Investors are Aiming for the Big Win, Not the Mean or Average
True story: many long years ago I had founders’ stock in a video game company. At one point they were just a few weeks from going public, but that’s not the point of this story. It was about a “hit” business, meaning a business in which you had to have a lot of products in play to get one of the big hits that paid for the rest of the disappointments. Video games in the early 1980s were such a business.
Books became a hit business in the 1990s when the retail chains took over from smaller stores. I followed that business as an author looking at royalties. The average book sale dwindled. The publishers that survived did so on by riding a big hit that paid for all the rest.
I tell those stories because angel investment is a hit business too. Statistics notwithstanding (my apologies to Rob Wiltbank, the world expert on angel investment statistics), it’s a business in which the rare big hit pays for all the failures. I was making that point in a post on my blog called Size Matters when I wrote:
Private investors generally want very high returns. They need to believe that every $30K put into your business will pay them back $1 million or so in 3 years and $3 million or so in 5-10 years. They know that only 1 of every 10 investments (or so) will be successful, so they need to believe each one has a chance to return 100 times or more the initial investment.
Where do those numbers come from? I was fleshing out the story. There’s nothing scientific there.
I like the comment added by Anthony Testi, who questioned my story. He said what I was suggesting was too high:
Say an investor invests $30K into 10 companies, for a total of $300K. Now ( I am about to use some nice round numbers ) because of the risks, significant returns are needed say ~24% or using the rule of 72 the money doubled every 3 years. Since CD rates ( They say CDs are risk free, but what is risk free? ) are now in the low (low ) single digits interest rates, a 24% return is a great, or what I would call a “very high return.” But that takes the $300K to $600K in 3 years, not ~$1,000K. To reach $1,000K an expected returns of ~72% per year is needed, e.g. $1,200K in 3 years. 24% is very high, but 72% seems to me off the scale high.
Yes, but then factor in the uncertainty. The actual return isn’t what we hope, and much less what the founders promise. Instead, it’s what the real world gives us, after the fact. And we invest up front, not after the fact. All of which, plus Anthony’s thoughtful comment, reminded me about the idea of the hits in angel investment paying for all the failures. We don’t aim for an average investment or a suitable return. We aim for the big win. Anthony’s right that doubling our money would be sufficient, if we knew that would happen. But the average investment never happens. So we aim high.
Written by Tim Berry
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