Early-stage Venture Capital: A Better Bet in the Long Run

Early stage investing is better in the long run

In today’s volatile market, early stage venture capital investing is often a better long-term bet than most alternatives. Managed well, it’s even relatively predictable.

Yes, each venture on its own is risky; only about 20% succeed. Although our team at VCapital, through especially rigorous screening over the past 30 years at previous firms has achieved an impressive 37% venture success rate, that still means 63% of the ventures lost money. Many of them their entire investments.  Sounds awfully risky.

So how does early stage venture capital investing translate to relatively predictable and a good bet?  Three conditions must be met:

1.    Commitment to a long-term time horizon. Success doesn’t happen overnight.
2.    Selection aptitude and due diligence. Critical to raise the odds of success.
3.    Diversification within the asset class. Invest in a large enough number of ventures.

The long-term results for early stage venture capital investment are compelling:
better bet chart

Public Market Unpredictability

Compare these returns to the realities of the broad public stock market. Too many investors there don’t practice the buy-and-hold discipline espoused by Mr. Buffet and most experts. On an average day, 3-4 billion shares change hands in NYSE composite trading. Even worse, too many investors rush in following market run-ups and then sell in a panic as prices plunge. In the midst of the recent volatility, small investors have even lost small fortunes simply waiting minutes for trades to be executed. High-speed traders rely on split-second moves.

After reaching a closing high of 2131 on May 21, the S&P 500 closed on August 25 at 1868, a 3-month drop of 12%.  Yes, the next day it rebounded almost 4% to 1940, and ended August at 1972, a 6.3% overall decline for the month. But who knows where it will be tomorrow, a month from now, or in a year or two?

The best way to win is to be patient, smart and diversified. Some early-stage ventures will ultimately pay off… Click To Tweet

Despite regaining nearly half its lost ground, future declines may be far from over. Troubling developments in China and smaller emerging markets won’t just disappear. Look at history. The S&P 500 closed on October 9, 2007 at 1565 and then dropped over 50%, to 752, by November 20 of the following year, its lowest level in over 10 years. It didn’t get back to the 1565 level until 2012.

That prolonged drop isn’t unique. I’ve tracked the S&P 500 at the start of each year beginning with 1973, as I was about to receive my MBA and so had started looking at these things. The index fell sharply that year and didn’t make it back to that start-of-year level for 10 years . . . and then dropped below that level again by the start of the following year. Not exactly the predictable, long-term gains we’re told to expect.

Beating the Stock Market

Back to venture capital investment. The key is diversifying your participation in early stage deals, when valuations are at their lowest, and then waiting patiently, often 5 to 10 years, for a small number to pay off. Historically, pretty consistently, a portion of those payoffs have been great enough to deliver an attractive return on the aggregate investment.

To be clear, I’m talking specifically about early-stage venture investment. By comparison, late stage venture investing, where valuations are much higher and the individual bets often much larger, can be even more unpredictable than the public stock market.

Share prices for privately held ventures don’t reset minute by minute or even day by day like publicly traded securities.  They only change when new money is being raised in another private round, an IPO, or sale to another company. On top of that, the prices paid in too many late-stage funding rounds have been breathtaking. Uber’s latest round pegged its value at $50 billion! Recent rounds pushed the value of other high-profile ventures sky high, including Airbnb ($26 b), Snapchat ($16 b, despite still negligible revenues), Palantir ($15 b), and Square ($6 b). They’re not alone. CB Insights calculates there are more than 130 unicorns – privately owned companies valued at $1 billion+.

Those sky-high valuations are based on assumptions that everything goes exactly as their optimistic entrepreneurs project.  That rarely happens. For those who bought into these latest rounds, the day of reckoning will come when the company goes public or sells to an established tech giant. Founders and early-stage investors may make fortunes, but if the company is valued by the market at anything less than the latest valuations, those last-round investors will lose . . . and some may lose big.

Considering all this, the most reasonable bet is that innovative ideas and disruptive technologies will continue to bring marketable benefits to society. The best way to win, then, is to be patient, be smart and be diversified. Some small portion of early-stage ventures will ultimately pay off big, delivering attractive, aggregated returns to investors who are: committed to the long-term growth of solid businesses, not buying the more expensive ticket to jump on a bandwagon; who find and work with experienced investors who have a long-term track record of picking winners; and who diversify within the asset class. Through all the financial market ups and downs, this formula has worked consistently and over time. I’m betting it continues.


Add Your Comments