Posts from Investing

The Power Of Diversification

I have written about this topic before but it's important and I want to say it again.

Investing in startups is risky. If you make just one investment, you are likely going to lose everything. If you make two, you are still likely to lose money. If you make five, you might get all your money back across all five investments. If you make ten, you might start making money on the aggregate set of investments.

The math behind this is pretty simple. If you assume that the average startup has a 33% chance of making money for the investors, a 33% chance of returning capital, and a 33% chance of losing everything and that only 10% will make a big return (>10x), then you can model this out.

Model startup portfolio

All the profit in that ten investment portfolio comes from the big winner. If you don't make that investment, you would have made nine investments for a total of $450,000 and you would have gotten back $450,000. You would have been better keeping the money in the bank.

So you need to make enough investments to be confident that you will get at least one big winner. And so that means making enough bets.

There's another important aspect of this. You should invest roughly the same amount in every investment. Don't try to pick the winners at the time of investment by putting more in the ones that are "sure things" and less in the ones you are less sure about. The only sure thing about startup investing is that there are no "sure things."

Let's look at the same portfolio with a set of random initial investment amounts.

Model portfolio with inconsistent investments

You can see that even with the same set of outcomes for each investment, the amount invested in each one has a big impact on the total return of the portfolio. It really all comes down to how much you have invested in your big winner. And since I do not believe you can predict which one will be your big winner, my view is you want to be as consistent as possible with your investment amounts.

When you are an investor, there are days when some of your investments are doing great and some are doing badly. If you are broadly diversified, those days are easier to take. If you are all in on one investment, then those days are brutal. Entrepreneurs go all in and are rewarded accordingly when they hit it. Investors should not go all in. They should be diversified.

#VC & Technology

Social Proof Is Dangerous

Hunter Walk has a post up suggesting that "social proof" is not as helpful of an indicator of startup quality as it once was.

I have always hated the idea of social proof. It's just the herd instinct at work. It's nonsense.

If you can't figure out why you like an investment and why it will be successful, don't make it.

Yesterday my partner Andy and I met with a company that has had a hard time raising capital. I talked to a bunch of big name investors about it and they all hated it. I told Andy "that makes me like it even more."

We may or may not make this investment. We have to do our work, figure out the market, make the calls on the management team, and figure out how big of a business it can be and whether we can make a good return on it. But we don't care who else wants to invest. In fact, I'd prefer if nobody else wants to invest in it. That would be great.

Make up your own mind. Don't follow the herd. Don't chase.

#VC & Technology

What If Web And Mobile Apps Are Like TV Shows?

I was having lunch with a veteran of the entertainment and the video game business this past week. It was an interesting and wide ranging chat. One of the things we discussed that stuck in my mind was the thought that web and mobile apps might behave more like TV shows than traditional software applications.

I've watched my kids go from myspace to facebook to instagram over the past seven years. And who knows what social app will be their "go to app" in five years. This has always been the case in videogames. Farmville to Cityville to something else. Words With Friends to Draw Something to something else.

This round trip from nothing to everything to nothing again is also true at some level with many tech companies. Digtal Equipment Corporation was founded in 1957 and shuttered in 1998. RIM was founded in 1984 and in all liklihood will be gone before the end of this decade. Same with Sun Microsystems, Silicon Graphics, and many more iconic tech companies.

This concern or observation depending on where you sit has wide ranging implications for valuations, returns, and many other aspects of the startup economy. Companies are worth the net present value of their future cash flows. Said another way, if you knew that a company was going to earn $1mm a year for the next ten years and then be shut down, there is no way you'd pay more than $10mm for that company and certainly you'd pay something a bit less than that.

There are web and mobile applications that seem more immune to the "here today gone tomorrow" concern. Utilities like search, email, calendar, document store, etc feel less likely to be subject to this issue. YouTube also feels fairly secure. But purely social apps, the ones that depend on having your friends on them, seem quite vulnerable to a mass exodus. RIM's demise among my kids' generation had more to do wtih everyone leaving BBM than anything else. For as long as all of their friends were on BBM, they all wanted to be on it too.

Network effects are powerful in both directions. They can help you grow exponentially. But when they are going against you, they work just as fast. Myspace's decline was mind blowingly quick. RIM's has been as well. Who is next?

I am not writing this post to pour cold water on the internet sector. There are so many amazing things happenning right now. We are investing actively and agressively and are not the least bit bearish.

But it is important to understand the entire life cycle of what you are investing in. If you are playing a game of musical chairs, you have to know that's what you are playing. Or you will be the one left standing with nowhere to sit. And that sucks.

#VC & Technology#Web/Tech

Some Thoughts On Public and Private Markets

I had breakfast with Alan Patricof last week. Alan is the dean of NYC VCs, he's been at this game longer than any of us. He was in the business when Intel and Apple went public.

The breakfast came about when Alan wrote this blog post in Business Insider about the problems with the IPO market. I read the post and emailed him with some feedback on the parts I agreed with and the parts I disagreed with.

We decided to have breakfast and chat about it.

My going into breakfast position was that the IPO market isn't all that it is cracked up to be. That the emerging secondary market is allowing companies to stay private longer (maybe forever) while allowing founders, angels, and early stage VCs to get liquidity. I believe that the IPO market should only be for the very best companies that can sustain value creation for long periods of time for their shareholders post the public offering. I think that is a very high threshold that most VC-backed companies cannot meet.

Alan's going into breakfast position is that we have lost our way (read his BI post for details). Back in the days of the IPOs of Apple and Intel, great tech companies would go public at low valuations, there were dozens of small market makers who would do research on the stocks, and most of the investors in these deals were individuals. Now we have markets that are largely closed to the individual investor. VC investing is largely instititional and limited to "qualified investors" (ie rich people). The secondary markets are also largely limited to qualified investors. And the IPOs these days are sold to a dozen or so large hedge funds who are also dominated by institutional investors and rich people.

Like all good discussions, we both came away with an appreciation for each other's point of view. I agree with Alan that we need a way to allow the individual investor to participate in the value creation that large tech companies can provide. And I recognize the the vast majority of people who have participated in the value creation from Facebook, Zynga, Twitter, and Groupon have been institutions and the very wealthy. That doesn't seem right or fair.

I think the SEC needs to rethink the capital market regulations and structure we have in our country. The secondary private market is a good thing and does allow great companies to stay private longer while providing liquidity for founders, angels, and early VCs. But there are issues with the secondary markets as they exist today. There are no disclosure requirements. There is little or no way for individual investors to participate. The 500 shareholder rule is creating all kinds of problems for companies. And we don't have a public market system that allows companies to be public at lower valuations with less capital raised. Alan believes we need a "new nasdaq" where companies can list for $250mm or less and have liquid markets in their stocks that individuals can participate in.

The US has a vibrant tech economy, a VC industry that is the envy of the world, and public markets that are highly liquid. We can and should stimulate the development of some additional layers of capital markets between the VC market and the current IPO market. A vibrant and fair secondary market that provides individuals some access and a new "low cap public market" are the natural additional layers to our current system. I'd also like to see more access for individuals into the VC market.

I hope the SEC is thinking about all of this. I hope they read Alan's post and this post. It is important stuff.



#stocks#VC & Technology

Doubling Down On The Overpay

One thing I've seen many VCs do wiith their initial investment in a company is invest more when the valuation gets expensive. They are ownership driven, not valuation driven. So if they originally wanted to invest $4mm at a $20mm post money valuation and buy 20% of the company, they talk themselves into investing $8mm at a $40mm post money valuation so they can still buy 20% of the company.

I have never liked this approach. When the price of an initial investment goes up, I prefer to invest less, or nothing at all. Investing nothing at all is a fairly obvious approach when the price gets beyond your comfort zone. Investing less is not as obvious.

My rationale for investing less has to do with the fact that most venture investments involve multiple rounds. If you believe there will be additional opportunities to invest in the company and you really want to be involved, then you can invest less and reserve more funds to invest later in hopes that the risk reward of the investment improves. Since you will be an investor in the company, you will be shown those opportunities before or at least alongside new investors in future rounds.

Investing more when the price is too high makes no sense to me. If you are overpaying by 2x, doubling down feels like overpaying by 4x.

I think the root of this "doubling down on the overpay" issue is that many VCs manage large funds of other people's money and they really don't care so much about how much they invest in each deal. They are looking to buy large stakes in companies and hope that one or more turns into a big winner.

I try to invest as if I have a fixed amount of capital and it is my own capital (some of it is). I like to think that every investment we make takes funds away from other investments we can make, even though this is not actually true. Our firm could raise more money if we wanted it and needed it. But I think raising larger funds will ultimately lower the returns we can deliver to our investors and we have resisted doing that.

So instead of being ownership focused, I prefer to be valuation focused. And the key figure I look at is average valuation of our entire investment. We take the total amount of capital we have invested in a company and divide it by our total ownership. We like that number to be as low as possible relative to the current value of the business. I believe that is the recipe for the best returns and that is what we seek to deliver to our investors.



#VC & Technology

Does Price Matter?

Most people assume that price is what matters most in a financial transaction. When you are raising money, you want to get the money at the highest price (least dilution). When you are selling, you want to get the highest price for your company. But that is not always the case.

Price matters, but my experience says that it often does not matter the most. In many of the venture deals we have done in the past few years, our transaction valuation was not the highest price offered to the entrepreneur. But the entrepreneur chose us as their partners anyway.

In the majority of the sale transactions that have happened in our portfolio, there were higher bidders for the company than the chosen acquirer.

You can get away with this behavior if you have a closely held business. If you have a public company, then you cannot. The Board has a fiduciary responsibility to get the best deal for the shareholders. And if you are a public company, that effectively means the highest price. That is one of many reasons I don't like being on public boards and operating as a public company.

Let's say you are one of two or three investors in a closely held startup company. Let's say that between the investors and the founders, the group owns ~90% of the company. And let's say that there are two purchasers. One is willing to pay $250mm in a clean transaction and the Board thinks they will be good owners of the business, will do everything possible to keep the team intact and the service vibrant. The other is willing to pay $300mm in a complex transaction, has a reputation for blowing up teams, and has been known to mess up the services they acquire. That would be a no brainer. The board should take the lower offer in a heartbeat, assuming they really want to sell the business.

When you are doing an important financial transaction that brings a new influential owner into the company, price matters but is not the most important issue. The most important issue is the chemistry between the existing owners and the new investor/owner and the reputation of the new investor/owner. You want to use the market to surface the right valuation band and you should do the transaction in that band. But once you have done that, you should optimize for chemistry and fit. And let price fall somewhere in the "market band."

If you cannot find an investor/owner who is a good fit in the "market band" then you should kill the process and not do a transaction unless you need to transaction to stay in business. If you are doing a transaction to stay in business, you have screwed up and put yourself in a bad position. And you should be prepared to be in a worse position soon. But that's the subject of another post.

So price matters but don't optimize for it. Not in a financing transaction. And not in a sale transaction. If you do, you will often regret it.

#VC & Technology

Contrarian Investing

My favorite investor is the contrarian. I know a lot of momentum investors that do well and I respect their approach to investing. But it is not an approach I can wrap my head around.

My favorite quote on contrarian investing is from Baron Rothschild who supposedly said:

the time to buy is when there is blood in the streets, even if the blood is your own

That is the kind of thinking that drove me to put a bunch of money into the market directly buying stocks in the fall of 2008, which I blogged about frequently here.

It was very hard to raise a venture fund focused entirely on early stage web investments in 2003 and 2004. Nobody thought that was a good idea. And that fund we raised will be the best venture fund I've ever been involved in. So I've had enough experience personally with contrarian thinking and excellent investments to know that it makes sense, at least to me.

I've been thinking a lot about what a contrarian would do in web investing right now. The easy answer is sit on the sidelines. But we are not paid to sit on the sidelines. We are expected to invest capital. In addition, I feel strongly about not trying to time markets. We like to put about the same amount of capital out year after year without too much variation.

We will only invest in things we know well so that takes non-web sectors off the table. Add to that our particular investment thesis around investing in large networks of engaged users and avoiding gatekeepers and you have a quandry.

I'm thinking a lot about this question these days so I thought I'd put it out there and see what you all think. Opinions of all sorts are welcome here, including the occasional kookery.



#VC & Technology

Apocalypse and Bubbles

Peter Thiel, entrepreneur, VC, angel, Facebook board member, and hedge fund manager, penned a long and thoughtful piece about the possibility of an impending apocalypse and how that might lead to financial bubbles. It was written in 2008 but I only came across it yesterday (on Hacker News). He calls it The Optimistic Thought Experiment. I you are an investor and haven't seen it before, I suggest you go read it in its entirety.

For those who would rather have the cliff notes, Peter's argument goes like this (Peter's words are in italics, mine are not):

1) if the truth were to be told, our slumber is not as peaceful as it once was. Beginning with the Great War in 1914, and accelerating after 1945, there has re-emerged an apocalyptic dimension to the modern world. In a strange way, however, this apocalyptic dimension has arisen from the very place that was meant to liberate us from antediluvian fears. 

Peter argues that science in all of its form (nuclear weapons, biological catastrophes, etc) has vastly increased the probability of some form of apocalypse.

2) A mutual fund manager might not benefit from reflecting about the danger of thermonuclear war, since in that future world there would be no mutual funds and no mutual fund managers left. Because it is not profitable to think about one ’s death, it is more useful to act as though one will live forever.

Peter argues that betting on the apocalypse makes no sense so rational investors don't do it.

3) Globalization may end by accident or by terrible miscalculation: It may end by world war.  Because there would be no winners in a new world war, every path away from globalization will end in catastrophe. Thus, in spite of the many uncertainties surrounding the costs and benefits of a more globally integrated world, investors have no choice but to bet on globalization. There are no good investments in a twenty-first century where globalization fails.

Peter argues that globalization is the anti-apocalypse bet.

4) Even the most preposterous bubbles of recent decades — Japan in the late 1980s and high-end real estate today — would have been far more restrained, had they not been stoked much further by the narrative of globalization.

He goes on to connect financial bubbles with bets on globalization. This is the most fascinating part of the essay to me. I've gone back and read it a few times now.

5) the pace and amplitude of these booms has accelerated tremendously, in complete contradiction to the widespread notion that markets are becoming more smooth and efficient over time. During the last quarter century, the world has seen more asset booms or bubbles than in all previous times put together: Japan; Asia (ex-Japan and ex-China) pre- 1997; the internet; real estate; China since 1997; Web 2.0; emerging markets more generally; private equity; and hedge funds, to name a few.

And then Peter explains that the recent slate of financial bubbles, which he calls unprecedented in history, are related to the growing sense of impending doom.

And here is the money quote:

But because we do not know how our story of globalization will end, we do not yet know which it is. Let us return to our thought experiment. Let us assume that, in the event of successful globalization, a given business would be worth $ 100/share, but that there is only an intermediate chance (say 1:10) of successful globalization. The other case is too terrible to consider. Theoretically, the share should be worth $ 10, but in every world where investors survive, it will be worth $100. Would it make sense to pay more than $10, and indeed any price up to $100? Whether in hope or desperation, the perceived lack of alternatives may push valuations to much greater extremes than in nonapocalyptic times.

It's a fascinating argument. I can't say whether I buy it or not. But it's in my head now and as a result it will be part of the way I look at the world, investing, and valuations. How much it will be a part of that remains to be seen.

At the end of the essay, Peter talks about China, Web 2.0, and hedge funds in the context of this "optimistic thought experiment". I've been thinking a lot about all three having most of my eggs in the middle basket and having taken a lot of eggs out of the latter basket and thinking about putting some eggs in the first basket. It was a good time for me to come across this essay.

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#stocks

My Favorite Money Manager

The Gotham Gal and I have our assets spread across a number of asset classes and money managers and our allocations and managers have changed a fair bit over the years. We’ve seen a bunch of managers in action up close and personal.

Right now, my favorite money manager is an optical surgeon named Robert Freedland. Robert is 56 years old, he’s been managing his own investments for 42 years, and he’s been blogging and podcasting about stocks for the past seven years. I invest with Robert on Covestor (which in the spirit of full disclosure is a portfolio company of Union Square Ventures).

About a year ago, we put a modest but non-trivial amount of cash into a Covestor account. We only invest with model managers in risk tiers 1 and 2 to keep our capital at lower risk. There were about five or six model managers in those tiers at that time so I put the minimum on all of them. I would check each month and slowly I left most of the managers. But I kept putting more money with Robert. And he kept performing. Now we have close to half of our Covestor portfolio with Robert and I am thinking of giving him even more.

We are up about 11% on the money we’ve had with Robert in the past year. Since some of those funds went in a year ago, but most went in more recently, I suspect our annualized returns are closer to the 17% return he’s annualized since he started on Covestor.

I like that Robert has delivered excellent performance with an emphasis on value investing in highly liquid stocks. I like that he doesn’t short stocks and doesn’t own anything I don’t understand or recognize. I like the fact that he has a strategy and he sticks with it. And most of all, I like that he is investing his own capital as well as mine.

If you want to invest with Robert, you can. He has a $5,000 minimum and you’ll need to open a Covestor account to do it. This is not a recommendation to invest with Robert, but it is an acknowledgement that there are great investors out there who don’t work on Wall Street and that thanks to the Internet they can manage your money as well as their own money and that is a very good thing.

#stocks

Off Balance Sheet Liabilities

In the past couple weeks we’ve talked about some costs that don’t always appear on the income statement; opportunity costs and sunk costs. Today, I’d like to talk about some liabilities that don’t appear on the balance sheet. The technical term for them is “off balance sheet liabilities” and they are something to be very wary of as an investor.

When you think about investing in a business, whether it is a public stock you can buy via Schwab, or a mature business you are acquiring with debt financing in a leveraged purchase transaction, or a growth company you are investing in, or even a young startup, you should take a close look at the balance sheet. You should see what obligations that company has built up over the years and how they compare to the company’s assets. When the liabilities are large and the assets are not and if the cash flow is weak or non-existent, then you should be extremely cautious because those liabilities can sink the company. We talked a bit about this in the post I did on financial statement analysis and the balance sheet.

But sometimes companies don’t put all of their obligations on the balance sheet. There are at times valid reasons for this, but there are times when the company is just trying to pull a fast one on the investor community. Enron is a classic business case story about this. What Enron did was create investment partnerships where they transferred assets and liabilities. But those partnerships had close ties back to Enron and at the end of the day, they did not eliminate the liabilities, they just took them off their reported balance sheet. When those partnerships blew up, Enron came crashing down. Billions were lost and executives went to jail.

Even if the company you are looking to invest in is totally clean and honest, there will be likely be liabilities that are not on the balance sheet. Let’s say you are looking at investing in a company that does mobile software development for big media companies. Let’s say they have just signed a three-year contract to develop mobile apps for one of the largest media companies in the world. Let’s say they got paid upfront $1mm to do this work. That $1mm will appear on the balance sheet as deferred revenue and that is a liability. But what if the company misjudged the amount of work it will take and they will ultimately lose money on the deal? What if it will actually take them $1.5mm in costs to do this work? The $500k of losses is an additional liability but it doesn’t appear on the balance sheet anywhere. But those losses could sink the company if it is thinly capitalized.

Real estate liabilities are a particularly thorny issue. Back in the early part of the last decade, right after the Internet bubble burst, I spent almost all of 2001 trying to negotiate a bunch of companies out of real estate liabilities. These companies were all growing like crazy in 1999 and 2000 and they signed five and ten year leases on big spaces (like 10,000 square feet or more) with big landlords. Many of these leases had rent concessions in the first year or 18 months and when those concessions came off, the companies instantly faced the dual reality that they could not afford the leases and that they were not going to raise more money with these huge lease obligations in place. But those lease obligations were not on the balance sheets. The annual rent expenses were on the income statement, but the future lease obligations that ultimately sunk a few of these companies were only disclosed in the back of the footnotes.

The footnotes are where you have to go to see these off balance sheet liabilities. If the Company is audited, then their annual financial statements will have footnotes and this kind of stuff is likely to be in there. If the company is publicly traded, it will be audited, and the footnotes will be in the 10Ks and 10Qs that the company files with the SEC. But many privately held companies, particularly early stage privately held companies, are not audited. So if you are going to invest in a company that is not  audited, you need to diligence these unreported liabilities yourself. You should ask about lease obligations and any other contractual obligations the company has. Read the leases and the contracts. Understand what the company is obligated to do and how much money it will cost. Make sure those funds are in the projected cash flows.

Balance sheets and income statements are important to understanding a company. But they do not tell the entire picture. They don’t tell you if the team is solid. They don’t tell you if the product is any good. They don’t tell you if the market is big. And they don’t even tell you about all the costs and they don’t tell you about all the liabilities. So you have to dig deeper and understand what is really going on before putting your capital at risk. That is called due diligence and it is critical to investing.  And looking out for liabilities that aren’t reported on the financial statements is an important part of that.

#MBA Mondays