Venture investing: Adopting a portfolio approach
Most venture capital (VC) investors that I have met fall into investing by accident. A friend or family member launches a startup and the budding VC investor is asked to make an investment. The investor evaluates the opportunity and then invests what is asked, or at least what they feel that they can afford. The investor does not invest in any other startups. This is not investing. This is not even gambling. This is charity. Why? Because nobody can evaluate whether a particular startup will succeed.
Investors today have an intellectual understanding of the characteristics of VC investing. An important characteristic is that most startups will fail and a small number will perform spectacularly. Yet VC investor behavior is inconsistent with their intellectual understanding. It makes no sense to invest in a single startup if you know that most startups will fail. If you want to invest in startups, your plan should include the idea of investing in a large number of them.
This leads us to the notion of allocation management. When you invest in a startup, the amount you invest should not be based on how much money you have nor how much the startup is looking for. The allocation decision should be based on your VC investment plan: How much do you wish to invest every year? To answer that you first need to decide how much of your annual investment budget should be allocated to VC. There are many good resources on how to think about VC allocation as a percentage of a total investment portfolio that you should look at, including examining factors such as potential liquidity needs, time horizon and sources of income, among others. Once you have an annual financial figure allocated you need to think about how many investments you want to make every year. Here, the major mistake most new investors make is using a public equity portfolio approach to their decision-making. Equity portfolios seek to create diversification to reduce the risk of a small number of investments having an undue negative influence on the performance of an overall portfolio. The idea is that the public equity market does well, just avoid the losers. This is why many financial advisers like the idea of an index fund; you are buying the market performance.
This approach is exactly why the idea of due diligence (DD) for a VC investor must not blindly copy the public equity approach.
For VC, the main aim of diversification is not to avoid losers, but to try to ensure that there are winners in the portfolio. There is zero chance for any VC investor, even the professional ones, of avoiding a large number of startup failures. The real risk is in missing out on the handful of massive winners.
This approach is exactly why the idea of due diligence (DD) for a VC investor must not blindly copy the public equity approach. In VC DD, the idea is not to try and predict performance, but to simply ensure that other major facets are true, such as the state of development of the startup’s product/service, legal matters and employment history. Trying to predict performance can lead to the catastrophic outcome of missing out on the winners. So how many investments a year should a VC investor make? The advice on the overall number of investments in a VC portfolio varies from as low as 20 to as many as 100. Considering the fact that as you invest many companies will fail over time, then you can see that to maintain an active VC portfolio of at least 20 companies, my personal rule of thumb is much more, and you would need to make five or more investments a year. This requires careful planning and a proactive approach to VC investing, which I will cover in future articles.
• Sabah Al-Binali is VC Partner, head of the Gulf region at OurCrowd. Twitter: @SabahALBINALI
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