Once you truly start appreciating the merits of value investing, you realize how difficult the world of start-up investing is.
Short Track-Record, Long Future
The word “start-up” is a bit of a buzzword. It’s used to describe any new company, usually tech related. The start-up world or “scene” is usually composed of high-energy, young (mostly male) entrepreneurs with grand visions. In many ways, these are the businesses of the future and can solve a myriad of challenges. They will provide solutions that enhance peoples lives through new products and services. To give easy examples, Facebook, Amazon and Google were start-ups in their early days.
Start-up investing, on the other hand, is a whole different playing field than founding or working for one. If you are an outside provider of capital to these projects, you are at the mercy of the entrepreneur and the story. By story, I mean the narrative of the business. Since there are no figures, the future is built on potential instead of demonstrable competence. Successful entrepreneurship requires high beliefs in an idea, thus the entrepreneur is the greatest salesperson for the business. And the greatest salespeople can seduce even the most rational audience.
I’m not taking the perspective of a venture capitalist. At that stage, capital is usually employed knowing that the start-up can fail and permanent loss is a real possibility. In the stock-market, you will find companies that are still considered to be start-ups. This is where the danger lies for individual investors. A company may have sales, but if it has no cash flow, how do you know what its value is? At some stage, that revenue must convert itself to cash. What about the time frame? Or that the assets are intangible in many cases? Will you know the value of the intangible assets five years from now? Capitalism is creative destruction and identifying moats or the birth of one is extremely difficult in start-up investing.
No Margin of Safety, But a Margin of Dreams
Since you won’t know what the business is worth, there is no margin of safety. Call it a margin of dreams instead. If the company succeeds, substantial returns can be made. If it fails, you loose your entire investment. As value investors, capital preservation is top priority. This makes start-up investing completely different from being a start-up entrepreneur.
The easiest example of what can go wrong is the IT bubble at the turn of the millennia. To quote random walker Burton Malkiel:
“Most bubbles have been associated with some new technology or with some new business opportunity (as when the opening of profitable new trade opportunities spawned the South Sea Bubble). The internet was associated with both: it represented a new technology, and it offered new business opportunities that promised to revolutionize the way we obtain information and purchase goods and services. The promise of the internet spawned the largest creation and largest destruction of stock market wealth of all time”.
To illustrate the madness, below is a picture of two indices, the Nasdaq Composite and S&P 500. If you put your money in the heavily tech weighted Nasdaq during the peak, it would have taken you 15 years to regain what you lost.
Some of the surviving companies from the era have since grown to become household names. But trying to separate (at the time) the winners from the losers was probably a fool’s endeavor. To further illustrate this point, below is a table from my undergraduate thesis on the spectacular rise and fall of some darlings of the day.
Eventually (like in all bubbles and bursts) people came to their senses and realized that many of these dot-com companies didn’t have any real underlying earnings. Business models were confusing combined with unsustainable future outlooks. When the dust settled and euphoria turned to sobriety, many firms of the era turned out to be completely worthless.
Conclusion: Despite the Occasional Excesses, We Need Them
Most start-ups fail. But the ones that succeed can have a major impact on many lives. Society does itself a great favor when they nurture entrepreneurship. Only productive companies produce wealth, which government can then tax and distribute. I wan’t the start-up community to be as vibrant as ever and this post is not about hammering down on start-ups themselves. This is only written from an investors point of view, and more specifically one that tries to figure out the value of businesses.
Even though the start-up world is exciting, it can be a minefield for the investor.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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