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Bottom Fishing with Venture Capitalists

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By NorthCarolinaKen
April 28, 2008

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This is a rather long essay but hopefully a useful set of concepts when picking over opportunities in a recession. It has made a big difference in my results.

The Investment Opportunity:

A friend asked me to join a group of venture capitalists and consult on an investment opportunity in the deep South. He was CEO of a large VAR (tech Value Added Reseller) with spare cash he needed to invest. The rest of the investors were a diverse group from all over the South East. Besides my friend, there were two privately owned Software company CEOs, three professional money managers representing private investor pools, a wealthy individual investing his own funds and two full time venture capitalists managing two separate funds. Breaking the all male stereotype, one of the two professional VCs was a woman. There were no California Sand Hill firms in the group.

This turned out to be an all week, intensive analytical session and an excellent advanced course in investing. The opportunity was a high tech company that had been in business for a little over five quarters, growing at about a 50% annual rate but had not quite broken even yet. The business proposition was to provide capital to grow the business beyond the break even point and then invest to continue the expansion at a high rate. The founder had invested all his savings, mortgaged his house and maxed out his credit cards. He had what appeared to be a great business opportunity but he was stuck and in trouble. This was in the summer of 2003 and there was no venture capital available and banks would not lend to technology companies as a speculative investment. The group was cherry picking opportunities at the bottom of the market.

Investment Attitude

Most annual reports come in three sections. The first is the "story section" where the company explains its industry viewpoints, its strategies, its technologies, its successes and on the darker side, excuses and explanations for results less than expected. The second is the numbers section with the familiar GAAP (Generally Accepted Accounting Practices) presentation of Income Statement, Balance Sheet and Cash Flow plus some explanatory data intended either to help the investor understand important aspects of the financial performance or to obscure it. Finally, there is the lawyers' section where anything bad that could happen to the company is enumerated in the spirit of full disclosure or pretrial defense in the spirit of pre-empting false representation claims.

I always read the story section first, perused the numbers and skipped the lawyers. The venture capitalists, however, did the opposite. There was no annual report so the group exhaustively explored all of the possibilities for problems that we could come up with and their consequences. They were all carefully enumerated and prioritized on probability. Rather than trying to answer the question "should I invest in this opportunity or not," the question was rather, "can I eliminate this opportunity from consideration." a major psychological difference.

  • The first element of the investors' attitude looking at an investment opportunity is profound skepticism with the intent of preserving capital above all else.

A practical way for individual investors to apply this lesson is to look at stocks in a group with key parameters in a spreadsheet. Next pick the best opportunity by eliminating all the others. This is easily done on the spreadsheet by sequentially sorting rows based on parameters in columns. When you read analysts' thoughts on a stock, look for points of view opposite from yours, particularly negative opinions. Perhaps they have information that you don't that can keep you from making a less than optimum choice. Large short positions are also a warning flag.

We did spend a morning doing the "story section" with the founder presenting strategy, financial projections and overwhelming enthusiasm for the project. The group was interested in the story but the focus was on the weaknesses in the presentation where they were politely critical. Optimistic assumptions were discounted and financial projections scaled back. Afterwards, we had a closed door session where the three technology CEOs and I gave our opinions of the business opportunity, the competitive defensibility, the technology, intellectual property and technology risks. We also provided an assessment of the founder's management ability which unfortunately was not very good. He seemed unable to delegate so he became the single critical path to scaling up the company. The price of investment would be a loss of the majority ownership and control of the company. The founder would be replaced by a seasoned professional. He would still be a vital part of the company as Chief Technology Officer and Executive salesman but would not run the operational aspects of the enterprise.

Most of the week was spent in the "numbers" section. We had five quarters of data with most GAAP line items. GAAP accounting, interestingly enough, was the medium used to coordinate data and projections, probably because it was a common accounting language where the meaning and nuance of the terms were well known by all the investors. Where we had no data, we decided on estimates. Projections were made on three levels: conservative, expected and aggressive. As we worked, we uncovered questions about technologies, markets, competitive companies and so on. We came back with answers and then recalculated the projections based on the new information. The main parameters projected were revenues, margins, cash flows and bottom line earnings. Once established, we did a present value analysis using each of the parameters. In this case, the present value analysis determined the size of the investments required to achieve the projected results.

  • The second element of attitude is careful and intense analysis of all the data available

We have an advantage over the venture capitalists of having vast amounts of data on all publicly traded companies we might consider investing in. We don't have to guess, or estimate key historical parameters. Further, this information is available for free on the Internet at sites like The Motley Fool (Fool.com), MSN Money (MSN.com) and Yahoo Finance (Yahoo.com). Best is to get the numbers into spreadsheets, Excel for example, and compare opportunities and project expected returns. Present value calculations are available as a function of Excel. In a nutshell, present value analysis is projecting financial results forward for some period of time (I use 5 years) and then calculate what the company should fetch then in the open market using average P/E, price to cash flow, price to EBITDA, etc. multipliers. Next, regress the stock price back to the present using some benchmark percentage for comparison purposes, often some multiple of US Treasury rates (I use 15% as my investment goal return). The result gives you the comparison value of the theoretical benchmark price against the current stock price and is a relatively objective way to determine whether a stock is expensive or not and roughly by how much.

I have always worked in Engineering. High school cheerleaders may think that the local nerds are devoid of passion but that is far from the case. Engineers have tremendous passion for the technologies they work in. In contrast, my colleges in Finance always seemed normal in social situations but at work became bloodless androids that saw only the numbers of past financial performance, ultra conservative projections but were oblivious to the excitement of the technologies and fast moving markets the numbers represented. They were totally locked in their spreadsheets and figures as if they could only see the score of the football game but never the game itself. However, by the end of the week I understood why complete emotional disengagement is so important to accurate financial analysis..

  • The third element of the investor's attitude is the complete focus on the flow of money, totally devoid of emotion

This is not at all natural for me. However, I have discovered that if I do my stock analysis on spreadsheets with the tickers beyond the field of view, I can come pretty close to completely dispassionate analysis. Sorting loses the original order of the securities and obscures which numbers belong to which security. Final investment decisions by the numbers are often far from intuitive based on my knowledge of the story or feeling about a company, an indication of the difference between emotion and analysis.

Goals

It was surprising how closely the VCs worked together as a team. All contributed and the group functioned like a shadow board of directors. Although everyone stayed until the end of the week, only four funds invested because although they all had the same information, they had differing investment criteria. This was an area of some play between them. Of interest were numbers like, how much did the individual members have to invest and what were their personal risk/reward goals? This was a bit of a poker game as each wanted to maximize their returns and minimize their exposure. However, one of the professional venture capitalists mentioned in an aside that he expected to sell an early stage opportunity like this to a stage 2 VC for twice his investment within three years. I calculated his expected return on an investment at nearly 40% annualized.

Did he really expect to make 40% return per year? That is the wrong question. Given that goal and the financial projections we made, the key investment decision falls out and as it turned out that he decided not to invest. Investment goals are made away from any opportunity or market condition. The goals create criteria that allow the most objective decisions possible. No one can know the future and any investment decision is always a question of probabilities within a time frame. That said, accurate decisions are more likely to have positive results than poor ones and hard investment criteria take the emotion out of the choices.

  • With investment goals, the investor knows when an opportunity meets his criteria or not and allows the most objective investment decisions possible.
  • Investment goals always include a rate of return and a time frame.

Risk and return are usually inversely related so goals with large percentages of expected gains are not necessarily good. The first lesson was that safety of capital is the most important criteria in investing. A 40% target is extreme, usually very risky and inappropriate for most people.

"Preparing for retirement" and "preparing for my children's education are too vague for decision criteria. What is needed is to start with these global intentions, calculate what kind of return is needed to achieve the goals and reject opportunities that don't meet it. My criteria is a common one, to double every investment within five years or 15% compounded which is an aggressive goal, probably on the borderline between an appropriate and dangerous risk to reward ratio. Do I expect to make that kind of return? Since I had this intensive "investment course" I have done better than that in a rising market but it is still the wrong question. Companies that cannot return at least 15% on invested capital are off the table for me. Out of the remaining opportunities, I chose the least risky and the outcome is likely to be rewarding and has been so.

Value vs. Price

We all have some sense that value and price, while often related, are not the same thing. We have had quite a lesson on that recently with the collapse of the mortgage backed securities or CDOs (Collateral backed Debt Obligations). Funds holding significant quantities of these instruments were hit heavily by investors demanding redemption of their capital. The funds sold stock, most often their most profitable holdings which were among the best public companies and the price of the shares tumbled. Did this have anything to do with the value of these companies as businesses? In most cases, no. Price and value diverged. If you looked at the CDOs themselves, they also had some value. Certainly there is risk of default but there is also the inverse, mortgages that are likely to run to term. The issue has been that no one can determine exactly what those ratios are and as a result, these instruments are impossible to trade. Their value was whatever it was but their price was effectively zero dollars as there are no buyers.

The use of the English word "value" when discussing securities is ambiguous. It is used both for the intrinsic value of an enterprise and the current price the securities that are traded in the public exchanges. Certain Finance professors have compounded this ambiguity by declaring that price and value are the same and that the public markets always efficiently reflect it. The Efficient Market Theorists have a point in that pricing on modern stock markets is amazingly efficient. The time between news releases and stock price movement is often less than a quarter of a second. The price moves may reflect changes in value of the underlying security or they might not. Price and value are related independent variables that can converge or diverge in either direction. The world of securities is far more complex than the single variable Efficient Market model professes.

This distinction became extremely clear in this venture capital engagement. The return on investment calculations were done on a rolling 3 year term. Why a rolling 3 years? This was the summer of 2003. It turned out that this was the end of the technology depression following the crash of 2000 but it was impossible to know that at the time. The plan was to sell the business to later stage venture capitalists within three years but there was no stage 2 money in the summer of 2003 and there was no way of knowing whether it would return within three years or 20 years. Many of the gloom and doom prognosticators were predicting a 10 year trough at the time. The "price" of the firm in the absence of any stage 2 bidders was effectively zero dollars.

  • Potential return from the sale of stock is only what the market presents moment to moment. The investor can accept or reject opportunities but the market determines the opportunity and the timing, not the investor.
  • "Hope that the market will turn around" or pining for missed opportunities are extremely counter productive and a waste of time.

The forward financial projections for this investment opportunity predicted profitability in a year and with the conservative growth projection, the cash flow would be returning the original investments within 5 years. The investors could hold the company indefinitely, recover their initial investment and reap an expanding cash flow after the fifth year. Looking at the outright ownership of the company made the value proposition very clear and from that a very workable definition of "value" in securities investing. It was the cash flow, not the moment to moment offers from stage 2 VCs.

  • The "value" of a company or a share of a company from the investor's perspective has two parts: the safety of the capital and the rate of return above the investment.
  • Both safety and return are functions of time. Capital is relatively safe for how long in this investment? What is the return over this period?

In this case, the investors were reasonably confident of the probability of being able to recoup their capital within 5 years if necessary. Following the first year to get to profitability, the return on the investment was conservatively calculated to exceed 15% per year for six years. At the end of the five years, the investors could decide to put the company into debt and retrieve their original investment or continue to hold and compound it based on the value proposition at that time. There was no need for stage 2 venture capital if the conditions did not warrant a sale of the company.

  • Be wary of forced allocation schemes that put percentages of capital into equities, fixed income, commodities and cash. A bad investment is a poor choice regardless of category and is likely to lead to unhappy results. If you "need" fixed income investments, it doesn't matter if the market does not present you with reasonable opportunities. A poor decision is a bad decision regardless of perceived requirements.

Finally, there is the relationship of the price of an investment to its value. The venture capital universe is a microcosm of the larger investment scene. Where the venture capital investment price to value of emerging technology companies was outrageously high in the early days of 2000, it dropped to zero with virtually no available venture capital until late 2003. The way these venture capital investors projected the price threshold they would consider selling this company was to look at more normal times where they took price multiples of cash flow and net earnings to set the potential range and then took the median as the target sale threshold.

  • Price is a function of the relative numbers and enthusiasm of the bidders for a value proposition or the relative lack of either. Conversely, it is also the relative numbers and fear of holders of a security that wish to sell.
  • Where value tends to be relatively static, price is typically very dynamic in both positive and negative directions.
  • The price to value proposition will have extremes and a mean over time. The current relative expense of an opportunity can be estimated from the bidding history of price vs. value.

The price to value proposition of an investment is not predictable moment to moment but the current price for value, extremes and mean can be estimated. You can always know where you are even though you can never know where you are going on the short term in this strange financial universe.


Lessons Summary:

  • The correct attitude in approaching an investment:
  • Skeptical
  • Analytical
  • Unemotional
  • Patient
  • The importance and how to use investment goals:
  • Numerical goals allow objective decisions on investment choices
  • Goals are made away from and before specific investment opportunities are considered
  • The value of an investment as distinct from its pricing
  • The Value of an investment has two parts:
    Safety of invested capital within the time horizon
    Return (cash flow, earnings) on the investment
  • The price of an investment:
    Negotiated at auction in private or public markets
    Can vary widely up or down for reasons irrelevant to value