Idea Stage Investing: Hitting Singles, Not Home Runs

I keep puzzling over the fact that only 2% of venture capital flows into early stage companies when it is also reported as a fact that early stage investment funds provide the highest average returns. Maybe VCs like to swing for the fence and only invest in companies that have huge potential–admittedly, most seed stage companies don’t. Many small businesses want to grow a bit, but aren’t necessarily aiming to dominate a multi-billion dollar industry someday and therefore disqualify themselves from getting venture capital.

At an angel investing seminar recently I heard one angel who has done more than 30 deals say that the first thing he does when looking at a business plan is check the five year forecast. If it’s not over some number (I think he said $50 million) he throws the plan out. Even though he knows full well that all revenue forecasts are just dreams, he still has decided that if the dream isn’t big enough he isn’t going to look any further.

So everyone seems to be swinging for the fences.

So what if a venture fund decided to go for all singles? Here’s an interesting scenario:

What if a $10 million venture fund decided to invest $100,000 in 100 different early stage companies who had modest plans but a very low risk of failure? There are a lot of factors that can reduce the risk of failure: low startup costs, established partnerships, proven sales model, experienced management team, growth industry, use of technology, internet marketing skills, etc.

In fact, what if the venture fund focused energy on training key employees in each startup (group seminars, executive curriculum, required readings, etc.) so they could develop the skills they needed to be successful?

What if 50 of these companies fail, and the other 50 end up growing to $1 million in annual revenue over a 5-year period, and were either breakeven or slightly profitable?

What if the venture fund had the right to liquidate each company that didn’t achieve more than $2 million in annual revenues in a 5-year period, and it’s equity stake in companies under $2 million in revenue were automatically pushed to 50%? In other words, if the management team doesn’t hit the milestones of $2 million in revenue, not only does the venture fund have the right to sell the company, but the management team doesn’t get all the equity they originally hoped for.

So back to the scenario. If 50 companies doing $1 million in annual revenue were each sold for 1x revenues and the fund owned 50% of each company, then the fund would return $25 million to its investors.

The little calculator at youcalc.com says this would be a 20.1124% annual return over the 5 year life of the fund–higher than the average return for venture capital funds over the last 20 years.

Does anyone know of any venture capital firm that systematically goes for singles, and tries to help every company it invests in to eliminate the possibility of failure? I think that VCs often increase the chance of failure by investing too much money and asking management to spend it quickly so they can get big fast. The VCs still win if only 2 out of 10 portfolio companies hit a home run and the others all fail. But what about the entrepreneurs? 80% of them end up with nothing if 8 out of 10 companies fail.

Has anyone ever thought of something like this, or tried it? I’m curious to know if there is any academic literature on this or if anyone can point me to any articles that explore this concept.

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10 Comments

  1. Part of the calculus is that regardless of the size of the venture, it’s going to soak up the same amount of your time to monitor and “advise” the entrepreneur and management team.

    A lot of the larger investments are “me too” follow-the-herd non-lead investments, so there is close to zero attention needed by the follow-on investors who simply let the lead investor do all the heavy lifting.

    Being “lead” is plain simply a lot of hard work, so there needs to be a “home run” in it, unless your doing it as a “social” venture.

    That said, I kind of like the idea of doing a zillion “micro investments” in “intriguing” smaller ventures. It enables a broader spectrum of innovation. But, I would say that the goal there is not meager, low-risk return for each venture, but more of a strike-out or home-run mentality. The problem is how to give those smaller ventures the “adult supervision” that they may need.

    — Jack Krupansky

  2. The 50% success rate seems a bit high. I am looking into what actual success rates for small companies. However once the true success rate is arrived at you can mathematically determine what the risk and the reward is. I beleive that you are on the right track. I have started working out the mathematics and will share it with you soon.

    I think it is possible to create a formalized process where you help small companies out with management, marketing etc. All start-up companies are flawed. If you can identifiy the flaw and then address it you can help them to become more succesful, thus increasing the reward and lowering the risk.

  3. I think Paul has a legitimate observation, though in execution it would indeed be somewhat of a challenge. But less than most traditionally-minded VC-types might think.

    The major objection to this approach seems to be that it takes as much effort for an investor to provide “adult supervision” to a $10M company as a $50M company. This reflects the typical (and somewhat arrogant) assumption that the VC/investor is by definition (simply by the fact that they provide $) more “adult” than the entrepreneur.

    While that is often true, and investors obviously have a right to be fully informed/involved in how their $ are spent, the ?home run? mentality does reinforce business decisions that would be considered foolhardy under normal circumstances. I would venture (no pun intended) that an equal number of good companies/concepts have been driven into the ground by big-headed, ill-informed and uninspired investors as by inexperienced entrepreneurs. This was CERTAINLY the case during the internet bubble, when?as Paul mentions, and some of us know from personal experience?entrepreneurs were basically forced to take too much and spend too fast.

    At the height of the madness, I wrote a parody song called, ?If I Only Had a Site,? the lyrics to which were printed in Business 2.0. If you have a masochistic penchant for amateurish homegrown recordings by geeky Weird Al Wannabees, you can find it at:

    http://www.geocities.com/kurthaug/Kurtoons.html

    http://www.geocities.com/kurthaug/08-if_i_only_had_a_site.mp3

  4. scott klossner

    Yes in answer to your question, unless they have changed business methodologies, UTFC.

  5. BB

    As an entrepreneur just closing a financing for a very similar idea, I found your post to be compelling. Some initial thoughts: (1) 80% of the companies represented by this year?s Inc. 500 list were started with $100,000 of seed funding or less. These firms represent every industry, geography and business models. So with the right selection criteria and a wide enough deal pipeline, it is feasible in theory. There are some decent academic papers on the topic, but still leave a lot of “art” in the selection process. (2) However, finding the right mix of entrepreneurs, who are competent enough to deliver and willing to accept your terms for ?a mere $100,000 investment?, may be difficult but still possible. Two-thirds of the above Inc. 500 businesses were seeded by the entrepreneur or friends and family. (3) In addition, the proposed conversion rights will have severe implications to downstream investors. Do you only fund deals that can be viable on $100,000 of investment, or does your right get negotiated away during the next round, or do new investors look to have the same rights, and if so, what is the implication to management incentives, etc. (4) What is the value of your training method versus what is available on the market or free from local Economic Development groups, and are they the key determinants of success?

    And lots of other obvious questions. I know of one group that attempted to raise a fund with the model in your post, but failed due to the team rather than concept. We ended up taking a slightly different approach in the end and built ourselves to be the financier and operating company (with multiple internal startups) all in one, which allows us to control and measure our elements of success and adjust as needed. Initially, we can rely on fairly measurable determinants (like past success in similar scenarios) and a leveraged model to our funding (and throughout every phase of the business process) to provide protection against the natural mortality of seed stage investing, show positive returns on the ?singles? and reserve for longer durated bigger payout projects. The difference in focus requires the ability to evaluate, fund, develop and exit projects in ad hoc, virtual manner. No guarantees of success here, but a stronger ability to influence the dynamic nature of risk/reward tradeoffs. And yes, a better website is on the way.

  6. Greg Mockett

    There are several suggestions tending toward automation. While I agree that technology can emulate and indeed replace much of the traditional mentoring provided by VCs; and while I also agree that many of these VCs who presume to mentor, more meddle; I think the ideal solution is more likely to lie in the human rather than machine. There are countless individuals who are of perhaps better industry experience than a particular VC, though many VCs stick to a known or comfort industry or two. These individuals will not risk starting a company of their own, as they are really forever employees. How inexpensive would it be, relatively, to hire some of these folks to do the mentoring for the fledgeling investment? Seems that one quality hired mentor might be able to handle oversight of two or three companies providing knowledge, experience and rollodex that could be invaluable. With the right trust factors in place, this might also widen the deal flow to a degree by allowing the investor to venture into areas he personally may not feel capable in.

  7. wilson ng

    I guess if you are a consultant, and given the choice of working 100 hours at $200 per hour, or working 300 hours at $70 per hour, you would want to choose the first one even if you are more pressured, but at least less hours.

    If you only have time to work so much, like oversee 10 companies, then you would rather make it big. I guess managing a $50 million company is as much work as managing a $10 million one?

  8. Marshall Burtcher

    I think that Paul’s theory has strong merit. What you would need to help reduce the time required for the “adult” supervision is an established system of auditing, reporting and interviewing. This can be accomplished with technology and tactful planning to start with. As always, there is a way once one decides to find and/or make it. Seed venture investors is something I have been wondering about – especially since most of my ideas are not $100 million dollar company ideas.

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