Should you double down on winners?

In the last article, we covered the Power of the Law of Returns which is crucial to understand before any investor starts investing in a particular company.

In this article, we’ll discuss the ways to maximize the Law of Returns. Understanding ways to identify high-potential opportunities is important as an investor needs to keep in mind the strategies that can be adopted to maximize their returns, These indicators can differ from Sector to Sector as well as the stage of the company.

Lakshay was once in a perplexing situation. The question was simple yet difficult to answer. The question was “Should I double down on Winners? Or Should I double down on Losers (average on Losers)?”

Now here’s a case he had to pick. The company was making losses. The entrepreneur was assuring Lakshay that the company would soon become profitable. All he had to do was pump in more money. The question was should he do so?

His friend Akshay, an avid investor, suggested he stay within this assurance. If you persist with investing in companies that are non-performing, hoping that one fine day they will start generating profits, then there’s a great chance that your portfolio will also become non-performing. Generally, Retail investors tend to average out stocks and add more shares where they are in losses & the moment share prices increase, they sell their shares. In fact the shares which were seeing a price increase were the shares that Lakshay should have held onto for long as these shares would have generated returns.

To further explain this, let’s understand with the help of a chart:

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Based on a ₹5 Crore model portfolio with over 50 companies, 02% write-offs & exits are distributed between ₹2 crores (~ 20x) & ₹20 crores (~ 200x).

Let’s understand this with the help of a chart:

Let's say a company had 1000 shares and investor owned 125 shares or 12.5% of the stake. Now the company plans to raise additional funds and it issues 200 shares, so the total shares would become 1,200. Now if the investor wants to maintain his stake he’ll have to own 150 shares. If they continue with 125 shares, they’ll own only 9.6% stake in the company after the new round.

The same thing happens in the chart. If the investor wants to maintain consistency of 3.3% w.r.t ownership, then they’ll have to invest in every new round. In case the owner doesn’t buy additional shares, while the number of shares remains constant the stake in the management gets diluted with every new round.

Now a question might appear ‘Why should we invest early in startups?’

Rajesh explained this in the form of a case study “Let’s take a case. Supposing Lakshay was asked to invest in 10 shares of ₹10,000 in a company whose valuation was ₹10 Lakhs at that point. So Lakshay acquired 10% stake but the entire investment was done in Seed round itself.

Lets take another case where Saurabh divided the amount and instead of investing in a single go during seed round, he decided to invest ₹2,600 in a company whose valuation was ₹10 Lakh. So Lakshay acquired 0.26% stake. In follow on rounds he invested ₹2,600, ₹6,660 & ₹13,200 respectively. All of you might be wondering why there is a sudden increase in Serie B & Serie C rounds. It is done assuming that during later funding rounds the valuation of company would have also increased.

Now let’s do a quick comparison by looking at the above chart as well as graph. By investing ₹10,000 during seed round Lakshay achieved a Funding multiple of 6.6x while sees his stake drop from 12.5% to 6.1%.

Saurabh on the other hand keeps on investing in multiple rounds and maintains a funding multiple of 3.4x while having a consistent stake of 3.3%.”

At this point Akshay asked a question "Should Lakshay invest again and double down or avoid?”

Rajesh replied “To answer this question, let’s go back to the previous chapter where we told you that with asset allocation you need to invest only 5% in every company. Now if there’s an outlier that ₹5 might become ₹500 but still it is advisable to pay caution on doubling down. This concept is similar to that of a casino. In Poker, you just sit back & relax once you earn a profit. Wait for the right time to liquidate your holding.

Many analysts have computed that after a certain point returns start saturating. So while you may earn compounding returns, you still won’t earn it at the rate that you did when you invested first. Hence it's advisable to invest early in high-potential private companies.”

You may experience numerous small wins along the way, but the majority of your returns will come from a tiny fraction of your investments. Massive wins are rare, regardless of who you are or where you invest. Since these big, rare wins drive most of your returns, it makes sense to maximize your chances of securing them. If you invest in 10 companies, you might have 5 potential big successes; with 20 investments, you increase your chances by fishing from a pond of 10.

Now what if VC enters the picture? So, when a VC comes in, VC always comes with an approach where if they want to invest 30 crores, they’ll set milestones where they’ll first invest ₹15 Crores and only if the company achieves the milestones will they invest the second tranche of investment.

Here is an important lesson to learn for the Investors. When a VC enters the picture, the investors need to sit down with the Founder and clarify the term sheet that has been signed with the VC on further rounds of investment. 95% of VCs set milestones for future rounds of funding. Milestones could be in the form of increased sales or profit or even investment in expansion to increase geographical presence in a stipulated period.

As was written earlier, Investors are advised to sit back & relax and discuss with the founder the term sheet signed with the VC on agreeable milestones.

Lakshay's story teaches us that winning big in the financial realm involves a judicious blend of diversification, compounding, and a disciplined approach that withstands market fluctuations and steadily builds wealth over time. The Law of Returns becomes a beacon, illuminating the path to financial success without unnecessary gambles.