Investing in early stage companies can be a beautiful and an ugly venture all at once. As an investor, it is easy to fall in love with the companies in your portfolio, but the truth is, sometimes they die. There is no way around the inevitability of this exit. As Heidi Roizen from leading venture capital firm Draper Fisher Jurvetson (DFJ) notes, we just hope they can ‘exit with honor’, but sometimes that isn’t possible either. Many die. We must walk away trying to take every lesson possible to apply to other ventures and hope that all involved can move on.
Being part of such a rapidly emerging industry, many companies come across our field of vision, with a wide swath of skills and shortcomings (sometimes all in the same company). Saying ‘no’ is not quantifiable in our performance, but there have been many times that declining an opportunity is one of the best investments for the portfolio.
By and large, we've found the single most important consideration is not the quality of the idea the company is built around, but the quality of the people who are manifesting the vision. This strategy is proven time and time again and is very apparent at this stage of the investable cannabis industry, as companies move from concept, to company and beyond. People are the beating heart and lungs of a company. If they fail to adapt and grow alongside their entity, the health and future of the company is in jeopardy. If the investors and the founders are not aligned in their objectives, this also becomes problematic. It is hard to anticipate how objectives can shift, but it is key to have strong and clear communication along the way to help keep the focus aligned and shifting together.
We want all companies to succeed; we want great things for the founders, their employees and for the industry. We can often take that feeling of wanting to fight to the bitter end for a company.
As Dylan Thomas wrote:
Startup failure rate statistics are unsettling with up to 44% of companies failing by year three, that number skewing to an even higher rate for tech companies (75%). With these high statistical failure rates and knowing every early stage company will struggle for a variety of reasons, why jump in?
The easy answer: because it's worth it. There is no other type of investing that will show this type of potential growth. Through being an active investor, providing a great deal of service and support to our founders, we constantly aim to de-risk these investments. Other well-known VCs attempt to provide support like this in the form of incubators / accelerators. The aforementioned Tim Draper has a show to help educate founders on ABC Family, called Startup U.
Know When to Walk Away
To fight is honorable, but an investor has to know when the fight is not worth the effort and when it can impact other investments. When a startup becomes a sinkhole, it is key not to allow it to absorb all available energy, attention and mind space. Sometimes, the best move is for investors to simply walk away, and therein lies the beauty of diversification.
Here are some key points why diversification as a strategy wins:
- Investing is an intuition game, but it is also a numbers game.
- Statistics! Investing in more companies = increased opportunity to find successful exits.
- When one company fails, it’s impact to the portfolio can be mitigated by having other holdings of various stages and capital structures.
- In cannabis especially, entire facets of the industry are subject to change, which means some companies may disappear altogether or become less profitable:
- Edible regulations have shifted at least one time significantly in Colorado alone, requiring different THC levels and labeling guidelines. They are probably going to shift again.
- Cannabis Delivery hangs in the balance while we wait to see what is going to happen in California.
- Medical / adult use laws are changing state by state and regulations for each can be streamlined, as they are in Colorado, or problematic, as they had been in Washington for some time.
- Corporate competition is looming, so understanding where companies true value is and who is poised to handle this is critical. Some may not survive the infiltration of large entities, while others may see lucrative buyouts.
- When one company starts to go down, an ‘honorable exit’ might be an acquisition by another portfolio company. This potential outcome is something we keep in mind as active fund managers.
- With a diverse portfolio, the basket is full of opportunity for shared resources and improved access for each company. When facing difficulty, founders have opportunity to leverage that basket of resources and can seek different outcomes. It may not prevent a company from failing, but it might offer that solution to help them transition, pivot or actually hang on.
Diverse portfolios mean more than including several different companies. We like applying this strategy of diversification from all angles:
- It can include diversity in stage of company, which helps to de-risk the overall portfolio. Later stage companies seeking investment capital are a great way to add value to a fund, with lower risk.
- Diversifying across the capital spectrum can be beneficial, as well. This means including investments as short term or convertible debt, preferred equity, straight (or common) equity, etc. Including this range of tools in the basket can add nice variation in the level of risk and exposure that the portfolio holds.
Investing is never easy. Investing in early stage companies is even more challenging. It calls on a lot of patience, reflection and foresight. Early stage investing also requires awareness that companies may not survive. Investors may hope for the best, but sometimes fixating on that loss can be more hurtful for other holdings. As fund managers, we take comfort in our range of holdings and believe in the strategy of diversification. As Jack Handey from SNL once wisely said, “If you ever drop your keys into a river of molten lava, let 'em go, because man, they're gone.”