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Value Investing

How Studying Bankruptcy And Working On Two Turnaround Assignments Prepared Me To Become An Early Stage Venture Capitalist

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The Chinese Character for Crisis; Danger + Opportunity (From The Ten Strategies For Leading At The Edge)
The Chinese Character for Crisis; Danger + Opportunity (From The Ten Strategies For Leading At The Edge)

 

When I started business school at NYU Stern in the fall of 2005 my plan centered on taking every class in Bankruptcy & Reorganization, and Distressed Investing that I could. I took 3 elective classes in that area; Bankruptcy & Reorganization with Prof. Ed Altman, Case Studies in Bankruptcy & Reorganization with Prof. Max Holmes, and Investment Strategies: Distressed Investing with Prof. Allan Brown.

By my logic, if I learned how to assess and invest in dying companies, and then nurse them back to health, analysing, valuing and investing in healthy companies would seem easy by comparison. I was so sure of this that I also tried to turn my Equity Valuation elective into a pseudo Bankruptcy & Reorganization course too, by opting to value a bankrupt company for my final group-project. I do not recommend trying that.

I was still in business school when the economy began to falter. I moved from UBS to Lehman Brothers in late March 2007. A few days later New Century Financial Corp. filed for Bankruptcy. I was let go from Lehman Brothers a year later, on March 12, 2008. Bear Stearns collapsed and was acquired by JP Morgan Chase on March 16, 2008. I graduated from Stern in May, 2008. On September 7, 2008 Fannie Mae and Freddie Mac were taken over by the federal government. Lehman Brothers collapsed on September 15, 2008. On September 16, 2008 the Fed bailed out AIG.

The rest of 2008 was a bloodbath.

It was in that environment that I joined KEC Holdings, KEC Ventures parent company, in December 2008. I was employee #2. I had been hired into a new role that had not existed before at the company. My responsibilities encompassed any direct and indirect investments the company had made, or might make in the future.

Most notably, the company had already made 2 private equity investments; one in a private jet charter company and another in a fine-dining restaurant group – they were struggling to stay afloat given the economic environment. My first order of duty was to “make sure they don’t die” and “help them come out of this mess stronger than they were going into it.” There would be no financial engineering gimmickry. No tried and true business school textbook “indiscriminate” cost-cutting shortcuts. I had to roll up my sleeves and work with each company as intimately as necessary to achieve the objectives.

This post is about how we navigated that period. It is also about what that period between December 2008 and August 2013 has taught me about the challenges startups face, and my role as a venture capitalist.

Every day is a journey, and the journey itself is home. - Matsuo Basho
Every day is a journey, and the journey itself is home.
– Matsuo Basho

Further Background

Both companies were generating top-line revenues in the range of $20,000,000 – $30,000,000 per year. Both had fallen short of budgetary expectations in 2008, but the aviation company had a more prolonged string of losses than the fine-dining restaurant, partly because the restaurant was a more recent investment at that point. I functioned as an “external management consultant”; I was not a full-time employee of either company, but I worked with employees across the hierarchy of both companies. The restaurant company employed between 400 and 500 people while the aviation company had between 30 and 40 employees after several previous rounds of downsizing.

Both companies had watched as some of their competitors ran into strong headwinds, and subsequently shut down operations because the economic environment was so bleak.

Lesson #1: Understand The Business

Once a company is in financial distress investors have to decide if it is worth saving, and they also have to answer the accompanying question; can it be saved given current known constraints? The only way to do this is to develop a deep understanding of the business, and the context within which it is operating.

Between 2008 and 2012, confidence in the economy was very low. People simply were not splurging on expensive meals or luxury jets. An economist would say that private jet charter and fine-dining both have a high elasticity of demand.

I had no prior experience working at, let alone helping to run a restaurant or a private jet charter company. So I decided to spend the first six months in learning mode. I studied everything I could about both markets while I helped the executives and managers at both companies deal with day-to-day nuts-and-bolts issues.

This was important if I was going to build personal credibility, and if I wanted to win buy-in for my ideas from the executives and managers later on. I had to be able to influence them into doing things they probably did not believe in at the outset, and I had to do this with little real influence.

How this applies to early-stage startups: Today, I look for founders who embrace their expertise, and demonstrate a knowledge of their business that surpasses mine. However, the founder also has to demonstrate an ability to assist me learn enough about their industry to make a decision, and act as a useful sounding board for decisions that have to be made in the future.

Lesson #2: Understand The People

During those six months, I also tried to understand the protagonists in each situation. I relied on a technique I had learned in my Literature in English classes during secondary school in Ghana; character analyses.

A character analyses involves performing an in-depth study of the key characters in a drama, and trying to figure out each character’s story; What motivates that person? Why is that person who they are? What is the person afraid of? What drives that person? How does that person communicate? How does that person respond to pressure and stress. What does that person gain the most satisfaction from? What’s the state of that person’s family life? How does that person perceive me? How do I perceive that person? Does that person buy into the need for a turnaround? Is that person willing to commit to the turnaround? What biases does the person exhibit that I can identify? How does that affect things?

I had to be honest, and to contend with the pleasant and the unpleasant, especially around the perceptions other people had of me at the outset.

I took copious notes, and added to them until I felt I had a decent understanding of each of the people with decision-making authority that I would be dealing with most often; executives, managers, and front-line employees.

Perhaps an important, but often overlooked insight is that an investor should strive to understand the people within the context of the business. For example, is this person a leader or a manager? The distinction matters because it can spell the difference between beating about the bush with no results to show, or getting to the heart of the matter and fixing the problems that need to be solved at a tactical and granular level. Fred Wilson writes about this problem in: Leaders and Executives.

How this applies to early-stage startups: We make seed stage and series A investments. That early in a startup’s life, the people make all the difference. The market is important, so is the product. However, at this stage the future is still so nebulous and difficult to envision that the team that has decided to embark on that journey matters more than anything else. So, I have learned to focus on questions like; How did this team come together? Do the founders take responsibility for outcomes, or do they have a habit of passing blame? Do they have the intestinal fortitude to withstand the difficulties they are bound to face as individuals, and as a team on this difficult path they have chosen or will they wilt under pressure? What evidence do I have to support my answer to this question. What is their approach to learning, as individuals and as a team? Have they faced crises together? How did they fare when the going got tough? I will not ask most of these questions directly, but I will be processing every interaction, every bit of information I get, to determine answers to questions along this line of reasoning.

Lesson #3: Create A Sense of Urgency, But Provide Hope

Unlike a startup, a company in financial distress already has a product that it has sold successfully in the past, it also has a sense of who its customers are and where to find them. It is easy for the people within the company to succumb to status quo bias. This is identifiable by statements such as;

  1. “Everything will be fine, we just need to close this one sale.”
  2. “I feel confident it will happen, we have this sale in the bag.”
  3. “They are not our competitor, they do not do what we do!”

In the face of incontrovertible evidence that “they are up shit’s creek without a paddle” people will still choose to do what feels comfortable.

It was my responsibility to shake them out of that rut. As John P. Kotter says in Leading Change: Why Transformation Efforts Fail; 75% or more of a company’s management has to buy into the need for change, otherwise the chance that the change effort will fail is unacceptably high.

How did I do this? In both cases I did not shy away from asking questions that I expected to generate conflict. Indeed, on several occasions I had to have unpleasant and difficult conversations with the top managers and executives in both companies. I did this even if it appeared that I was “meddling” in areas where I had no business poking around. Of course, the idea that there was a part of either company’s operations that I “had no business” exploring was a fallacy only someone keen on maintaining the status quo would believe.

The message, delivered by the investors and the board, and reiterated by me during my frequent field trips, was simple; “The status quo is unacceptable, and failure for lack of effort is out of the question.” We had one chance to get it right, and we had to make the most of that chance even if it meant discomfort some of the time. We could get there with or without conflict. It was entirely up to us to make that choice.

How this applies to early-stage startups: The time for the whole team to start thinking about the Series A Round of Financing is the night before the Seed Round closes. Some one on the team should always be thinking about what it will take to raise the next round.

The time to start thinking about revenues is yesterday, even if you do not implement those plans immediately. Always have a plan. Always test your plan.

Lesson #4: Investors Have Ideas, But Management Runs The Business

Investors will always have ideas about how a business should be run. Sometimes investors know more about a certain topic than management. It is okay for investors to make suggestions, and to offer ideas to management. However, responsibility for choosing which ideas to accept and which to reject has to rest on the shoulders of management, and management has to accept accountability for the outcomes.

There are a number of ways this aspect of the relationship between investors and management might unfold;

  1. Investors can dictate to management what investors think management should do, or
  2. Investors can teach management how and why things should be done a certain way.

I chose the latter. That approach takes more time, but it is also more likely to lead to permanent change in behavior than the former. Also, once the lessons had taken root that approach allowed me to gradually pull back my involvement without jeopardizing the progress that management was making in improving results. It is an approach that builds self-sufficiency.

As part of the process, we cultivated the practice of communicating:

  1. Why a certain goal or strategic initiative was important for the company’s near term goals and long term vision.
  2. What had to get done in order for that goal or strategic initiative to be successfully executed.
  3. Who specifically was primarily responsible for seeing that it got done, and which executive they could go to as often as necessary in order to navigate what ever obstacles they might encounter.
  4. How it would get done, not in excruciating detail, but in broad terms. For example; Which teams needed to collaborate with one another in order to make it happen?
  5. When the team expected to be able to report back periodically on their progress, and importantly, when the project needed to be complete.

To do this successfully, I had to focus on asking questions and encouraging deeper levels of inquiry than was the custom beforehand. Asking probing questions helped us cut out the “bullshit” of conventional wisdom that is seductively easy to accept.

Each time I heard; “You do not understand, that is not how it is done in our industry.” I would ask; “Why?” That would lead to an examination of the assumptions behind the choices that had been made in the past. Often there was no good reason to refuse to try something different even if it seemed out of step with accepted industry convention.

How this applies to early-stage startups: I am looking for founders at the seed or series A stage whose judgement I can trust enough to feel they do not need me to opine on every decision they ever have to make. That does not mean I am passive. It means I need to trust their decision-making skill and maturity enough to feel confident they will consistently make the right choices for all the startup’s constituents without the need to run everything by investors.

From the investors’ perspective, a policy of “show, don’t tell” goes a long way. To paraphrase the oft quoted saying; “Give a founder a fish and . . . . ” If I feel there’s something a founder ought to learn, I’d rather provide a guide to enable that founder learn the applicable frameworks and how to apply them in day-to-day decision-making situations.

Lesson #5: Create Internal Value By Increasing Organizational Capacity

The way we defined it; Organizational capacity is the harnessing of a company’s human, physical and material, financial, informational, and intellectual property resources in order to enable the company to continually perform above expectations and strengthen its competitive position.

In difficult times especially, it is important that companies do not lose sight of the need to continue to find ways to increase organizational capacity.

One way we did this, in both cases, was to shift both companies off MS Exchange Server and onto Google Docs for Work. This was not easy because of cultural attachments to MS Exchange and fear of having to learn something new. Both companies made the shift, eventually. The immediate benefit they experienced was a dramatic reduction in the costs they incurred for IT assistance. A more important, though less tangible benefit was that both businesses could then afford to give every full-time employee a corporate email address and access to a corporate intranet portal. The benefits were enormous; easier collaboration, easier information transfer and sharing,  and increased security of corporate information and trade secrets. Quicker turnaround on tactical decisions because people could now communicate by chat.

Given the improvements in tools for collaboration, we encouraged the formation of cross-disciplinary teams to tackle some of the problems that each company was dealing with. This allowed people from one area of each business to interact more closely with their colleagues from another area of the business. They developed a better understanding of one another, and of the challenges and constraints that they each faced in trying to execute their day-to-day responsibilities. In turn this fostered a more collaborative relationship across the entire organization. It also enhanced the learning environment for all employees.

How this applies to early-stage startups: It does not take a lot by way of resources to create an environment that is rich in opportunities for cross-functional collaboration and learning. This comes in handy during due diligence because every member of the team will be able to speak knowledgeably about the startup’s immediate and long term plans.

Lesson #6: Direction Must Be Set From The Top, But Engagement Must Begin at The Bottom

We started working on trying to develop a strategic plan for both companies in summer 2009. Before this time, neither company had previously had a coherent strategy.

In consultation with the executives in each company, the board of directors set out the broad areas that the strategic plans ought to cover; Finance, Operations, People, Demand Creation, and Expansion.

Once those had been agreed on, it was my job to meet with front-line employees as well as managers in the field in order to obtain data and insight about how the strategic plan would have to be set up in order to function effectively for them given what each company was trying to accomplish.

That sounds easy. It is not. It took multiple meetings, of several hours each. The restaurant had multiple locations in NYC, one location in NJ and another in CT. I did not visit the location in Chicago, the CFO held discussions with them during his quarterly visits. I had to sift through everything I heard during those meetings, and I had to extract broad themes. Then I had to reconcile that with the strategic framework established by the board. Finally, I had to interpret that information from the perspective of the competitive landscape for each of the two companies. Finally, I had to synthesize it all into digestible chunks for the board, the executives, the managers and rank-and-file employees.

The goal of spending so much time on having these meetings with people across all ranks in each company was to ensure that once the strategy was developed and implemented, there would be complete alignment behind the vision embodied in the strategy, and just as important that every employee would be engaged in and committed to executing the tactical initiatives required to make the strategy succeed.

How this applies to early-stage startups: The founder creates the vision that investors and the startup’s team buys into. The team executes to turn that vision into a living, breathing, growing reality. Investors hopefully act as a positive catalyst to help the process unfold more quickly.

Lesson #7: Do Not Ignore The Soft Issues, Emphasize Both Hard and Soft Issues Simultaneously

My experience might as well be called The Tale of Two Turnarounds. In one company leadership admitted things were awful. They also admitted that they could use whatever help I could offer. They readily admitted their limitations as a team. We had many instances of conflict, but starting from a position of optimism and a willingness to try, the process moved along slowly, but steadily. We created a survey that we administered twice a year to get a sense of how employees were feeling, data that might not be captured in the key performance metrics we monitored weekly, monthly, quarterly, and annually.

We launched the strategic plan in January 2010 after 9 months of work specifically focused on that task. A year later the company made its first ever payments from a new profit-sharing plan that we had created as part of the new strategy. The payments were not huge, but they were evidence that the team’s hard work was paying off. It also created a feedback loop about how actions by employees affect the bottom-line performance of the company.

In the other company the founder, who was also the ceo, was grumpy and relatively uncooperative with investors. To cut a long story short, we launched the strategic plan in April 2010, after about 9 months of work specifically focused on that assignment. Within 6 months 75% of the managers with whom we had worked to develop and launch the strategic plan had left the company or had been fired. It was a classic case in which we would take two steps forward only to take four steps backward.

Morale dipped ever lower. The founders incessant talk about “a vision” and “a mission” became the butt of jokes among rank-and-file employees. It became clear that employees were becoming disillusioned with what the company stood for. While the company fared better than it would have if there had been no attempt at executing a turnaround and developing a strategy, it continued to perform well below its potential.

At a board meeting one day, the founder/ceo went into a vituperous rant about all the areas where the company was falling short. This was in early to mid 2012. I had to burst out in laughter. He might as well have been reciting problems whose solution formed the core of the strategic plan we created in 2010. Implementing that plan would have started the process of solving those problems he was so exercised about that day. We had lost two years for no good reason.

No amount of emphasis on key performance metrics made a difference. Without the founder’s full embrace of the strategic plan, nothing else mattered. I should point out that he had been intimately involved in crafting the strategic plan. This was not a plan that was forced down on him “from on high.” It became clear how badly things had deteriorated when a long time employee quit, this individual was the only employee at the company who had been there as long as the founder.

How this applies to early-stage startups: I am of a firm belief that the team is really important at the seed and series A stage, or at least until uncertainty around product market fit has been largely eliminated. So, I need to develop a sense that a founder is someone I can work with over the long haul . . . Actually, the kind of founder I am happy backing has to be someone I could envision myself working for if circumstances were different. Age, race, gender, religion . . . That is all irrelevant. Early in my process for assessing a startup I focus almost entirely on soft issues.

In one example, I sensed something amiss about the body language between 2 Spanish co-founders pitching a startup to my partner and I in 2013. I decided to tune out what they were saying in order to better observe their body language. There was something about their body language towards one another that did not align with what they wanted us to believe, in my opinion. We passed on their seed round, and decided to watch them till we could get more data about the relationship between the co-founders. That was nearly 3 years ago. I have heard no reports to suggest we made an error in that case.

Let chaos reign, then reign in chaos.

– Andy Grove, Only The Paranoid Survive

Lesson #8: Be Prepared For Chaos; Harness, Focus And Direct It, Empower People

Once employees understood the strategic plan as well as the tactical initiatives that accompanied it, they began developing ideas related to the various functional areas in each company and making suggestions to managers and excutives.

At first this was overwhelming . . . Managers had to do their own work, manage the work of the groups of people that they managed, and now . . . . They also had all these ideas being thrown at them from “left, right, and center.” The initial knee-jerk reaction was to try to “make it stop.”

That would have been a mistake. Among the deluge of ideas were some real gems.

For example, a maintenance department team member at the aviation company noticed that the company could cut down on its electricity usage by changing all the bulbs in its main hangar . . . No one had thought about that over the years, but our discussion about the strategic initiative around improving the product while reducing costs prompted him to take another look at the company’s hangars in search of opportunities to reduce operating costs. Thanks to improvements in technology over the years this was now a measure that could be implemented relatively easily.

In another instance, the team at our restaurant in CT had observed that on certain days of the week large groups of Chinese tourists visited the casino resort in which they are located. They had been thinking of a way to capture some of that business, but had assumed the corporate office would object to the menu changes they thought they had to make in order to execute that plan. As part of our implementation of the strategic initiative around increasing revenues, I suggested they conduct an experiment, analyze the outcome, and then seek assistance from the corporate office if the results looked promising. They did that, and saw a jump in revenues on two days of the week when business would otherwise have been slow. The corporate office gave its blessing, and assisted in making that practice more entrenched by using corporate resources to give it the polish required for company-supported initiatives.

How this applies to early-stage startups: A startup stops being a startup once its search for a repeatable, scalable, and profitable business model is complete. While that search is in process it is important that every member of the team feels empowered to contribute to the discovery of that business model. It can’t be the job of only some members of the team, it has to be part of everyone’s job. The faster a startup gets through the discovery process the better.

Lesson #9: The Turnaround Should Be Its Own Reward; Incentives Should Reinforce Change Not Drive It

It was nice to be able to make payments from the profit-sharing plan that we instituted. The payments were relatively small, yet they were tangible evidence to the employees, managers, and executives that they were collectively well equipped to make it through the ongoing turbulence and correct the mistakes of the past.

The sense of accomplishment employees felt translated into a number of things, among them;

  1. Newfound and increasing pride in being associated with a company that was succeeding where many of its rivals had failed.
  2. High levels of morale and optimism about the future of the company, and their place at the company. Less stress about employment security.
  3. A greater willingness to take the initiative in situations where the possibility of generating business for the company exists.

Basically, every employee was empowered to function as a salesperson on the company’s behalf. We arranged training sessions to equip every employee with the vocabulary they needed to understand in order to do that effectively. We also developed simple tools that they could use. They did not replace the company’s professional salespeople . . . They became an auxiliary sales force.

How this applies to early-stage startups: As startups grow, founders and early team members need to get better at the art and science of “managerial leverage” . . . What is managerial leverage? It is the process by which a manager creates output that far supersedes that manager’s input by using all the resources at the manager’s disposal to influence the work that is done by the group of people whose on-the-job effectiveness and work-output is affected by interactions with the manager.

What is a manager’s output? According to Andy Grove, co-founder and former CEO of Intel “The output of a manager is a result achieved by a group either under his supervision or under his influence.” Great managers create positive output that far exceeds expectations. Below average managers create output that fails to meet expectations given superior resources. Average managers? The team’s output would not be any different if the manager were absent.

The art of managerial leverage is in determining; how to apportion time, where to pay more attention, where to pay less attention, who to pay more attention to, who to pay less attention . . . . etc etc. The science of managerial leverage is in determining; what to measure, when to measure it, how often to monitor what is being measured, where bottlenecks are most likely to occur and why, and how to eliminate them . . . . etc etc.

Managerial leverage drives output. Output drives results. Results are measured and reflected in the KPI’s that founders and investors measure. Getting that order right is critical to a startup’s success.

Lesson #10: Learn To Listen, And Communicate Effectively

It is amazing how many problems can be solved relatively quickly if people would communicate more effectively internally and externally. Communication involves two actions; first listening actively in order to understand what is driving the actions of other people. Second, responding to what other people have said in a way that gets to the root cause of the problem being discussed.

During one of my field visits, I spent 8 hours on my first day listening to the executives talk about all the problems they each perceived, and how they felt the issues ought to be tackled. I spent that day with the CEO/President, the CFO, the Head of HR, and the Head of Sales. I encouraged open disagreement and debate.

On my second day I spent about the same amount of time speaking with the middle managers; again we discussed the problems they each perceived, and how they each felt the issues ought to be tackled.

On the third day I brought both groups together, and moderated an all day discussion about the problems the company was facing. Once again, I encouraged open disagreement and debate. Also, I put the inter-personal issues and conflicts that I had uncovered on the table. Things often got heated. It was my job to function as a pressure-release valve during those episodes. It was not pretty.

For example, I explained to the entire group how the CFO who was disliked by a large number of people within the company had made payroll on too many occasions by dipping into his personal 401(K) savings for example. The irony, the folks who disliked him routinely failed to provide the finance team with the data they needed in order to collect on accounts receivable from the company’s customers.

The outcome of this exercise was that;

  1. Everyone felt they had been given a chance to speak and be heard by the rest of the leadership team, and
  2. We discussed expectations in a fair amount of detail, enough so that more work could be done laying them out in adequate specificity rather than vaguely wondering what people could expect from one another, and finally
  3. Created an environment in which each member of the leadership team contributed in creating a communication framework against which they agreed to be held accountable

Our goals for the communication framework were that;

  1. Every employee should know what is expected of them, as individual team members,
  2. Every employee should know what to expect from every other member of the team,
  3. Employees should know what to expect from executives and managers, and lastly
  4. Accountability should be about improving team and company performance, not punishing individuals.

As Rosabeth Moss Kanter says in Four Tips for Building Accountability; “The tools of accountability — data, details, metrics, measurement, analyses, charts, tests, assessments, performance evaluations — are neutral. What matters is their interpretation, the manner of their use, and the culture that surrounds them. In declining organizations, use of these tools signals that people are watched too closely, not trusted, about to be punished. In successful organizations, they are vital tools that high achievers use to understand and improve performance regularly and rapidly.”

How this applies to early-stage startups: Startups typically have to move quickly, especially if they have taken in capital from institutional venture capitalists. A culture of blame, lack of cohesive teamwork, and a lack of organization-wide accountability is an insidious tumor that will eventually lead to failure. The founders who are most successful in the long run are those who do not shift responsibility when things are difficult, but instead serve as a model that other team members can emulate.

Closing Thoughts

Executing a turnaround and getting a startup through the phase of discovering a business model are really just two sides of the same coin. That experience has led me to the belief that it is when things seem bleak that great early stage investors prove their worth.

Further Reading

Blog Posts, Articles, & White Papers

  1. The Psychology of Change Management
  2. Motivating People: Getting Beyond Money
  3. The Irrational Side of Change Management
  4. The CEO’s Role in Leading Transformation
  5. The Role of Networks in Organizational Change
  6. All I Ever Needed To Know About Change Management I Learned at Engineering School
  7. Changing an Organization’s Culture, Without Resistance or Blame

Books

  1. High Output Management
  2. Only The Paranoid Survive
  3. How Did That Happen?
  4. HBR’s 10 Must Reads on Change Management
  5. HBR on Turnarounds

Revisiting What I Know About Network Effects & Startups

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The recently announced IPO of Alibaba got me thinking last week about network effects 1Any errors in appropriately citing my sources are entirely mine. Let me know what you object to, and how I might fix the problem. Any data in this post is only as reliable as the sources from which I obtained them. – what they are, how they develop and evolve, and how network effects can help or hurt a startup. 2You can find Alibaba’s SEC Form F-1 here. Accessed online; Sept. 12, 2014.

That is something I think about a lot, practically every day. In other words each time I am sitting across from a founder listening to that founders’ explanation of a startup’s market, the problem it is solving, and its business model, I am also thinking about the economic moats it might build around itself in order to sustainably fend off competition. One way it might do that is through network effects.

To ensure we are on the same page, let’s start with some definitions. In the rest of this discussion I am primarily focused on early stage technology startups.

Definition #1: What is a startup? A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model. 3I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports. As an investor, I hope that each early stage startup in which I have made an investment matures into a company.

Definition #2: What is an economic moat? An economic moat is a structural barrier that protects a company from competition. 4Heather Brilliant, Elizabeth Collins, et al. Why Moats Matter: The Morningstar Approach to Stock Investing. Wiley. Hoboken, NJ. 2014; p. 1 In my case, when I am studying a startup, I am interested in the economic moats that will enable the startup to mature into a great business, and hence a great company – one that can keep competition at bay while earning great returns for its investors. Morningstar identifies 5 moat sources; Intangibles, Cost Advantage, Switching Costs, Network Effect, and Efficient Scale.

Definition #3: What is a network? Any group or system of interconnected people or things. Think; my nuclear family is a network to which I belong. My extended family is a larger network which includes my nuclear family, as well as the nuclear families of each of my relatives. A small business exists in a network that is comprised of its customers, its suppliers, its competitors, its regulators, and so on and so forth. A large network might be formed by a collection of smaller networks. 5I know this seems obvious. However, I was having a discussion via email with Kate Bradley Chernis while writing this. She and her co-founders are building a product to empower SMB’s manage their marketing campaigns. When I told her the topic of this blog post she stated that she finds that many SMB owners have no understanding of the networks that they belong to, or how they can use their networks to enhance their business. I added this definition after that exchange.

Definition #4: What is a Network Effect? A network effect occurs when the value of a good or service increases for both new and existing users as more customers use that good or service. 6Network effect is often colloquially referred to as network externality. However, the two are not precisely the same. The network effect is a virtuous cycle that allows strong companies to become even stronger. 7Ibid; p. 27 Network effects are also known as direct-benefit effects. I think direct-benefit effects makes it easier to remember why network effects can be such a powerful economic moat.

How do network effects develop? Direct-benefit effects develop and become stronger in settings where some form of interaction, or compatibility with others is important. 8David Easley and Jon Kleinberg. Networks, Crowds, and Markets: Reasoning About a Highly Connected World. Cambridge University Press, June 10, 2010 draft version. P. 509. Accessed online on Sept. 12, 2014. In other words, the number of other people using the technology has a direct impact on how valuable that technology is to each individual user. Direct-benefit effects contribute to the strengthening of an economic moat only in so far as they directly contribute to increasing positive externalities for the members of the network. What is an externality? It is “any situation in which the welfare of an individual is affected by the actions of other individuals, without a mutually agreed-upon compensation.” 9Ibid. One can have positive or negative externalities. A positive externality occurs when individual and aggregate welfare increases with the addition of more users to the network. A negative externality occurs when welfare decreases with the addition of more users. 10As an example, think of a website or app that starts to crash and become inaccessible due to capacity constraints as the number of users increases dramatically. Network effects evolve positively for a startup if the members or users of the network derive both inherent value and network value from their use of the product. Inherent value is value that an individual user derives because of that individual user’s consumption of the product or service. For example, even if I were in a network compromising only me, I would derive inherent value from owning one copy of MS Office running on Windows because I could now more easily do word-processing using MS Word or analyze quantitative data using MS Excel. I derive network value from MS Office and Windows because if other people buy and use those products, it becomes easier for me to share my work with them and for them to share their work with me. I derive network value from being able to collaborate with every other person who also uses MS Office and Windows.

Types of Direct-benefit Effects: To fully parse through how a startup I am studying might build an economic moat based on network effects I need to be able to understand the subtle nuances that differentiate one type of network effect from another. 11This is based on the work of Prof. Arun Sundararajan. Accessed at http://oz.stern.nyu.edu/io/network.html on Sept. 12, 2014.

  1. Direct network effects or one-sided network effects occur when increased usage leads explicitly to increased welfare for the members of the network. Think fax machines, telephones, messaging apps.
  2. Indirect network effects occur when the proliferation of network members leads to the proliferation of complementary goods and services such that the welfare of the network’s members increases significantly. Think iOS, Android, smartphones and apps.
  3.  Two-sided network effects are distinct from indirect network effects. A two sided network effect occurs when an increase in usage of the product by one group of network members increases the welfare of a separate and distinct group of other members of the same network. Think marketplaces, platforms that combine hardware and software, and software pairings in which there’s a reader and writer.
  4. Local network effects occur when an individual network member’s welfare increases not because of an increase in the overall network user base, but as a result of growth in the users within a  localized subset of the network’s membership. Think; as a user of Whatsapp, my welfare increases when more people in my cellphone’s contact list join the Whatsapp network. So, while I think it’s great that Whatsapp has 500 Million users, my welfare has no positive correlation to the size of  Whatsapp’s network. However, it does have a positive correlation with how many of my friends, family, colleagues, social and professional acquaintances become members of the Whatsapp network.

This diagram by Ray Stern conveys the power of positive network effects, and the corollary – negative network effects can help erode the competitive position an incumbent occupies. 12Eric Jorgenson, The Power of Network Effects: Why They Make Such Valuable Companies, and How To Harness Them. Accessed on Jun 27, 2015 at https://medium.com/evergreen-business-weekly/the-power-of-network-effects-why-they-make-such-valuable-companies-and-how-to-harness-them-5d3fbc3659f8

The Power of Network Effects (Image Credit: Ray Stern, former CMO of Intuit)
The Power of Network Effects (Image Credit: Ray Stern, former CMO of Intuit)

How might a startup start to experience negative network effects? One of the most exciting things about the Internet is that it has lowered the barriers to competitors entering a space in which they perceive an opportunity to earn economic profits. That is great if I invest in a startup that is earning such profits, but not so great if events unfold such that other startups can launch a credible attack in order to win business away from the startup in which I am an investor.

  1. Lock-in or switching costs occur when a member of one network cannot switch from that network to another without suffering substantial costs. The switching costs could be monetary and non-monetary. Often, the non-monetary switching costs far outweigh the monetary costs. Non-monetary costs might include the loss of massive amounts of information and data, business process disruptions, and so on and so forth. Antitrust regulators do not like to see situations in which such costs bar new competitors from entering a market and create a monopoly for an incumbent – IBM, Microsoft and Apple have all faced antitrust action. Switching costs can also exist in physical goods industries, for example razors and blades, and also printers and printer-cartridges. Switching costs are not an issue as long as users perceive that they derive more value from being within the network than the inconvenience they suffer as a result of lock-in or switching costs.
  2. Network congestion occurs when the experience of each member of the network deteriorates as the network’s membership grows. In other words the network becomes less efficient from the users’ perspective. As a result of this each member of the network derives decreasing inherent and network value from the network. Think; A website, web or mobile app that is consistently unavailable because too many people are trying to access it simultaneously.
  3. Conflicts of interest occur when a network operator behaves in ways that limit or restrict the ability of network members to freely form sub-networks. According to David Reed: 13David Reed. That Sneaky Exponential – Beyond Metcalfe’s Law to the Power of Community Building. Context Magazine. Accessed at http://web.archive.org/web/20080526050751/http://www.contextmag.com/setFrameRedirect.asp?src=/archives/199903/digitalstrategy.asp on Sept. 12, 2014.

But many kinds of value are created within networks. While many kinds of value grow proportionally to network size and some grow proportionally to the square of network size, I’ve discovered that some network structures create total value that can scale even faster than that. Networks that support the construction of communicating groups create value that scales exponentially with network size, i.e. much more rapidly than Metcalfe’s square law. I will call such networks Group-Forming Networks, or GFNs.

That observation might be used to explain the demise of Friendster and Myspace in the face of competition from Facebook. It has also been used to predict the success of Ebay during a time when Yahoo was the most dominant web-portal. 14David Reed. Weapon of Math Destruction: A Simple Formula Explains Why The Internet is Wreaking Havoc on Business Models. Context Magazine. Accessed at http://web.archive.org/web/20080526050751/http://www.contextmag.com/setFrameRedirect.asp?src=/archives/199903/digitalstrategy.asp on Sept. 12, 2014.

What exactly do I mean by conflicts of interest? I love to buy books from Amazon. To save money, I prefer to buy used books if that is at all possible. Amazon has allowed independent merchants to market their goods in its marketplace. many of these merchants sell used books at substantial discounts to the price of a new book offered by Amazon. Let us assume that each time I wanted to make a purchase Amazon compelled me to purchase its own offering of that item, or pay a penalty if I insisted on making the purchase from one of its independent sellers. What effect do you think that might have on my behavior? What effect might that have on the behavior of the independent sellers? What if an Amazon competitor did not impose that penalty? How might that shift the competitive landscape? That is a relatively simple example. It should illustrate the point. When the operator of a network platform starts to compete with its platform partners it is engaging in behavior that will lead to the destruction of the network.

What strategies should a startup that’s competing in a market in which network effects matter employ in order to win? There are a number of strategies that might be employed 15Based on Prof. John M. Gallaugher’s Understanding Network Effects. Accessed at http://www.gallaugher.com/Network%20Effects%20Chapter.pdf on Sept. 12, 2014. independently or in combination with one another by competitors seeking to compete effectively against a rival, or by market leaders seeking to maintain that position.

  1. First mover adoption matters – a lead of a few months can be the difference between winning the market and losing it.
  2. It can pay to subsidize adoption – in order to seed the network it might be worth it to subsidize adoption by providing an in-network benefit of some sort. Dropbox offers free storage to new users, and members who help it acquire new users also get rewarded with free extra storage. However, it is important to strike a balance between subsidizing adoption and maintaining a tight control on costs. Ideally, the marginal cost of subsidizing adoption should be far far less than the marginal benefit of acquiring a new network member.
  3. Viral marketing matters – the success of mobile and web products that benefit from network effects can be greatly enhanced by encouraging viral promotion through social networks like Facebook, Twitter, Pinterest, Instagram, Snapchat, etc etc.
  4. Redefine the market – this has the benefit of bringing in more users who might previously have been inaccessible. It also makes it possible to develop a product or service that envelopes several distinct markets into one. Think; smart phones becoming capable of performing the functions of a media player, a camera, an email editor, an internet browser, a gaming device, a phone, a medical diagnostic tool, a fitness tracker, a notebook, an alarm clock, a GPS navigation system etc. etc.
  5. Form alliances and partnerships – when competing with a powerful incumbent this might make it easier to gain a toehold from which the competitor can then launch an entry into the market. Think; Google’s Android strategy at a time when it appeared Apple’s iOS was an unstoppable force in the smartphone market.
  6. Leverage distribution channels – to pry an opening into a market think of non-obvious ways by which a distribution channel might be created. A popular approach is to bundle a new product with an existing product from the same provider.
  7. Seed the market – one way to do this is to subsidize adoption by making room in the budget for a financial outlay specifically geared towards acquiring new users. For example, a messaging app might pay people in a foreign country to download the app and start using it in hopes that enough of them fall in love with the app and tell their friends about it. Another strategy related to this is to give away product to one group of network participants.
  8. Encourage the development of complementary goods – this is now a widely used strategy through the publication of SDKs and APIs to encourage the development of complementary products and services.
  9. Leverage backward compatibility – to do the opposite would be foolish since that would mean that at the beginning of each upgrade cycle the incumbent has no advantage over a new entrant competitor.
  10. Build-in compatibility with the market leader – this changes users’ options from one in which they have an “either-or” decision to make to one in which they have an “and” decision to make. Who does not like “and”? Every new entrant rival should consider this. For example new social networks ought to build seamless integration with Twitter, Facebook and other leading social networks into the product from the very outset.
  11. Close-off access to new entrants and existing rivals and innovate constantly – this makes it nearly impossible for rivals to steal away business from the incumbent leader in the market.
  12. Pre-announcements – from a large, well known, and well liked producer of a product or service can have the effect of slowing down the adoption of a rival’s competing offering. Some people might want to wait till they can compare the options more directly against one another. Think; when one of Apple’s competitors quickly schedules its product announcement to precede a major product announcement by Apple, but only after after Apple announces an event at which it will discuss a new line of products. The extreme case is when a rival rushes to announce and release its product prior to Apple’s product release date once Apple makes an announcement. 

Understanding networks effects and how they unfold for an early stage startup is critical. Markets in which such effects are present are often characterised by fierce competition and a bandwagon effect tends to take hold thanks to positive-feedback loops. Also, the nature of these markets is that a winner can emerge in remarkably short order and that winner typically garners a commanding market share lead over its competitors. Furthermore, once a winner has been established it is extremely difficult for competitors to win users away from it.

Further Reading

  1. Platform Power – A free book by Sangeet Choudary,  available for download at Platform Thinking Lab’s website.
  2. The Power of Network Effects: Why They Make Such Valuable Companies, and How To Harness Them – blog post by Eric Jorgenson
  3. Exponential Organizations: Why new organizations are ten times better, faster, and cheaper than yours (and what to do about it) – by Salim Ismail, Michael S. malone, and Yuri van Geest

References   [ + ]

1. ↩ Any errors in appropriately citing my sources are entirely mine. Let me know what you object to, and how I might fix the problem. Any data in this post is only as reliable as the sources from which I obtained them.
2. ↩ You can find Alibaba’s SEC Form F-1 here. Accessed online; Sept. 12, 2014.
3. ↩ I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports.
4. ↩ Heather Brilliant, Elizabeth Collins, et al. Why Moats Matter: The Morningstar Approach to Stock Investing. Wiley. Hoboken, NJ. 2014; p. 1
5. ↩ I know this seems obvious. However, I was having a discussion via email with Kate Bradley Chernis while writing this. She and her co-founders are building a product to empower SMB’s manage their marketing campaigns. When I told her the topic of this blog post she stated that she finds that many SMB owners have no understanding of the networks that they belong to, or how they can use their networks to enhance their business. I added this definition after that exchange.
6. ↩ Network effect is often colloquially referred to as network externality. However, the two are not precisely the same.
7. ↩ Ibid; p. 27
8. ↩ David Easley and Jon Kleinberg. Networks, Crowds, and Markets: Reasoning About a Highly Connected World. Cambridge University Press, June 10, 2010 draft version. P. 509. Accessed online on Sept. 12, 2014.
9. ↩ Ibid.
10. ↩ As an example, think of a website or app that starts to crash and become inaccessible due to capacity constraints as the number of users increases dramatically.
11. ↩ This is based on the work of Prof. Arun Sundararajan. Accessed at http://oz.stern.nyu.edu/io/network.html on Sept. 12, 2014.
12. ↩ Eric Jorgenson, The Power of Network Effects: Why They Make Such Valuable Companies, and How To Harness Them. Accessed on Jun 27, 2015 at https://medium.com/evergreen-business-weekly/the-power-of-network-effects-why-they-make-such-valuable-companies-and-how-to-harness-them-5d3fbc3659f8
13. ↩ David Reed. That Sneaky Exponential – Beyond Metcalfe’s Law to the Power of Community Building. Context Magazine. Accessed at http://web.archive.org/web/20080526050751/http://www.contextmag.com/setFrameRedirect.asp?src=/archives/199903/digitalstrategy.asp on Sept. 12, 2014.
14. ↩ David Reed. Weapon of Math Destruction: A Simple Formula Explains Why The Internet is Wreaking Havoc on Business Models. Context Magazine. Accessed at http://web.archive.org/web/20080526050751/http://www.contextmag.com/setFrameRedirect.asp?src=/archives/199903/digitalstrategy.asp on Sept. 12, 2014.
15. ↩ Based on Prof. John M. Gallaugher’s Understanding Network Effects. Accessed at http://www.gallaugher.com/Network%20Effects%20Chapter.pdf on Sept. 12, 2014.

A Reexamination: Can Venture Capitalists be Value Investors?

by

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. 1Any mistakes in quoting from my sources are entirely mine.

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. 2Jeffrey 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. 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. 3Steve 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 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. 4I am greatly simplifying things for the sake of brevity, but this covers the basics.

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 Time 5J. Dennis Jean-Jacques, The Five Keys To Value Investing, New York, McGraw-Hill, 2002, page 2.

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.” 6Benjamin Graham, The Intelligent Investor, New York, HarperCollins, the 2005 reprint of the original 1949 edition, page 241. 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.” 7Seth Klarman, Margin of Safety: Risk-Averse Value Investing Strategies for The Thoughtful Investor, New York, HarperCollins, 1991, page 92. 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. 8While 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. 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. 9Tobias 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 investing was designed for mature companies with stock trading in the public markets. 10Value investors might be able to adapt their approach to suit mature privately held companies. 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: 11Since 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.

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. 12All customers are not created equal. 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 earnings 13I am using terms somewhat loosely here; technically revenues are not the same as earnings. 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. 14Christopher H. Browne, The Little Book of Value Investing, New Jersey, John Wiley & Sons, 2007, page 68.

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. 15I 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/ For each area, I rate the startup I am studying as high, medium, or low. These are the areas:

  1. Sustainable competitive advantage; why does it exist, how long is it likely to last?
  2. Network effects; why do they exist, how long are they likely to last?
  3. Revenue; how predictable is revenue, once it is secured?
  4. Switching costs; once a customer is secured, do switching costs exist?
  5. Gross profitability; is gross profitability high, medium, or low? How does gross profitability evolve as the startup grows?
  6. Marginal profitability; is marginal profitability high, medium, or low? How does marginal profitability evolve as the startup grows?
  7. 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.
  8. 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. 16Alyson 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
  9. 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.
  10. 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. 17Bruce 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. 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.

 

 

References   [ + ]

1. ↩ Any mistakes in quoting from my sources are entirely mine.
2. ↩ 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.
3. ↩ 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.
4. ↩ I am greatly simplifying things for the sake of brevity, but this covers the basics.
5. ↩ J. Dennis Jean-Jacques, The Five Keys To Value Investing, New York, McGraw-Hill, 2002, page 2.
6. ↩ Benjamin Graham, The Intelligent Investor, New York, HarperCollins, the 2005 reprint of the original 1949 edition, page 241.
7. ↩ Seth Klarman, Margin of Safety: Risk-Averse Value Investing Strategies for The Thoughtful Investor, New York, HarperCollins, 1991, page 92.
8. ↩ 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.
9. ↩ 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/
10. ↩ Value investors might be able to adapt their approach to suit mature privately held companies.
11. ↩ 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.
12. ↩ All customers are not created equal.
13. ↩ I am using terms somewhat loosely here; technically revenues are not the same as earnings.
14. ↩ Christopher H. Browne, The Little Book of Value Investing, New Jersey, John Wiley & Sons, 2007, page 68.
15. ↩ 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/
16. ↩ 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
17. ↩ 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.