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
Some time ago, I joined a discussion with a group of impact investors, about the best ways for sourcing deal flow, and, which are the best practices for the sharing of deal flow.
The elephant in the room was the tension between keeping a deal to yourself versus cooperating, i.e., competitive edge (access) to investment opportunities vs. co-developing deal-flow.
I believe that the best way forward for impact investors regardless of their stage or scale is by joining resources with other impact angels. My goal is not to be the best impact investor in the world, but rather to contribute to its improvement. In my view, this is best done by working together with other persons. Ergo, please feel free to contact me to discuss the potential sharing of investment opportunities.
Going from one-to-one to a more structured approach
How to more easily share deal flow/resources among impact business angels?
Finding excellent investment opportunities is quite challenging, and at a minimum time-consuming. Besides deal flow, there is a lot more we could share and syndicate (*) to foster opportunities for great companies to connect with great investors.
Besides the time consumed by deal sourcing, it is also difficult and time-consuming to keep track of everybody to know who is doing what?. How most investors find and share deal flow is based more on ‘who do you know’, i.e., your current network, and mainly done in an unstructured manner. Even professionals have admitted that most of their deal flow development efforts are carried out on an ad hoc basis. Most often, via word of mouth, using email or phone.
A common theme for most successful investors is being overwhelmed by their overflowing mailboxes. Receiving a lot of applications but finding few startups that are suitable for investment. This results in a lot of time invested in screening and triage of potential investment opportunities. Furthermore, investors are more likely to invest in startups that they actively identified and sought to the detriment of those that may have just shown up in their email inbox. As with VCs, an intro from another founder never hurts.
Finally, another perhaps obvious but not always applied lesson is not to recommend things that you haven’t done due diligence on.
How to do it? Deal flow sharing toolkit
Email: schedule it to go out on the same day and at the same time every month. “Every month or so, I sent out an email with some info on between four and eight companies. If investors are interested in a company, they let me know, and I do the intro. I vet everyone on the list to make sure they’re an accredited angel or from a fund“.
Slack community: needs to be appropriately managed and nurtured so that people can get access to support, partners, co-investors, and excellent deal-flow from around the world. Some Slack communities regularly share notes on startups, split up attendance to demo days, and collaboratively hunt to fill open roles at each other’s portfolio companies.
- easy penetration with (likely) little resistance;
- essentially becomes a two-sided marketplace within the investor community;
- strong network effects if it catches on; and
- improved pipeline for all (or at least an increased number of companies on their radar).
- a balance needs to be found on the number of internal thoughts and analysis to be shared for each deal vs. just sharing deals ‘objectively’;
- relies on each member of the channel to provide and not only consume;
- possible adverse selection — some investors unlikely to share their top deals if they fear they could miss out on rounds if they do;
- legality — be sure to talk to your lawyer before posting.
Database / Mapping tools- any such devices should have the ‘right filters’ for the identification and screening of the relevant startups that will fit the investment criteria of other investors. There are some databases such as The Impact Investment Network Map, Toniic community; however, access is limited to members only.
Physical meetings – organizing physical meetings such as meetups, theme-based networking events. One of the best practices is to distribute a deal book and to collect feedback about the investment opportunities on the spot.
(*) Many things that could be shared, such as deal opportunities, risks, resources, mentoring, information.
“If you want to go fast, go alone. If you want to go far, go together.”
Ludovic Libert, Co-founder of Happy Hours Market (*) shares how to overcome the challenges of scaling up a food waste avoidance startup.
Why did you start Happy Hours Market, and what do you do?
About 7 tons of food are wasted every minute in Belgium. At the same time almost one-third of the population is considered close to the poverty threshold. We offer the possibility to buy via our app unsold products at half price, and then donate any leftovers to affiliated charities.
Why do your clients shop with you?
Basically, for two reasons. First, they are interested in saving some money with their purchases (most of our items are at half the price of what the retail store charges typically for them). Second, they are conscious of the ecological impact that they avoid with their purchases.
What are your plans for this year?
We are trying to expand our operations to cover all of Brussels this year. In the future, we envisage deploying in other major cities in Belgium and abroad.
Which are your main challenges for this year?
We have to execute our growth strategy. This includes partnering with new stores, adding more users to our platform, and developing new tools and systems to cope with the increasing complexity of our logistics.
What are the most challenging areas for Happy Hours Market’s growth and for the waste avoidance industry?
They are multiple and concern:
- the management of the logistics of this business,
- the scaling up of our management systems,
- offering new services to our stakeholders and
- incorporating block-chain based solutions to ensure the trace-ability (from reception to end of life) of any food and perishables that are marketed through our platform.
(*) I am an investor in Happy Hours Market
About 7 tons of food are wasted every minute in BelgiumLudovic Libert, Co-Founder Happy Hours Market
I don’t care that much about valuation, and thus pay slight attention to this parameter when deciding whether to invest or not in a startup. Apparently, I am not the only one. In a recent post, Sam Altman, of YC fame, provided his recipe for successful investment in startups, which doesn’t mention valuation at all.
Hunting for a diamond
Similarly to what Fred Wilson stated in his post “Venture Fund Economics: When One Deal Returns The Fund“, I don’t try to “swing for the fences“, I just try to create a reasonably well-diversified portfolio that corresponds to my values and interests.
Some will read this and suggest that our business is all about swinging for the fences. But I don’t think so. There are hitters in baseball, the best hitters in fact, that hit balls out of the park when they are just trying to make good contact. That’s how you have to do it in the venture business. You try to make 20 great investments and you work with them closely in hopes that four years in you have six or seven that have home run potential, and after ten years, you maybe hit one or two out of the park. If you try to hit every one out of the park day one, you’ll strike out way too much and the fund won’t work out very well. – Fred Wilson
Swinging for the fences would require being in the 1% of the angel investment community, and being capable of identifying entrepreneurs that are also in the 1% of their industry. It implies being capable of making extensive use of second-order thinking. Without contradicting the above, Altman’s guidance for “thinking big” additionally applies:
You should try to limit yourself to opportunities that could be $10 billion companies if they work.
From hypothetical to real value
Investing in seed rounds is going from hypothetical value to real value.
In seed investments don’t focus too much on hard metrics but rather on more intangible factors such as the grit of the founder, size of the future market, optionality (did anybody say pivot?) and potential systemic leadership of the startup that you are considering funding.
In my view, most financial analysis is backward-looking, and the discounted cash flow analysis performed at the due diligence stage is only based on the founder’s promises/narrative. With these tools, how are we supposed to appraise the potential income or impact of a startup?
This said I am one of those that firmly believe that you should hold founders accountable for their projections vs. real achievements. Once you have agreed to the goals self-imposed by founders, do hold them accountable for the gap between expectations and reality, and let them explain how they will overcome any obstacles that they didn’t initially anticipate. You should challenge the action plan if it is not bold enough or clearly pointing in the path to failure, in all other cases I normally stay put until the next investor update.
Another way to look for value
Asking hard questions in addition to those that I included in doing due diligence as per my investment criteria
- Are you meeting your financial targets?
- What’s your path to profitability?
- How much fundraising is required to get there?
- How much will investors get diluted?
- What’s your burn?
- How much runway is left?
- What are the anti-dilution rights?
- What is the liquidation preference of the money already raised?
Valuations measure the trade off between current prices and a very long-term stream of expected future cash flows. Every useful valuation ratio is just shorthand for that calculation. Every valuation ratio that fails that criterion is inferior, and you can show it in historical data.John P. Hussman, Ph.D.
President, Hussman Investment Trust
I really get upset when weeks go on and I don’t get any news from some of the startups in which I have invested. In the case of publicly-traded stocks, I can find out the market cap almost every minute, get quarterly reports and follow discussions with the management for those companies that hold investors’ calls.
When it gets to startups, a few of them provide regular updates. Some founders only get back to you when they are running out of money or even worse, when the major crisis or bankruptcy is looming or irreversible. Why??? – What benefit do you get from keeping your shareholders and investors in the dark? Even if you are not making much progress, they will eventually find out.
I understand that reporting takes time and that the founders’ priority is growth, but by neglecting to communicate regularly with your investors, paradoxically you may be missing some opportunities to accelerate growth.
What I (and probably all investors ) want from you:
- No bullshit communication, straight and to the point.
- Provide a few KPIs – Trends – Goals – Highlights and Low-lights. Asks.
- Do it every month, on a rigid schedule.
Here is a model form from the Founder Institute
Information rights are not very frequently considered in pre-Series A shareholders agreements since there is a scarce chance to enforce them, nevertheless, I am considering starting to insist on their inclusion as a condition for investment, at least as a system for the self-identification of the “bad apples”.
Effective communication is 20% what you know and 80% how you feel about what you know.Jim Rohn