Morgan Housel has an interesting post comparing investing in startups with investing in established publicly traded large-cap companies. To summarize his points:
Both types of investing rely on a small percentage of positive outliers that will account for most of the profits. VC investing is considered riskier because of the velocity of the wealth creation and destruction involved. A VC fund can lose everything or make a 10X return on capital in a few years:
A VC portfolio can go from a standing start to a point where two-thirds of your companies have whiffed and one or two knock it out of the park in three or four years.
In public equities that same distribution can take 10 or 20 years to play out.
That’s the risk difference between the two asset classes. It’s not how the individual companies perform. It’s the amount of time it takes for those companies to log their performance. VC is just like investing in public equities, but at 5x speed.
If VC generates higher returns than large-cap public equities, it’s not because investors have to endure more risk. They just have to endure about the same amount of risk crammed into a much shorter period. Which is hard. There’s a cost to it. You pay for it, not with money but with worry and doubt.
I want to make three points that add to his analysis:
- It is not that private startups grow wealth a lot faster than publicly traded large caps. The first are apples, the second are oranges. It’s a lot harder to achieve a 100% annual sales growth when you are already a 100-billion dollar company. Startups are by definition smaller companies and can grow a lot faster. Yes, some startups go up 100X in a few years and publicly traded companies might need 20 years to achieve similar returns, but the former enrich only a small number of people and the latter provide that opportunity to millions of investors.
2. Investing in startups does not necessarily involve more volatility and stress for any of the sides involved. VCs don’t need to report quarterly earnings. They have the luxury of a long-term capital. Yes, they send the occasional annual letters to their general partners, but no one expects from them wonders in a short period of time. Their investors know they might need to wait seven to ten years before they see a substantial return or any money back.
Compare VC partners’ situation to publicly-traded large caps. The latter give detailed reports on a quarterly basis and are covered by hundreds of analysts on a daily basis. Meeting Wall Street’s short-term expectations is a priority for most. Public companies’ investors have the luxury of liquidity, which is a double-edged sword if you don’t know what you are doing.
3. Timing matters a lot, in both private and public investing.
One of the most important questions that angel and VC investors ask startups is “Why now?”. Is the world ready for your product or service? There were hundreds of internet video startups in the late 90s and early 2000s, but most of them failed, because the tech infrastructure was not ready to support them. Youtube was founded in February 2005 and it was bought just a year and a half later by Google for $1.65 billion. It was an all-stock deal, so Youtube’s founders had the opportunity to make even more money. Google went up 250% in the next ten years.
You can achieve angel investing returns in public markets after big corrections. The bigger the correction, the bigger the opportunities afterward. If you look at the best-performing stocks of the past 10 years, you will notice that not a single one of them has delivered a 100X return. Netflix went up 44X, Priceline went up 30X, Amazon went up 20X. Only 29 stocks went up more than 10X between 2007 and 2017. Public markets were close to all-time highs in 2007. If you measure performance since the financial crisis lows in March 2009, you will find hundreds of stocks that went up 20x, 30X, 50X in the next five to eight years. There are some that even went up more than 100x.