This is Part 2 of a 3-Part Adventure. To read Part 1, see blog post below from July 17.
“Great company,” said the man in the bow tie. “But it’s looking like a crappy investment.”
I was sitting on a swanky leather couch in a Fifth Avenue office, chatting with a well-known venture capitalist. He’d been making successful early-stage investments for more than 40 years. Now he was telling me about a new business he’d been doing due diligence on.
Frankly, I’d been daydreaming a bit, distracted by his bow tie – a golden, silky thing that, without a word, vouched for the financial success and wisdom of its owner. But his comment brought me back to full attention. Wouldn’t a great company = a great investment? I asked myself. What’s the difference?
If you read this column last week, you’ll recall that I was considering making an investment in GameCo. I’d been trying to figure out if it was a great company. Maybe I’d been focusing on the wrong question…
I smiled and lobbed one up high. “Interesting,” I said. “Tell me more.”
As I picked up my notebook, ready to jot down my friend’s wisdom, my eye landed on the last bits of research I’d done on GameCo – including a big check mark on the page.
I’d started my research by talking to two industry insiders. They knew tons about the gaming sector and the competition, and tons about GameCo in particular. Then they’d sent me research to read, websites to review, and introduced me to other people I should talk to.
After a week of intense digging, the verdict was clear. There were many risks – as there always are in early-stage investing – but this looked like a great company.
I’d put a check mark in my notebook, made the tentative decision to move forward with the investment, and brushed my teeth in preparation for the next step of my process: bedtime. It was time to sleep on it for 24 hours.
It was the next day, about midway through my 24-hour clock, that I found myself on Fifth Ave, listening intently to the man in the bow tie.
He was explaining the difference between a good company and a good investment. I suspected that he’d given this lesson before: his delivery was concise and elegant. I’ll recap his main points here.
Sensitive, that is, to valuation. A company can be great – can even be acquired for a large sum – but that doesn’t mean an investor will profit from it. For an investor to make an attractive return in early-stage investing, he or she must follow the traditional adage of Buy Low, Sell High.
But what’s “low” mean in early-stage investing? Let’s look at a keep-it-simple example:
Let’s say you believe that a company has some possibility of being acquired for $100 million. Let’s further assume that, because of the risk of the investment, your target return is 10x your investment. In that scenario, you’d have to invest in the company when its valuation is $10 million or less.
So be aware of the valuation of the company when you’re making your investment. If it’s too high relative to what you believe it might sell for in the future, it might not be a good investment.
One of the most important elements of a successful financial investment – especially in technology, or with a consumer internet company – is finding a big market.
A company addressing a small market might be a great company. Perhaps it makes a wonderful product and earns a nice profit. Maybe it even does great things for its community and for society. But unless it’s making tons of this product, and reaching a very large market, it’s unlikely to be a good investment for its early-stage investors.
The fact is, smaller, niche companies are less likely to be acquired for a big sum or go public in an IPO – and those are generally the two ways early-stage investors get liquid on their investment.
Which scenario do you prefer?
1) Invest $10,000. 1 year later, receive $20,000.
2) Invest $10,000. 10 years later, receive $30,000.
I don’t know about you, but I’d take what’s behind door #1. Remember, money has a time value: a dollar today is worth more than a dollar – or even $1.50 – tomorrow.
A great company might eventually be acquired for a fair price, but if it takes too much time to get there, or too many rounds of financing to get there, early investors might not make an attractive return.
As I left my friend’s office and walked down Fifth Ave, I thought about our conversation in the context of my current investment decision. I believed GameCo was a great company… but was it a great investment?
Curious how GameCo stacked up as a potential great investment? Find out next week!