“Concentrated positions in a few companies is the mantra of making money in investing”, said a legendary public market investor, as I felt extreme dissonance in how startup investing is done
Perhaps I was wrong. I had seen quite a few VCs say that they back a few high-conviction bets each year. They were alluding to the same concentrated positions that the public market investor was talking about. Few investments, high amounts of capital, high ownership. But when you looked at these very VCs data, and historical VC data, the best VCs made numerous investments with only a few succeeding.
To resolve this conundrum, I turned to what I had studied many years ago - quantum theory
The fundamental principle of quantum mechanics is uncertainty, encapsulated best in Heisenberg’s uncertainty principle. Unlike classical Newtonian mechanics, where everything follows a certain predictable path, quantum mechanics is built on the principle of uncertain probabilistic paths. At an atomic level, classical mechanics fails while quantum mechanics succeeds.
In my hypothesis, the principles of public market investing fail at startup investing similarly.
Public market investing is in large companies. They are predictable, follow paths that tend to mirror classical physics. A good/bad company tends to continue to be good/bad (inertia). Changing the path of a good/bad company tends to require immense company effort (F=ma). Every large corporate action faces an equal and opposite competitive reaction (self explanatory). These companies have a lot of information available, systems that are built that continue to roll, and are well tracked.
Startups fail on all three Newtonian laws.
A good startup can become bad, and vice versa, in 3 months. Honestly, it isn’t even clear what a good/bad startup is for very long. The path of a startup can change due to anything, sometimes even due to the market, because they are so small, and not in the company’s control. Nobody cares about what a startup is doing because they probably don’t even know of its existence. There is no reaction. Given classical laws fail, what may be the right laws to look at and see their governance?
Quantum mechanics could be an answer, with an uncanny number of similarities.
Unlike large companies, for whom capital raising is an ongoing process, capital raises by startups actually can make step-function changes. In quantum theory, if an electron in an atom gets energy, it does not move slightly. If it get enough energy to change its quantum level, it jumps directly to the next level. Startups are similar, and their fundraising is even called “stages”. Fundraising can be the difference between life and death for a startup due to this very reason.
Additionally, as Schrodinger postulated with his equation, particles are in a composite of different states (0/1) with different probabilities till they are observed and collapse into an outcome. Similarly, startups are in a composite of different states (good/bad) with varying probabilities till they are observed and collapse into an outcome. Many particles and startups are never observed. Nobody could tell what they were or what they could be.
Building on this, Schrodinger/Heisenberg also added that observation itself influences the outcome of a quantum particle. If you try to observe an electron, you need light. But light photons itself have enough energy to move the electron, thereby changing its state. Similarly in a startup, observation itself can change its trajectory. A large top-tier investor, which is also an LP in ajvc, said that “ajvc’s pre-seed funding of companies can itself be the reason why a company’s trajectory changes, because without funding we’d never know”.
Given there is a tight enough relationship between quantum mechanics and startup behavior, there are all kinds of outcomes that are similar. Most quantum systems display one fascinating behaviour - they behave non linearly. Examples are abundant. Quantum jumps, which I already talked about, are the most frequent non-linear behaviour. Quantum tunnelling, which is when quantum particles unexpectedly cross energy barriers, is because low probablity events can happen in the quantum world. At certain critical points, changes in parameters can entirely change the state of systems - called quantum phase transitions.
Startups do the same. Startups jump through states very regularly. Low probability breakouts happen in hard industries, regulated and ossified. Due to changes in parameters, certain startups suddenly pick up and explode. Non-linear behaviour is everywhere, known more commonly as the “power law”. You can study quantum mechanics and see that those behaviours could be replicated in the startup world.
Where does that leave us on how to invest?
Low probabilities of success and uncertainty rule this world. The implication is that you must invest with systems that identify startups with a higher low probability. Additionally, due to extreme non linear events, investing in a large “system” or a big “portfolio” of startups is necessary to catch that “breakout” particle. Deluding yourself into believing that you can predict the outcome of any startup is not what works. When I see investors saying “we predicted this once in a generation outcome” it is exactly like predicting you knew which particle in a quantum system broke out.
You can do the prediction at a systemic level, but almost never at a particular level.
The best startup investors in the world have a probability of success (here, a unicorn) at 5-6%. The reason they win is not just because of the numerator, but also because the denominator is so high. The ability to systematically invest in a startup portfolio of 400 is in itself an achievement. Systems of investing that believe in the rules of probability and uncertainty thrive in this world.
The legend was right classically, but wrong quantum mechanically.