Intuition is nothing more and nothing less than recognition.Thinking, Fast and Slow | Daniel Kahneman
Before discussing a methodology, i.e., a logical investment decision-making framework, I would first address the elephant in the room: emotions. Whether you admit or not, emotions are always involved in decision-making. When contemplating a prospective investment, greed and fear are the first things that loom in my mind. One of the sentiments that I associate with seed investments is Fear of Missing Out (FOMO). There are two components in FOMO: 1) the idea that there must be something better out there and 2) the sentiment of exclusion or scarcity. Some accelerators advise startups to capitalize on investor’s FOMO and manufacture pressure and competition to allure such investors.
FOMO concerns to sleep if you stick to your competitive advantages and if you trust your brains and guts when saying ‘no.’. Similarly to some VCs, as part of my regular practice, I keep track of my anti-portfolio. I am sure that due to the law of large numbers, at some point, I will regret learning that one of the ‘pass’ opportunities has become a unicorn. Still, I accept it as part of the rules of the game.
What can you do?. Typically two things: preparation and trusting your guts. The practice consists of some form of due diligence, knowing the market (particularly who are the competitors and their strategy), interviewing the founders, etc. The second thing I do is to trust my guts, i.e., my instincts. I share Malcolm Gladwell’s view in Blink, that in most cases, spontaneous decisions are often as good as—or even better than—carefully planned and considered ones. Unconscious pattern recognition should allow me to spot cases to be passed or considered for further research, i.e., startups that seem to have some anomaly. To enable some reflection and to avoid any compulsive buying behavior, I usually impose a 24-hour wait rule before making any investment decision. Then I tend to act swiftly.
Part of the FOMO problem in seed investment arises from the fact that in general, there is no cooling-off period. Once the check has been sent and the documents are signed, usually, there is no turning back.
Investment decision framework
After a cooling period, I then apply my investment criteria and the following framework for deciding whether to invest or pass:
- Product/Market fit – Who are the customers? Competitors?
- Secret sauce
- Will this investment ‘return the fund’?
- Estimate value at exit
- Time to exit
- Path to exit: How many rounds? How much funding? How dilutive?
- Free Cash Flow / Leverage / Liquidity (path to exit)
- Pre-Money Valuation vs. benchmarks
- Margin of Safety
Some additional tests that I would love to implement, but haven’t done so far are the following:
These are the podcasts that I regularly listen to about the following topics:
- Impact Alpha
- Energy Gang
- Inspiring Social Entrepreneurs
- Crazy Good Times
- The Next Step by Luni Libes
- Ted Talks
- 23 more podcasts for social entrepreneurs
- Masters of Scale
- Evolving for the Next Billion – GGV Capital
- The Pitch
- This week in Startups
- Angel – Podcast
- Angel Invest Boston with Sal Daher
- Crossing Borders – Nathan Lustig
- The Full Ratchet
- Pro Rata Dan Primark
- Founders Insight Podcast
- How I built This
- Starting Greatness
- Animal Spirits
- What goes up – Bloomberg
- We Study Billionaires
- Meb Faber
- Trend Following – Michael Covel
- Investing with IBD
- Nasdaq Dorsey Wright
- Investing Insights – Morningstars
- Rule Breaker Investing – Motley Fool
- Exchanges at Goldman Sachs
- Capital Allocators
- Capital Ideas
- Stansberry Investor Hour
- Invest Like the Best
- Inside the Strategy Room – McKinsey
- i3 – Investment Innovation Institute
- Tim Ferriss Show
- History on Fire
- Martyr Made
- Hardcore History
- Conversations with Tyler
- The Compound Show
- Business Wars
- Against the Rules
- Trail Blazers
- HBR Ideacast
- The Knowledge Project
- Knowledge at Wharton
- Wall Street Journal – The future of Everything
“The main handicap of authoritarian regimes in the 20th century — the desire to concentrate all information and power in one place — may become their decisive advantage in the 21st century.”Yuval Noah Harari
“If they spend too little time tracking the efficacy of their work, they could waste resources and lose the confidence of their backers. But if they spend too much time on it, they could still end up wasting resources and doing less of the good they initially set out to do”.
Many groups have been working in recent years to develop frameworks for measuring impact that satisfy the needs of both standardizing and allowing for a certain degree of customization. StartingUpGood provides an overview of the most prominent ones, including: IRIS (Impact Reporting and Investment Standards), GIIRS Rating (Global Impact Investing Rating System), B Impact Assessment, SASB Standards, and GRI Standards.
Regardless of whether metrics are focused on development, capacity, or markets, it is vital to remember the reason behind tracking them in the first place. The purpose is to work together towards achieving a real, lasting impact.
Jed Emerson, who developed the Blended Value Approach, explains:
“Metrics are only as good as the integrity of the data going into their calculation and the degree to which we understand their purpose.” We need to understand our intent:
- Are metrics being used to assess the efficacy of a given impact strategy?
- To improve the performance of a firm at the enterprise level?
- To justify the investment of philanthropic or market-rate capital?
- To help us understand a dynamic venture, a diverse portfolio of capital, or a public policy strategy?”
I have also found that there have been some efforts to simplify the deployment of impact KPIs and metrics. To speed you up, I recommend considering any of the following:
“If you can’t measure it, you can’t improve it.”Peter Drucker
The critical question is whether value investing techniques can be applied or not to early-stage investing in startups?. The conclusion is that although you may adopt the methodology, for seed investment, valuation or margin of safety is not the most relevant critérium. As Hunter Walk mentioned in his reply below, most likely, you will only find out in hindsight if you were paying ‘fair value.’
There always is a dichotomy between price vs. value. As Warren Buffet correctly pointed out:
Price is what you pay. Value is what you get.Warren Buffett
In the financial world, as in many other life orders, everything is narrative. Financial statements look into the past, not the future. So they are not the absolute truth, but merely a starting point for assessing the potential earnings of a company. Similarly, any discounted cash flow analysis is based on our expectations and hypotheses, which may or not correspond to the reality of future outcomes.
In what comes to startups, particularly at the seed stage, they generally have no financial history or only a very short one, and thus lack strong financial statements. Furthermore, most of the information that gets to the investors is the founders’ pitches containing exuberant projections and growth promises. Also, it is tough to find any competitors with whom to compare them or experts in the market that they are addressing.
So how can we determine if you are paying a ‘fair price’?. One way is to look at comparable companies, i.e., those addressing similar problems. This requires assuming that you can get financial statements for their valuation from competitors that are or were roughly the same stage of corporate life. An even better approach is to look at the replacement costs. What would happen if this new startup didn’t exist, and how much in terms of revenues, cash, and income do the incumbent solution(s) generate?.
Contrarian Thinking – Two ways of fishing for ‘value.’
I categorize value investing approaches mainly into two methodologies: (i) finding and then picking up the proverbial ‘cigar butts’ or (ii) paying for growth at a reasonable price. For seed investments, GARP seems more relevant. We are trying to identify suitable companies, i.e., promising startups with reasonable growth projections for which the investor should be willing to pay a fair price. Contrast this with trying to convince founders to accept you as an investor and haggling with them about valuation.
Benjamin Graham (cigar butts)
Benjamin Graham’s (the father of value investment) world view was to “buy it cheap.”
The Intelligent Investor sits high in my pile of bedtime reading material. I occasionally peruse chapters 8 (The Investor and Market Fluctuations), and 20 (Margin of Safety).
Chapter 8 has a sub-chapter concerning the difference between business valuations vs. stock-market valuations. Even though angel investment occurs in mainly non-public markets, the manias, overpricing, and inflated valuations tend to cascade to and permeate the mentality for early-stage investors. Conversely, investors tend to panic, disappear, or deflate during prolonged recessions. It is worth distinguishing, as Graham suggested, between the company valuation and the market multiples. They tend to go hand in hand; however, there are always mispriced companies: either because they are overpriced or undervalued.
Chapter 20 contains the most valuable lesson for any investor: that the risk is not in the stocks but in ourselves. In sum, an investor always needs to be protected against loss in the case of a future decline in net income. Consequently, any investment requires a reasonable safety cushion to protect ourselves, acting as confident investors in our valuation skills, against our biases and unrealistic projections.
Warren Buffet (GARP)
Warren Buffet, a Graham alumn, added a little twist to Graham’s investment philosophy that probably made him one of the wealthiest people in the world. He essentially said, “well, if I can buy a good business cheap, that’s even better.”
In the case of angel investments, timing and access to deals are critical. When you find the right startup, don’t haggle with the founders trying to convince them to lower their valuation. Focus on getting in with the correct check size, i.e., the one that allows you to continue sleeping well at night, provided that the pre-money valuation that the founders offer is reasonably justified. If you decide to go ahead and invest, then hold the founders accountable for achieving the goals that they promised to reach.
Combining it all
Value investing is almost always correlated to contrarian thinking. To find real gems, you need to have a non-consensus view about the future. Most success in investments (not just in startups), comes from three factors:
“There are three ways to make a living in this business: be first, be smarter, or cheat. Well, I don’t cheat. And although I like to think we have some smart people here. It sure is a hell of a lot easier to just be first.”Margin call (film)
I have mentioned before my investment criteria. For the sake of brevity, I would just state that I look at the valuation of early-stage investments as a GARP exercise. If the estimate is reasonable and within my valuation range criterium, I go ahead with further due diligence. I place more importance on identifying unique technologies or competitive edge, that fit with my impact investment philosophy, than on ensuring that I am paying fair value.
To achieve superior investment results, you have to hold non-consensus, contrarian views regarding value, and they have to be right. That’s not easy …Howard Marks – The most important thing
Elliot Coad, Co-Founder of Offset Earth recently asked me(*) to answer the following questions (kind of a personality test for someone that has worked for over twenty-five years in the energy industry):
- What’s your current view on climate change?
- How urgent you think it is?
- Thoughts on the fossil fuel industry and the decarbonization of our global economy?
My current views on climate change
I will start by stating that I genuinely believe in being impact first and strive to be 100% impact-focused.
I am certainly not a climate denier. I don’t have a scientific background, but I am convinced that climate change is not a hoax and that its detrimental effects will particularly impact those less capable of mitigating the adverse consequences or adapting.
In a professional capacity, I have been working on topics related to the mitigation of climate change, such as commercial-scale carbon capture and sequestration projects, since 2008. In 2010 I started a blog to track climate-change legislation enacted in Latin America (I abandoned it after years of waiting for the enactment of such legislation). Around that time, I started switching my investment portfolio to impact investing, with a partial focus on clean energies.
I am a rational optimist, and trust that climate change may be managed (rather than solved). I don’t think that we will end up in a SevenEves situation (read the book, I will not spoil it for you). Still, we have to be increasingly careful, particularly with space debris.
Urgent action to combat climate change and its impacts
‘Taking urgent action to combat climate change and its impacts’ is Goal 13 of the UN Sustainable Development Goals. It concerns EVERYONE.
The time to act was years ago. Nevertheless, technological advances have to catch up with cultural changes, and vice versa. Climate change is like watching a train wreck in slow motion. I am particularly concerned about the passengers in the front rows, Vanuatu, and similar situations.
The fossil fuel industry and the de-carbonization of our global economy
The fossil fuels industry will not follow the route of the dinosaurs unless a regulatory or huge litigation meteorite suddenly impacts it. With different speeds, businesses based on the exploitation and transformation of hydrocarbons, are adapting to the new world. They all seem to be very conscious that large volumes of discovered oil and gas may remain in the ground forever. The vast majority of oil and gas companies took write-downs on their reserves and are looking to position themselves as energy providers in the broad sense of the term.
I am still more skeptical concerning the reaction of governments (particularly those rich in hydrocarbons). Last, we should all acknowledge that there are still billions of persons without access to energy, who, on top of that, may become the victims of climate change externalities. We can not only rely on governments or the incumbents to provide solutions to climate change. Instead, I would place my bets on a solution based on funding impact startups focused on addressing climate change issues.
“Science and technology revolutionize our lives, but memory, tradition, and myth frame our response.”Arthur M. Schlesinger, Jr.
(*) These are my personal views and do not represent the position or views of anybody else.
The question that he answered, and which I will also address here was:
How would you spend a million dollars to fight against climate change?.Tweet
A political path
Another point that I would like to highlight is that the solutions to prevent global warming and to avoid the accumulation of CO2 emissions are mostly known, e.g. Project Drawdown.
— Gaston Bilder (@gastonbilder) January 30, 2020
According to a recent study, the social tipping interventions that could help us achieve a decarbonized future by 2050 are:
- removing fossil-fuel subsidies and incentivizing decentralized energy generation;
- building carbon-neutral cities;
- divesting from assets linked to fossil fuels;
- revealing the moral implications of fossil fuels;
- strengthening climate education and engagement; and
- disclosing information on greenhouse gas emissions
Angel investment in clean technologies
Mr. Lacey suggested that an alternative strategy for fighting climate change could be based on spreading the million dollars on financing startups creating the technologies required to solve these issues. You can find them in any of these places:
- Powerhouse Fund
- Greentown Labs
- Clean Energy Trust
- Urban Future Lab
- Accelerating Climate Change Solutions in Africa – ACCESS
- Elemental Excelerator
Mr. Lacey further explained that he would apply the following recipe to get the most ‘bang for the buck’ for the identification of the relevant startups:
- High potential reward
- Focus on interesting areas
- Not too high tech: not requiring too much capital or dependent on scientific breakthroughs
- Demonstrated resource efficiency
- Data plays
- Other enabling technologies to help deploy clean energy faster
He explained that the most obvious way to address the issues relating to fighting climate change is to focus on startups contributing to the reduction of CO2 emissions. Other than that, he said he would invest in:
- Urban agriculture (my addition)
- Reducing waste (my addition)
Our investment conviction is that sustainability- and climate-integrated portfolios can provide better risk-adjusted returns to investors. And with the impact of sustainability on investment returns increasing, we believe that sustainable investing is the strongest foundation for client portfolios going forwardLarry Fink, CEO Blackrock
I like to think of money as fuel and not as a destination. A fuel for supporting people and ideas that basically align with my values and interests.
Alex Danco has argued that most of the seed investment merely results in a transfer of wealth from investors to founders, and more noticeably, only in social bragging rights for the angel investors.
I tend to agree with this realistic view of the early-stage investment market. Besides, I caveat other investors to be particularly attentive to the opportunity costs – both in terms of time and money – required by trying to contribute to improving the world.
Alex also argues that the social aspects of angel investing depend on the density of the network that sustains them:
Once you have that sufficient density of people who care about the social return to angel investing, and you establish a genuine “early stage capital market” that is subsidized in part by the social and emotional job that it’s doing for its angel members, you create something really special. You get the rare conditions where capital is available for founders at high enough valuations, with no strings attached, and by investors who are evaluating them “the right way”, that you actually sustain a scene that produces startups in sufficient numbers to generate those few unlikely mega-winners that replenish angels’ bank accounts and keep the cycle going
I also observe the social network spillover effects identified by Alex but dispute the need for such density to be geographically driven. Increasingly the value of such networks will not be conditioned by where you live, but by whom you know and even more precisely, by its quality. Thus my call to share deal flow among impact investors. This will hopefully not just result in a wealth transfer or ‘innovation subsidy’ in favor of social entrepreneurs, but more critically, will probably contribute to the strengthening of the early-stage capital market system.
The crucial role of the rich in a capitalist economy is… to invest; to provide unencumbered and unbureaucratized cash.George Gilder – American economist