Thursday, April 2, 2015

Value Investing in Start-Ups

Summary:
What to look for in a start-up:
-A committed group (could Polyvore be an acquisition target for Pinterest?)
-A monopoly ( can Tesla find a monopoly? )
-Growth ( does Domo fit Benchmark's standard?)

Especially near Silicon Valley, it seems almost weekly start-up are making huge amounts of money going public or becoming Google's next acquisition.  It seems with that much upside it should be easy to make a major gain, just pick your favorite start-up, get in and wait for them to make it big? Well things might not be quite that easy as a quick sampling of the start-ups or number of applicants to start up incubators or Y Combinator will show. There are nearly infinite start-up ideas and almost as many dollars willing to bet on them, so is there a way to know which one will succeed and perhaps more importantly which will be most profitable?

Pierre Omidyar Left with Robert Kagle right
doanhnhansaigon.vn/khoi-nghiep/ebay-cua-pierre-omidyar/1039849
/
Venture capitalists devote their lives to spotting potential in start-ups and Robert Kagle who holds the record for the most successful venture investment ever is quick to warn that venture capital is an extremely high risk business. "In venture capital you lose all of your money over half of the time. In fact 10% of your investments deliver 90% of your returns." He goes on, "failure is the norm in venture capital, if you're not striking out you're not swinging for the fences." For Kagle and other venture capitalists, a healthy recognition of failure is a good idea so that when company looks like its going down they aren't freaking out about the lost investment. Accepting possible failure has allowed Kagle to get on early with Twitter, Uber, Snapchat, Instagram among others but it is probably his treatment of entrepreneurs has been more important. Before him entrepreneurs were considered employees to the investor, but he recognized Venture Capitalist's role not as one of superiority, but as "a privilege to invest in someone else's dreams." "We would be the stage hands and they would be the stars." he says.

Still, Kagle never claimed be able to consistently identify start-up successes, he knew the risks and took a swing, which kind of flies in the face of Warren Buffet's timeless wisdom that "You don’t need to swing for the fences in order to achieve satisfactory investment returns...”  But Buffet also says "risk comes from not knowing what you're doing." Implying that if you know enough of what you're doing you can avoid the risk, so you have to wonder, can anyone know enough to consistently recognize and invest in start-up successes? Building on Kagle's fundamental approach, I would argue one of his partners has done just that.

Peter Fenton at Benchmark Capital TechCrunch.com/ Flickr Creative Commons
Peter Fenton was likely drawn towards Kagle's team because of his history of seeing his dad's negative experiences dealing with Venture Capitalists, who to his young mind were like monsters, out of touch with the realities of running a business, abstract, with a false sense of their ability to predict the future. In his undergrad at Stanford and learning from his own experience Peter already had come to similar conclusions "If you can be in service to extraordinary people who are changing the world for the better, that’s a noble calling." Later after Kagle managed to bring Fenton onto his team, Fenton further refined Kagle's approach and avoided some of  his mentor's lost investments. He has gone on to be one of the most consistent, professional, successful, recognized, and awarded venture capitalists alive setting a high mark for others to follow.

How does he does it?  Although many would like to chalk Fenton's and others like Peter Thiel's ( who is a little more vocal and accesible that Fenton) success up to luck, their succesful exits seems to indicate otherwise. Calling their innate mental abilities, upbringing and graduate programs at Stanford luck is a different discussion, but as far as their ability to repeat their performance and make consistent investment in high growth start-ups, as Thiel says, attributing their results to luck is just an excuse for not thinking. And while their background no doubt plays a big part in their success, even for those who don't have their opportunities, there are still a number of basic lessons that all investors can apply.

https://www.etsy.com/market/wedding_silhouette
The first and foremost of these is long term commitment. Peter Fenton is a triathlete and that attitude of endurance is similar to his approach to business. Polyvore is a good example, Fenton has stuck with Polyvore through an initial change of CEO, slow growth over an 8 year period a major recent pivot as Pinterest has gained some major traction Polyvore seems to be finally picking up along with Pinterest and making it a possible acquisition target for Pinterest. Even with companies that have gone public, Fenton continues to sit on their board looking out for the long term welfare of the companies he's invested in. Although there might seemingly be a lot of differences between venture capital and more established business, long term commitment is a theme that is consistent throughout.  It is applicable in start-ups and established public companies.  As Buffet says,"you should invest like Catholics marry: for life." When you plan on investing long term you think more deeply about what you are investing in. As Peter Thiel likes to ask, has the team been working together for awhile and are they going to give up at the first sign of trouble? Will they enjoy working together or are they just sticking it out for work's sake?  Long term relationships between great people are both emotionally and in business is a lasting source of wealth.

musk scratching head
Elon Musk and the First Tesla
http://www.businessinsider.com/tesla-co-founder-sues-elon-musk-2009-6
Monopoly-Genuinely useful, original and new ideas are interesting, beautiful and rare and when effectively made reality are one the most valuable phenomena on the planet. For Warren Buffet, he's happy with just one a year. Such ideas tend to be closely tied to their owners life experience and be protected like a child. To discover them you often have to go where others are uncomfortable going. This is another way in which traditional value investors are actually similar to VC's. They both must look from a contrarian point of view because when everyone is thinking about it, it is likely over-valued. Where traditional value investors find value in macro fears or over-reaction to bad news, venture capitalists tend to find it in novelty and being technologically advanced.  As one of the central ideas in Peter Thiels book Zero to One suggests a successful company really needs a monopoly because competition in fact kills business. This can be a problem where new ideas are seemingly obvious applications of current technology which can then be duplicated.  At the time of Elon Musk's first Tesla, it was effectively a monopoly but as companies like BMW, Audi, Chevy, Toyota Musk will have to remain committed to keep Tesla afloat.

Josh James Domo
http://www.deseretnews.com/article/865575453/
Growth-The widely recognized number one reason that start-ups fail is that they are building something people don't actually want. As Benjamin Graham observed, "obvious prospects in a business do not translate into obvious profits for investors."  Benchmark handles this by focusing on  products that delight the user and  favoring open source and consumer market. This has been essential to their success because the business to customer (B2C) market will always have more growth potential than business to business (B2B). Sometimes in looking for growth, investors want to see revenue, but as with value investing getting caught up in the immediate returns isn't as important user growth. In a sense it is odd than that Benchmark funded Domo as it seems to diverge from these characteristics. DOMO is sales driven over product driven as their CEO openly states: sales is number one. Also, Domo is focused solely on products for CEO's which is not at all consumer market. But even though Domo is well outside of Benchmark's usual sweet spot, as with Tesla, as long as they have the eccentric CEO Josh James, he'll find a way to make it work.

Obviously this is not the longest list start up rules but a place to start when weeding out potentials either as investments or job opportunities. As the examples show, it is nearly impossible to come up with absolute rules because the genius, renegade CEO will always break them. But since Silicon Valley seems to only become more and more relevant as technology progresses, understanding how to find value in the world of tech start-ups seems to be worth the effort.

Benchmark group interview forbes-https://www.youtube.com/watch?v=b_nChmdMOgs

https://www.youtube.com/watch?v=ipmfg-A1LQw    How do we find new companies?