So I see that the chairman of another major private equity fund has decided to bestow his wisdom about starting a business upon the general public. I’ll summarize it for you:
Seek out massive compelling opportunities and pray you have the timing right.
There’s only one massive problem with this. 99% of these paths lead to failure.
Which isn’t a recipe for putting food on the table.
In the aggregate, startups and venture investing is a game of skill. Expertise matters. However, at a micro-level (single investment), you are making a low probability bet where the median result is failure.
Early success on an investment is not a guaranteed of a payout; many companies hit key funding milestones yet flounder before they can engineer a paying exit. Worse, the game is cursed with accelerating returns which encourage you to stay in the game after an initial success at a company in hopes of “going all the way”. “Must be present to win” is the usual policy.
And yes, most of the returns come from a few massive home runs.
For a portfolio investor with 50+ companies, this isn’t a problem. You’ve got a large enough sample that you have a high probability of finding that big win that pays for everything else.
Oh wait. You (founder) most likely don’t. You get one bet (at a time).
In which case, you need to look at this table. (distribution of single investment returns)
65% chance of loss, 10% chance of life changing upside. So while the “average” outcome is awesome, the expected outcome is you’re going to lose your cash.
Investor Size: Anything Smaller Is Useless To Them
You know why billionaire venture capitalists hunt unicorns? Because when you’re running a few billion dollars of capital, that’s the only meaningful way to get a bump in your portfolio performance. Nothing else matters.
Which means there is an irrationally high price for potential unicorns, since that is the only deal size which makes sense to a large institutional investor.
Except I’m not a billionaire. Neither are you, most likely.
Our “portfolio results” can be moved by far smaller amounts. I don’t know about you, but making an extra couple thousand dollars a month sounds great to me. Bootstrapping a business to low six figures? Life-changing. $5 Million dollar exit? I’m out – beach time!
And we’re probably not competing with billionaires. So the odds of success are far higher and the deals are priced at a more reasonable level.
A Better Formula For Main Street Entrepreneurs
I was taught to replace something before you tear it down. So, here’s three better criteria for selecting a small business or side project (from a person who has actually done it)….
- It should be big enough to earn a fair return on your time, but no larger. Large markets attract large competitors, who can easily crush you and limit your margins. Select your opponents carefully. The best side projects are completely absurd and address market niches that were ignored by established competitors.
- You are clueless and your initial assumptions will be dead wrong; instead of waiting for a unique opportunity, become a top expert on a market you enjoy. This maximizes the odds of you stumbling across an opportunity to become unique.
- Your timing will be as wrong as your assumptions. In fact, by the time you finally hear about trends as an outsider, you’ve likely missed the point where you can profit. Instead of trying to second guess insiders, work to establish a sustainable position (zero cash burn) and acquire the expertise and intelligence networks to become an insider going forward. Seek to be the strongest player in a niche others ignore.
Not to mention the Fourth law of Finance: as an outsider, spread thy bets!
Will you create a Unicorn? Probably not. But your chances of achieving a life changing success with this strategy are probably a lot higher than 10%….