Ideas for Angel Investors #1: Indexing
Why rational investors should have much larger startup portfolios
In early stage investing, outlier deals are all that matters.
As I mentioned a few weeks back, even amongst Y Combinator’s 70+ unicorns, the top 10 have produced well over 2/3 of the value.
The Power Law is so… powerful… that it actually makes statistical sense to invest in a lot of companies. Way more than you realise.
Based on some research from Steve Crossan1, you should probably aim to have at least 150 deals in your startup portfolio, but more like 300 if you can.
If you have a 300 deal portfolio instead of a 30 deal portfolio, your chance of tripling or quintupling your money is ~80% higher:
Perhaps more surprisingly, your chance of 10xing your money doesn’t decrease. The upside of a true outlier outweighs the downside risk of losing money on all the others.
Plus, as your portfolio grows beyond 30 companies, the chance of losing money altogether declines from as high as 10% to close to 0.
Research from Abe Othman at AngelList (the biggest startup investment platform in the world, with a larger dataset than any other organisation) supports Crossan’s findings:
“We did do some simulations… on what indexing at seed actually looks like over human timescales. Over a ten-year investment window, indexing beats 90-95% of investors picking deals, even when those investors have some alpha on deal selection. So the idea that there are some terrific seed investors that soundly beat indices is not inconsistent with our results.”2
This all sounds like common sense to public markets investors. It’s very similar to the strategy first promoted by Jack Bogle (the founder of Vanguard) almost 50 years ago. Indexes and ETFs now dominate the public markets.
However, “spray and pray”, as it is known, is viewed with disdain by many VCs.
Most VC firms have portfolios of 15-25 companies per fund. Very concentrated, the exact opposite of the strategy I’m proposing.
This is despite the fact that the concentrated strategy is only working out for a small number of firms. Most of them barely even break even.
So why do VC’s have such small portfolios?
There is an argument that it’s a function of bandwidth - there isn’t time to review all the deals and write so many small cheques, handle governance, board seats, etc. There is obviously truth in this; if you want to take an active role in companies, you cannot spread yourself to thinly. But do you need to sit on all those boards? Could you achieve the level of control you need without having to do board meetings?
As Charlie Munger once said, “Show me the incentive, I'll show you the outcome.”
Venture firms charge hefty fees. The classic model is “2 and 20” - 2% in cash per annum (dropping off a bit as the fund matures), plus 20% of profits on exit.
If you’re charging such high cash fees in particular, you need to look like you’re doing something to justify all the money your investors are paying you. So you sit on boards, hire a team of analysts, build financial models and spend a ton of time assessing deals and debating at great length which ones to invest in and which ones to pass on.
For 5% - 10% of VC’s this seems to work. For everyone else, it doesn’t.
The other factor at play is ego - despite the fact that only 5 - 10% of VCs are really performing, 95% of them think they’ve got an above average shot at being in the top decile.
So how do you build your index?
If you decide after reading this that you’re going to try the indexing approach, remember - you still need a quality filter. You shouldn’t just be investing at random, since the bottom 90% of startups will return nothing substantial.
If you’re a newbie, the chance you’ll end up indexing the bottom half is pretty high.
This is why investing smaller cheques via syndicates & funds with access to quality makes a lot of sense.
If you’re doing it yourself, you need to spend a lot of time honing your ability to identify great founders going after big market opportunities (much harder than it sounds) and then work very hard to get access to their funding rounds.
Finally, assuming you only get exposure to 10 or 15 deals a year, you also need to be willing to commit to investing in this asset class as a long-term endeavour.
And, finally, regardless of your strategy you must be prepared to suffer a lot along the way.
🤔 and 😂 stuff
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My boy’s wicked smaht
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