Quantifying the power of diversification in seeding money investments
Seed money is a form of securities offering in which an investor invests capital in exchange for an equity stake in the company. The term seed suggests that this is a very early investment, meant to support the business until it can generate cash of its own or until it is ready for further investments.
Also, in the venture capital industry, a unicorn refers to any tech startup company that reaches a $1 billion dollar market value as determined by private or public investment. The term was originally coined by Aileen Lee, founder of Cowboy Ventures.
Let us use a very loose interpretation of this definition and add a couple of additional concepts. We define a horse as a startup company that reaches an intermediate level of market value and is able to adequately compete but does not have the strength to become yet a unicorn. And we refer to dogs as all those projects in which seed money invested did not turn into a successful project-to-be.
Investing in this kind of business is tricky. You are betting for the next unicorn (companies such as Uber, Xiaomi, Airbnb, Palantir, Dropbox or Pinterest). However, in order to find it, you would have to invest in many seed projects. Some of them would eventually become horses, but most of them will just become dogs or throwaway money.
Also, remember diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. A common path towards diversification is to reduce risk or volatility by investing in a variety of assets. What we want to test here is how many projects you should invest as a seed-money investor in order to minimize your risk by this principle of diversification.
Defining net cash flows for each type of project
Imagine a seed investor willing to put money on many different projects. How many projects would he have to invest in order to make it at least, better than the odds of throwing a coin into the air (50/50 chance).