A quick guide to seed investing for public market investors

Successful public investing doesn’t translate to successful startup investing. Intuitions and strategies that work well in the former simply don’t work in venture. As the private investment market liberalizes, and marketplaces like AngelList grow, there will be an increasing number of crossover investors.

And seed investing, the most accessible round for most smaller private investors, is really an exaggeration of all the characteristics that distinguish venture from public.

There are three important things that distinguish venture from public investing.

Selection

In public markets, you can buy stock in any company without permission. In venture, the selection process is double-sided. Investors choose companies, but companies also choose investors.

Half of the problem is about information: you don’t know what you don’t know. While Sequoia could identify Whatsapp by seeing their numbers from publicly available signals, it’s hard to find two hackers in a garage from public signals. Plus, you’re not Sequoia. And the best founders aren’t going on AngelList yet (I am still a fan) which creates adverse selection both in founders and in investors.

The other half of the problem is that having money isn’t enough. Money at the seed stage is commoditized, and the skill of a seed investor is about gaining access, by building trust and reputation in the founder communities you want to reach. Just because you find a company doesn’t mean they’ll take your money.

Risk

In public markets, companies very rarely go to zero but never grow to be worth a thousand times their market cap. In venture, you lose most of your money most of the time but sometimes get really big returns. The outsized return potential and the frequency of wipeouts create a power law return distribution.

The counterintuitive nature of venture forces you to rewire your natural risk perception. A seed investment has the potential to 1000x: it’s impossible to 1000x in the public markets. When the best you can do is 3x, a zero is very bad.

On the other hand, a great seed fund will have many investments go to zero because they are taking risky bets– and only are rewarded for the risky bets, not for avoiding zeros. For this reason, it is incredibly important to have a large and varied seed portfolio to catch the butterflies. Repeating this because it is trickiest thing to understand in seed investing: if you have a 1000x return, all your zeros won’t matter. This means you need to have as large a portfolio as necessary to catch that special butterfly.

Timeline

In public markets, you can sell at any time. In venture, investments are illiquid and it will be years before you can take your money out.

In seed you’re investing at the beginning of the creation process. This means that along with the greatest possible return of any kind of investment, seed also has the longest lockup. Not only does the seed investor have no control over exit timeframe, exits take 5+ years. In fact, the better investments usually take longer. If you exit within 18 months, that usually means an acquihire or worse.

In general, successful venture companies raise more money: raising venture means the recognition of the opportunity to put money to work. This means dilution. Much better to own a smaller piece of a larger pie than a larger piece of a small one.

But I suspect that with the growth in the size of seed rounds and reduced cost of experimentation, there will be more seed companies that design themselves to never raise again, which will create new return profiles and exit paths. After all, development has never been so fast, deployment never so easy and distribution never so cheap.

Thanks to Dave Ambrose, Jeff Weinstein, Semil Shah, Jess Peterson, Ryan Dawidjan and Selby Walker for reading earlier drafts of this post.