Why Inventors Go Broke and Investors Get Rich

I’ve often said that 997 out of every 1000 inventions never make any money. How do I arrive at that precise figure? I’ve been told by venture capitalists that they listen to some 100 pitches for unfeasible inventions for every one invention that they feel has enough potential to invest in. Further, out of every 10 projects that they put money into, only around 3 of them will succeed on average.That works out to 3 out of every 1000 inventions making money while the rest do not.

Clearly the averages are much worse than this for the individual inventor. There are probably hundreds more inventions every year that the venture capitalists never get a look at. The average inventor might be looking at something like a few chances out of 5,000 or worse. In any case, if an inventor puts all his money into one invention, the chances are not far from 99.7% that he will become 100% broke. So why don’t investors go broke as often? They have this Simple Arithmetic on their side that I’m about to show you, which inventors can also take advantage of.

Suppose an investor is careful and selects inventions that based on his experience will each stand a roughly 3 out of 10 chance of prospering. Suppose then that the investor combines his money with that of a group of investors so that as a group they are able to invest $1M into each of 10 inventions.
Early stage investments are made at a discount rate of a few cents on the dollar or less. For arguments’ sake we’ll assume that 0.10 is the rate of discounting on the value of the invention based on its estimated future value. The investors’ capital therefore stands to be worth 10 times as much in a few years when the inventions gets off the ground, were it not for the high probability of most of them failing. With a portfolio of 10 businesses bought at a discount rate of 0.10, how many of them need to succeed in order for the investors to break even? That’s easy. At least one out of the ten must succeed to cover the losses of the remaining nine. To double their money, two must succeed; to triple requires three successes and so on.

The probability of the first business failing is 70%. The probability of the first AND second ones failing together are 0.7*0.7 = 0.49 or just under 50%. The probability of the first three businesses failing in order is

If we keep going, we find that the probability of all 10 businesses failing is

But if this isn’t what happens, if you follow the logic, then at least one business will have succeeded. And if at least one business succeeds, the investor has broken even. The probability of at least one in ten businesses succeeding, which is the same as saying the odds of NOT having 10 failures, is

This is a very important fact for inventors to take note of.

While an inventor has at least a 99.7% chance of losing his shirt, an investor has a 97% chance of keeping his.

Now for some fun with numbers. What is the probability that exactly one of these hypothetical businesses succeeds while the others fail? One way this could happen is described by the following calculation:

In other words, the first 9 fail and the last one succeeds. The probability of that exact thing happening is 1.21%. Are there other ways to have 9 failures and one success? Yes: you could have the first one succeed and all the subsequent ones fail; the first fail, then a success, and then eight failures in a row, and so on. There are 10 different ways to have exactly 1 success and 9 failures if the order that they come in doesn’t matter.

This is called a “combination” and is calculated in this way:

And in this instance, it is

The probability of having exactly one success is therefore 10 cracks at a 1.21% chance = 12.1%.

In a similar way, there are

ways of having exactly 2 successes and 8 failures in any order. The probability of one of those 45 combinations occurring is

By continuing through all the possibilities, we can make some general groupings. The chances of having 2 or more successes is 85%. Three or more is 61.7%.

The investor who chooses carefully which projects to back and who diversifies over 10 projects at a given time will be almost assured (97%) of not losing any money at all. He stands a pretty good chance (85%) of actually making money, and almost a 2 out of 3 chance (62%) of at least tripling his money. With those kinds of odds, who wouldn’t want to be a venture capitalist!

What can an inventor do to increase his odds of success other than become an investor? Any inventor is well advised to think more like an investor by following these three rules:

1. Evaluate your invention ideas the way an investor would. Be passionate about your inventions, but do not fall in love. The passion isn’t enough: it must also be an outstanding investment opportunity. Determine the commercial potential, estimate the return on investment, make a valuation of the business, and assess the risk. Risk is not just some bad feeling in your gut: it is the probability of something happening multiplied by the cost of it happening. If there is a 70% chance of losing $100,000, the risk is $70,000. If the potential return on investment is 1000% with a 30% chance of ever seeing it, the reward is 0.3*$1,000,000 = $300,000. Is the reward worth the risk? Would you like to play that game once only, or as many times as possible?

2. Share The Risk with others. Don’t hoard it all for yourself. If something is going to cost a lot of money to develop, concentrate first on getting investors on board BEFORE you start spending money on prototypes.

3. Diversify over a number of inventions over time. If you pick your 10 best ideas with real commercial potential, I give you pretty good odds that at least one of them will succeed. But if you blindly devote yourself heart and soul to the first hare-brained idea that pops into your head, you’d be better off taking your money to the dog track.

Should I Build a Prototype?

Inventors are universally confused about what to do first. One of the most attractive distractions from the real work of innovation is the potential for building a "prototype."

Because inventors are usually the type to enjoy tinkering, or are people who think more clearly while holding a physical object with their hands, or because they simply don't know what else to do, building a prototype becomes a serious temptation. But it is the wrong thing to do!

It is a waste of time and a waste of money.

A big part of the problem is that the word "prototype" is so general as to be devoid of any real useful meaning. It could mean anything from a proof-of principle setup, a proof-of-concept device, an operating principle test rig, a development platform, a performance testing platform, a pre-production model, a market test, a production proof limited run, a first-article production run, or the "version 1.0" release.

When an inventor jumps the gun and rushes out to build a prototype, he usually has no idea which of these he really wants or needs.

The first step to inventing is rarely anything to do with a prototype in any of its forms. The first step is always evaluating the idea and its potential, followed closely by learning all about the customer and his needs and wants. But that is another post for another time.

When the time finally comes to build a prototype, the inventor is advised to take a more practical approach by asking first what he needs it for, what he needs it to be and to do. Dispensing with the word "prototype" and adopting the more specific language I offered above goes a long way towards helping the inventor decide exactly what to do, and the cheapest and fastest way to do it.

Proof of Principle. Is the underlying operating principle of my invention actually correct?

Usually this has already been worked out by someone somewhere, and very likely the result can be found in a high-school science textbook. In many other cases, the information that building such a device might yield can be found in university engineering textbooks, published papers, or by doing a bit of simple analysis using pencil, paper and a 4-function calculator. Unless you're developing ground-breaking technology in a laboratory, you probably don't need to spend money investigating proof-of-principle. Talking to a qualified Innovation Engineer will usually answer all your questions.

Proof of Concept. Can the principle actually be used for my intended purpose?

The information provided by a proof-of-concept article is usually available through less expensive means. "But don't I need at least this in order to attract investors?" When looking for financing, you do not actually need a prototype. If the market research and business plan makes sense to the investor and his engineering advisors give the thumbs-up, you'll get the money. If an investor asks to see a prototype, it's because he is hesitating, he doesn't like the business plan, and isn't going to invest anyway. He's just looking for an excuse to say no.

Test Rig. What specific design parameters will result in the required performance?

This is specific knowledge that is best obtained through a methodical study rather than building "prototypes" all willy-nilly. You must know in advance exactly what the question is, and design a system for answering that specific question. Then you must have the skills for collecting, analyzing, and interpreting data. This is another area where an Innovation Engineer provides invaluable assistance and saves you enormous amounts of time and money that might have been wasted. In a lifetime and with all the money in the universe you can't learn everything you need to know to do it all by yourself.

Performance Test Platform. What can I promise my customers? Can it be improved through minor changes?

This stage is beginning to look more like a complete product, but it contains many more features that your customers will never need or want. These features are included for YOUR benefit. Knowing what to put in is something an Innovation Engineer does. Sensors, adjustable parts, fail-safes, and features that simulate real-world conditions are just some of the elements of a test and development platform.

Pre-Production and Production First-Articles. Will the production processes actually work and result in the desired product?

The production engineering phase is usually much further down the road than many inventors realize. It often comes after a second round of investment and is in itself a specialization that professional production engineers need to help you with. The process is the product, and no one gets it right the first time.

Do not start building a prototype unless you know its exact purpose, you understand exactly what you need to learn from it, and you have the exact skills in place to make it not be a waste of time and money.

More information, advice and resources for inventors is available at: www.Smart-Inventor.com.