Tuesday, April 10, 2012

Local vs. Global Maxima in Early-Stage Investing

Note: this post is one of several drill-downs on the topic of why angel investing and early-stage venture investing are not just different in scale, but different in type.

Venture investors who seek to maximize returns face a difficult problem: unlike publicly-traded securities, private company investments are highly illiquid -- no returns, no exchanges.

In addition, the mean time from venture investment to exit is more than five years, and any realized gains (typically) can't be reinvested by the fund because of way fund returns are treated for tax reasons.

Finally, fund managers are often contractually barred from raising a new fund until a majority of their current fund's capital is committed (i.e., via actual investments plus funds reserved for follow-on investment in existing deals).

This is why venture fund investments are like silver bullets...

Every fund investment is (essentially) a bet that:
  • irrevocably depletes the manager's capacity capacity to make future bets, 
  • consumes some portion of the investor's finite time and attention (more on that later), and 
  • either contributes to portfolio returns or doesn't.

Contrast this situation with that of the angel investor investing from personal capital.

A failed angel investment may reduce the angel's personal net worth (and require some explaining to her spouse or partner), but typically has a negligible impact on the angel's capacity for future investment, her time, and her expectations of future professional compensation.

Why do angel investors and "professional" investors behave differently?

When investment decisions...
  • are irrevocable, 
  • deplete a finite pool of capital and time, 
  • are burdened with significant legal and ethical obligations, and 
  • have outcomes that correlate directly with the investor's future expectations of compensation...
...the manager responsible for those decisions can be expected to allocate capital with an extraordinary degree of care.

What does this mean in practice?

The raw material of any venture investment process is deal flow -- the pool of companies who are currently seeking capital and assistance in building their businesses. This market is slowly becoming more transparent and liquid (aided by high-quality enablers like Y CombinatorTechStars and AngelList), but remains an extremely localized, relationship-driven and opaque trading environment.

Under these conditions, angel investors are more likely to attain a local maximum with their investments -- participating in the best deals they see, but with fewer deals to compare against, and limited time and appetite for intensive diligence.

Why is that?
  • Because angel investors participate in this market part-time, they generally see only a subset of the total available deal pool.
  • Because they aren't as visible to the market as full-time players, they also tend to get a skewed view into the pool, with deal pipelines heavily weighted to opportunities sourced from a limited set of personal relationships.
  • And because -- as described above -- the personal stakes for their investment outcomes are lower, angels tend to screen their investment decisions less intensively than professional investors are both obliged and incented to.

By contrast, professional fund managers are driven by both obligation and incentives to seek the global maximum for their investments -- going to extraordinary lengths to:
  • see as many deals as they can; 
  • doing the most intensive diligence on them that they can; and 
  • only committing capital to the deals that pass the highest possible standard for long-term contribution to fund performance.
Whether the fund manager achieves this goal is up to the market -- and their LPs -- to decide. But it shouldn't come as a surprise when venture investors challenge entrepreneurs for "not thinking big enough" -- because that's exactly what what their incentives require them to do.