Last week, as part of The Angel Initiative, Wayne wrote about the massive profits investors can earn when they get in early.
But here’s the thing:
Historically, the only folks able to capture these profits were big venture funds.
Recently, however, a series of “Big Bang” events changed everything:
Now, not only can investors like you get in early – but you actually have a competitive advantage over the venture funds.
Today, I’ll share some of the research and insights we uncovered about these exciting developments.
Only For the Venture Capitalists
Back in the 90s, the upfront costs to launch a new tech start-up were huge:
UNIX servers, Oracle licenses, load balancers… the list went on and on.
These costs could add up to $2 or $3 million – and that didn’t include a marketing budget to attract customers, or salaries for the team.
With “all-in” costs approaching $5 million, start-ups had few choices for funding:
The only entities able to write checks that big were traditional venture capital firms, like Kleiner Perkins or Sequoia.
The 3 Big Bangs
But then came three “Big Bangs” of innovation:
First, free “open-source” software became available.
By replacing UNIX and Oracle with Linux and MySQL, entrepreneurs were able to slash their upfront costs by about 90%.
Then, Amazon.com started a new business “renting out” its excess computing power.
So instead of buying, setting up, and maintaining expensive hardware, now start-ups could just plug themselves into Amazon’s low-cost “cloud computing” service.
This resulted in another 90% reduction in operating costs.
And finally, companies like Google and Facebook emerged as marketing channels.
Now, even the smallest start-up could cost-effectively reach billions of potential customers.
Sensing an Opportunity
Thanks to these 3 big bangs of innovation, the cost of starting a tech company went from about $5 million in 1995…
To $500,000 in 2005…
To $50,000 or less today.
Sensing an opportunity, a new breed of “seed-stage” venture capital fund emerged.
Instead of writing multi-million dollar checks to a small handful of companies, these funds “seed” many new companies with investments of $50,000 or $100,000.
Sure, some of these companies fail, and others still need millions of dollars from larger funds like Kleiner Perkins once they’re ready to establish a bigger operation…
But some simply get acquired, delivering big profits to their early investors.
As we discovered as part of The Angel Initiative, one of the most successful practitioners of this “seed-fund” strategy is an investor named Dave McClure.
Dave McClure: Seed-Stage Success Story
McClure, who was born and raised in West Virginia, got his start as an internet and e-commerce consultant. But by 2008, he got hooked on angel investing.
In 2013, The Silicon Valley Tech Venture Capital Almanac revealed that McClure was “the most active seed investor in Silicon Valley tech companies.”
And he wasn’t just making investments… he was making money:
- He invested in Mint.com and made 10 times his money when it was acquired
- He invested in SlideShare and made 20 times his money
- He invested in Wildfire and made 40 times his money
And a bunch of his investments like Credit Karma, Twilio and Lyft haven’t even “exited” yet – and they’re already valued at 40 to 50 times what he paid.
What McClure realized is that companies like Google, Facebook and Microsoft like to acquire innovative start-ups – and they often acquire them when they’re still early-stage and relatively inexpensive (i.e., at a price less than $100 million).
Given the low cost of starting a company nowadays, not only can McClure’s small infusions of seed capital make a big impact – but since he’s investing at the company’s earliest stages, he’s able to get in at low valuations.
Getting in at a low valuation means that, even with acquisition prices of less than $100 million, he can still make big profits.
(Next week, Wayne will tell you more about this critically important topic of valuation, and its relationship to profits; you’ll definitely want to read that!)
Venture Capital Funds at a Disadvantage
One of the major insights we gleaned from The Angel Initiative is that venture capital funds aren’t the only game in town anymore for start-up funding.
Given the low cost of launching a tech start-up nowadays, seed-stage investors like Dave McClure have become a major force.
In fact, some might say that, compared to seed-stage investors, big funds are at a disadvantage in this new world:
Traditional venture funds have enormous pools of capital to allocate – Kleiner Perkins, for example, has raised over $2.7 billion in the past 5 years.
To make the “math” work with so much capital, it needs to make big investments. This generally means investing in later-stage deals, where companies might already have valuations of $50 million, $100 million, or even more.
For Kleiner to make money on these investments, it needs its portfolio companies to be acquired or go public for hundreds of millions, or even billions, of dollars.
And the fact is, these “homerun” scenarios happen far less often than a start-up getting acquired for under $100 million.
Seed-Stage Profits Are Now Available to You
McClure continues to prove that there’s big money to be made by allocating small amounts of capital into many, many early-stage companies.
After about a year in business, for example, his latest seed fund had an IRR of 48% – it's too early to calculate what the ultimate returns of the fund will be, but 48% in a year isn't too shabby: that’s about 600% higher than the average annual returns of the stock market.
But McClure’s not alone:
As we learned during our research, top-tier seed funds from First-Round Capital to Founders Collective are following the same playbook.
Their secret to success? As McClure wrote so elegantly:
“INVEST EARLY at LOW COST.”
And today, because of the low cost of starting a new company – and because of the rise of Equity Crowdfunding, where many people contribute small amounts of capital to start-ups in exchange for equity – seed-stage investing is accessible not just to professional investors like McClure, but to a broader range of investors…
Angel investors like you.
Stay tuned for Wayne’s article tomorrow about the secrets of another successful seed-stage investor: Mark Cuban.
By the way, if you missed our first two articles from The Angel Initiative series, you can check them out here: