Timing Uncertainty
Nothing in life is certain. A forecast of the value of any future measurement can only be known with a probability of certainty. Actually, the measurement can have any value, and each value has a probability of occurring. The probabilities for each value in a range is the probability distribution of the forecast measurement.
This is a chart of the value (in black and grey) of a hypothetical company. For some given method of calculating, the past value is known with perfect certainty for the past 3 years. The probability distribution of future value is represented vertically with a darker color representing a higher probability.
Several interesting attributes are apparent going into the future.
Extreme measurements become more probable. It is very unlikely that the value will increase 100x or go to 0 in year 1. But both possibilities are more likely in year 10. In other words, it takes time for a company to either grow towards its full potential or fail.
In the future, the most probable value has a lower probability. As extreme values become increasingly probably, the value that is most probable has a lower probability of occurring. In other words, it is harder to forecast the distant future than the near future.
The most probable value declines over time. Since there has been growth through the past 3 years, the most probable value in the next year is somewhat higher than in the past year. But over time, the most probable value declines. In other words, the longer time it takes to reach an exit, the more likely it is that the company will exit at a disappointing value.
From this, we can see that investment with an early exit are more likely to have a good return. But a company that will give great returns is both unlikely and takes a long time.
The chart also shows the probability of liquidity as purple bars. A liquidity event in year 1 is quite unlikely, but increases as time passes. The company develops its products and becomes ever more attractive to acquirers or public markets for an IPO. However, if the company does not reach a liquidity event, the probability of it ever happening eventually drops off. A company that takes more than 10 years to reach an exit has a low probability of ever doing so. After too much time, it becomes increasingly likely to fail with no distributions to investors. It is common for the highest probability of liquidity through acquisition or IPO to occur around the 7th year in the life of a company.
The amount of returns possible if an investor had invested in something else is the opportunity cost of having made this particular investment. It is the cost of the capital used for this investment. Since investments grow and compound over time, the cost of capital increases exponentially. The cost of capital for investing in the company is shown in the diagram as green bars. As time proceeds, the opportunity cost of having made the investment increases.
What all this means is that investments with a likely short time to liquidity more predictably give a desirable return. Investments with a likely long time to liquidity are much more of an unpredictable and expensive gamble but with a greater potential for a large payback.
Several interesting points are not apparent from the diagram.
A better fund manager will pick companies with distributions skewed higher.
Because of the distant future distribution has a greater spread, the effect of the difference between a better and worse fund manager is greater for deals that exit quickly. Therefore, skill and experience are relatively important for investors in later stage companies that will exit in a shorter amount of time. Skill and experience are less important for early stage investors who are making relatively long term investments.