Investing is an Art and a Science

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Industries that have been slow to adopt to technological changes inspire entrepreneurs to change current methods. However, identifying growth opportunities and making proper risk-adjusted decisions has been a balancing act for investors since time immemorial.

“If I take 30 steps linearly, I get to 30. If I take 30 steps exponentially, I get to a billion.” — Ray Kurzweil

You’ll often hear the phrase “you only have to be right once.” In the investing world, firms across all stages are looking to identify growth industries where they believe that if the industry has a high conviction (CAGR) that it will outperform the market. Bad experiences like taking a taxi, driving to the store, picking up groceries, cooking, etc. creates opportunities to flip industries on their head and innovate new methods that can be both economically and financially advantageous. Ideas that are aimed to change the current processes of outdated industries are called “disruptors.” At a glance, these sound facile but in practice are hard to invest in. Early stage ideas are often neglected and viewed as long shots with against the grain concepts that can be often neglected by the market. Majority of these never gain traction and die trying. But when ideations start to grasp product-market-fit, they experience explosive growth and outsized returns. Being right on only one or two of these will make up for all other attempts, due to the power-law distribution (relative change in quantity results in a proportional relative change in another quantity, independent of the initial size of those quantities).

Most start-ups see early-stage success by minimizing burn through the lean start-up method. This was popularized in Silicon Valley and puts a focus on validating product-market-fit with potential customers before capital is deployed to build out the product or service. They are tasked with verifying two things before moving forward: if the problem is real and big, and people are willing to pay (along with how much) for an alternative solution. For example, I have talked to a group of founders that did customer discovery on over 300 potential customers to validate that they would be interesting in using the solution if it was created. This process can take months by locating people to talk to, along with adjusting your solution to properly align with potential product-market-fit.

While still in the hypothetical stage, you are not in any better situation until you have further de-risked the concept by being methodical on execution. Almost all start-ups that make it to unicorn status have one thing in common: 10x. This means that a product has to be ten times better than the current solution to be worth an investment. Before I were to make an investment in an early stage company, it is best to wait for them to follow the process which looks like this:

  • The founders identify potential customers in the niche and conduct use case interviews
  • Potential customers agree that this is a problem and they would use/pay for a better solution if brought to market properly
  • The product is built by the founders (seed round)
  • Go back to those who were interviewed and deliver the minimum viable product (MVP)
  • Collect payment and continue to gain more adoption by repeating this process in the niche to gain product-market-fit (series A-B)

As this is not a one-size-fits-all strategy, I would argue that by minimizing initial build costs and getting to the market rather lean you can come out with a defensible company. I would like to point out that with technology there are new methods which have not been conceptualized but are in fact needed by the market, but they don’t know it. This is rather onerous and is near impossible to invest in a repeatable manner. Take for example social media networks, I would call this a category-creator since it was a new concept that was manifested through primitive desires to communicate and form communities, but it was not derived from an older industry lacking ideation.

Investing in companies that experience prodigious future growth is a combination of science, art, and luck (sorry). Some start-ups could have the idea but arrive to the market too early for adoption, some might have rejection and struggle to get out of stages 1–2 but once the product is built they become a category-creator. To be successful in properly identifying these niche forms of investments, creating a repeatable process has the potential to reduce your down-side and align with an unassailable capital allocation strategy. In conclusion, some companies must walk so others can run and category-creators open up new opportunity for applications that can be built on top of these networks.