Most people stay away from investing in startups. They believe it’s too risky. This post will tell you they are mistaken. It will tell you that startups are actually one of the most attractive asset classes out there. It will teach you how to identify markets that bubble and burst, and how to be successful investing in startups. In the process, you will meet a man who escaped death row to become the most powerful man in France and learn about the birth of modern economics. In the end, aspiring startup investors will learn the most important fact about startup investing. Facts are everything. Use them.
About three hundred years ago, a murderer awaiting his execution from a dark prison cell in London would change global financial markets. Forever.
John Law had killed a foe in a dual and received death penalty for murder. But, John Law managed to escape prison and flee to continental Europe.
Law spend his newfound freedom studying finance. He developed the theory that countries should abandon gold and silver, and use paper instead.
At the same time, France was on the brink of bankruptcy. The ruling elite feared revolution and needed a solution, fast.
As soon as the desperate French elite learned about John Law and his monetary theory, they made contact. Law convinced them to establish a central bank and start issuing paper money. In this way, the government could pay back its creditors in cheap paper instead of gold. To the ruling elite, John Law was god sent.
For Law’s theory to work, he needed the paper money to start circulating. To make this happen, he created demand for paper money by offering a unique product that required his paper money to buy. The product was shares in the most valuable company in France. Or so Law made it sound.
The effect of easy credit
The company was Compagnie des Indes and it had a monopoly on overseas trade. The company first issued stocks at 500 Livres per share in 1719.
But Law made it easy to loan paper money to buy stocks in Compagnie des Indes. Suddenly, everyone could buy the stocks. And they did.
Only one year later, the price had soared to 10,000 livres per share. Now everybody wanted to own a piece of Compagnie des Indes, and Law continued printing paper to satisfy the demand for his new currency.
In the end, the bubble crashed. France and most of Europe went into a depression. It was one of the earliest examples of asset bubbles. It would not be the last.
The devastating effect of bubbles
Since Compagnie des Indes, the world has seen one bubble after the other. And for most investors bubbles become their worst nightmare.
Bubbles are disastrous for investors because they deflate much faster than they built. It took Nasdaq five years to go from 1000 to 5000, but only a year to erase most of that gain.
This means that investors spend years on accumulating value and see most, if not all, this gain evaporate in a heartbeat.
For this reason, investors should be wary of any asset with tendency to bubble. And those assets are quite easy to identify. John Law taught us that.
Before Law, Compagnie des Indes was struggling. The company was far from being the hot investment it would later become. So why did it change?
The fundament for bubbles
First, the king and his closest supporters initially funded Compagnie des Indes. If you were not part of this group, shares were not available.
Secondly, it was hard to obtain credit to buy the shares. Only those with enough gold on their hands could afford it.
Law’s invention of paper money and the offering of the stocks to the public changed all of that. Law simply made it easy for everyone to participate in the market for Compagnie des Indes shares.
The story teaches us the characteristics of assets that bubble. Their market is easy to access and it is easy to loan money to buy the assets.
Both characteristics of markets that bubble have roots in human nature. We simply disdain doing anything hard. But as soon as it becomes easy, people flock to play. Furthermore, people hate saving because it delays gratification. We love getting something for nothing, and borrowing money feels that way in the short run.
No other market has developed these characteristics more than the modern stock market. Today, anyone can buy stocks with a few swipes on their phone. Technology even offers automatic investing by algorithms. On top of this, many people are being forced to participate in this market through pension schemes.
The access to leverage your investment in the stock market is equally easy. The same service that allows me to invest with single swipe, also offers me to loan money to buy more stocks. Moreover, large institutional investors, such as hedge funds, uses vast amounts of credit to leverage their bets.
The consequence of the continued development of the access and credit in the stock market has resulted in ever-increasing bubbles and bursts.
Timing not an issue with startup investing
In contrast, the market for startups is very different. (I don’t consider pre IPO companies such as Uber and Airbnb as startups nor the listed internet companies in the late 90’s).
Participation involves tons of friction. Investing in startups still requires lots of research, travel, meetings and due diligence. Worst of all, selling shares is almost impossible. There is simply no established marketplace for trading shares in startups. That’s the main reason why venture funds are much smaller than hedge funds. Venture capital isn’t liquid and doesn’t scale well.
Secondly, it is very hard to obtain credit for investing in startups. The return is extremely asymmetrical which is difficult for loan givers to accept.
But, at the same time these are the exact same characteristics that makes startups undervalued assets. The friction and lack of credit ensure that startups valuations don’t bubble. Obviously a specific startup can bubble, but not the asset class as a whole.
The absence of bubbles ensures an attractive price point no matter when you start participating. Unlike the stock market, timing is not a big issue. This means investors can sleep well at night because the rapid and broad declines in valuations just don’t happen.
Startups built value over time and is perhaps one of the best long-term investment strategies out there. But only if your portfolio is broad enough. And this, I believe, is the most important fact in startup investing.
- Easy access and credit create bubbles. The stock market is a good example.
- Startup investing has too much friction and lack of credit to bubble.
- Startups are a great long term investments, but the asymmetric return profile requires investors to have very broad portfolios.
Visit us at www.accelerace.dk. We invest in startups.