The Returns Are Higher Because It’s Harder

“It’s supposed to be hard. If it wasn’t hard, everybody would do it. The hard… is what makes it great.”

That’s a quote from one of my favorite baseball movies, A League of Their Own. It is said by manager Jimmy Dugan (played by Tom Hanks) to a player after she tells him she’s quitting because the game is too hard.

To paraphrase Jimmy Dugan…

Early investing is supposed to be hard. That’s why the returns can be so high.

I like the baseball analogy. In baseball, players who fail to get a hit seven out of 10 times are considered great hitters. But if they fail eight out of 10 times, they’re bums.

Hitters never mosey up to home plate intending to strike out. But it happens. My Baltimore Orioles just completed a three-game series where they averaged 17 strikeouts a game. (They’re still a playoff-worthy team!)

Similarly, no startup investor plans for his investments to fail. But it happens.

Because baseball has accumulated over a century’s worth of statistics, players know exactly where they stand. A quick look at a handful of player metrics will reveal how good (or not) he is.

Equity crowdfunding is brand spanking new and stands at the opposite end of the spectrum. It has a complete dearth of hard information to indicate how well or poorly you and your startup portfolio are doing.

This also makes equity crowdfunding different from public stock investing and most other kinds of investing where track records exist.

Many Questions and Few Answers

For early investors and new crowdfunders, there are many questions and few answers. (But don’t worry; I have some.)

What metrics should you slap on your portfolio? Should you go for a 30% hit rate, like a ballplayer’s “.300” batting average? How much profit should your portfolio generate?

Ballplayers who generate or drive in 100 runs (called “runs batted in” or RBIs) in a season are on top of their game.

What are your benchmarks for driving in dollars? Where should you look? At the VC world? At the public stock investing world?

What constitutes a reasonable but ambitious goal?

You should have some idea. Otherwise, you could be doing extremely well and not realize it. The opposite is worse. You surely don’t want to be underperforming and not know it.

Equity crowdfunding is a new type of early-stage investing. Lacking historical data, let’s do the next best thing. Let’s see what clues we can glean from how public and private stock investors rate their own performance and portfolios.

What Can the S&P 500 Do for You?

Over the past five years, the S&P has returned just over 10% a year (the Nasdaq more and the Dow Jones less). Over the past 10 years, the S&P 500 has given back 5% annually. The Dow Jones has given slightly more. The Nasdaq nearly doubles their performance with a compound return rate of 9% a year.

So, let’s say 10-year returns range between 5% and 9%.

Most experts agree that future growth will more likely imitate the markets’ mid-range 10-year return rate than the 5-year rate. It’s likely the markets will be giving investors mid-single-digit returns – at best, upper-single-digit gains.

That’s the benchmark public stock investors will seek to match or beat.

Three VC Rules of Thumb

But how about private shares? How high do venture capitalists aim? What metrics do they use?

Here are the three industry standards…

• 10X returns sought from each startup. But that’s aiming high. Too high, in fact. It’s nearly impossible to achieve. Ten times or higher winners are the exception and not the rule – something VC investors readily acknowledge.

  So why go after 10X returns in the first place? Aren’t VC investors just setting themselves up for failure?

  Only if you define failure by having more losers than winners in your portfolio.

  Truth is, most of their holdings come up short, generating little, if any, profit. But the ones that fulfill or exceed their 10X potential? They offset those other holdings and are expected to generate a handsome profit for the portfolio.

  According to research by William Sahlman at Harvard Business School, 80% of a typical VC fund’s returns are generated by 20% of its investments. That’s one out of five investments that hits.

  For a baseball player, that average is a death sentence. But for a VC investor, it’s a formula for success.

  Here’s some simple math to show you what I mean…

  Let’s say your fund is $100 million. If 20% of it – or $20 million – is invested in deals that return 10X, your return is $200 million. Even if the rest of the fund – that is, the remaining $80 million – generates nothing, your annual gain over five years comes to about 15%.

  Fifteen percent gains aren’t earth-shattering, right? My simple math leaves out some things. Like what the rest of the portfolio does. It won’t return nothing. There will be some 1X to 3Xers mixed in. And if instead of 10X, 20% of your fund could return 11X or 12X or 13X… or 50X? You get the idea.

  What the 10X/20% formula does is get a VC portfolio over the hump.

• 3X returns for a fund as a whole. The key variable then becomes over how many years. For five years, returns are 25% a year. For 10 years, they’re 12%.

• Some VCs use the S&P 500 as a benchmark. For example, the S&P 500 return plus 5%. Or the S&P 500 return times 1.5.

Should you aim higher or lower than VCs? Or, like some VCs do, should you use the S&P 500 as some kind of benchmark?

An Argument for Higher

Whatever you call yourself – angel investor or equity crowdfunder – this much is true. You’re investing extremely early. At the seed stage or thereabouts, perhaps pre-seed or post-seed.

Valuations are very modest, with tons of room to grow. So if one of these startups can survive the always-tough first few years and eventually scale revenue, your profits should surge right along with the growth.

The growing number of micro-VC funds (nearly 250) and the super-angel-led syndicates will pick off a large portion of the most promising startups. But not all, and with the advent of equity crowdfunding, more and more quality startups from outside Silicon Valley will be raising their seed money from everyday investors.

Most institutional money is in the later rounds, when there’s lower risk and a better chance of a startup surviving in the short term and thriving in the long term. Quality of deal flow is pretty good but, in general, the cream of the crop goes to the roughly top 2% of VC firms.

You won’t be able to match their performance. But why shouldn’t you aim as high as or higher than the remaining 98%?

An Argument for Lower

The majority of companies VC investors go after have the potential to blow up into huge winners. For the most part, these companies are led by outstanding founders and are addressing huge markets with game-changing technology/products/business models.

What’s more, the VC firms give them the tools and connections to help them realize their big ambitions…

A set of advantages that new angels and crowdfunders would find hard to match.

Time for Some Answers

How can current ways to measure portfolio success help you measure your own startup investing performance?

What I’ve done is steal from the VC playbook and substitute different numbers to give you two options…

Option No. 1. The S&P 500 benchmark. Truth is, your startup returns don’t correlate well with the public stock market. A terrible year in public stocks, for example, can easily coexist with good returns from your private shares. But feel free to use multiyear trends. (Five years would be fine.) Go ahead and follow the same standards as some VC investors in doing 1.5 times better than the S&P 500 or going by its returns plus 5%.

I believe your S&P 500 benchmark could be higher. Doubling its returns seems at once both reasonable and ambitious to me.

Option No. 2. For VCs, remember, two out of every 10 holdings need to develop into outsized winners of 10X or more. For everyday investors? Half that would allow you to earn back your entire stake.

At which point you’re playing with house money. Here’s the math that proves it…

You have a portfolio of 10 startups. You invested $1,000 in each. Two give you 5X for a total return of $10,000. You’re now at breakeven.

For your remaining eight companies, let’s say that four go under and you make only $0.30 on the dollar, or $1,200 in all. And on the other four you make between 1.5X and 4.5X. Splitting the difference, that comes to 3X, or $12,000. That’s a 132% profit on your portfolio.

Over five years, that comes to 19% annually. Over seven years, 13%.

Remember, these are minimum returns. If one of your two 5X companies turns into a 20X company (not uncommon for VC investors), you’ve just made nearly 4,000%, or roughly 30% annually in five years.

So you don’t have to aim as high as VC investors to get outsized returns. And by aiming lower, you decrease risk, increase your chances of getting more than two outsized winners (for every 10) and lower the risk of ending up with failures.

The 10-Year Portfolio Challenge

We’ll probably need another 10 years to see how equity crowdfunders do compared to VC firms. But compared to the traditional stock investors?

Equity crowdfunding investors should do much better.

The math says their annual returns could be anywhere from 13% to 30%. Even at the lower end of this range, it’s at least 50% higher than what the public markets are expected to return.

Invest early and well,

Andrew Gordon