Investing in early stage companies; mental challenges for a public market investor

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I have been involved with stock markets for more than 10 years. Over the years, I learned that a lot of commonly held beliefs can be misleading. For example, one of the first things finance students learn is ‘not to put all eggs in one basket’. Yet, the best asset managers of the world generally prefer to do concentrated investing. The logic in this case is that risk does not have to be minimized by pure diversification (which will tend to reduce return also), but rather by studying the business very well and buying with a margin of safety. Also, why would someone buy the 40th best investment idea when he could concentrate in the top 15 to 20 stocks.

The above is just one example of the type of lessons I learned which served me well in terms of public market investing. The problems appeared when I decided that its time I become an angel investor also. I quickly realized that some of these need to be ‘unlearned’ if I wanted to succeed. Below I am going to list down a few of these.

• Diversification is not just recommended but absolutely mandatory: In early stage investing, there is no way to know in advance which company will succeed and which company will fail. No amount of research can predict where revenues will be 3 years from now. As a result, concentrated investing in early stage companies is a recipe for disaster. Most veteran angel investors recommend that one should build a portfolio of 30 to 40 companies.
• Valuation is not the most important factor: My biggest challenge even today remains getting comfortable with valuation. In public market investing, return performance depends on the ability to buy a stock below its ‘fair value’. Thus valuation is pretty much everything for a value investor. For startups, what matters is betting on the right companies. If you have invested in a company growing revenues 15% per week, it does not matter whether you invested at a valuation of BDT20mn or BDT30mn.
• Qualitative factors over quantitative: While qualitative factors such as corporate governance plays an important role in public market investing its much more pronounced for startups. For early stage companies, there is often no track record do be able to do any numerical analysis. We really have to judge how good an entrepreneur will be at execution based on his or her personality or communication ability.
• Friendly activism can help improve success rates: As a public market investor, we seldom try to influence the management. Although there are examples of activism in developed world, its still pretty rare in this part of the world. For startups however, the ability to connect the founder with clients, quality talent, suppliers, media etc can all have profound impact on its chances of survival. In fact, the founders will probably select investors on their ability to make these introductions.

These are some of the most obvious differences I have found between stock market investing and startup investing. There are probably more which only time will teach me as I continue on this journey.