# Will the numbers behind volume investing change your thoughts on crowd funding?

One of the key axioms of angel investing is that you need to be diversified in a portfolio of companies because 1-2 companies will carry your portfolio’s returns given the high fail rate (75% to 90%) of startups.

I set out to answer the question of:

How many investments should an angel/seed investor make to be adequately diversified?

The easy answer is to say as many as possible. However, diversification is tough. It’s tough to find good companies to fund, and thus it’s tougher to fund 50 companies than it is to fund 5 or fund 500 instead of 50.

## My Assumptions

I started with looking at the historical angel investing returns from the Kauffman Foundation’s Angel Investor Performance Project (AIPP) [1].  I slightly modified the data, so here are my expected probabilities.

So for every ten investments, seven will go bust and you will lose all your money, one will return 5x, one will return 10x and one will return 20x.

#### What does a 20x return look like?

Here are two sample 20x return scenarios.

1. You invest part of a \$1mm seed round @ a \$3mm pre-money valuation (\$4mm post) and the company raises no further money and exits for \$80mm.
2. You invest part of a \$1mm seed round @ a \$3mm pre-money valuation (\$4mm post). The company raises a \$3mm Series A at a \$8mm pre-money valuation (\$11mm post) and exits for \$110mm.

## The Expected Return

The expected return is calculated by multiplying the scenarios listed above:

`(0 * .7) + (1 * .0) + (5 * .1) + (10 * .1) + (20 * .1) = 3.5`

If there was no variation and the probabilities held exactly true, you would expect to return 3.5x your money (i.e. if I invest \$100K, I would expect to get \$350K back). However, regardless the probabilities, the outcomes are never 100% certain – for example, if I flip a coin, will I get 50 heads and 50 tails even though the probability is 50% head, 50% tails)?  In the table below, we can see how time to recover our investment affects IRR – let’s use 20% IRR as the hurdle for “venture style” returns, so we’re looking at a 7 year window to exit.

#### A couple more notes

1. There is no pro rata follow on investment.
2. The same check size is written every time.

Before moving forward, the test and its results/implications are all predicated on these assumptions about the probability of outcomes of angel investments holding true.

## The Test

Based on the probabilities of angel investment outcomes above, we ran a simulation of what the expected returns of a portfolio size of 5, 10, 20, 50, 75, 100, 150, 200, and 500 would look like. We set out to run the simulation 10,000 times for each portfolio size, but Excel kept crashing so we shrunk each simulation down to only being run 1,000 times per portfolio size.

You can download the raw Excel data here (which includes further explanations of how to run this same test yourself).

## The Results

Here are the results in table form. It doesn’t get too exciting until you skip to My Take Aways.

To be clear about what’s in Column A

Mean – the quotient of the sum of the returns divided by 1,000
Median – the middle of the range of 1,000 simulated outcomes
Min – The lowest outcome/return in the 1,000 scenarios of the portfolio size.
Max – The highest outcome/return in the 1,000 scenarios of the portfolio size.
% – 0x – Percentage of the time the investor loses all his/her money
% > 1x – Percentage of the time the portfolio returns at least 1x
% > 2x – Percentage of the time the portfolio returns at least 2x
% > 3x – Percentage of the time the portfolio returns at least 3x

## My Take Aways

We set out to answer the question of: “How many investments should an angel/seed investor make to be adequately diversified?” Assuming our probabilities of outcomes hold true:

• At 20 investments, you have a 98.7% chance of at least getting your money back (> 1x).  This is probably the minimum number of deals I would look to have in an angel portfolio.
• At 50 investments, you have a 96.9% chance of at least doubling your money (> 2x).
• At 500 investments, you have a 96.2% chance of at least tripling your money (> 3x). As you diversify through volume investing, the closer you get to being assured of your expected value.

The other interesting take away is that variation in outcomes decreases through volume investing.  In the graph below, notice how the maximum and minimum portfolio outcomes converge to the expected return of 3.5x as the portfolio size increases. Through volume investing, an investor can almost lock in a certain return and know what they are going to get.

While volume investing may decrease risk, it also decreases potential reward (one of the main axioms of investing) and chance to generate returns above the expected 3.5x.

## The Possible Implications

Dave McClure’s 500 Startups is the only fund I know of that invests at this kind of volume > 500 deals (although his check size varies and 70% of his money is ear marked for follow on).  However, “spray and pray” funds (popularized by Ron Conway) seem like a more stable investment thesis than they are made out in the press. The sheer volume of investments (and large class sizes) done by Y Combinator start to make more sense as well.

However, we don’t all have millions of dollars to angel invest, but how can we put this data to use for us? Between Angel List, Funders Club, and WeFunder, you can start volume investing with as little as \$1,000 (Angel List) to \$2,500 (Funders Club) with those sites screening and doing the due diligence since clearly it isn’t feasible to source 500 good deals yourself individually.

Hypothetically, with \$500k, you could conceivably do 500 investments at Angel List and have a really high chance of > 3x’ing your money (probably even more since the current crowd funding deals on Angel List are hand picked by Nivi and Naval).  Even a smaller portfolio of 50 deals (investing ~\$50K) has a 96.9% chance of at least doubling your money.

Note: it’s also expected that the crowd funded deals would be fill out the rest of rounds led by VC’s and angels (who would be more hands on investors) and have absolutely no qualms about them getting into the deal at discount.

## Future Studies

I’ve been on record of being a skeptic of crowd funding.  However, volume investing through Angel List, Funders Club and WeFunder plus foreign crowd funding sites like SeedMatch.de and OurCrowd seems like a viable investment strategy. I’m going to continue running studies with modifications.  For example,

• This example doesn’t include black swan outliers (like how AirBNB and DropBox make up the majority of Y Combinator’s returns)
• This example doesn’t include management fees as part of a fund structure

Again, assumptions have to hold true. Lower expected returns.

Disclaimer: I am not a financial advisor.  You should not rely on anything stated in this blog post as legal, financial, accounting, investment, tax, or any other kind of regulated advice.

Continue this conversation on Branch.

Footnotes    (↵ returns to text)

# Making a Case for Performance Based Vesting

Equity is a very important part of startups. You don’t need to look further than the graffiti artist who painted murals on Facebok’s first office’s walls, opted to take payment solely in stock, and proceeded to watch it appreciate to a value of ~\$200mm at the time of their May 2012 IPO.  While that example is a black swan outlier, part of working at a brand new company that has a 75% to 90% chance of failing is being compensated in stock that represents a higher potential value (if the company is successful) than being paid the same equivalent in cash.  After all, one of the main axioms of investing is the higher the risk, the higher the potential reward, and this doesn’t just pertain to investing dollars but also investing your time. Continue reading

# Good is the Enemy of Great

Today, it’s easier than ever to build a product (heck, Startup Weekend builds products over a weekend and can count Zapier, Zaarly, Foodspotting (acq. \$OPEN), LaunchRock, and Rover.com among its alumni). The same is true with creating and publishing content – case in point Demand Media who are a content creation machine driven by an algorithm to tell them what people are searching for. Continue reading

# Why App.net is a loser and G+ will be a winner

Note: Alex LaPrade and Ray Angel both got on App.net today amidst the the free version being released (despite Dalton’s insistence that it’s a paid social network).

Full disclosure: Ray Angel is a Facebook shareholder and Twitter shareholder. He doesn’t let them stop him from trying new stuff and loves tearing even Facebook and Twitter to shreds when he can.

I just don’t see App.net making it.

Alex LaPrade (8:03 pm): First of all, I don’t claim to be an expert in social or consumer internet. That said, I just don’t see App.net making it. That’s why I was so hesitant to sign up in the first place. Best case scenario they end up as a niche social network to talk about tech, etc. topics (which I would be happy with). I think social is always going to be dominated by free + supported by ads. It just comes down to network effects and I’m going to spend the most time on the network(s) where users are. Network effects are incredibly defensible and the backbone of any social network. I would use things like Path more but my “muggle” (non-tech) friends that I would want to share stuff with aren’t on there, so the network isn’t valuable to me, especially if I have only a finite amount of time for social networking so spending time on app.net is going to take time away from something else. Continue reading

# Why Entry Price Matters for both Entrepreneurs & Investors

Cambridge Associates, an advisor to institutions that invest in venture capital, says that only about 20 firms – or about 3 percent of the universe of venture capital firms – generate 95 percent of the industry’s returns, and the composition of the top 3 percent doesn’t change very much over time.

This is a number I’m always referencing, but it’s a reality of life that the “A List” VC’s (USV, A16Z, Sequoia, Accel, Benchmark, etc.) are going to get into the best deals (i.e. the companies that are going to be < \$1bn).

The sooner we realize that life isn’t fair (thanks for teaching this to me mom), the rest of us can get back to thinking of how we can innovate and figure out how to play by a different set of rules since we can’t compete with them (the aforementioned 3%) head to head. Continue reading

# Why I Will Never Ever Ever Invest in a Husband-Wife Team

In the oh so wise words of Taylor Swift, “We are never ever ever getting back together” – ok, it’s not a perfect comparison, but I will never ever ever invest in a husband-wife / boyfriend-girlfriend, etc. team.

Come on, Alex. This is a terrible investing rule – you’re just stereotyping.  ”Mom and pop” business are commonplace (and you could make an argument they’re the backbone of the American economy). The data supports it too – 90% of all U.S. companies are family-owned, and husband-wife teams account for around 1/3 of that (Source).

Not to mention, you wouldn’t have even batted an eye at great companies like:

That’s not enough data for you? Isn’t there a great appeal to you in co-founders who have a history of working together and getting through ups and downs together?  Husband-wife teams are closer and have more trust in each other than any friendship, college buddy or previous work experience.

# Startup Interviews: Adi Bittan of OwnerListens

OwnerListens is one of the businesses on our watch list.  It is a website that allows customers to speak directly with business owners before taking to their disappointment to review sites such as Yelp or TripAdvisor.  It takes average reviews one step further–allowing customer feedback to go directly to the person who can make the company change for the better.  The system benefits business owners because they get direct feedback and benefits customers because their opinions are heard and can be responded to.

The founder is a highly motivated and skilled entrepreneur, Adi Bitan.  If her MBA from Stanford University wasn’t enough to impress you, she also has worked at Stanford, Google, and Clarium and was a mentor with Berkley’s Lean Startup classes, an advisor at Upwest, and an attorney in her previous life. Continue reading

# Why Crowdfunding should be the next big thing but won’t.

1. The numbers make sense

A study from Global Entrepreneurship Monitor (GEM) showed \$51 billion invested in start-ups by individuals in 2010 with \$9.4 billion coming from angel investors and \$41.6 billion coming from friends and family. For a point of reference, the National Venture Capital Association (NVCA)‘s data shows venture capitalists invested \$22 billion in 2010. Now, the friends and family number is obviously skewed upwards because it’s money invested in just that, friends and family, but it’s just to illustrate money being deployed by these potential “crowd funding investors.”

2. A growing enthusiasm about startups and owning stock in these early stage private companies

The rise of Second MarketSharesPostAngelListFunder’s Club, etc. are all examples of a growing appetite for owning stock in early stage private companies.

3. An unbundling of advice and money

Conventional wisdom states that you should raise money from a strategic partner (i.e. someone who is a value-add beyond just being a capital provider).  However, we are beginning to see this unbundled.  For example, Y Combinator puts in a  tiny amount of money (\$18K) but contributes a huge amount of advice.  Yuri Milner / Ron Conway’s Start Fund, which invested blindly in each of the graduates from each YC class, put in money but minimal advice.  The ‘bundled’ strategic investor is becoming unbundled to where crowd funding investors can provide money (but no advice or expertise) and other investors could come in and provide a lot of advice and expertise but little money (even possibly at a discount).

## …BUT WON’T

Year One and Year Two are probably going to be great (just like the warm and fuzzy feeling around the marquee funded Kickstarter projects). It seems certain that lots of money will be deployed but what happens when the following scenarios happen? Continue reading

# Startup Interviews: Alaxic Smith of Communly

Recently a good friend of mine, Steve Franks, posted on Facebook about a site called Communly. Communly brings the experience of communities online by allowing users to join in online communities and create content that is catered towards everyone in the community they join.

Communly presented a demo of their product at the 2012 TechCrunch Disrupt Hackathon.

Alaxic Smith

Alaxic Smith is involved in the design and development of Communly along with Neil Parikh. Alaxic is a 17 year old website designer and Rails developer who lives in Silicon Valley. Unlike many 17-year-olds, Alaxic enjoys Brotips, Hacker News, General Catalyst Partners and many other things that only those older than him in startup communities tend to enjoy.

I had the pleasure of speaking with this young entrepreneur about what makes him tick, his work/life balance, and his startup.  This is the interview and this young entrepreneur’s inspiring story.

# Startup Weekend – The True Value

Full Disclosure: I used to be the CEO of Startup Weekend when it was run as a for-profit entity and an LLC before being converted to a non-profit. My opinion here as been formed from my time during that role in addition to having attended several events since the conversion to a non-profit.

It has been written in places around the Internet that Startup Weekends rarely if ever produce companies of value. Most companies formed at a Startup Weekend will fail.

Then again, most startups will fail regardless if they were created at a Startup Weekend or not. Ideas aren’t the value in a startup. The execution is where a startup will flourish or flounder.

What people attending will find at Startup Weekend as the true value will vary and I’ve tried to list out a few of my own personal observations having attended a many of these events.

Startup Weekends are some of the most exciting and worthwhile events for networking you will ever attend. If you’ve ever wanted to be thrown in to a room with more like-minded people this is the event you will want to attend.

Many of the companies built at Startup Weekend are going to fail. The ones that don’t fail immediately that weekend will likely fail over the next coming weeks. A few will go on.

The connections you build at a Startup Weekend however can continue and with the right fostering they will continue. When I attended my first Startup Weekend I met a great deal of wonderful people who I had no idea were in my area doing cool things. I added many of these people on Facebook and Twitter.

It has been years since that first weekend event and I still keep in touch with many of those connections I made. Some of them have gone on to graduate and start ventures, one has closed a Series A from some amazing investors, others have even gone on to be partners at Venture Capital firms. As for myself I’ve launched many ventures since then and every time I’ve capitalized those connections I made at that first Startup Weekend to get feedback, bounce ideas around, help me promote new projects and even help me with some of the finer parts of building.

Startup Weekends aren’t purely about networking though. The element of learning plays a major role for many who attend the event and could be one of the biggest benefits for those who have never attended an event in the past.

At a Startup Weekend event you aren’t simply a passive student learning about the art of starting a company but rather an active participant. Testing new theories, building new concepts, making new connections, and building a company. Learning has been such a passive process in the world of startups with a great deal of books, blogs and videos being created to tell you how to do certain things. With Startup Weekend you are learning them by doing them.

Startup Weekends bring out people who normally may simply stay at home and work alone on things, it brings out people who want to try a startup but not quit a day job and it brings out people who are DTF on startups.

If you are looking for people to work on a company with you or a project a Startup Weekend could be the right opportunity to find the right people for your startup. I’ve seen several relationships built at Startup Weekends turn in to partnerships that turn in to new companies.