Why do American investors like taking risks and pay a huge amount to a startup that eventually might fail?

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JASON LEMKIN

No investor wants to lose money.

But, first any serious startup investor comes up with a loss ratio.

For a true angel investor, the loss ratio could be as high as 80% — i.e., 80% of the investments fail.

For a seed investor, it might be as high as 50%. 40% by number — but less by dollars, see the next point — is pretty common.

For me, I’m quirky, but it’s 20%. I am OK if 20% of my investments fail. But I prefer to invest “late seed” where the odds of failure in SaaS are lower. Not low, but lower.

Second, especially if you have a fund, you can modulate the size of your losses.

For most funds, losing 1% of the fund or less on an investment is OK. Not great, but OK. If the fund does 3x overall, e.g. turns $100m into $300m … then losing 1%, i.e., $1m, on any given investment is OK. It’s a cost of taking risk. You won’t even really notice that $1m loss on the $300m in gain.

As the loss approaches 5% of the fund, though, everyone gets really nervous.

As as an investment approaches 10% of the fund, it sort of has to work. The VC partner loses her job if it doesn’t, usually. Unless she also has a great IPO/unicorn/acquisition in that fund.

In fact, many funds have concentration limits of 10%-15%-20% in their documentation.

This is why VCs get nervous when you ask them for a second and especially a third check, if you aren’t doing really well. Their job starts to be on the line.

Also this is why you should be careful before taking an investment from someone where their investment represents too much of their net worth. They will try to manage you as if their job is at risk. You don’t want that.

Third, the model is based on the size of the exits (the price at IPO or sale). The U.S., and now China and India, has historically had the biggest exits from tech. Traditionally, European and U.S. non-Silicon Valley venture was modeled around smaller exits. In fact, many “smaller market” VC firms are modeled around $50m exits. Most Big Silicon Valley Venture Firms are now modeled on $1b-$10b exits. That’s a huge difference. The bigger your exits, the more small losses are irrelevant.

(chart from The CrunchBase Unicorn Leaderboard | TechCrunch)

In a $100m-$250m venture fund, you basically need a unicorn ($1b+ exit) + some other good exits to do OK.

So if you’ve never had an exit > $400m-$500m or so, the U.S. venture model will seem crazy and broken and way, way too risky. Way too risky. But if you’ve had a few unicorns, a few great IPOs and/or big acquisitions … you get the pattern. Power laws start to work, and upside is almost boundless, while downside is limited to the amount you’ve put in.

More here from a founder’s perspective: https://www.saastr.com/dont-worr…

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Published on July 6, 2017
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