Beating The Dragons

Contrary to conventional wisdom, Syndicate Room’s latest study reveals that investing at random in at least 30 start-ups could help you beat the returns of not only the infamous TV Dragons, but also most professional venture capitalists.

The study tracked every UK start-up that raised seed or venture equity finance in 2011, for which reliable data was available: that’s 506 in total. This includes now-household names like TransferWise, The Culture Trip, and Nutmeg.

Using the same dataset, we looked at the venture capitalists and Dragons that invested in this cohort to determine their 2011 start-up portfolios. Comparing the performance of these portfolios with that of the cohort as a whole, we discovered that radical diversification can help you outperform venture capitalists for one very important reason: by picking and choosing just a few businesses to back, these big investors are very likely to exclude the companies that go on to perform best.

So, if a large and broad cohort of start-ups out performs the Dragons and most venture capitalists, this begs the question…

IS IT TIME FOR A START-UP INDEX FUND?

Overall, the cohort of 506 start-ups grew in value at an average rate of 28% per year between 2011 and 2018 (compound annual growth rate, or CAGR). Over the seven years, it saw:

• 83 exits

• 93 deaths

• 86 companies enter venture stage

• 74 companies enter growth stage

• 170 companies become zombies

Had you invested £10,000 in the full cohort back in 2011, by the start of this year your portfolio would have been worth £72,800. Given that the majority of the 2011 raises will have been eligible for EIS tax relief, the gain for qualifying investors would have been even greater.

By comparison, publicly reported investments made by the Dragons in 2011 and 2012 grew at an average rate of 16% up to 2019. Our data also followed the 2011 portfolios of 479 venture capitalists, which together grew at 19% CAGR.

Indeed, based on investments made in 2011, only 38% of UK venture capitalists were able to outperform the start-up cohort as a whole. This means that most venture capitalists would be better off picking their investments at random, rather than trying to pick the ones they think will succeed.

RADICAL DIVERSIFICATION

After carrying out repeat simulations of various investment strategies (100,000 simulations per strategy), we found that one of the most successful was to spread your risk among as many companies as possible. We dubbed the strategy ‘radical diversification’.

We simulated investing into companies that raised between £500,000 and £5 million in 2011 to create portfolios of varying sizes. The simulations assumed that a fixed amount was invested into a single round of each company, with no follow-on investments being made.

On average, a portfolio of 30 investments returned 3.7x of the initial investment in total over a seven-year period; when diversifying even more dramatically into 80 companies, this figure returned 4.7x.

Radical diversification continues to hold true when applied to smaller start-up rounds (£150,000–£2 million), though the rate of return slows once the portfolio reaches around 30 investments (2.3x return; here a portfolio of 80 investments averages 2.5x return).

This strategy allows investors a much higher chance of backing massive success stories like Funding Circle, which more than pay for any failures in the portfolio (according to Companies House, Funding Circle’s 2011 investors saw a staggering 231x return on investment from its 2018 IPO).

ARE YOUR BIASES DAMAGING YOUR PORTFOLIO?

But it isn’t only the size of your portfolio that impacts on potential returns – it’s diversification.

If your investment strategy employs biases that lead to certain opportunities being excluded from your portfolio, for example based on geography or sector, you may be shooting yourself – and your returns – in the foot.

DIVERSIFYING WELL

The numbers seem pretty conclusive – diversify into more start-ups and achieve a higher likelihood of returns. The problem? Many rounds will have a minimum amount you must invest, so unless you have a significant amount of wealth at your disposal, the number of businesses you can feasibly back is limited.

And that’s before you remember that many businesses will approach angel groups and venture capitalists first, meaning they’re the ones who get first dibs – and the lion’s share – of the equity.

With that in mind, here are two things you can do to bolster your odds of building a strong start-up portfolio.

1. GAIN ACCESS TO ANGEL NETWORKS

We used the 2011 portfolios of 479 venture capitalists to work out their average compound annual growth rate (CAGR): 19%. While this figure falls short of the 28% CAGR demonstrated by the full cohort, it is worth noting that the spread of venture capitalists performance is very wide. These venture capitalists had the best-performing 2011 portfolios:

1. Oxford Early Investments: 90% CAGR

2. Cambridge Capital Group: 83% CAGR

3. Nexus Investments: 81% CAGR

4. White Rose Technology Seedcorn Fund: 78% CAGR

5. Fusion IP: 70% CAGR

What’s more, the combined 2011 portfolios of business angels came to an average 35% CAGR. To combat your own network bias, which is also likely to discriminate by geography and sector, get access to the networks of these venture capitalists and angels, and diversify.

2. INVEST IN 30-PLUS START-UPS

As described above, the data suggests that for £150,000–£2 million rounds, a spread of 30 investments will give you the biggest jump in returns. For bigger rounds (£500,000–£5 million), the upward trend maintains velocity past 30 companies, so the more businesses you invest in, the greater your likelihood of higher returns.

Both of the above points support SyndicateRoom’s ‘investor-led’ investment strategy and, to a greater degree, that of Fund Twenty8, which seeks to back no fewer than 28 businesses per fund (the last two funds achieved portfolios of 32 companies).

THE THREE GOLDEN RULES

While the 2011 cohort has performed better than the oft-cited statistic that nine out of ten start-ups fail by year five, you must remember that the nature of earlystage companies makes this asset class super highrisk. Diversification isn’t a new antidote, but it is one hitherto untested in this space – particularly to the degree suggested in this study.

TO ACHIEVE RADICAL DIVERSIFICATION, START WITH THREE OBJECTIVES:

• Invest in 30-plus start-ups

• Avoid adverse selection of any sort

• Combat network bias by getting into top venturecapitalists networks