What if we could go back in time, and I gave you an opportunity to make an early stage investment in the Harris & Harris Group portfolio company BioVex, right as it was being founded? BioVex developed a new potential treatment for cancer and was purchased by Amgen in 2011 for up to $1 billion. It would seem like a sure-fire way to make a fortune.
What if I told you that there were seven rounds of financing for BioVex and that investors in every round except the last two lost money on their investment? Only the last two rounds paid off, and they paid off very well.
In early stage investing, even if you have a company that ends up being wildly successful, you can still lose as an investor. You’re doing very well in early stage investing if you make money on a third of your investments.
So, with these dangers, what makes early stage investing so attractive? In a word: asymmetry. While the most you can lose is the amount of your investment, there is much less of a limit to how high that investment can go.
The returns on early stage venture capital are not on what is called a normal distribution curve or a “bell curve” – where the most of the results cluster around some sort of middle area and the rest taper off on both sides, like a bell. The distribution of the height of human men is a good example of a bell curve. I can pretty safely predict that a male will grow to somewhere between five feet and seven feet tall as an adult in a predictable distribution.
Venture capital doesn’t work like that. It is in a tail distribution. Most of the results in early stage venture capital cluster around zero – no return (or in fact, a total loss). A very few investments have very, very outsized returns. But the asymmetry of the returns can work in investors’ favor. I can never lose more than 1X in an investment, but my return could be 10X, or even 100X.
According to written reports, Accel Partners invested $12.2 million and owned 10 percent in Facebook. At the IPO price of $38, its 10 percent ownership was worth approximately $10 billion. That’s an outsized return by any measure. Harris & Harris Group (H&H) had a similar experience in the 1990s, investing approximately $1,200,000 and having that return over 25 times the investment. Not only is this asymmetry true across companies, but it is true across different raises of capital for a single company.
As in the story of BioVex, there are usually one or two rounds of financing that yield an outsized return compared to the other rounds. It is just difficult to predict which round it will be. In the case of one of our portfolio companies, Solazyme, the first $310,000 we invested was worth $20 million at Solazyme’s IPO price of $18. That’s an incredible potential return. For BioVex, it was the reverse. The last investors in BioVex made approximately 10X their money in about a year, but the first investors, particularly those that did not invest in subsequent rounds of financing, lost most of their invested capital. We’ve had deals where early rounds of capital lost us money but where the final rounds made us back all of our money and more. We have also had deals where we made money only because of the first rounds of investment. Early stage investing is very, very asymmetric.
H&H manages our investments very carefully to account for this asymmetry and unpredictability.
For one, we don’t invest all of our dollars into a company on day one. There is a saying that “lemons ripen before the plums” – that is, you will know if a company is going to fail sooner than if it is going to be a success. So, we invest in a company in stages, watching for early signs of potential success or failure, making a fresh decision on whether to invest more money at each stage of the company’s growth.
If we do decide to continue investing in a company, we make sure that we understand how each round could be the asymmetric round and earmark capital appropriately. We also make sure we have enough capital to invest in future rounds so that we don’t miss the round that is asymmetric. The only way to be sure we benefit if there is a big return is to make sure we participate in that asymmetric round. Knowing that it could be the first round or last round or somewhere in the middle, we make sure we are there for the entire life cycle of a successful company.
We often also invest in multiple companies participating in a similar space. Like everything else, you want to have as diverse a portfolio as possible to spread your risk and broaden your opportunities.
You can also change the odds by working with a great management team, or by being in on an emerging technology that is on the brink of catching on with Wall Street. We make extensive use of those strategies in our investing – but let’s save a more in-depth discussion of those for another day.