An Engineer’s Introduction to Private Investing
As a recently graduated mechanical engineer, with limited background in private investments, working at Clockwork for the past few months has been an enlightening experience. Reflecting on my introduction to the venture capital world, I’ve decided to share a few key concepts I have learned so far.
1. Private investing exists!
Of course, I knew you could invest in public companies. You register with a broker and can choose from a ton of different stocks and positions to buy and sell. All the information is public and if you have the patience, you can do your own research.
The private market is quite different. Every startup will sell itself as “the next big thing”, but these pitches may create an overly positive impression of the company’s progress and potential. Due diligence depends entirely on you as the investor, and your ability to communicate with the founders. In some cases, you might just stop receiving information after a while, so it's always important to be careful about forming these relationships.
2. Things can get out of hand quickly
In contrast to your brokerage account, when you invest in private companies your investment performance is not updated in real-time. If you are lucky, and the founders are transparent with their reporting, you may receive some form of updates every month or quarter. The information you get about your portfolio companies will likely be limited to investor letters and a few financial statements in your inbox. All of these are likely to be shared in different formats, at different frequencies, and with different data. It is the investor’s job to process that information to keep track of the company progress and investment performance. You can see why this can get out of hand surprisingly fast as you start investing in more founders, especially if you have other businesses to attend to (aka a full time job).
3. Many companies will go bankrupt
I was very surprised when I learned how common it is that companies fail to ever really take off. It makes sense that not every startup ends up becoming the next Facebook or Uber. But in some, and probably too many cases, you just might never see your money again.
4. It's hard to get your investment back
Even if the company does not go bankrupt in the first year or two, getting your money back is not as easy as selling your stocks through your brokerage account and asking for a wire back to your bank account. When you invest in a private company there are only a few ways to get your investment back. 1) A secondary sale in which you sell your part of the company to another buyer (if you’re allowed); 2) An IPO in which the company makes it to the public markets and you can choose to sell your shares (hopefully at a higher price than you bought them); 3) Through a merger or an acquisition with another company (in which you may receive cash and/or stocks from the other company) or; 4) If the company pays out dividends (which could also be a bad thing for further growth). Simply put, in any case, you are in for the ride, and it’s usually a long and windy road.
5. Returns (can) make it all worth it.
Annual returns on the oft-quoted public market reference, the S&P 500, for the last ten years are around 13.6%. In venture capital, your success depends on how many deals you make and how many of them maintain or grow their value over time. When investing in early stage companies, one might expect that one third of the companies in the portfolio will lose all of their value, one third of the companies would roughly maintain their value, and the majority of the returns would be derived from the remaining one third. In some cases the concentration of returns can be even more extreme, in which 1 or 2 companies drive the vast majority of the portfolio gains. In any case, if you end up with a 3x gross return (or even 2x) across the portfolio over, say, 10 years, you are beating the S&P 500, and perhaps that does something to make up for all of the risk and uncertainty involved.