Why Venture Capitalists Should Invest Like Poker Players

No matter your level of experience, early-stage investments are considered high-risk & a gamble. Why not treat it like one?

The private equity model is well established. You analyze hundreds of companies and opportunities in detail and buy a minority or majority stake in a good company to manage it over a few years with the goal of achieving a profitable exit. Rarely do PE funds deal with write-offs, and PE-owned companies in distress are known to do better than their publicly listed peers.

The venture capital (VC) model follows the same approach. Partners in venture funds review over 100 different opportunities to pick one winner and build, over a five-year investment period, a portfolio of 15–20 start-ups. They screen against multiple criteria, yet the industry-wide outcome shows a pretty weak track record. Statistically, according to Correlation Ventures, over 60% of all companies invested in by VCs will return less than the invested capital. We asked: Can this model be improved?

How have VCs done?

The Correlation Ventures data on VC returns shown on the graph above is quite discouraging. If two-thirds of companies are largely written off, you need the remaining third to average at least a 6x return. For this you need several 10x deals, which VCs on the whole pick only 1 in 25 times, or one 50x deal, which VCs pick only 1 in 250 times. The reliance on rarely picked mega-winners makes the asset class very risky; the large fraction of losers picked depresses total returns.

The Kauffman Foundation, one of the active venture investors since the 1970s, supports the above data with actual investment results from their portfolio: Under one-tenth of their VC funds returned 3x or 13% annually after fees, while over 40% of their funds showed negative returns. The median return in Kauffman’s portfolio was 1.3x or 3% annually.

This makes the whole asset class questionable from a risk return perspective. Unsurprisingly, many institutional investors refuse to invest in venture capital at all. Many attempt to reduce risk by restricting themselves to funds or managers with demonstrated past success.

False positives and false negatives

Besides the false positive problem of two-thirds of its portfolio companies failing, VC also has a false negative problem. It is easy to miss the big winners that can make early-stage investing worthwhile.

Bessemer Ventures, one of the world’s oldest and well-known top-quartile VC firms, openly shared their anti-portfolio, i.e. companies they had the opportunity to invest in, but passed on. It includes Google, Facebook, Paypal and eBay, and other top companies that were turned down by their partners — and at the time for solid reasons. For instance, they felt that Friendster’s position meant Facebook had no chance.

Is the takeaway that VCs — despite having smart teams — merely roll the dice? Is it that the future is inherently unclear at such an early stage in a company’s existence?

Indeed, data clearly shows that venture capital is fundamentally different from private equity. VCs invest at an earlier stage, when little is known about a company.

So why treat it like a private equity business when the information available at the point of investment does not allow for a traditional due-diligence process? Why not just accept that we do not have all the information needed to pick winners?

What if the future is unpredictable?

A number of industry players, especially in the very early-stage angel capital space, follow a quite different approach. They pick perhaps one in ten of the companies that come to them for funding, and deploy a small amount of money into each, often leading to a portfolio exposure to 250 start-ups or more. Ron Conway and 500 Startups are two well-known practitioners of this method.

This approach is often derided as ‘spray and pray’. And yet there is logic in it. The strategy does a better job of avoiding the false negative problem. If one of 250 companies is a Google or Facebook, your portfolio will do just fine in aggregate. And given the fact that the chances of finding that 50x mega-winner are 0.4% for VCs as a whole, 250 companies looks like a good starting point for a venture portfolio.

What does this approach do to your returns, though? If a Ron Conway or a 500 Startups is as good at predicting winners as the VC industry as a whole, we can assume that the returns will be about 1.3x in aggregate, or 1.6x before fees. Investors can then expect that few funds will return less than the starting capital. But returns  barring finding a Google   will likely turn out to be consistently unexciting.

Texas hold’em as an investment strategy

A weakness of the ‘spray and pray’ approach is the ‘pray’ element. You scatter money and hope things will work out, with limited follow-on investments in the successful ones.

What if the ‘spray’ part (i.e. investment process) was not treated like an investment strategy, but instead like a Texas hold’em poker game? In poker, you invest a tiny amount in ‘table stakes’ to see what sort of a hand you will be dealt. If it looks good, you then bet more to see the next card. In each subsequent round, you decide whether to give up and fold, or bet more –sometimes up to 50 or 100x your initial table stake as the game progresses.

In other words, what if you treated the ‘spraying’ like a data-gathering opportunity? While this is time-consuming work and not suitable for casual angel investors, it is possible to use early-stage investments to gain inside intelligence on a company’s prospects, the founder team’s skills and the company’s development over time. This gives you an information advantage when making follow-on investments and maybe (just maybe) even helps in predicting the future.

VCs still can’t predict the future perfectly. But they will know whether they are better or worse off — i.e. whether the company is trending upwards, has stalled or is in a downward spiral.

In fact, poker aficionados will agree that the last situation will be the most obvious. A poker player can often see after just a few cards that his hand has very little hope, whereas a winning hand may show only potential, until more cards are drawn.

Cutting your losses

The secret to winning consistently in poker is to cut your losses on your bad hands early, and to keep re-investing in those that still have the potential to win, based on the additional information gathered. So why not use the same approach in early-stage VC investing?

The 7 Step ‘Poker Capitalist’ Strategy

• Put small ‘table stakes’ into 100s of start-ups
• Rigorously gather data and analyze ‘your hand’
• ‘Fold’ and don’t re-invest in the obvious losers
• ‘Buy more cards’ and invest more into the rest
• Watch their progress, and re-evaluate
• Bet big on winners, fold on losers
• Hand your winnings to your LPs