Angel Investing and the Power Law

The Power Law has become a widely accepted reality in venture, particularly as it applies to a classic venture portfolio.  While it may be an important factor when understanding future or past venture returns, I think it’s a mistake to extend it to all forms of venture, especially angel investing.

At the risk of oversimplifying, the Power Law states that venture returns are highly skewed towards a small number of big winners and that one or a small number of these winners drives the eventual returns of a venture portfolio.  A more erudite explanation is here.  I was recently reading an article that implied that, by extension, if you didn’t have a good way to find these potential Unicorn deals and participate in them that your angel investing was doomed.

My venture partner David Hehman and I have been investing in angel deals for over 20 years and what we have seen is different.  Our biggest wins have been deals that were not “Unicorns” where we invested a small amount of money that then multiplied by 1,000 and “made the portfolio.”  Rather, our success has come from backing excellent entrepreneurs very early, receiving a relatively large amount of equity, working hard for the company, and sticking with the investment for a long time.   There are several reasons why our style allows us to avoid relying on the Power Law.

First, by working hard to avoid failure, we have a higher success ratio (fewer zeros) than the average venture portfolio.  Part of this is that we often accept lower risk, knowing that it means in some cases a lower potential reward.  Also, when a company isn’t working out we help the entrepreneur on a soft-landing strategy, which I describe in detail in my book, “The Start-Up J Curve.”  These soft landings reduce the impact on the entrepreneurs and our investment.

Second, we hold investments much longer than most would, thereby enlisting the magic of long term compounding.  Having an imperative to sell an investment that is otherwise doing well, I believe, really reduces returns and especially wealth creation.  My rule here: “You can’t get rich selling!’”

Third, we are open to what we refer to as “cash flow” deals.  These deals are not and will likely never be venture candidates, nor are they ever likely to IPO, but that doesn’t mean they aren’t wonderful businesses.  Eventually if they succeed, they generate cash flow and distribute out to investors.  Because we organize these companies as Sub-S corps or LLCs, they don’t pay taxes at the corporate level.  This is incredibly efficient and in some cases the yearly distribution exceeds our original investment.  I would argue that most of Warren Buffet’s investments are actually just a form of “cash flow deals.”  His businesses send cash home to Omaha where it piles up until he and Munger figure out what to do with it.  This is one of the reasons a recent article is titled “Warren Buffett has a $73B problem: cash is piling up faster than he can invest it.”  His cash pile is not because he just ka-ching’ed a Unicorn in an IPO, because actually he almost never sells his investments.  Currently, his combined 90 businesses generate $1.5 billion of cash per month!  One of the big advantages of cash flow is that they provide cash flow to invest in new deals.  They also are a good reminder that you own a real business that can generate a profit.  Because we are open to these types of deals, we are able to consider a much, much wider range of businesses than if we were wedded to pursuing a Power Law oriented strategy.

A significant problem with Power Law strategy is that it encourages some bad behavior on the part of the investors and management, such as overinvesting and a “go big or go home” mentality.  Quite often, start-ups who are beholden to this strategy break the golden rule of “Nail it before you Scale it.”  By prematurely scaling, they can often end up slamming into a wall because their product or business model is not fully baked.  Quite often, patience is required with start-ups.

David and I do occasionally invest in companies that are clearly going to be running the Power Law strategy playbook and we are fine with that.  We have a number in our portfolio that are doing very well indeed and we look forward to one day helping them ring the bell at the NASDAQ on IPO day.  But my point here is that it is not the “only” way to invest in start-ups.  As Warren Buffet once said, “There is more than one way to get to investment heaven!”

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