Opinions expressed by entrepreneur Shareholders are their own.
Before I jump into this, let’s start with the basic fact: Statistics are subjective to the data sets used to create statistics, and as such, statistics can be skewed in any way a person wants to twist to make something appear realistic, relevant, or the source of truth simply by highlighting sets Quarantined data and obfuscate others. You can smear lipstick with any pig with enough effort. I think this is a good place to start, because I want to save readers time and energy trying to justify what is, in my opinion, a failed/failed concept.
Building a portfolio using a “power law” model as a source of truth to do so at an early stage of investing (such as venture capital) is not only logical, it is lazy, ignores basic facts, and is dangerous for investors who trust their money to GP (general partners). ) who “invest” using this portfolio creation logic. Let’s dive in.
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How investing really works
Before I make my points, let’s first understand how investing works, in ideal cases. In investing, the overall goal is to maximize capital while mitigating risk to its lowest common denominator. Simply put: make as much money as possible while taking as little risk as possible for the return you want to see annually. In general, the way in which a person, company, fund, etc. pursues this goal is through diversification.
Essentially, what you are trying to do is spread your investments across different linear and non-linear asset classes to create a mix of investments that will hit your target rate of return annually and protect you from huge losses when the markets are not performing well. Depending on market conditions, if you build your portfolio well, you can adjust the allocation ratios according to market conditions to further hedge against losses and still make some gains.
A good example of this is the inverse relationship between stocks and fixed income investments. Normally, when the stock market is doing well, fixed income isn’t – so while you still have fixed income investments in your portfolio during a “bullish market,” you’ll have a higher percentage of your equity investments to capture for better returns during a strong market. On the contrary, in a bear market, you will do the opposite.
What I have provided is a basic example of context to illustrate what most investors are trying to achieve in the long run. The exciting thing about investing this way is that with the rise of mutual funds, ETFs, and professional money management companies like Fidelity, Charles Schwab, etc., most investors can invest passively, meaning someone else builds and manages the portfolio for you (for a small fee). , of course), so you can sit back and enjoy the proceeds.
In venture capital, venture capital firms offer the same opportunities to earn passive income. The difference lies in the fact that what is invested in is significantly different. In general, when you invest in stocks through a mutual fund or ETF, you are investing in tried and mature companies that are publicly traded and, oftentimes, have already stood the test of time. This is not the case in venture capital. In venture capital, what you invest in are startups with little or no track record. This is vital to understand, because the dynamics between a startup and a mature business are as different as night and day. The challenge here is that VCs themselves take passive positions in early stage firms using power law as the primary justification methodology.
Related Topics: The Need for Diversification in Venture Capital Firms
Force law model problem
The law of power from a venture capital standpoint says, in basic terms, that the odds of generating huge returns for investors increase the more they invest in early-stage companies. The idea is that if a venture capital firm invests in a lot of early-stage companies (say 35-50 per year), they have a higher probability of finding a company that will reach the level of a unicorn (1B+ rated company) or decacorn (A company with a valuation of 10 billion +). The argument made by venture capitalists is that finding a unicorn or decacorn will allow them to generate returns for their investors that will offset the losses incurred by the venture capital company while searching for the unicorn and provide a good profit for the investors.
This sounds great in theory, and even looks cool when you put a lot of math behind it, because math always makes things look smarter than they are. This is due (in large part) to the fact that most people are not proficient in mathematics. However, when you really boil down this “investment” technique into simpler terms, it’s really just throwing sh*t against the wall hoping something will stick. No matter how much math you put into this, no matter how many fancy models you create to make this approach seem smart, the basic premise remains the same.
Overall, the masses of the venture capital community over time have basically convinced people that this approach is somehow something smarter and smarter and that they should be trusted to invest other people’s capital in this way, because it’s the best way – so just “trust” them on it.” The truth is, when you look beyond BS models and math formulas and keep it really simple, you see that a venture capitalist who invests in this way has no better chance of finding a rhino or decacorn than a blind man picking random companies out of a hat.
This is not an investment, this is a guess. It’s a gamble, not unlike taking all your money to the casino and hitting the roulette table. 94 percent of venture capital-backed companies go on to fail! Either they fail completely, and the investors are not able to get back the capital they have invested, or the company is able to return the primary investment but cannot provide any higher returns than the initial investment. Investing is about getting more money back than you originally invested. If the company could only give you back what you invested in the end, you might have put your money under your mattress, saved yourself the stress and come back to get it from under your mattress later. It doesn’t take a math genius to understand that a 6% pass rate under any evaluation criterion is a failing grade.
Related Topics: 6 Important Factors Venture Capitalists Consider Before Investing
Why do investors still use this model?
How can VCs get away with investing like this, and why do investors who invest in these funds continue to believe in the process? A better question is, why do general practitioners in a venture capital firm, in general, stand so strongly with this “investment” approach? Here’s what I noticed: First, studies show that the average venture capital-backed company takes at least three years to mature to failure. It’s easy for a company to appear healthier and more viable when it’s awash with investor capital and spending a lot of money in PR to paint a more optimistic narrative than it actually is. Venture capital firms use the narratives created by their portfolio companies’ PR campaigns to demonstrate to their investors that they are making good investment decisions. LP investors (who generally don’t know much about how things really work or what it takes to build a viable business at scale) are tricked into believing the narrative and end up investing more money with the venture capital firm.
In terms of general practitioners, here’s what I’ve noticed: To raise capital, they often tout their Ivy League education and limited experience as a way to prove their goodwill. It is not uncommon to see things like “Harvard Educator”, “Former Google employee”, “Goldman Sachs youth” and so on. The fund is highly qualified to do so. Here’s the truth: a college degree has almost no relevance when it comes to building a business. College cannot teach you how to build a business. You learn this concept through trial and error. It’s a stressful process to fail over and over again, learn lessons from those failures and apply the lessons learned until you gain enough knowledge and experience to get them right! You can’t read your way of experience, you have to work in a real environment, so a college degree doesn’t mean much.
You have no idea how many times I’ve found out, after doing a deeper search, that the “former Google employee” was an intern or had a nickname that sounds cool, but in reality, he was nothing more than a rookie on a team. The same can be said of the many so-called “Goldman Sachs alumni” who promote these qualifications in the VC space. A lot of venture capital GPs spend roughly one to three years on Wall Street, and that’s not nearly enough time to gain subject matter experience in anything! outliers By Malcolm Gladwell Explains the fact that it takes nearly 10 years to become an expert at anything.
This is the reason why many venture capital firms take a “gamble” approach to investing in early stage companies. They lack enough subject matter knowledge and experience to do anything more than give someone else’s money to a founder they “feel” good about and hope for the best. Investing in early stage companies is not something that should be done passively. This must be done actively. Venture capital firms should take a pragmatic approach to investing in early stage companies and bring their real-world knowledge and experience to the table to help the (often inexperienced) founders produce a viable company and product that can lead to scalability and viability. I call this a ‘cumulative value proposition’, and cumulative value is the only way you can eliminate early stage investment risk and increase the number of companies you intend to exit.
It’s not about how many companies you invest in, it’s about the time you spend helping the founders develop the companies you’ve invested in into something great, and that can only be done if you have the right mix of real-world experience (eg, IPOs, mergers acquisitions, structured finance, and related business development experience) to do so. If you haven’t seen the end before, how can you add value in the beginning? Companies that successfully exit share all common themes, and the only way you can determine this is if you’ve already participated in the exits yourself. When you understand the common themes from the experience, you can help founders build their companies out from scratch. This is what I call the end to the beginning. When you approach it this way, the company has a much greater likelihood of going forward to make a way out, which is how we all make money in the venture capital space.
Investing isn’t about trying to succeed every time you come to bat, which is the mindset that a lot of venture capital firms have. The goal is to achieve basic hits, because consistent basic hits lead to runs, and the sum of runs scored is what wins the game. My honest advice (which comes from nearly 16 years of experience in the areas required above) to all investors in this field is not to put up capital with a venture capital firm full of GPs who have never seen a business failure, overcame failure and went looking for success as a player.