A Different Approach to Early-Stage Investment

I admit it - I am green in the world of early-stage investing. Three years experience, 18 deals, $1.5 million invested, three exits (one has happened but is not yet disclosed). That said, I feel like I am in and around the early-stage investment scene enough and have done enough to have an opinion. And it is somewhat different than the classic VC definition of early-stage investing that I’m familiar with. I’ve always been told that a VC perspective can be summed up as follows: “A successful fund is characterized by a few home runs and a bunch of failures. This is the nature of the venture business.” That always seemed to me like a scary model. Swing for the fences every time, strike out a ton and hope to connect on a few in the World Series. Fred Wilson’s post on the Union Square Ventures weblog did a better job describing what I expect is the more conventional VC return pattern, where roughly 1/3 of the deals fail, 1/3 underperform and 1/3 meet expectations. But does this mean that VCs are still swinging for the fences every time, but that there are some duds mixed in with the complete goose eggs and the home runs? I don’t know, but I expect that most are striving for at least a 10x on each and every deal.

I have taken a somewhat different view of early-stage investing. I have sought to build a portfolio diversified not only by sector and business model but also by another key dimension of risk: exit path and timing. What this specifically means is that I actually invest in deals where I expect to generate a return of, say, 3-5x in a fairly short period of time yielding a high IRR and risk-adjusted return. What does this mean? It means that I invest in both intelligent, needed features and applications as well as potentially disruptive technologies and business models. Mytrade? Great application. TheLadders.com? Disruptive business model. Mashery? Great application (but with great upside). Buddy Media? Disruptive business model (combining real high-value, monetizable commerce with social networking? Huh?). My portfolio is littered with great applications and features that will likely never be billion-dollar companies but where the entrepreneurs are laser-focused on commerce, making money from their IP and business approach. These are the deals that get taken out quickly, for that 3-5x type multiple, and get bolted on to a larger company’s core offering. Is this a failure because it wasn’t a “home run” and failed to get a 10x? Hardly. I’ll take those all day long. But I do want the disruptive bets in my portfolio, but I don’t want them to dominate. And I don’t want a 1/3 failure or 1/3 underperformance rate. I want a much, much higher batting average with lower volatility of outcomes.

One might say that my approach is foolhardy, that all I’m doing is giving up a large portion of the call option for a bit of a put option. And I can understand that concern. But my experience tells me that my perception of value is pretty good, and that by backing entrepreneurs who are focused on making money and not on some technological breakthrough, and where my relationships and experience can add value yields a very attractive, risk-adjusted result. Clearly time will tell but my three years in the business indicate to me that I’m on to something. I’m not sure anyone would give me money to run such a seemingly unconventional strategy but it is certainly working for me.

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COMMENT:

AUTHOR: Darren Herman

EMAIL: darrenherman@gmail.com

URL: http://www.darrenherman.com

DATE: 12/14/2007 10:27:44 PM

An extremely smart way of investing if the thesis is clear that your portfolio is going to perform this way.

We look for homeruns all too much but that leaves a lot of other startups that hit singles, doubles, and triples out in the open.  A solid way to look at the market, as long as you have strong deal flow.

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COMMENT:

AUTHOR: Yaser Anwar

EMAIL: yaser@yaseranwar.com

URL: http://www.yaseranwar.com

DATE: 12/14/2007 10:36:16 PM

Interesting post as always. Would be interested to know if you look for any specific metrics on the valuation side i.e., cash flow generation (or expectation of cash flow positive/breaking even); comps analysis of acquisition price, if any, when buying in; and any other similar metrics.

Thanks.

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COMMENT:

AUTHOR: bryce

EMAIL: bryce@oatv.com

URL: 

DATE: 12/14/2007 11:38:19 PM

That theory works until you bring in larger VCs (ala TheLadders, Clickable and Mashery) at which point they are not going to be happy with a 3-5x return and extends your return time frame and overall IRR, no? Or are you just happy to have a small part of a (potenitally) larger pie?

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COMMENT:

AUTHOR: howard Lindzon

EMAIL: howard@lindzon.com

URL: http://www.howardlindzon.com

DATE: 12/17/2007 10:16:10 PM

we should be partners :)

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2 years ago | view comments |  Investing