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The Reality of Seed Investment Mathematics

The Reality of Seed Investment MathWhen a market goes digital, the initial costs of developing startups, products and services are reduced substantially. However, the expansion and growth costs increase later because you’re competing on the global digital market front.  As a startup entrepreneur or seed investor, you’re not worried about that at first. Your main objective is to build startup momentum.  

The shift of power is going upstream—away from the investors, to the developers and innovators who create the actual value of the product or service. In other words, if you can develop and launch your startup through sweat equity and intellectual capital, your startup valuation increases. 

As a result of the lower cost to entry in terms of product development, the investment landscape is also changing rapidly. Some of the players are getting squeezed—although, “getting squeezed” is relative. As an entrepreneur, if you obtain angel money in the founding stages of the startup, technically those angels should be part of the founding equation and you should see them as part of the team. (continued below)

The options for startup funding have expanded over the last ten years. Today, a startup can be angel-funded, crowd-funded, customer-funded, accelerator-funded, and if you’re lucky—venture capital-funded. Whatever the investment route, you and your investors are fighting the physics of the power law.

Simply, a power law predicts that super hits will occur, but the frequency and magnitude of those super hits is uncertain. In our startup terminology, a super hit is a startup that ends up being acquired for more than $1 billion dollars or goes IPO.

What is certain is that any genre of investor, from angel to venture capitalist will experience the smaller successes, non-performers and plenty of failures. Startups are like non-linear ecosystems experienced in nature. You never know when a dinosaur will go extinct, only to be overtaken by a smaller organism such as the human.

The Math Behind Investor Mathematics

Angels are good examples to study when it comes to the possible outcome of investing into a startup monster that turns into a billion dollar super hit, because they invest mostly in the early stages of the startup cycle. Angel investors drive the American economy. They are the Johnny Appleseed of the seed and early stage of investing for startup businesses.

Johnny Appleseed was an America pioneer nurseryman who introduced apple trees to large parts of Ohio, Indiana and Illinois. He became an American legend while still alive, largely because of his kind and generous ways, his great leadership in conservation, and the symbolic importance he attributed to apples.



American angel investors are no different. For example, in 2008, angels funded 55,480 deals to the tune of $19.8 billion dollars—mostly in the early stages of the venture lifecycle.[1] Compare that to the venture capital industry in the same year, which funded 3,800 deals for a total of $28.3 billion—mostly in the later stage of the venture life cycle.[2] 

As an aggregate group, angels are more powerful than the venture capital industry in terms of number of deals transacted—but the equity power for fast growing private companies is actually concentrated in the hands of venture capitalists due to their industry concentration, and higher investment purchasing power. Of course, all this is changing due to accelerators, and crowdfunding options for the seed stages of the investment cycle.

"No matter how you slice or dice the math, the formula and the principle driving it is simple. Investment Formula: The more investments you make, the higher the likelihood of success."

It's not easy being an angel investor today. Angel investing is a numbers game, as it is for most types of investors. If I’ve learned anything as a venture capitalist (having invested into 25+ early stage companies), it is that statistics and complexity science drive the seed investment formula. No matter how you slice or dice the math, the formula and the principle driving it is simple.

Investment Formula: The more investments you make, the higher the likelihood of success.

David Amis and Howard Stevenson discuss the statistics behind the investment formula from a simple mathematics perspective.[3]

The statistics formula: 1 - (% likelihood of all failing) number of investments

In their example, they made the assumption of 10% succeeding or a 90% likelihood of falling. This formula is applicable to investing into startups, films, products or services, and you can play with different percentage scenarios. 
However, the formula needs further fine-tuning because the likelihood assumption could swing between a small or larger percentage than 10%.

"This formula is applicable to investing into startups, films, products or services, and you can play with different percentage scenarios."

For example, the assumption that each opportunity has a 10% likelihood of succeeding does not account for the factor of investor experience and clustering of startups in a small area as evident in Silicon Valley. 

Clustering of startups in a highly concentrated area helps startups find exit strategies because there are multiple options for an exit.

The Likelihood Assumption is a Variable

Why 10% likelihood? Why not 20%? Why not 30%? This is the problem with predicting the outcome of any future event. Even the assumptions can be flawed—and I think using a 10% likelihood assumption in the math formula, as an example, might not reflect investment reality. But let's go through the math exercise anyway. 

Imagine an angel is investing into multiple startup investments with the following assumption:

Each investment has a 10% likelihood of succeeding or 90% likelihood of failing.

Follow the simple logic:

1. The likelihood that one venture by itself will succeed is therefore 10%.

2. The likelihood that two ventures will both fail is 81%, which is determined by doing simple math: 90% X 90% = 81%. 

Looking at it from a different perspective, the likelihood that at least one will succeed is therefore 19%, which is calculated by 100% - 81% = 19%.

3. Following the same process, if an angel invests into 5 startups, the likelihood of at least one winner is 40.95%.

4. Go even further, if an angel invests into 10 startups, the likelihood of at least one winner is 65%.

5. If an angel invests into 20 ventures, the likelihood of at least one winner is 88%.

6. If an angel invests into 30 ventures, the likelihood of at at least one winner is 95.76%.

This statistical formula does account for the fact that more than one startup may succeed. But the problem arises in the assumptions of 10% likelihood. As an angel investor, you can't assume the 10% likelihood assumption unless you can afford to make that many investments.

As an early-stage seed investor, I've gone through this statistics exercise and the math behind this formula cannot work unless you line up backup capital or venture capital to come into the future rounds quickly when your startup investment needs to grow. Most angels will not have sufficient capital for subsequent rounds because the need for larger investment dollars increased as a function of startup growth.

"Most angels will not have sufficient capital for subsequent rounds because the need for larger investment dollars increased as a function of startup growth."

In my experience as a VC, the venture capital industry generally looks at investments in aggregates of 10. We look for that one major hit to make up for the other 9 investments that will be marginal successes, dogs or complete failures. Arthur Rock, a famous venture capital investor, said that the venture capital industry did not make money as an aggregate in the last ten years.[4] 

Unfortunately, the individual angel investor cannot afford to think in terms of 10. Angels need to think in terms of 5, which makes it all the more difficult but the risk is reduced substantially by investing as a collective. As an entrepreneur, you have to understand the challenges each seed investor faces when you ask them for money. Investing into seed stages is difficult.

The difficulty arises from the fact that angels, because they play in the seed and early stages of the investment cycle, are investing into chaotic, unpredictable systems. Angels, banding together to aggregate their purchasing power and reduce their risk, increase their likelihood of finding a successful investment because of the frequency of invested numbers. However I observed angel organizations increase their investment risks as a group when some of the members had their own personal agendas and influenced the group to invest into companies they had invested in previously on their own.

In summary, the 10% assumption is a flawed mentality for angel investors because individually most can't afford to invest substantial capital into multiple startups in order to reduce their seed risk. Whether an angel invests alone or with an angel group, they should take into consideration the following variables that make it more difficult to assume any likelihood scenario: 

VC Fundability: Various metrics are involved in determining fundability but one simple rule is whether the startup management team has been previously VC funded. If you're an angel, you need to have an exit strategy in place before you even invest. Obviously, one angel option is to have venture capital investments in the subsequent rounds, which reduces angel risk but doesn’t offer an immediate exit.

VC Dilution Effects: If the angel investment succeeds in receiving subsequent rounds from the VC industry, there is a dilution effect —which indicates that the seed investment formula is diluted as well.

Competitive Intensity of the Sector: If the angel invests into a sector where the competitive intensity has increased, unless your startup has traction in the marketplace, the angel investment risk is intensified because of chaos incurring within the sector due to entry of new competitors. I've seen this scenario play out in the technology sector more than once. For instance, when the B2B online marketplaces where hot in the early 2000’s, there were thousands of entrepreneurs entering the online marketplace sectors. The good news was that the sector was getting a lot of attention. The bad news was that the sector was increasing in competitive intensity because of the attention it was getting. Hundreds of companies were being funded and launched into the marketplace. 

There are many other variables to consider in terms of how they affect angel risk. My point is that making wrong likelihood assumptions can play havoc on the number of startup investments necessary to generate a super hit. As an entrepreneur, you have to understand the seed risks your potential angel is facing. The more you understand the mathematics behind seed investment risk, the more you can look for ways to reduce risk. The same seed investment formula can be applied to launching products or services. The more products you launch, the higher the probability of developing a super hit. 

There are enough power law scenarios where a product was launched and it became a super hit overnight. But we both know overnight success is not overnight.

If you have invested into startups, how many angel investments did you make before you got your first super hit?

If you have invested into new product launches, how many products did you develop before you got your first super hit?

In both of these questions, I defined my own definition of “super hit” so our exit reference points might differ. You can define super hit in your own words as long as you consider it a success. Some entrepreneurs are happy to just sell for $100 million over a three-year period. There is nothing wrong with that.


[1] Source: UNH CVR

[2] Source: source: NVCA/PWC/Thomson Reuters.

[3] Winning Angels: The 7 Fundamentals of Early Stage Investing, David Amis and Howard Stevenson

[4] Arthur Rock interview with Wall Street Journal.

Copyright © 2013 entrepreneurdex

 

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Damir Perge, author of Entrepreneur Myths: The Startup Reality, is the founder of entrepreneurdex, a startup studio using complexity science to fund, launch, accelerate and scale startups and growing businesses.

An entrepreneur and investor, with more than 25 years experience, he's worked with ventures in the technology, internet, media and publishing, entertainment, energy, and manufacturing sectors raising more than $300 million in capital for various companies and investing more than $50 million into startup and emerging ventures. He's sat on the boards of 11 companies, served as editor-in-chief of Futuredex, a private equity magazine. Follow 

Pre-order Damir Perge's upcoming books at damirperge.com >

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