Let’s begin with some disclaimers. I have never actually been a value investor. I have also never made individual picks of stocks traded on the public markets. I was completely oblivious of stock markets until soon after I had graduated college in 2001. Before I arrived in the United States in 1997, I would not have been able to answer the question; What is a stock? During my 4 years of college I stayed narrowly focused on mathematics and physics, in which I completed a double major.
It was not till I began my professional career as an actuarial analyst at Watson Wyatt that I began to read the Wall Street Journal, and also to pay attention to news about the economy and the financial markets. I bought and read a copy of Roger Lowenstein’s Buffett: the Making of an American Capitalist. I bought the book because what I had read about value investing in the popular press at that time seemed made me think it was an investment philosophy that would agree with my temperament.
In business school at New York University’s Stern School of Business, I decided that I should petition the committee on academic standing to let me pursue an independent study on value investing. I drafted the petition, drew up a syllabus, won approval from the school, and then persuaded a professor to act as my course supervisor. My goal for the course was to learn enough about value investing to allow me to apply its precepts in what I hoped would be a career as a buy-side equity investment research analyst, studying publicly traded companies. That was 2008. Things did not work quite as I expected. I did not land at what one would traditionally think of as a securities analysis outfit. Honestly, for a while I did not know if I would land anywhere.
Eventually, I did land somewhere. Initially, my job required me to focus on helping two small companies navigate the treacherous economic climate that was the reality in 2008, 2009 and 2010. For two years that was all I did. Eventually, my responsibilities at work evolved. Now, I primarily spend my time assessing early stage technology-enabled startups for investment consideration by a venture capital fund that makes seed, series A and series B investments.
As you might expect, the shift in my responsibilities has led me back to thinking about value investing. I have asked myself what role it plays in my work. I have also been thinking about how I might apply its main precepts to my work.1
Jeffrey Bussgang tackled this subject in a piece for Fortune in October 2010, coincidentally this was not too long after I had started my very first seed stage venture capital assignment.2 I was knee deep in trying to teach myself the basics of venture capital investing. I still am. I was happy that someone else had already seen the need to tackle that question, and so I read that blog post eagerly. However, I felt a sense of intellectual dissatisfaction after I was done. So I am revisiting the question he raised. I hope I do a good job of adding to the discourse that he started. For the record, I agree with Jeff Bussgang’s conclusion – in general, it is difficult for venture capitalists to apply the concepts of value investing in a straightforward way to their work. That said, I wonder if it is not possible to apply the framework to early stage venture investing, even if the details about that application differ from what one might be accustomed to seeing or doing.
To begin the discussion I will lay out some terms that have guided how I think about this question.
When I think of a startup I prefer to use Steve Blank’s definition. According to that definition:
A startup is a temporary organization in search of a scalable, repeatable, profitable business model.3
I paraphrase that definition very slightly. A startup is a temporary organization established for the purpose of finding the solution to a problem, and to search for a scalable, repeatable, profitable business model. It is important to emphasize the process of finding a solution to a problem because it is not unusual for venture capitalists to encounter startups that have developed a solution that is seeking a problem. I try to avoid such startups. Once the startup has found a scalable, repeatable, profitable business model it begins the process of transforming itself from a startup into a company.
Venture capitalists invest in early stage, high growth startups. Usually the startups that attract the attention of venture capitalists are going into business on the basis of some innovation; technology, business model, or even a completely new invention. Generally venture-backed startups are most concentrated in areas where science, technology, engineering and mathematics play a central role. Venture capitalists typically invest after the startup has already raise some capital from friends and family, and subsequently from angel investors. However, some venture capitalists have begun to invest exclusively in seed stage startups where often the only previous capital raised by the startup is that raised from the founding team’s family and friends. The venture capitalist provides capital in exchange for an equity stake in the startup. Therefore the venture capitalist earns a return when there is an exit – an acquisition by a larger company, or an initial public offering in which shares are sold to the investing public. Venture capitalists tend to speak of themselves as people who know how to build companies. The most sought after venture capitalists tout their prior entrepreneurial experience taking innovations from idea to startup to company, and ultimately to exit. They insist that experience makes them an invaluable source of advice and ideas for entrepreneurs traveling the entrepreneurial path. There is a debate in some quarters as to wether venture capitalists’ returns derive from their ability to pick securities much like is the case for investors in the public markets, or if instead it is in fact the company building activities of venture capitalists that lead to the returns that they have realized.4
For a succinct description of value investing I turn to J. Dennis Jean-Jacques;
The goal of the value investor is quite simple: To buy solid businesses at exceptional prices in order to achieve adequate after-tax returns over a long period. The mental model is as follows: Good Business + Excellent Price = Adequate Return over Time5
One of value investing’s most important concepts is the concept of a margin of safety. To emphasize its importance in value investing Benjamin Graham says ” . . . to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy – often explicitly, sometimes in a less direct fashion.”6 Seth Klarman is considered one of the most successful practitioners of value investing. In discussing the concept of margin of safety he says: “A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.”7 Generally, margin of safety is analyzed quantitatively – in terms of a discount to intrinsic value, remembering that value investors only buy when a stock’s market price is well below their estimate of its intrinsic value, under the assumption that they understand how the stock price will gradually recover until price approaches intrinsic value.
Another central concept in value investing is the concept of an economic moat. Warren Buffett is credited with coining the term “moat” in relation to investing after he recognized that the companies that yield the most profitable investments over long investment horizons typically possess one or more characteristics that give them a durable competitive advantage. Generally, economic moats are built through some combination of economies of scale, switching costs, network effects, and intangible assets. Some value investors speak of a soft moat as the competitive advantage that a company derives from a unique corporate culture. However one does the analysis, studying the presence and durability of economic moats involves performing a qualitative analysis that is aimed at understanding how competitive advantage may be developed, and maintained.
Consider this example of an early stage startup.8 An entrepreneur raised $200,000 in seed capital 3 years ago and formed a startup with his co-founder. Working with a small team of in-house developers as well as some contractors, they have a near-final product. The product they have developed is a software product delivered over the Web to the startup’s customers. They won a competitively-bid contract with 1 country office of a large multinational corporation that has operations in more than 200 countries, selling 3,500 different products. That contract earns the startup $50,000 a month. The contract is for 3 years. They are only 3 months in. The customer is already initiating discussions to increase the number of its employees that have access to the product. The customer also wants to act as a sponsor to introduce the startup’s product to the global corporate headquarters in a bid to make the startup’s product a part of the suite of software products made available to all 200+ country offices of the corporation. These talks are in the early stages. In addition to this, the startup is in advanced discussions with other large companies that could benefit greatly from its product. Use of its product would provide these companies with a conduit into markets that they have not yet been able to access due to resource constraints. The co-founders feel they can increase monthly revenues to $100,000 a month very soon after they obtain additional capital. So far it appears that the co-founders have done a remarkable job building the product and gaining customer traction. The startup is starting to reach the point where it needs to expand in order to keep up with demand for its product, and also to access other customer segments that it has not yet been able to pursue in a focused way. The startup is raising $2,000,000 in series A financing. It holds 1 issued patent, and has submitted non-provisional applications for 4 more. All 4 are in patent prosecution. The startup expects to raise a series B financing in 18 months after it closes the series A financing. It has no debt. The post-money valuation from the previous round is not outrageous.
Is it possible to apply the precepts of value investing to this scenario? I think so. However, to do so it is necessary to extend how one applies the traditional approach to value analysis. The difficulty here is that this startup confronts us with a situation in which there is no track record, and no clear sight of the future.9 Value investing was designed for mature companies with stock trading in the public markets.10 So, how might a value-oriented venture capitalist analyze this startup?
First, I am assuming that our value-oriented early stage venture capitalist is not considering investing the full $2,000,000 that the startup needs. I am assuming that the venture capitalist will invest a minimum of $750,000 and a maximum of $1,000,000. The startup already has revenues of $50,000 per month. Assuming nothing changes, that revenue stream is locked-in for 3 years. I expect that our venture capitalist will perform some customer calls in order to assess the probability that this revenue stream will be placed at risk anytime soon. Given that the startup is already in talks with that customer to expand the scope of their relationship, I would wager a guess that the probability of that $50,000 per month revenue stream deteriorating is low. I would expect the venture capitalist to focus even more attention on the probability that on-going discussions with other customers will lead to the increase in revenues that the management team has described. Assuming a 24 month investment horizon between the completion of the series A financing and the completion of the series B financing, and assuming that the new revenues do not show up for the first 6 months after the series A financing is completed:11
Total Revenues = (24)($50,000.00) + (18)($50,000.00) = $2,100,000.00
Remember our definition of a startup? One of the main sources of uncertainty that the venture capitalist faces is that the startup could run out of capital before it concludes its search for a scalable, repeatable, and profitable business model. In this case, I think our value-oriented venture capitalist can take comfort in the fact that the startup has already engaged with one customer, and is in talks with others.12 Moreover, in addition to the capital that it will raise, the startup has significant revenues coming in that will help ensure it has enough cash to complete the most important tasks that lie ahead – growing its base of customers, growing its base of users, growing its revenues, finding its product & market fit, and settling on its business model. If the management team successfully completes each one of these tasks, there’s no reason to believe that the startup will have difficulty raising a series B round at a step-up in valuation.
So, the primary questions for our value-oriented venture capitalist are these: How acute is the problem that this startup is solving for its customers? What alternatives exist today? Does the startup solve the problem in a way that is fundamentally better than the way that problem is solved by the alternatives? Do the startup’s customers think so? What is the relative value of the solution that the startup has developed? Do its customers perceive its solution as high-, medium- or low-value? Does the startup have a culture of continuously observing its customers and improving the product in such a way that the product evolves as the startup’s customers evolve? Or, does it take the approach that its product does not need to evolve?
Looking at earnings13 in order to make an assessment about margin of safety is not something new in value investing. This is the approach Christopher H. Browne applied in his analysis of American Express after the September 11 terrorist attacks on New York City. In his own words:
Investors who realized that companies of this quality are rarely this cheap and that the income stream from the credit card business offered a margin of safety have been amply rewarded in the years since.14
Second, I expect our value oriented venture capitalist to devote some time to studying the prospect that this startup can create an economic moat around itself. To do this, I think there are at least 10 areas that the venture capitalist should study.15 For each area, I rate the startup I am studying as high, medium, or low. These are the areas:
- Sustainable competitive advantage; why does it exist, how long is it likely to last?
- Network effects; why do they exist, how long are they likely to last?
- Revenue; how predictable is revenue, once it is secured?
- Switching costs; once a customer is secured, do switching costs exist?
- Gross profitability; is gross profitability high, medium, or low? How does gross profitability evolve as the startup grows?
- Marginal profitability; is marginal profitability high, medium, or low? How does marginal profitability evolve as the startup grows?
- Customer concentration; how profitable is each additional customer? I prefer startups that will quickly evolve to avoid falling victim to buyer power. Many small but highly profitable customers is better than a few powerful and demanding customers.
- Partner dependency; is the startup dependent on its partners? What is the nature of that dependency? I prefer the startup not to be so dependent on its partners that an adverse change in the relationship proves fatal for the startup. Several startups have failed after Facebook and Twitter changed the nature of the partnership relationship they had with startups that built products on top of the traffic produced by Facebook and Twitter.16
- Demand creation; how much will it cost the startup to create additional demand? I prefer startups that do not need to spend large amounts of money in order to create new demand. I spend a lot of my time thinking about this.
- Future growth; what are the prospects for future growth? Or, how big is the opportunity that is available to the startup? Bigger is always better in this case – room for more than one player to earn an attractive returns for early investors.
This line of analysis fits well conceptually with a 3-part analysis framework for value investors that is outlined by Bruce Greenwald and Judd Kahn in their book.17 The areas of analysis they highlight are asset value, earnings power value, and value of growth. For any startup asset value is none-existent, or almost nil. Allowing for variability, once the startup has found its product & market fit its ability to generate earnings should increase. Lastly, if the startup is solving an important enough problem in a big enough market, there should be enough room for future growth to earn an attractive return for our value-oriented venture capitalist.
There are numerous pitfalls to the approach I have tried to describe above. First, it is really difficult to estimate intrinsic value for an early stage startup. Second, the approach I have suggested does not change the fact that what our value oriented venture capitalist cannot possibly know far exceeds what is known in relation to the future prospects for this startup. Third, the venture capitalist must spend a considerable amount of time studying the management team of the startup in question. Building an early stage startup is an extremely daunting challenge. Much of our value-oriented venture capitalist’s ability to earn a return rests upon the management team making the right decisions at crucial periods in the startup’s life-cycle. Certain individuals, or combination of individuals, simply lack the temperament to succeed in leading an early stage startup successfully. Last, even after taking all the precautions that one can take, our value-oriented venture capitalist might still wind up making a poor investment – that is true for every value investor, but I expect the frequency of poor results to be higher for a value-oriented venture capitalist than for a traditional value investor.
I have glossed over numerous details by necessity. Fruitful implementation of a value-oriented approach to early stage venture capital investing is all about the details of each specific situation. For instance, I do not know if one can apply a value-oriented approach to startups raising capital at the seed and pre-seed stage. I think this approach only works when the startup has gained some market traction. I have not discussed how investment horizons might factor into this. I default to Warren Buffet’s view that one should invest as if one were buying an ownership stake in a company for the long-haul and not as if one is buying tradable pieces of paper.
I do not know if venture capitalists need to be able to see around corners, but I think they have to do in-depth analysis of the startups in which they invest, and I think they have to spend sometime thinking about the similarities and differences between the early stage startups that they study and the traits of the most successful public companies that were themselves early stage startups at some point in the past.
Early stage venture capitalists can apply the tenets of value investing to what they do, provided they are willing to do some extra work, and are willing to look beyond the most obvious methods that other value investors use.
Any mistakes in quoting from my sources are entirely mine. ↩
Jeffrey Bussgang, Can VCs Be Value Investors?, Fortune, October 6, 2010. Accessed at http://finance.fortune.cnn.com/2010/10/06/can-vcs-be-value-investors/ on August 10, 2013. ↩
Steve Blank and Bob Dorf, The Startup Owner’s Manual Vol. 1: The Step-by-Step Guide for Building a Great Company, California, K&S Ranch Press, 2012, page xvii. ↩
I am greatly simplifying things for the sake of brevity, but this covers the basics. ↩
J. Dennis Jean-Jacques, The Five Keys To Value Investing, New York, McGraw-Hill, 2002, page 2. ↩
Benjamin Graham, The Intelligent Investor, New York, HarperCollins, the 2005 reprint of the original 1949 edition, page 241. ↩
Seth Klarman, Margin of Safety: Risk-Averse Value Investing Strategies for The Thoughtful Investor, New York, HarperCollins, 1991, page 92. ↩
While this specific example is entirely fictitious, it is not entirely dissimilar to many of the situations that early stage venture capitalists have to study in order to make an investment decision. ↩
Tobias Carlisle discusses this in a post from October 7, 2010 entitled Venture Capitalists, Value Investing and Facebook. You can find it here: http://greenbackd.com/2010/10/07/venture-capitalists-value-investing-and-facebook/ ↩
Value investors might be able to adapt their approach to suit mature privately held companies. ↩
Since this is a software startup we expect expenses to increase at only a fraction of the increase in revenues, so I will not focus too much on expenses. ↩
All customers are not created equal. ↩
I am using terms somewhat loosely here; technically revenues are not the same as earnings. ↩
Christopher H. Browne, The Little Book of Value Investing, New Jersey, John Wiley & Sons, 2007, page 68. ↩
I use a grid that I developed based on Bill Gurley’s post; All Revenue is Not Created Equal: Keys to the 10X Revenue Club. You will find that post here: http://abovethecrowd.com/2011/05/24/all-revenue-is-not-created-equal-the-keys-to-the-10x-revenue-club/ ↩
Alyson Shontell, An Obvious Reason Why Some Startups Fail Shortly After Raising Tons Of Money, August 8, 2013: www.sfgate.com/technology/businessinsider/article/An-Obvious-Reason-Why-Some-Startups-Fail-Shortly-4717874.php ↩
Bruce C. N. Greenwald and Judd Kahn, Value Investing: From Graham to Buffet and Beyond, New Jersey, John Wiley & Sons, paperback edition, 2001, page 35 – 47. ↩