There is a lot of hype around venture capitalists, the VC 10x return requirements, their high flying exits when companies like Facebook IPO, and their exclusive carried interest income that is barely taxed. It is certainly well deserved hype, there is a lot of money to be made (and lost) in venture investing, what is interesting though is that the basic principles used in venture investing are principles that any investor can and should use. Have a look at this recent report on GeekWire on the returns of venture captialists, you will see an obvious trend that VCs returns are long term and not short term. The thought here is that these returns are based on longer term fundamental or value investments and not shorter term momentum or technical investments. When you are looking at investments in your own portfolio and life, there are a few lessons we can apply that come right out of the VC handbook.
I am certainly not suggesting that if you can invest well in the public market, you will do great as a VC or that there aren’t any differences between the two. There are differences, for example the analysis of growth and financial situations is different – yes the same general principals apply (make more money then you spend, sell more tomorrow then you did yesterday, etc.) – but how you analyze those things are different for VCs than they are for investing in publicly traded companies as Brad Feld describes in his three magic numbers. There are also a lot of things that are shared and that we retail investors can learn from good venture capitalists. These include things like reducing the risk (de-risking) of our investments. There are many others and I will start to explore the lessons that VCs have for us in this series on Investing Lessons From Venture Capitalists. To kick things off, I'll start with Chris Sacca - an interesting guy and a good investor. I pulled these out of the interview that you can watch below. Enjoy the reading and let me know if these ring true for you.
Lesson #1 - The Team Matters
This is a pretty common one that is often overlooked by retail investors. Too often news about products or macro industry news crowds the judgment when we invest. If we look at what VCs are doing when they invest, the team is one of the most important components to the investment. This is because the people are what comprise the company - not the other way around. Who is on the management team, what have they done in the past, are they someone who I would like to be involved with? Watch the video at the end of the post, it is an interview with Chris Sacca, in the interview Chris talks about investing in teams that he would be willing to spend weekends with at his property in California. Not that retail investors need to go to that extreme as we won’t be inviting the CEOs of the firms we invest in to our homes – but think about it – do you trust that this person can make the right decisions?
When I invested in JC Penney, a major factor for me was the team. Ron Johnson is a turnaround king and has disrupted two major retail brands (Target & Apple). This isn’t just some guy with an idea to change the department store experience. This is a guy who has experience re-imagining the retail experience. This is a guy that with the right level of management and shareholder support, can influence a real change on the company and industry he is working in. This is a guy that I can get behind! Of course I didn’t invest just because of Ron – but Ron is a major component to my JC Penney thesis.
Lesson #2 – Support Systems Are Important
Again, another often overlooked area that VCs examine closely. This stems directly from the team running the firm as the support system that stands behind that team will also make or break the acceleration. There is a slight advantage that venture capitalists have with startups that most retail investors don’t have. The VCs often help to shape the board of directors and board of advisors. As retail investors we don’t honestly have an active role in this sort of activity. There are large active investors who have this capability; however, our small votes on proxy statements don’t make a difference. The lesson then, is to examine the support system – who is involved in supporting the management team – are they the right people?
Recently Ford added to its board of directors. At first glance the changes look like cronyism… The former Republican candidate for president Jon Huntsman joined the board. Looking a little deeper, there is some growth value in having Huntsman join the board. Huntsman served as the ambassador to China just before Locke took over. Interestingly, if we look at Ford’s market share, China is an area that is lacking. Adding Huntsman to the board adds a wealth of experience and connections in a place where the firm has room to grow. Of course Huntsman was just added so is not the reason that I initially invested, I did recently add to my position though given this new potential growth area.
Lesson #3 – What Product
This area is different for every company. Sometimes VCs invest in a products, trends, or themes. Sometimes they invest in the expertise of a team to build a great product. When VCs pick products, they are picking specific execution of technology, packaging, and execution based on the obvious (or not so obvious) situation in the macro economy. Sometimes this means that the product is new and maybe the population at large is ready for something different. Sometimes this means that there have been a number of attempts to get a product right and it appears that this team is going to do it. Other times the team is so good at building great products based on interactions with customers that a VC will be willing to bet that this team can build a great product after getting started (meaning they are expecting the team to pivot one or two times). In the retail space it may be tough to bet on a team to build the right product. That is not to say that there are not opportunities to invest in companies that are executing on products in impressive ways.
When I invested in iGo, I invested because they have patents on a chip that will allow them to stop the draw of power. These chips could be embedded in devices or wall outlets themselves. Meaning that if your iPhone had this chip inside and was plugged in, when it was done charging it would stop drawing power. Similarly if the wall outlet had this chip it would be able to stop delivering the power. Now I have lost a lot of money so far on the investment, so don’t go thinking that I am a genius for making an investment in such a cool technology. I invested because they had the patent and were close to a deal with Texas Instruments who they would sell their chip to. This is all fine and dandy… well it would be if the company could execute on delivering this technology. Considering they haven’t been able to as of yet, there is still room for another firm to build a similar chip first.
Lesson #4 – Customers Make The Difference
Customers make all the difference in the world. Will people use the great products, will those people pay for the benefit of using the product and thus become customers? Will there be enough customers for this one company? How long will the customers stick around in relation to the profitability per customer. Obviously there is a lot of thinking in the space of customer acquisition. A lot of times VCs use their gut reaction on this one. Can they envision themselves or their daughters using this product on a regular basis? Have they already seen first or second hand the gap in products out there that this new product will fill? Can they understand why someone would pay money for this thing? You should ask yourself these questions. You should look at the actual products that the companies you are investing in are selling. Would you want to use it? Do you know other people that would? Can you convince someone else to use the product? Ok so I through that last one in myself. I figure that if I can convince someone else to start using a product then there must be some value in the product. This is true for startups as it is for publicly traded companies.
When I invested in Jamba Juice, I invested because it was undervalued in my opinion. Being a smoothie company though, it may have been undervalued for good reason. Jamba was in the process of adding distribution channels (you see the smoothies & frozen fruit at stores now) as well as adding retail stores across the country. This growth strategy meant that they had an opportunity to start bringing in more revenue (a few simple calculations of return on investment in these new endeavors and one could see where the profits would come from). The question though still remained. Would people care if they grew? Would anyone buy their products? I started going to their stores, buying some of their drinks, trying their oatmeal, etc. It turns out… these were great products! So I put it to the test and mentioned the good food I was finding at Jamba Juice. After talking a few folks into trying their products, I converted a few people to regular Jamba Juice drinkers. Not bad! I think that if I can convince someone to become a regular just by having them try the product there is a safe chance that their growth strategy will be well received.
Lesson #5 – Money Matters
Lesson 1-4 lead to what matters most for the firm and the VC… actually making money. After all, if there was no money to be made what would all these people be getting together to create a company for? The difference is that a VC looks at the potential of profitability - the balance of profitability and growth. They look at this in a few different ways and all of these ways are ways that we retail investors can evaluate a company as well. The first and most obvious is how much net profit can the company be expected to make? The second is how will they get out of the investment? As a retail investor, you have the same methods of looking at the money you are investing. For some companies, those that are undervalued and have the potential to grow their revenue and profits based on internal activities and macroeconomic factors are firms that you can safely expect to rise in market capitalization (or stock price). These companies you are interested in buying near or below what you determine is fair value and sell when the firm reaches fair value or sell when the market is so hyped up on the company that it seems ridiculous not to sell. For other companies, those that have a buyout potential, a retail investor should look at what a fair buyout looks like and who may be making the buyout.
When I invested in Talbots, I invested based on the buyout potential. There was a single offer on the table for $3 per share and the shares of Talbots were trading below this amount. Being a prudent investor, I looked at the fair value of the company and determined that it was greater than $3 (meaning the buyer would be getting a deal). The problem of course is that Talbots has not been executing well in the recent past and their valuation would be declining over time, so it was sort of a situation where they had something of value now but may not in the future. I bought in to capture the buyout arbitrage. Similarly VCs buy in to startups on the basis that the startup will quickly be sold to a larger firm and they will turn a profit. This basic arbitrage takes an analysis that incorporates all of the factors above as well as an understanding of the M&A procedures and potential.
Of course these five lessons aren’t the only things we retail investors can learn from venture capitalists. Nor are these the only things that retail investors can learn from startups who are looking for investors (remember companies raise money on the public stock market for a reason). Most investors like to learn from the success and failure of other investors. Look for the rest of the upcoming posts in this series Investing Lessons From Venture Capitalists.
Here is that Chris Sacca interview... It is roughly an hour but well worth watching if you are interested in learning how to invest in public companies in the same way that venture capitalists invest...