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Should Early Stage Tech Be In Your Portfolio?

Does early stage technology investing belong in your personal portfolio? Is it too risky? Should you stick with more predictable asset classes? How could you possibly replicate the results of more experienced investors who have more early stage experience and greater deal flow? These are the questions that need answering before investing in alternative assets, including early stage technology deals.

I’ve long been interested in why investors who are not involved in the startup scene on a daily basis don’t invest a small portion of their portfolio in early stage companies.  I got more interested in this question after reading two posts/series in recent months by David Rose (@davidsrose) and Brandon Gadoci (@bgadoci). These posts addressed key questions about investing in early stage technology deals. More on that later.

Your personal psychology is the place you should start in answering these questions. Early stage tech investing is not for the faint of heart; you will see investments go to zero. Some investors are simply not ready for this reality. If that describes you, then early stage tech is not for you.

Conversely, one or more investments going to zero does not define the return of a portfolio of early stage tech investments. In fact, a significant portion of the investments in any early stage portfolio will likely post a goose egg.  If you can tolerate that type of uncertainty by keeping focus on the overall portfolio value, then this asset class is an option to consider.

It also helps if you have a working knowledge of the technology marketplace and how innovative companies change and serve markets. This could be obtained from working in the space or from exposure gained in some other way.

If you conclude that you have the risk tolerance profile to consider this asset class, there are several questions you’ll need to answer:

• What portion of your portfolio should you allocate to this asset class?
• How large a portfolio should you have to consider allocating to this asset class?
• How do I maximize my chances of getting professional investor-sized returns in this asset class?
• What are my chances of investing in a company with a life changing exit? Is there anything I can do to increase my chances of such an exit?
• What strategies exist to help me reach these objectives?
• Given the ways the above questions have been answered, how can I get into this asset class?

Dead Equity is a Killer, Really

Ever heard of “dead equity”? That’s the equity that is held by founders or others who are no longer participating in the business on a daily basis. This doesn’t really matter so much until you try to get outside investors interested in putting money into the company. Then it moves from “non-issue” to serious impediment to progress.

If you are considering investment, an event that puts a value on the company either has occurred or is about to occur. This changes the psychology of the non-participating shareholders. What was once a shareholding with an indeterminate or seemingly negligible value now has a numerical value attached to the shares that a non-participating founders own.

I can understand the position of the founders who aren’t in the business anymore:

“I was there when the idea was created”.

“I put a lot of hard work into the company”.

“It wouldn’t have gotten off the ground without me”.

There’s of truth in all of those. That doesn’t mean that these arguments will carry the day.

• The average successful company takes a long time to reach its goals. It usually has to raise money several times in the process. Getting your first investment with material amounts of equity in the hands of non-participating founders increases the probability that the remaining founders will be diluted down to levels that don’t provide enough incentive for them to remain committed to the start-up.
• The original founding group, those that departed and those that have remained, have their original equity stakes. Those that have departed the business will not be there to do the bulk of the hard work necessary to create a successful company. This creates incentive distortions that are a concern for anyone thinking of investing. Why should those who are no longer there have the same holdings as those who have moved on to other endeavors?
• Most importantly, investors will seldom invest if a material amount of shares are in the hands of people who are not participating in the business on a daily basis. They want the rewards to be distributed to those who “make it happen”.

Given the length of the journey to success, the typical company has moved a few percent toward their success goals when investment becomes a possibility. In my experience, this is where the non-participating founders overestimate their contribution to the enterprise. It’s easy to understand the psychology of this; no one wants to part with something that has just become more valuable in their eyes. But this can be an absolute bar to investment in the company.

Most investors are willing for the non-participating founders to have some stake in the company as it goes forward. This stake needs to be in the single digit range in the aggregate. This leaves the departed founders with something to recognize their contribution and leaves the company with sufficient equity to compensate its current and future employees.

The issue can easily be dealt with in advance, when the company is formed. All founders can “re-vest” their shares so that if they leave they may vest a portion of their shares but return a portion to the company so that enough equity remains available for the team members who are continuing with the company. This way, the founders are all protected against unforeseen circumstances affecting their co-founders and there’s no difficult problem that has to be resolved before a financing can occur.