Monday, January 5, 2015

Venture Capital and Sardines

Traditional VC investment has focused on firms in the rapid growth stage. These firms have passed the seed or idea stage by demonstrating an ability to generate sales-not necessarily profits. The current trend is an increasing focus on earlier stage investing known as pre-IPO investing. It is driven by the need to invest the large sums of new capital raised venture firms. In 2014 they raised over $30B which is 60% higher than 2013-albeit still substantially below the record in 2000. The investments are rationalized as part of a preemption strategy. These earlier stage investments have a host of different issues compared to more traditional VC-e.g. increased failure and liquidity risk and due diligence needs. I hope they come with higher returns as well.

VC hopes to invest in promising startups before traditional later stage competitors do so. Unfortunately, this is not much help if everyone is adopting the same early stage tactic. The newly funded startups can then exploit Network effects to achieve a First Mover advantage.  Both Ralph and I have expressed concerns with alleged first mover advantages. Its value seems as elusive as synergies in justifying M&A. The impact of all of this earlier stage investing is that VC is focusing more on momentum than the fundamentals concerning the firm, industry and the management team. As money flows in it inflates implied values - and prices. This positive feedback effect then justifies further increased investing at even higher prices.

This reminds me of studies on POW camp behavior during WWII. Prisoners used all sorts of things as money to trade among themselves and even the guards. One such medium of exchange was sardine tins obtained from Red Cross packages. Every now and then some hungry prisoner would open a can and eat the sardines. One day such a hungry soldier opened a tin only to find the sardines were rotten. He brought this fact to the attention of his superior. The wise superior calmed the soldier down by explaining there were two types of sardine tins-one for trading and one for eating. He had just opened a tin meant for trading.

Some day someone eventually opens a sardine tin and discovers they are rotten. Then investors start raising embarrassing questions about the nature of these seed firms such as who is going to buy their app and at what price for how long, their cash burn rate and can they raise additional cash if needed-especially if market conditions tighten. Then the market will re price and the price of sardine tins like seed companies will collapse. This is plight of most momentum based investing strategies. So just like the Wizard of Oz told Dorothy-don’t look behind the curtain or inside the tin.


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