How risky is seed investing?
Perhaps not as risky as many investors think.
And with more upside.
A study by private equity fund-of-funds Horsley Bridge Partners (HBP) offers up some surprising facts.
HBP is a large far-flung investment company founded in 1983. Based in San Francisco, it also has offices in London and Beijing.
It works closely with leading seed and early-stage venture investors.
Its strategy sounds a lot like our new First Stage Investor service – “the pursuit of top investment opportunities with outsized return potential.”
HBP recently took a deep dive into its massive database of 5,500 “realized” deals. The objective?
To gain more insight into the risk/reward trade-offs of investing in the early stages versus late stages of private startups.
Specifically, it wanted to know if the current views reflected what was happening on the ground. To date, data-driven studies on the risk and reward of startup investing have been few and far between.
Which makes this study something that the startup investing community should take very seriously.
Unfortunately, this may not happen.
The study was never published. And as far as I know, the press has not written anything on it. I picked up its findings in my Twitter feed.
The Accepted “Truth” About Startup Investing
The current consensus on the general contours of what the risk/reward trade-off looks like can be summarized as follows…
At the seed stage, the ability to get huge returns is much greater than it is at the later stages. But the risk is also much greater. Why?
Because these young companies are still figuring out what their final product looks like and how to market it. Information is scarce. Hard metrics mostly absent. Investors often don’t even know what they don’t know.
So the risk is substantial, but considered worth it because of the huge financial rewards that are also possible at such early stages.
At the later stages, the thinking goes, the situation is almost reversed.
The product is finalized and marketing has begun. The company could even be starting to scale. And a growth strategy is in place and open to scrutiny. This explains the perceived “lower” risk in later stages.
On the other hand, the startup’s success to date means a much higher share price. You’re not buying really low anymore. So the upside isn’t nearly as high as when you invest at an earlier stage.
So that’s the consensus.
But HBP’s explosive findings suddenly place this consensus on shaky ground.
What Is REALLY the Best Time to Invest?
The data suggests that the best return/risk package offered by private startups comes at the early stages of a startup’s journey.
And it’s not even close.
A big reason why is the risk.
It’s simply not that much greater than investing in the late stages.
The failure rate – where your investment return is less than zero – is 62% for seed/early stages and 52% for mid-to-late stages.
And the upside?
Early-stage investors still have a great advantage. They’re 60% more likely to achieve 10X gains than those investing in the later and more expensive rounds.
In HBP’s own words: “The downside protection afforded by investing later is fairly small, while the upside potential is significantly dampened.”
Some Startup Math
So, let’s see how these portfolios would work in practice…
If you’re an early investor with 10 startups in your portfolio, six will fail (on average). Of your remaining four, you need one or two big winners for the portfolio to perform as you’d like.
If you’re a late-stage investor, five out of your 10 holdings will fail. You are also looking for one or two big winners out of your remaining five holdings.
And this is where the early-stage investors hold much better cards.
Even with one fewer “non-failing” startup in their portfolios, early-stage investors have a much better chance of hitting it big.
Again, that’s because they have a 60% greater chance of achieving 10X winners.
Unfortunately, HBP doesn’t get into the whys.
But I have a pretty good idea.
To hit it big, a seed-stage company valued at $10 million would have to return at least $100 million (or 10X).
That means going through two to four more rounds and roughly doubling the valuation each round – a fairly typical progression for startups able to show growth.
A late-stage company valued at, say, $500 million would have to IPO or get bought out at $5 billion.
Out of the 149 Unicorns (startups with valuations of at least $1 billion), only 15% are worth $5 billion or more.
And the number of tech companies that can afford to buy a startup worth $5 billion or more? My estimate is that it’s limited to about a half-dozen to a dozen companies.
When it’s all added up, the earliest stages represent the best balance of risk and reward.
I’ve always believed this, and now I have some hard evidence to back it up.
Can the SEC Admit That It Was Wrong?
The HBP study is also an overdue riposte to the government.
The SEC has always thought that the new equity crowdfunding rules would expose new investors to an excessive degree of risk at these early rounds, even when compared to potential upside.
It seemed to tout its concerns as a badge of honor.
It has now been presented with an opportunity to re-examine its cherished elitist notions.
Can the SEC admit that the new rules have granted everybody access to the best stages of startup investing – the early rounds where you get the most upside for the risk assumed?
Somehow, I doubt it.
It wouldn’t just be adopting a more positive spin… it’d be adopting a 180-degree reversal of what it has believed… with plenty of alarmist public comments to boot! (See my article here for some choice quotes.)
Fortunately, we’re not as conflicted.
For us, it’s definitely a nicely timed piece of news.
We’ve just launched our new equity crowdfunding service First Stage Investor, where you can find the top early-stage deals exclusively hand-picked by my partner Adam and me.
Just click here for more information – and immediately get three high-upside early-stage startups to put in your portfolio for as little as $100 a pop.
Invest early and well,
Founder, Early Investing