Tough Road for Startups Still Gives Investors Big Profits

We’re interested in seeing if any scams derail the momentum toward more openness.”

One of the top executives at a leading startup-investing website company said this to me recently.

He thinks opening up startups to everyday investors is a tectonic shift in how we can and should invest.

And I think he’s understating its importance.

So no, I’m not agnostic about this, nor have I ever pretended to be.

I think the government’s ban on investing in startups – applied to everybody except the wealthiest and most well-connected investors – smacked of crass elitism.

It deprived everyday Americans of investing in some of the most lucrative investment opportunities I’ve seen.

Just think of the early days of Google, Twitter and Facebook… and the number of investors who got much richer (who were already wealthy).

My colleague Adam and I want startup investing to succeed. If nothing else, the country needs it to succeed. It would boost entrepreneurship and small business, increase employment and, most importantly, improve the financial security of ordinary Americans.

We both worry about liftoff. How many companies will choose to crowdfund? Will they be quality startups?

And looming over these concerns is big brother… watching, judging and, we fear, waiting, ready to pounce on the first hint of trouble. Speaking of which…

How Reality Is Shaped

Will the disgraceful behavior of big banks ever end? This time it’s Deutsche Bank and Wells Fargo in the spotlight. But better the Teflon banks than the still-vulnerable startups that – for the first time in more than eight decades – can legally seek investment funding from everyday investors.

There’s really been only one major scandal, starring Theranos. This clinical lab company offered services that proved too good to be true. Theranos raised years before crowdfunding was legalized, thank goodness. And it raised not just from the big boys, but from the biggest boys, some of the most reputable venture capital firms in the U.S.

So scandals haven’t been a problem. But I worry about the next worst thing. Bad press.

The media shapes perception. And perception shapes reality.

If enough journalists and talking heads think startup investing is just another state-sponsored lottery… just another clever way the government empties the pockets of innocent Americans who don’t know better (or can’t help themselves), then who are we to argue?

That was why my heart jumped when I came across this chart…

ei_mattermark-chart

Source: Mattermark

It portrays the drop-off of startups as they make their way from fundraising in a seed round to a Series F round.

At first glance, it looks crazy scary…

From seed to Series A, the drop-off averages a third. Then it goes down by half from round to round.

When I first laid eyes on this chart, I thought it was from the SEC – another piece of agitprop from our “sophisticated” government bureaucrats to protect us “non-sophisticated” investors.

A Massacre?

Take another look at this chart. It’s a massacre. The survival rate seems every bit as bad as Custer’s Last Stand or the Alamo.

By the last round, the number of startups had been reduced to between 0.1% to just over 1%.

But, after my initial cursory inspection, I read more of the article.

It’s from Mattermark, a research- and media-startup-focused company. And it isn’t as bad as it looks.

In fact, it’s confirmed what I generally believe.

In a post written to you a couple of months ago, I said that the drop-off rate averages about 50% at the beginning and a little less thereafter. Not too different from this chart.

Mattermark noted that the journey between seed and Series A was so perilous due to “running out of money, team breakups and other factors.”

After Series A, the somewhat steadier drop-off was because “acquisitions and reaching financial sustainability” became “larger drivers.”

Its explanation isn’t controversial. Ask most venture and angel investors to explain the chart, and it’s likely they’d say something along the same lines.

But…

We are still left with an ugly-looking chart that is data-driven… and an explanation that is not.

Your Personal Rorschach Test

It’s an open invitation for people to treat it like their own personal Rorschach test. If you suspect startup investing is a losing proposition, here is the visual proof.

If you think startups opt out of fundraising because many are bought out or develop into self-sustaining enterprises, the chart’s decline looks like an exciting and rewarding ski run.

We know which camp the SEC is in.

What was Mattermark thinking?

Where’s the PROOF that its explanation is something more solid than mere wishful thinking?

Data-Driven Study Shows Seed Investing’s High Upside

Fortunately, I got the proof, courtesy of venture capital firm Top Tier.

It took a deep dive into its database of 2,011 U.S.-based software companies that raised seed rounds between January 1, 2009 and December 31, 2012. It found 1,100 realized exits – meaning not only acquisitions and IPOs but also those dreaded write-offs.

In other words, it’s looking at ALL outcomes – the payoff when a company IPOs or is bought out as well as the loss side.

Here are its data-driven conclusions…

  • For buyouts, the increase averaged 57% over companies’ last valuation.
  • For investors who like to follow up (putting an equal amount into the company’s seed through Series C rounds), they made more than 10X on companies that were bought out.
  • In the same scenario but for companies that IPO, the profit was 36X.

We still don’t know how many startups get written off versus how many drop out because they don’t need to raise more money versus how many get bought out.

And versus how many went the IPO route…?

We actually do know that. Top Tier says that 11% of its 1,100 realized exits were unicorns at the time and “most” of those went the IPO route. So let’s assume 8% to 10% of its exits were IPOs.

What we also know?

There were enough acquisitions and IPOs among the inevitable slew of write-offs to make a very nice profit.

SEED INVESTING DOES PAY OFF.

I’ve found proof in the past. (See this article.) I’ve found more proof today.

And I’ll continue to look for additional proof.

It’s needed. Like the election season we’re in the middle of, many people are undecided. I understand. Equity crowdfunding is new and different. The opportunity to invest in seed companies is probably just as scary as it is exciting.

But you should know that I’m seeing some terrific startups raising funds under the new Regulation Crowdfunding (Reg CF) rules.

If you’re not investing, you really should give it a try. And if you’re not sure how to choose the best startups listed on Wefunder, SeedInvest, Republic and other sites, then give our new startup investment service First Stage Investor a try if you haven’t already. We have the knowledge and experience to help members find the most promising investments. And avoid costly mistakes.

Just click here for more information.

Invest early and well,

Andy Gordon
Founder, Early Investing