Investing in Young and Start-up Firms: Using the Fermi Estimate

Early stage venture capital investment is more strategic and legal than financial analysis-the reverse of traditional investments. This reflects the lack of not only firm but also market history. What is needed is structure to help improve our estimates from a wild ass to reasoned guess. A modified Fermi Estimate provides such a structure. It involves starting with some defendable assumptions, updating the assumptions with observations, forming revised assumptions and repeating the process. This requires learning from facts as the investment unfolds using a Bayesian Inference approach. A key is to take small (baby) steps as the start-up evolves beyond the idea stage (no revenue) to stage one growth (revenue validation) and finally to stage two growth (profit validation). A lack of hard data does not mean anything goes. Instead, substitute reasonable assumptions which are updated as the process unfolds.

A useful framework is as follows:

1)     Industry: Porter 5 Forces

a)     Customer: who are the customers and how much bargaining power do they have?

b)     Suppliers: who are the suppliers and how much bargaining power do they have?

c)     Competitors: existing competitors and their relative positions.

d)     Substitutes: what substitutes exist?

e)     Entrants: what entry barriers exist?

2)     Strategy: what is our strategy regarding the 4 Ps

a)     Pricing

b)     Place-market segments and geography

c)     Promotion

d)     Products

3)     What is our business model for revenues and ultimately profits? Can we identify any sustainable competitive advantages? Is there enough built-in flexibility to allow for mid course corrections?

4)     Value realization plan

a)     Liquidity event: IPO;M&A

b)     Timing of liquidity event

c)     Realistic pricing expectations

Now we can turn to a DAR (Decisions at Risk) analysis:

1)     Asymmetric information

a)     Adverse selection-selecting the wrong firm, team or idea

b)     Moral hazard-failing to monitor the investment

2)     Bias: either the VC firm or the team suffers from over confidence, excessive optimism, the illusion of control, confirmation bias

3)     Control Mechanism: get a good lawyer and conduct appropriate due diligence to make sure you get the deal you thought you were getting. Consider:

a)     Monitoring: Board representation

b)     Incentives: Alignment of interests; make sure the founders are financially committed

c)     Governance: VC investor veto rights over compensation, management, vesting rights, redemptions and strategy.

d)     Investment Allocation and Timing: Stage investments based on milestones being obtained. Purse string control over the burn rate is needed to avoid incremental over committing. Balance against any first mover advantages requiring a fast rollout.

e)     Control: tight control over cash flow, assets, voting rights and dilution. Reflected in complex capital structures involving multiple instruments with different features.

The above helps avoid undue reliance on comps which can wildly overvalue start-ups when firms in the same industry are overvalued during bull markets.

J