Conventional thinking in venture capital is that success requires aiming for the fences. Home runs (or even grand slams) are necessary to generate a reasonable rate of return in light of the large majority of portfolio companies that go out of business. But is this the most sensible approach?
Identifying unicorns at the nascent stage is nearly impossible. Especially because early-stage investors are forced to put greater emphasis on subjective or qualitative factors like the founders’ personalities and team dynamics rather than more analytical or quantitative factors like a company’s KPIs. How many of us can honestly say that had they heard a pitch in 2004 from Mark Zuckerberg, a college dropout with no startup experience, for a pre-revenue company targeting college students called Thefacebook (its original name), that they would have written him a check? I certainly wouldn’t have. If you speak to those who did invest early in Facebook, and you get them at a candid moment, they will largely credit luck as the reason for their fortunate investment.
I am uncomfortable relying on luck. Although I am fully aware of the high level of risk and speculation involved in early-stage venture capital investing, I prefer to increase my odds of success and greater IRR. How? By investing in companies only after they have some initial indication of product-market fit and some traction. For example, at Forefront Venture Partners, we do not invest in pre-revenue companies. This criterion alone helps to reduce the number of zeroes in our portfolio.
Is Anyone Willing to Pay For It?
Early revenue can only occur after a company has done a lot of hard work, including building and marketing a product. Many startups never make it to this stage. There is a quantum difference between a pre- and post-revenue company, and this huge leap is often not fully captured in the increase in valuation from the former to the latter stage. Getting a customer to actually pay for something is a major milestone — an indication that the company is building a product that a customer in its target market finds valuable. Before that first sale is made, it’s all just speculation.
Yeah, But Can You Get Lots of People to Pay For It?
Another key indicator we look for is a company having identified at least one efficient, scalable marketing channel. We want to know that our investment can be used to pour fuel on the fire powering the company’s growth. Knowing that the company has already identified scalable marketing channels that enable it to acquire customers at a reasonable cost (relative to projected lifetime value) eliminates another layer of risk.
More Certainty and Faster Exits
uilding and marketing the product and having it in use and generating customer feedback are important milestones that some companies never achieve. Companies at this stage as opposed to pre-revenue, pre-product companies have lower odds of failure. But, one could argue, investing at this stage may also reduce the odds of hitting a grand slam. Why? Companies that end up being unicorns often raise a lot of money and build a large enterprise prior to ever generating any revenue. Think about the traction Twitter generated for 5 years before beginning to monetize.
In these situations, waiting for initial revenue precludes investors from participating at an early stage in terms of valuation. So while we may invest in some of the same companies that ultimately become unicorns, we will wait until they have early evidence of product-market fit. Therefore, we will invest at a somewhat higher valuation than those willing to invest at earlier stages and will realize a lower overall return (ROI) upon exit. So instead of a higher-risk grand slam, we will assume less risk and hit a triple.
An offset to this lower ROI is that it often takes pre-revenue companies longer to exit than post-revenue companies. This increased time horizon makes earning a reasonable annualized return (IRR) even more challenging (more time = lower IRR). More mature companies will, on average, exit more quickly, thus boosting IRR. So while investing in the very same companies as pre-revenue investors, we may experience lower ROIs, but we may at the same time experience higher IRRs.
Cash is King
Another reason post-revenue companies boast lower odds of a flameout is that post-revenue companies have longer runways than their pre-revenue counterparts. Whatever amount of revenue they are generating will supplement the capital they’ve raised to buy them more time before they hit cash flow zero than the same investment in an equivalent pre-revenue company. This additional runway often serves as a lifeline, affording startups the extra time they need to make necessary marketing tweaks or product iterations, or sometimes a complete pivot, before running out of cash.
The Law of Averages Only Applies with a Large Sample Size
Investing in the highest-risk sector of the venture capital space is best suited to investors who are building very large portfolios that will best reflect the law of averages required to benefit from a grand slam investment. Most angel investors who are building smaller portfolios don’t have this luxury. For them, it’s best to pursue a strategy of achieving a higher batting average. Controlling for luck, investing in a relatively small portfolio of companies with a product, some revenue and initial marketing channels yields better, more reliable annual investment returns than investing prior to these milestones being achieved. For an angel investor or small fund, this strategy translates to less risk, higher overall portfolio returns.
I appreciate the role investors in the earliest stages of startups play in the venture capital ecosystem. They are taking on outsized risk in hopes of realizing the largest gains of any investor in the funding stack. I am grateful that they play this role because they enable pre-revenue companies to innovate, build products, test marketing channels and begin to assemble a team. And hopefully their investment helps these companies to begin generating revenue. By doing so, they reduce the risk associated with investing in these companies at the post-revenue stage — the stage at which we prefer to invest. Our investment fuels the growth of these startups once they have demonstrated initial traction. This symbiotic relationship between pre- and post-revenue investors is critical to providing companies with the capital they need to flourish.
De-risking at a Bargain Price
The result of all this is that our portfolio consists of fewer companies that are total busts (0% ROI) and fewer companies that are grand slams. We have more companies in our portfolio that are in between these two polar extremes. More exits in less time, with potentially higher annualized rates of return, but often at lower overall rates of return, than the earliest-stage investors might earn. We believe that the significant reduction of risk that comes with investing at a slightly later entry point is only partially offset by a commensurate increase in valuation. In other words, we are able to buy the de-risking at a bargain price. Put yet another way, we believe that the additional risk assumed by investing in pre-revenue, pre-product companies is not offset by an equivalent additional reward.
Overall, building a portfolio focused on post-revenue companies with scalable marketing channels enables investors to be less reliant on hitting grand slams to achieve desirable investment returns. Although we all appreciate being lucky, an investment strategy for angel investors should revolve around likely IRR, exclusive of luck. Great returns can be realized without assuming the risks of swinging for the fences on every pitch.