The old investing adage “Cut losers short; let winners run” provides a valuable reminder of how to achieve superior returns, but misses one essential element: bet sizing.In venture investing there are really two key metrics: (1) mortality rate (batting average); and (2) average bet size of losers vs. winners. Assuming a common mortality rate, an investor will be more successful by having deployed less capital in losers and more capital in winners.
This places a premium on risk analysis and discipline at every stage of the investment life cycle. Those who can face into painful but quick losses and double down on longer-term winners will be far more successful than those who defer pain and invest more capital in highly risky follow-on rounds, hoping that something good will happen to bail them out. Hope is generally a poor driver of investment returns, even if it feels better in the short run.
But the real question is: how do you keep great managements building great businesses for the long run in the face of early-but-attractive exit opportunities? How do you let those winners run when hungry, cash-strapped managements have $5, $10 or even $20 million dangled in front of them, notwithstanding the fact that these amounts could be 10x or more in 3-5 years?
As a venture investor, I am in an admittedly conflicted position. I selfishly would like my great teams pursuing large market opportunities to go for it, not settling for the $25, $50 or even $100 million deal, when the company has a real shot at being a $250, $500 million or even $1 billion exit in the future. However, as someone who cares deeply about my entrepreneur-partners, I haven’t stood in the way if an entrepreneur was firm in their resolve to sell. The exit is one event where alignment of motives sometimes get wonky, and I constantly think about how to manage this dynamic in the face of cash-rich acquirers looking to round out their technology stacks or product lines.
I am personally finding this to be an extremely clear-and-present issue, and one which requires creative thinking to get investor-entrepreneur alignment back in sync. But when I’ve really delved into the issue with entrepreneurs, much of the time the feeling isn’t “I want to sell,” but “Wow, I’ve been living tight for a long, long time, and it would sure be nice to have some financial stability” or “I want some financial security for my family, and if I had a chance to sell and get ($x million) and let it go by and something happened, I couldn’t live with myself.” Entrepreneurs thinking about their families and their futures after killing themselves to build a successful business – makes total sense to me.
One approach I’ve used which I believe in is the partial cash-out. By this I mean letting the entrepreneur sell 5-10% of his/her shares either as part of a follow-on financing or directly to an investor seeking to get exposure to the company outside the context of a fund-raising. While this never results in the entrepreneur receiving “f&*k you” money, it often can provide a level of comfort and a peace-of-mind that can actually heighten focus and intensity on building the business and not simply managing for a short-run liquidity event. And from my perspective, it keeps the entrepreneurs in the game for the big win and in the right frame of mind, the one which enables me and my investors to optimise our outcomes while offering the entrepreneur the chance of the life-changing event.
Hunger and fear are powerful motivators, and have catalyzed mind-boggling innovation and creativity among entrepreneurs since the beginning of time. However, utility functions shift when those efforts begin to get third-party validation in the form of acquisition offers, frequently causing founders to become increasingly risk-averse for fear that what they have built can be lost. This risk aversion can be very costly for both investors as well as the marketplace, both of whom can benefit from continued development of the company. One way to change utility functions is by helping entrepreneurs take a measure of risk off the table through a partial cash-out. In my opinion, this seldom-used technique represents the wave of the future. While only appropriate once a company’s business is generating substantial revenues and is in the growth phase, I believe it will become a proactive tool in a venture investor’s arsenal to ensure that their biggest potential winners are allowed to run.
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