Part 1: “Diversification”

From time to time people ask me whether investing selectively in start-ups as a “profession” is not quite an irresponsible gamble, especially if, like in my case, you have practically no other current sources of income. This question is meant rhetorically, because the people who ask and I, we know

1. that the risk I am prepared to take again and again is quite high indeed, but
2. that it is quite impossible to actually assess, how responsible or irresponsible this is, since the person who does the assessment and the person who bears its consequences are one the same.

Kind Advisors

Such rhetoric is usually followed by a second question: Are there no better alternative or at least one or more complementary investment classes and strategies at hand?  Is it really “wise” to allocate all your bets on just one class of assets, a class which is known for its particular high exposure to risk and, on top of this, its illiquid character?

To this I regularly have no answer. Of course, I could instead pay into a savings account (bad idea), buy federal treasury bills (almost as bad?), invest in open and closed funds or ETFs or commodities or Hamburg apartment buildings.

But I would classify such undertakings as “asset management”, which I would like to leave to those who know something about it. It just isn’t my “profession”, because for me “profession” and “vocation” are roughly the same. Why do I find investing in start-ups enjoyable and why do I consider it a calling? I guess, it might have something to do with experience (“track record”), i.e. my slightly better understanding of start-up matters as compared to the topics mentioned above of which, frankly, I don’t understand a thing.

Most of all: I need to have the means to be able to deal with the above. So, I must generate (considerable) assets with my vocation before I might hand them over to overpaid asset managers later on.

After this has been clarified, there is almost always a third question, which my kind advisors ask me: “Okay”, they say, “you have got some track record with start-ups and want to monetize it. But how do you make sure you don’t go bust?”

“Only One in Ten Makes it”

“It is well known” they continue, “that on average only one in ten seed investments will bring back a significant return. These 10 percent need to overcompensate the remaining ninety percent of flops or quasi-flops to allow for a reasonable overall return. That’s what the statistics say. But in a case like yours, where the number of investments is infinitesimally small compared to the average portfolio size of VC companies, you can’t even rely on statistics. Your risk of total loss is therefore much higher than it is for VC companies, where it is not exactly small either. Plus: Because it is so small you can’t diversify at all. How can you in any way spread your investments over industries, company phases, company sizes, business models, product categories if you merely invest in, say, 10 entities?

Wrong Inference from the Particular to the General

That above questions and the assumptions on which they are based are in part factually and in part logically incorrect. One can recapitulate them in a slightly formalized fashion as follows:

1. Of all seed financed start-ups, an average of 90 percent are either total losers or, at best, return the invested capital without interest after some years. Unlike VCs the typical angel investor cannot even bargain for decent liquidation preferences.
2. The remaining 10 percent thus need to overcompensate the losses of the above ninety, if the overall portfolio is to generate a return at all.
4. The typical business angel has a small portfolio with, say, ten target entities max. For such an angel the bad chance that the statistics as shown in (1) and (2) do not apply to her/ his investment reality is much higher than in the case of a VC, with, say, a portfolio of 20 or 50 or 100 entities.  
6. Therefore, the risk for such angel investors to go bust is considerably higher than it is for a VC as described in (3).
7. This prompts the question, if such a business angel should actually pursue his business at all. It certainly raises the issue, which strategy of risk mitigation he/ she can follow, if there is any at all.

What is Wrong with this Reasoning?

Actually everything!

@ 1. There are many statistics available on the default rate of VC companies. All come from considerations of VC-specific databases. These statistics obviously differ depending on which industries, regions, time periods and case numbers are being considered. What matters here is that all these publicly available statistics are exclusively based upon VC and not angel or other venture investors. Therefore, they cannot be generalized for any type of seed investment.

@ 2. The second argument above is linked to the first one (1). It is not true that 10 percent of all venture investments have to pay for the losses or near losses of the allegedly remaining 90 percent. This attribution may apply to VC investments, but not to angel investments. There is no data evidence available at all to back this conclusion.

@ 3. Because (1) and (2) are wrong or not proven, also (3) is wrong or not proven. However small an angel portfolio might be, it is not possible to infer a risk magnitude relative to a VC risk from portfolio size alone.

@4. Consequently, the presumption that an angel’s business is considerably riskier than a VC’s, is either wrong or unproven. Thus, it is an entirely open question, how commendable the business of an angel is and what strategies are advisable to minimize her or his risks

@5. Hence, there is no evidence at all available as to what impact the size of an angel portfolio may or may not have on its performance. There is at best common sense telling you that you should not juggle with too many balls.

Is Diversification Possible at all for Angels?

The false assumption of a particularly high business risk for angels as compared to VCs is not just based on unsuitable databases, but often also on the usually implicit but, as in my case, sometimes the even explicit recommendation that one should diversify in order to manage and mitigate risk. Now, since it is unproven that diversification actually would make a meaningful difference the recommendation for business angels to diversify appears strange to the say the least. But is it possible in the first place? Is it possible at all for angels to diversify given their small portfolio size? This we shall discuss next week. My take is that it is neither the number, nor the type, but the quality of the eggs which determines an angel’s return. Trivial? Sure, but value investment in the venture industry is possible, though not easy.