advent of a follow-on round brings with it the option to make a further investment in the company. Some investors feel perplexed by this decision: 

Should they invest in the follow-on opportunity, and put more of their capital at risk — which will imbalance their portfolio towards that marked-up company — but could also magnify the size of the positive outcome, IF the company eventually has a solid exit? 

Or is it better to preserve their available capital instead, and use it to make new investments in additional early-stage companies that will diversify their portfolio?

It shouldn’t surprise anyone that there’s no ironclad rule that guarantees the right decision here. (If investing could be reduced to simple rules, we’d all be gazillionaires.) However, there are at least some guiding principles that investors should bear in mind, as they assess whether to participate in follow-ons. 

A first principle is that follow-on deals that have higher valuations than previous rounds will yield lower rates of both risk AND return, relative to the original capital invested in the company. Risk goes down for follow-ons at higher valuations because a startup’s probability of failure has been shown to decrease with each major funding round completed. However, the expected ROI drops as well. The follow-on is being done at a marked-up valuation, which means that the effective entry price for investors is now higher. Although that startup could still become a billion-dollar company, the opportunity’s remaining upside is lower now. That’s because your follow-on dollars will be getting in at a higher “effective cost basis” (i.e. valuation) than your original dollars did.

Another principle to remember is that investment decisions about whether to participate in a follow-on opportunity are never made in a vacuum. There is always an opportunity cost to consider! The capital that you’re considering committing to that follow-on could also be used to invest in another seed-stage company raising its first-ever round. For all you know, perhaps it will be that new seed-stage addition to your portfolio, and not the follow-on deal, that ends up becoming a coveted unicorn.

A good framework that forces an investor to consider the opportunity cost of a follow-on is to treat it merely as just another deal to be reviewed. In other words: don’t bias your decision in favor of the deal — OR against it — simply because it’s a follow-on. Instead, treat it as merely one more opportunity drifting its way along the stream of your dealflow. If the potential upside of the follow-on deal is superior to all the other deals you’ve seen lately, then invest! But if you recognize that the remaining upside in this deal is capped, then ignore the siren song of the follow-on and go invest in some new companies instead. 

[Note: the above principles refer to follow-on opportunities where the company has received an UPTICK in valuation. If instead a company is raising fresh capital in a flat round or a down round, then investors should proceed with extreme caution. As a rule, startups that are healthy and succeeding are able to raise new capital at increased valuations — so down rounds should absolutely be viewed as a basis for heavy skepticism about a company’s prospects.]


Mistake 3 – Being Surprised by the J-Curve

You’ve done it: you have managed to assemble a portfolio of startup deals, each of which seems to bear the promise of becoming an impactful company. You step back to admire your portfolio, excited to see how all of these ventures will transform their respective industries (and, with a little luck, enhance your net worth in the process). Life is good.

That is, until you check your holdings a few months later and are alarmed to find that your handpicked, ostensibly well-diversified portfolio has not only failed to skyrocket in value — but worse still, has actually dipped significantly below its starting value! 

Don’t fret. Your portfolio isn’t necessarily a failure. More likely, it’s simply going through the phenomenon that almost all early-stage portfolios (even ones that will ultimately become huge successes) initially undergo: the J-Curve.

The phrase “J-Curve” refers to the fact that venture portfolios tend to drop in value during their early years. And that’s true even for portfolios that end up soaring in value later.

This upfront dip in portfolio value occurs because the failures in your portfolio companies will largely occur much earlier than your positive exits. Your most successful exits will tend to happen last of all. It takes a very long time — sometimes a decade or more — for category-defining companies like Airbnb or Spotify to reach their exits. 

By contrast, the ventures that are doomed to collapse (which typically happens because they weren’t making something that the market actually wanted) tend to fail within the first two or three years of their existence.

This mixture of early failures and delayed winners makes most venture portfolio ROI look downright awful for the first few years. But once its failures are already purged, a portfolio will see its breakout successes grow and grow, until their markups finally overtake — and then dwarf — the losses from those early failures. And that’s when you, as a venture investor, can finally stop singing the J-Curve Blues. 


Mistake 4 – Failing to Build a Long-Term Portfolio

It’s difficult for most investors to grasp the full measure of patience required to assemble a vibrant portfolio of startups and then tend to that portfolio until all the positions finally reach their eventual exits. 

Changing the world takes time. The companies that disrupt entire industries take years to expand into new cities, then countries, and finally across multiple continents. For investors, this means that their early-stage investing endeavors may prove to be the longest-standing commitments that they make in their lifetimes. Unlike stocks or bonds that are commonly traded after holding periods of only a few months or years, the best-performing startups that you invest in today may very well still be sitting in your portfolio a decade from now. Early-stage portfolios take longer to reach their natural conclusions than a college degree or even a PhD program. Simply put: your startup picks will be with you for quite a while. 

Patience is an indispensable trait for early-stage investors. It’s patience that keeps them from distracting founders. Or from becoming too discouraged by the J-Curve. Or from giving into the temptation to do that follow-on in the company whose recent traction is too flimsy to justify its excessively high current valuation.

But beyond forbearance and self-restraint, there’s another trait that’s a must-have for early-stage investors: an eye towards the future. You need to think in terms of building a portfolio for the growth areas of tomorrow, not just the buzzy trends of today. Far too many angel investors become preoccupied with chasing startups in industries that are the darlings of today’s consumers and VCs. The problem with this approach is that those so-called hot sectors will fall out of favor sooner or later! 

So, as hockey legend Wayne Gretzky recalls being taught by his father, “Skate to where the puck is going, not where it has been.” The very best early-stage investors develop an intuition for the direction in which a given industry, technological field, or even society itself is headed. They are able to load up their portfolios with startups that have a chance of becoming the breakout enterprises of the decade to come.


Conclusion

Early-stage investing is a fascinating journey. For newcomers, it can feel like the process is loaded with pitfalls. But with the right frameworks and approaches, it’s a path that can be navigated with confidence.

I hope that you’ve gleaned some useful knowledge from this series! If you’ve had the persistence to read all four articles, you now have some guideposts that will help you avoid common errors at each step of the startup investing process. Conceptually, you know how to use standard check sizes across a diverse portfolio. You can capture the potential of the power law by targeting companies with huge contingent upside. For deal flow purposes, you’re comfortable sourcing fairly priced opportunities across a range of platforms, geographies, and even some unorthodox sources. When it comes time to select deals, you know better than to be preoccupied with trendy deals, negotiation of terms, trivial signals, or the waiting game. And once you’ve assembled a portfolio, you’ll know how to approach follow-ons sensibly, while taking care to avoid distracting founders or becoming anxious about the J-Curve — so that you can focus on building an enduring portfolio. 

Happy Investing — and may the power law be with you.

 

Note: this is the last of four articles on common mistakes in early-stage investing.

Links to the rest of the series: Part I, Part II, and Part III.


4
About: Rob Ness

Rob Ness is the General Partner of seed-stage VC firm Asymmetry Ventures. He also runs one of the largest syndicates on AngelList, managing a community of over 1300 angel investors. Over the past decade, Rob has invested in more than 150 early-stage deals. He graduated from UC Berkeley with a triple major in mathematics, economics and interdisciplinary studies - and completed an MPA at Harvard University.

View Rob Ness's articles

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