Stars, dogs & zombies: three fates of start ups
There is a common myth that ‘all start ups are good’, followed closely by the implication that “all” or “most” start ups succeed.
In my experience, founders universally assume that their start up will be a blazing success. Accordingly, if you fail to see the light and invest in the founder’s company the founder deduces that you, the angel investor, must be both stupid and rude. The truth is, I probably am both rude and stupid, but the fact that I did not invest in your start up is not evidence of these traits.
From an investor perspective, start ups evolve into one of three types of companies:
- Zombies (Land of the Living Dead companies)
Numerically, there are very few stars, lots of dogs, and the vast majority of all start ups evolve into zombies.
The vast majority of companies are not great companies, but even a company that is great for its employees and customers and still be a terrible investment. Only a company that makes its investors more money than they could have made elsewhere, adjusted for risk and lack of liquidity, is an investment star.
Only a very rare set of start ups generate positive investment returns for their initial investors, and only a subset of this rare breed generate good returns when you consider the compound annual rate of return from investment to exit (which is what you must consider as an investor).
Making double your money may sound great, but if it took 10 years, that is only a 7% compound annual rate of return for enormous risk and not nearly enough to justify the risk assumed by most angels. Making a 20% compound annual rate of return requires 6x in a decade, 36x in 20 years – and hence high investor returns are strongly correlated with rapid exits. If the time from genesis to exit is long, almost by definition the investment returns will be mediocre at best.
Investors need to realize the very low odds of a start up being an investment “star”, and act accordingly.
Founders need to realize that what they have to offer may not be the wonder investment they think it is. Put another way, I believe that many founders would benefit from understanding that they may be starting a great company, but it is very unlikely that they are starting a great investment opportunity. If they did, they would spend less energy cashing capital and more energy chasing customers.
Interesting, as an investor is there anything we can do to get our money out of the Zombies?
Sean – Many thanks for the comment. Yes, I think that there are things that investors can do before they invest to improve their odds, and then they have to actively assert themselves later. A rant coming on this very topic – “Identifying and Exiting Zombies” is my tentative subject.
Good, simple, concise, valuable rant. Are you going on to discuss how to tilt the odds in favour of stars?
Duncan – thanks for the feedback.
Yes, there are things we can do to a) make some companies more successful, and b) make some investments more successful. Stay tuned – lots more rants on both issues coming soon.