Investing in start-ups
You need each of your nine lives if you invest in start-ups. It’s the opposite of Russian roulette: each chamber except one contains a bullet. The game involves finding that empty chamber before running out of money.
Early stage investing is one of those areas where experience can be a handicap. It doesn’t pay to worry too much about how difficult it is to make money from start-ups because it makes you too cautious.
To be sure, investing in start-ups is fantastic fun and can be financially rewarding. But we should be honest about how rewarding. Investing in start-ups is safest using someone else’s money. Here’s why:
Most ideas are crap. Listen, this isn’t as judgemental as it sounds. I’ve come up with plenty of crap ideas of my own. There’s a reason I’m a consultant and not a business owner. Even if the idea isn’t crap, the chances are good that it’s been poorly researched and is being done already. Ten seconds on Google will often establish this, which, unfortunately, is often ten seconds more than the budding entrepreneur has spent before they bring their idea to you.
Wackiness. The opposite of the above. The idea might sound bonkers but turn out to be a winner. No one knows, especially those that claim to know.
The impossibility of proper analysis. The world is too full of stories about, for example, there being global demand for only 5 computers. When products are completely new, the normal standards of market analysis don’t apply. Whisper it, but luck and timing play as much a part as fulfilling unmet customer needs.
Confusion about how value is added. It’s cruel, but the people that came up with the idea are not normally well placed to carry it all the way to maturity. Neither should they receive the lion’s share of the value which should instead flow to those that are able to carry the idea to market. Misplaced sentimentality for the founders can blind investors from taking the necessary action to ensure founders step aside if they don’t have the skills.
Failure to give due weight to sheer bloody-mindedness. Again, whisper it, but true entrepreneurs aren’t very nice people. They can be rude, dogmatic, sons of bitches. Sometimes that’s what it takes. Don’t overlook prickly, difficult characters because they’re not like you.
Trying to run their business for them. Once invested, many investors feel that they must nurture their seedling, help develop the business and its management. Maybe. Better I think to let them sink or swim. Your job is investment. Join a management team if you want to be more involved in the operational side.
Hobby investors. Save us all from wealthy individuals that see investment as a way of ‘giving something back’. More likely they want something interesting to talk to their golfing buddies about, or a way of being semi-retired until they are ready for full-time retirement. Investment is a serious business, don’t get into it unless you have one, and only one, objective: making money.
Soft-money investors. The worst of all. These are people more interested in how many meetings they’ve had, how many entrepreneurs they’ve ‘supported’, and how many businesses they have formed (note ‘formation’ is not the same as ‘trading’). Metrics of this sort will allow them to apply for a government grant which will allow them to continue recording such metrics. Making money doesn’t come into it. This, unfortunately, is the model for economic development in the UK.
Does this sound nihilistic? If so, I don’t apologise. Starting new businesses is hard work, investing in them leads to more failures than successes. Don’t get me wrong. Working with start-ups has been a career highlight of mine. It’s raw and especially engaging when everything’s new. If only we did it better in the UK, we’d be more prosperous. What I observe instead is amateurish and wastes a lot of public and private money.
What would I do differently? Here’s my prescription for managing start-ups.
1) Plan on a 15 year time horizon. Forget early exits.
2) Have a realistic expected return on investment, say, 13.75% before tax. To achieve this you’ll need 20 or more companies in your portfolio otherwise those that fail will sink you.
3) Outsource and rotate the portfolio management, say, every 5 years, even if they’ve done a good job. No one involved with start-ups should feel ‘settled’. Not the entrepreneurs. Not the investors. And certainly not those managing the investment portfolio.
4) Shut it down if it doesn’t get over your hurdle rate of return. Don’t keep flogging a dead horse in the hope it will come good. The temptation to keep doing this is powerful. Resist it.
5) Do this exactly the same whether with private or public money.
In practice what does this mean? Instead of putting any money at all into ‘economic development’, the government could set up its own start-up investment fund and manage it on the principles I’ve outlined. Any in-house corporate venture fund should do the same; as should universities.