The Perils of Diversification

As anyone familiar with the conventional wisdom on investing in the stock market knows, the most fundamental rule of investing is to diversify your investments across a number of different stocks in different businesses.  And while there is some room for argument as to whether some small subset of investors can consistently beat the market over time, for the vast majority of investors following a diversification strategy to mimic the market’s overall return is pretty solid advice.

The diversification strategy can reduce risk within a business as well.  While assembling a group of widely divergent businesses under one roof – the conglomerate approach pioneered in the 1960s by Harold Geenen at ITT  – is, these days, mostly frowned upon (with mutual funds, it is easy enough for investors to get this kind of diversification on their own), the idea of a large company diversifying its risk by investing its capital in multiple initiatives, be they product lines, technologies, business models, suppliers, etc. is something most larger companies do as a matter of routine.

Alas, while managing risk by diversifying capital investments makes sense for most large businesses, it makes no sense for high impact entrepreneurial businesses.  There are a couple of reasons.  First, as noted in earlier blogs, the venture capital and other high risk/reward investors who back these companies have a business model that is based on every deal having home run potential.  These investors do their own diversification by diversifying their own investments across a portfolio of, in most cases, at least ten or so companies – each one of which, for the model to work, needs to have a 10x return potential.  Put differently, high risk/reward investors limit their investments to companies with high risk/reward profiles: by definition, they are not looking for individual portfolio companies to reduce their risk/reward profiles.

A second reason early stage high impact businesses are better off focusing their capital investments on a very narrow front – or, if you prefer, another take on the first reason – is that venture and other high risk/reward capital is so scarce, which is to say expensive.  That means that it is very hard to get: as any entrepreneur knows, cash is always scarce.  As a practical matter there just isn’t enough of it around to fund multiple initiatives – even if there was enough talent around to do that, which, talent being so stretched at most early stage high impact businesses there seldom is.

This all may seem abstract, but in my experience investing in, starting/managing, and counseling high impact entrepreneurs, I have seen all too many of them look for ways to lower the risk of their business by investing in “fall back” business models in case the “home run” they are really after doesn’t pan out.  For example, I recall a stem cell business awhile back where the entrepreneur’s pitch included the idea that “and if our therapeutic strategy doesn’t ultimately work we will have this business selling stem cells to other companies as a backstop.”  It took several years for that entrepreneur to attract funding – several years being the time it took him to separate the two businesses (both of which ended up getting capital, from two very different kinds of investors).

So, if you are a high impact entrepreneur remember this: high risk/reward investors like venture capitalists want to see you focus virtually all of your limited resources, capital as well as human, on “the big one.”  Like Cortez, they want you to hit the beach with everything you’ve got, and burn the ships on the beach so there is no temptation, when things get dicey ashore, to think about plan B.

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About Paul A. Jones

Serial venture capital backed entrepreneur, angel investor and venture capital investor; Co-chair of the VentureBest team at Michael Best & Friedrich, LLP.
This entry was posted in Angel Investing, Entrepreneurship, Venture Capital, Venture Captal and Angel Investing and tagged , , , . Bookmark the permalink.

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