The Virtue of Failing – More on Incubators

Following on from our last post on incubators, since Mark and I don’t come to our investment decisions whimsically, I wanted to flesh out our logic and rationale for investing in an incubator.

First, and most importantly, failure is a huge part of business and investing; heck, it’s a huge part of life in general! Capitalism without failure is like intercourse without an erection!

Protecting people from failure, in our opinion, is why the developed world economies are in such a shambles, and in particular the US and Europe. Capitalism isn’t the enemy, protectionism is.

Thinking people realize that in much of the developed world capitalism has long ago been replaced by fascism, cronyism and corporatism. Notice how those all coincidentally stem from some form of protectionism. Add to that liberal doses of stupidism, absurdism and hopeism and you see why the world is at the breaking point, financially.

Our leadership, be it at the elementary education level or the federal government, has resorted to “protecting us from failure.” Take the case of youth soccer leagues in the US. Keeping score is no longer accepted. Everyone gets a trophy – don’t want little Johnny or Jenny feeling like a loser. Think of the idiocy of that premise and the long-term damage it will inflict.

Gladly, clear-thinking realists immediately acknowledge that type of behaviour and belief system as problematic, so I will not dwell on the topic.

Suffice it to say that anyone that gets involved with investing in start-ups and thinks that there won’t be ANY failures, has spent too much time reading fairy tales, watching the idiot box or listening to PR people.

The problem lies not in failing, but in realizing those failures quickly and adjusting to the new reality.

The benefit to investing in an incubator, and it is an enormous benefit, is that management has the control to cut losses early on when a particular business is not performing to expectation, while allocating additional resources to those businesses which are performing. This significantly reduces the risk of the incubator taking massive drawdowns that could wipe it out.

For purposes of example, I have several friends who trade currencies, commodities, stocks futures, options on futures and the like. One friend in particular, who trades only FX, has a trade failure rate of about 76%! Regardless, he makes a TON of money. How is this possible?

The money is made by limiting losses and letting the home-runs… well, run. 76% of his trades lose money, that’s a fact, but he caps the losses at 5% per trade. His remaining (24%) trades are profitable. Those profitable trades generate an average return of 55%. The math works (feel free to do run the numbers yourself).

So, like my FX trading friend, in an incubator we can fail often, but do so as “cheaply” as possible by cutting the losses quickly, letting the winners ride and putting the accelerator to the floor on those businesses that are working.

The reallocation of capital towards successful businesses and away from losers is something every profitable trader and investor I’ve ever met does routinely. What Mark and I are doing with regards to our investing in an incubator is no different.

What about being your own incubator?

We’ve heard it argued that you may as well simply invest in a selection of startups. The problem is that you have no liquidity in private start-ups. If a particular deal is going south, typically the founders won’t want to, or even be able to, realize the flaws and adjust accordingly (it’s a common trait of founders to fall in love with their idea even where it is not a money maker).

An incubator run by management who fully understand this process, have had some failures and also hit some home runs, is in our humble opinion the single best way to enter the start-up space.

The capital required for some of the new technology and mobile media businesses we’ve recently funded and or done DD on has amounted to as little as a few hundred thousand dollars. This is in stark contrast to the “old days” (aka 10 years ago), where the seed investments used to routinely be in the 7-figures.

Technology has driven costs through the floor. This allows an incubator to build many more projects with the same amount of capital that it would have required some 10 years ago.

Failure is not what we’re concerned about. Failure to recognize failure is the problem. We’ve spent a loooooong time looking for the right setup to invest in the tech space, and we believe we’ve found it through the incubator we refer to. We may be wrong and will take our losses if that is the case, however we don’t think that’s likely, and if we didn’t expect to make a multiple of our original investment we wouldn’t even be contemplating it.

We’ll delve deeper next time. Meanwhile we’d like to know about your experiences with incubators. Leave us a comment or two below.

Have a great weekend!

– Chris

“Don’t look where you fell, but where you slipped.” – Proverb


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