The relative non-risk of startups

Based on recent events I suspect an investment axiom might exist that says: The further an investor is abstracted away from the underlying asset they’re investing in, the greater the risk.

This has been shown recently to be true with Mortgage backed securities, credit default swaps, the black box that is the hedge fund industry and even sovereign debt may qualify.

When you are shielded from your investment by layers of structure, marketing, repackaging and sales teams, you are too far away to hear the alarm bells when they’re ringing.

That got me thinking about the relative risk of being an angel investor in young companies. Angel investors meet with the founders, use the product and in many cases craft the investment terms themselves. Spending a few weeks negotiating a deal with an entrepreneur is itself a revealing process. The investor is exposed to a mountain of data on the underlying asset they’re investing in.

The recent excellent Bloomberg article on the under performance of commodity ETF’s brought this difference home for me. Suited and booted bankers sell commodity ETF’s daily with a prospectus that tells you you’re investing in gold or oil or copper. The impression created is that you’re investing in the underlying asset when in fact you’re investing in a fund that is trading monthly futures contracts for the commodity. Two years later you’re left wondering why your investment has lost 20% while the underlying commodity has gained.

The complexity of financial products and the distance between the average investor and the underlying assets they’re investing in has, I believe, peaked. As the financial crisis that was started in 2008 continues to play out, during next decade I strongly suspect there will be a return to less complexity and a desire to know, touch and meet with the assets that underlie each investment.

While the likelihood of failure in young businesses is high, as an angel investor you know exactly what you’re getting and you have the ability to influence the performance of your asset. Try finding that on Wall Street.

7 thoughts on “The relative non-risk of startups

  1. I remember hearing Buffett say this in an interview and I think it’s very diplomatic. I’m also a big fan of his focus on fundamentals. One of the tests he applies is: If you had infinite money and time would you be able to compete with the business you’re about to invest in?

  2. That’s an investing rule of Warren Buffet:

    “There are all kinds of businesses that Charlie and I don’t understand, but that doesn’t cause us to stay up at night. It just means we go on to the next one, and that’s what the individual investor should do.”

  3. Like a natural ecosystem, a market can systain even tiny companies if they target a tiny niche and keep their costs low. Personally, I love the concept of a lifestyle business where it’s something the owner is passionate about and can provide a steady paycheck for the owner but not much else. CellarTracker and other small companies are great examples of this. Tiny companies are better with simple legal structures (no sense paying $50k and a chunk of equity for legal fees for funding) and only one or two founders who are passionate about their market.

    For larger companies, there will _always_ be a reason to take outside investment if it provides more than just money. Microsoft is a great example of this because they took VC in the early 80s even though they had income of $1 million/year. Instead, the VC was able to demonstrate to Gates, Allen and Ballmer that they could open doors to companies in the Valley and that was worth the dilution.

    In our case, the founder gave an advisor and another board member 1% fully diluted _each_ for promises of their occasional help. Generosity is fine if it is commensurate with effort, but that’s a hefty grant for scant time that all came out of a small employee option pool. So it would have been better to have at least gotten funding for giving up that much equity for so little advisor time.

    Have you read Founders at Work by Jessica Livingston? It’s an amazing book of interviews with founders. Lots of good insights there.

  4. I think in addition to the abstraction, the more “commodified” your investment is, the more other people there are who stand to gain on your loss. And of course, the more of them there are whose jobs are keeping the reward for themselves and putting the risk on someone else. Individuals in the finance industry are doing remarkably well for being part of a sector that reportedly crashed and took down the entire economy,

  5. Thanks for the insightful post Eric, great to hear from you again. Jobster was 50/50.

    Interesting perspective re hardware. I remember doing similar math – in the late 90’s I had a dream of working from anywhere with a server based in a data center in London and cost was a barrier to entry to me back then too. No longer.

    I wonder if we’re going to look back in 2020 and laugh at how we thought investment at all was required for a consumer web businesses. Right now the thinking is that you don’t need cash to start but you need cash to scale. Perhaps if we move away from the build to flip mentality then revenue will scale with growth and investment will become strictly optional.

  6. Very true. Wall Street is all about selling product – stocks, bonds, exotic ETFs, CDOs, etc. If people are stupid enough to buy the sausage — and some of them usually are — Wall Street will make it. The unwashed masses herd into commodity ETFs while Wall Street goes short near-term futures and long the following expiration, waiting for the inevitable contract roll. People who want to invest in commodities for the long term should go long distant futures _directly_ or stocks of companies that produce those commodities.

    Startups that raise capital only to keep up with traffic growth — Facebook, Bonazle, Picnik, etc. — are much less risky than those that raise tens of millions on hype in an attempt to buy growth. Hopefully you got most of your WorkZoo sale in cash — my Jobster common stock is clearly worthless. And yet Jobster was featured on the front page of the Seattle Times as one of the new generation of “frugal startups” in 2004.

    A few technical founders with a good idea, SEO savvy, design sense, and a VPS can do wonders. It’s a lot easier to start a startup now than 5 or even 10 years ago. I know because I took a semester off college in 2001 to look into starting a company based on a web app I created for Yale (and that the rights to the code). Colocating a single webserver cost $300/month and that didn’t include the cost of the server! A $2,500 server had 1 GB of RAM and an 18 GB HD — for that config now you can lease a VPS for $90/month. More importantly, open source hosting software is as good or better than anything from Microsoft. MySQL sucked in 2001 compared to SQL Server or Oracle.

    The key is investing in people who understand this new reality and don’t think raising millions is a badge of success. At my day job we raised almost $2 million (SEC filings _are_ public) and the extra million was wasted on PR, consultants, and lousy community hires. It has been a great learning experience (and beats paying for business school), but it has taught me that it only makes sense to raise capital to keep up with growth because angel and VC funding is too expensive to use to buy growth.

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