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
Great insights! I love that you have included Benjamin Graham’s example as well!
I also loved how well you are able to express your opinions- so clear and effective.
I want to remain updated with your work, so I have followed you! 🙂