No matter what you think, you are probably not good at picking winners amongst startups.
Famously, a Wall Street company specialised in asset allocation once asked a highly confident group of financial professionals to pick the best stocks from a list of companies in the newspaper. Based on their in-depth analysis – involving deep knowledge of price to earning ratios, discounted cashflow valuation and other expert due diligence – they made their selection. In parallel, there was a group of simulated monkeys who were given some darts to throw at a wall with the same company names. In that experiment, the monkeys actually performed better over time than the highly trained financial professionals, because at least their approach didn’t have all sorts of human bias.
Although we haven’t run an experiment with monkeys… we are willing to say that the same probably applies to selecting startup investments. When a company is only a few years old there isn’t a lot of hard data to analyse, to begin with. If you use a spreadsheet and an analytic approach of some sort, then that is fine for you… but don’t expect it to be a working crystal ball. Even your own ‘gut feel’ is not likely to be a perfect predictor of the future, let’s face it. Unfortunately, there is no consistent or reliable way to assess whether the team will turn out strong, the product right, the market large enough, or whether you will be able to get a good exit. A lot of success in early-stage investing is just the luck of the monkey, with some of your experience and approach sprinkled on top.
Now let’s emphasize that we haven’t really done a proper scientific investigation. But nonetheless, here is the investment approach that we recommend for startups investors as a starting point:
1. Build a portfolio. You need to spread your bets over 5-10 companies. The reason is: since you don’t know exactly which ones will be successful you should cast your net wide. When there is a hit you can expect a >5X return, but don’t expect to have more than 1 or 2 of those in any portfolio.
2. Avoid the weakest companies. This is where you can use your judgement and experience best. Many of the ‘startups’ out there will just have a brief run that ends nowhere. Try to avoid those. You want all of your portfolio to ‘have legs’. That means that they are running for years, create real value for customers, and have some kind of exit. You may not be able to pick only the 10X winners, but you can probably avoid a lot of companies that go nowhere and end with a 0X.
3. Practice playing peanut poker for the first few years. You should probably only be investing amounts that are very small to you at the beginning. That way: if you lose an investment it is not a traumatic experience, but just a learning experience. Once you have been making small investments for a few years, and your confidence grows, you can start investing bigger amounts. You don’t know how it feels to lose an investment until you have actually been through it.
4. Be consistent. It is an old saying that ‘lemons grow faster than pearls’. While you are building your portfolio you will see the first failures within a few years… the successes will only come much later. You need to have a consistent approach if you want to last all the way to that finish line.
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