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By Andrew Gordon on April 3, 2015 Editor's Note: Recently, I spoke at a conference put on by our friends at The Oxford Club. Many people asked me whether investing in startups would be "right" for them. Much of what you'll read below is reconstructed from my conversations with them. This is my "Dear John" letter to them. But it's also to you - if you're wondering whether early investing is for you.
Dear John,
First off, thanks for sharing with me your concerns.
I was sorry to hear of the beating you took in the currency markets. And I appreciate that you want to be extra careful this year.
So, you want to know if startup investing is for you.
Fair enough. It's a question I get all the time.
It's a very different way of investing and not for everybody.
Of course, at the end of the day, it's your choice to make.
But that choice becomes much clearer, in my opinion, if you approach it in a certain way - as a business...
The business of investing in startups.
Playing the Odds
John, you were a successful businessman. So I know you were making cost-benefit calculations all the time.
You constantly played the odds to achieve a single objective - make a profit at the end of the day. Am I right?
Leads and potential customers that didn't pan out? It's just part of doing business. Any businessman understands this and doesn't give it a second thought.
Really, you don't even blink.
So, why should investing be any different? Your aim should be to make thoughtful decisions that will bring you a profit at the end of the day.
Chasing Risk While Seeking Safety
John, I'm going to tell you how I made sure I made a profit every year as CEO of a global trade and finance firm.
You see, we made a big chunk of our money from infrastructure projects outside the U.S. I calculated we needed to close at least one of every five deals to make a profit.
We tried to have about 20 deals in the pipeline at all times. Our goal: to do a minimum of five of these projects every 12 months.
My calculation was completely different for projects that were unusually big. We tried to close one out of every 12 to 15.
So I divided my pipeline into two.
The first was where I put all the normal-sized projects.
The second was made up of supersized projects.
And I prioritized the first pipeline. Got my five deals.
Only then did I go after the much bigger money represented by the second pipeline.
I never put my company in a position where we had to close a deal in the second pipeline to survive the year.
I called projects in my second pipeline my "Bonus Baby" projects, because that's what they were.... |
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And that is exactly how you should think of your startup portfolio.
It certainly should never be used to make up for losses absorbed in your more traditional investment assets.
It should never be used as the difference maker between survival and bankruptcy.
You should approach the construction of your startup portfolio the same way I looked at the odds of my mega-project pipeline.
If you can get just one of your early-stage holdings to the IPO stage, you've most likely done well.
Conservatively speaking, you'd make at least 10 times your money on that single investment, perhaps more.
Moving the Needle
In a roughly five-year period, we targeted about a dozen supersized projects. And we captured one mega-sized project.
Was it worth it?
The opportunity costs were pretty clear. We could have captured two to three more projects per year and made 20% to 30% more.
But that extra handful of projects would NOT have moved the needle, not like what getting one of those mega-projects would have.
Capturing that one mega-project opened up a whole new class of opportunities for us.
It greatly enhanced our reputation and gave us enough extra money to move up and compete for bigger and more sophisticated projects.
It was a very big deal...
Much in the same way that the early investors in Twitter and Facebook boosted their reputations, and became widely admired and followed.
And the similarities don't end there...
One big early-investment winner could benefit you in ways that your other lower-reward and lower-risk investments simply cannot match.
For instance, startups could start chasing you instead of the other way around (especially if you're an active investor).
You'd be getting a higher quality of deal flow to choose from.
And, of course, the extra money doesn't hurt, either.
The Ideal Complementary Portfolio
So, John, I'd advise you to keep on investing the way you always have if you're happy with the returns you've been making over the years.
But with one small difference.
Dedicate about 2% to 5% of your portfolio to startup companies.
It could turn out to be the best move you've ever made.
As a business proposition, it makes eminent sense.
As an investor, you should feel exactly the same way.
Of course, there are risk and opportunity costs involved. But I believe the upside is needle-moving and too important to ignore. And there are ways to minimize the risk.
Next week, I'll discuss the ideal startup portfolio size. It's one of the most effective ways to handle risk.
Good investing,
Andy Gordon
Founder, Early Investing    
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