Positive Impact at Exit
I recently became aware for the first time about the concept of positive impact at exit time, when Andrew Kuper with Leapfrog Investments discussed how his company combines profit with purpose, even at the exit stage. This principle, which makes part of the Operating Principles for Impact Management, posits that the investor should ‘conduct exits considering the effect on sustained impact’.
The Operating Principles for Impact Management are the following:
My exits so far …
So far, there are two ways in which I have exited the startups in which I had invested:
We all know that startups are experiments and that many fail due to different reasons (albeit always the same). I will post another day the reasons why the startups mentioned above failed. Here, I want to bring your attention to the fact that even in exits due to bankruptcy and reorganization, there are conflicts and tensions between the different stakeholders, particularly the creditors.Different legal systems provide for different arrangements, but in general, equity holders lose all of their investments at this point.
The bankruptcy system’s role is to provide for an upfront, known, fair, and foreseeable arrangement among creditors. The legal systems that prevent a company from going bankrupt or reorganizing result in perverse incentives and moral hazard. Even in the case of large financial institutions, ‘too big to fail,’ bailouts, and the like are out of favor. There is an increasing tendency to avoid asking the taxpayers to pay. The new trend is the bail-in in which debt creditors have their claims written down or converted into equity.
In the case of startups looming with bankruptcy, despite the pleads of the founders, there is almost no sense in throwing good money on to a dead body. The best thing to do is to learn and move on.
Even though there is a signed shareholders agreement in place that supposedly rules the relationship among shareholders, receiving an offer to be acquired usually triggers some tensions. There are generally explicit and hidden conflicts between the stakeholders, namely, employees, founders, shareholders, and VCs. In acquihires, founders can find many ways to be compensated by the potential acquirer without any obligation to share such gains with the other shareholders. As Mike Brown stated in What Everyone Should Know About How Talent is Bought and Sold, this is the time for founders to be honest and transparent. As he says, “Your investors had the courage to take a risk in backing you, so don’t hide things from them — be clear about what the deal says. They’ll figure it out,”
As a business angel, if the exit price is fair, you should not fight with the founders. You can get the proceeds from the sale and fund your next future unicorn. The founders are the lucky horse that you had been riding, and you should be happy that someone with larger pockets has identified and validated your investment thesis. It is not worth being sour; instead, we should accept this outcome as one of the regular possibilities when investing at the seed stage.
I hope to be able to see one of my startups be acquired, as part of a transaction where the purchaser is interested in more than the founders’ team, or exit via an IPO. When this day arrives, I will ensure to remember to decide what is best for me, considering the effect on sustained impact.
When conducting an exit, the Manager shall, in good faith and consistent with its fiduciaryImpact Principle No. 7
concerns, consider the effect which the timing, structure, and process of its exit will have on the
sustainability of the impact.
Sameer from my portfolio company, FAE Bikes, a Bangalore headquartered company, that recently launched in several Indian cities, a low-cost, compact, smart IoT-powered Electric Vehicle charging station, challenged me to answer the following:
Should we make the city center EV only?Sameer Ranjan Jaiswal
Should we create low-emission zones (LEZ) and zero-emission zones (ZEZ) in our cities?
Without being an expert on this matter, I can just express what I am witnessing from my advanced outpost in Europe.
There are no zero-emission zones in force that I am aware of. Prohibiting the circulation of internal combustion engine (ICE) powered vehicles at present when they represent the majority of the cars in circulation, seems to be – as of today – unrealistic and impractical.
There are several low emission zones and ultra-low emissions zones in various European countries, including Belgium. The phase-out and restrictions are gradual and incremental. The enforcement is achieved via fines and monitored by cameras and police. LEZs exist in over 250 cities in Europe, and they are considered as a success case in terms of the environmental and social consequences.
What do you need to create a LEZ or ZEZ?
You can find the answer here. Besides, support from the government and stakeholders, the relevant EV infrastructure needs to be in place before any LEZ or ZEZ is created. Moreover, alternative means of transportation should be available such as walking, cycling, and public transportation.
The experience in Latin America shows that transport electrification at scale is best carried through private-public partnerships. The government is tasked with setting the rules, and sometimes initially subsidizing or providing incentives for the transition from ICE to EVs. The private actors, which generally comprise vehicle manufacturers, utilities, EV charger manufacturers, and other actors from the electro-mobility ecosystem, bring these components and usually finance these types of projects. Some of the most salient examples of successful PPPs are the electric buses in Chile and Costa Rica.
LEZs generally target freight delivery activities due to the high levels of pollution emitted by today’s urban delivery fleets. There are even some LEZ that are implemented solely for goods vehicles or heavy vehicles and not cars. This forces the modernization of the delivery fleet, albeit it punishes the small companies that are unable to keep up with the required investments. Besides, a lot of chargers are needed to allow the efficient circulation of electric trucks and pickups.
A Plethora of Investment Opportunities
The electrification of urban activities – even without the introduction of LEZ or ZEZ – has given me a wide range of investment opportunities. From new manufacturers of utilitarian electric vehicles (I passed), urban electric charger networks such as the one operated by Clem’, pedestrian-friendly electric chargers such as the ‘pop-up’ charging hubs manufactured by Urban Electric, Happy Box for last-mile delivery logistics, among others.
My recent investment in Blissway, a tolling as a service company that enables traffic management at no cost to the cities, is not strictly related to LEZ or ZEZ. Instead, it concerns the creation of smart highways. I am betting that intelligent roads will be cheaper than high-speed trains and hyperloops and will foster the introduction of driverless cars and related technologies.
Low Emission Zones (LEZs) have had a positive impact on air quality in many European cities. They are one of many measures that are implemented in cities to improve air quality. Poor air quality has an impact on our health. Improving air quality improves our health and lets us live longer.Urban Access Regulations in Europe
Most of the pitch decks that I receive include a Boston Matrix of some kind. Typically the startup that is pitching places itself in the upper right corner (superstars), far away from all existing and future competitors.
As Hunter Walk said:
Most of us equate startups with innovation. Sometimes the novelty lies in the product or service, sometimes on the business model itself (ask Mark Zuckenberg of TheFacebook fame).
I am particularly attracted to startups operating at the crossroads of radical ideas, i.e., ideas or businesses which are simultaneously being implemented in different industries or geographies. As I will explain below, there are many sources for achieving a lasting strategic competitive advantage. Being a first-mover is only one of them.
Strategic Advantage and Systems Thinking
Mike Ghaffary, GP at Canvas VC, discusses in the video below the concept of ‘strategic advantage’, i.e., what is your long term sustainable reason for succeeding in business.
Every startup needs a strategic advantage or a combination of them: it can be summarized with the phrase ‘what is your moat?’ (a.k.a. defensibility). You should be concerned if you have no strategic advantage since copycats and fast followers will soon put you out of business.
Some types of strategic advantage include the following:
- Marketplace with network effects – Mike published this post on how to evaluate strategic advantage in a marketplace.
- Same-side network effect
- Data Moat
- First Mover / Brand
- High switching costs
- Proprietary Distribution
Some signs of competitive advantage:
- ‘Liquidity’ / frequency of use / Average transaction size
- Take rate / ‘rake’
- Low risk of disintermediation
These are the steps that Amazon took to systematize their moats.
I strongly recommend watching the full video!
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