31st October, 2021
Week 44/52
Unused Saturn Rockets from the Apollo Program, Cape Canaveral, by me
⚖️ Compensate
I feel like the theme of the moment, if we read the news, is the growing list of things in which we have collectively under-invested:
Hospitals; Schools; Water; Energy (renewable generation, storage, transmission), Transport (public transport, roads, ports, airports, etc); Affordable Housing; Science & Technology (R&D), etc.
In many of these cases the under-investment is chronic.
This makes me wonder: where have we over-invested?
Likewise we are increasingly faced with constraints caused by skills shortages.
We don't have enough teachers, nurses, builders, engineers, etc.
So, what do we have too many of?
Any debate around this seems to quickly descend to the question of who and when. Normally it’s those currently in power blaming those who were previously in power for the decisions they made. Or those previously in power unironically asking those now in power why they haven’t fixed the problems yet.
But I’m more interested in the why. What are the structural things that cause these errors to be made? And, how can we change those things?
The best time to plant a tree is 20 years ago.
The second best time to plant a tree is today.
💸 Invest
Here are four simple but uncommon ideas about investing…
1. We can't invest in nothing
Especially when there is a lot of volatility and uncertainty it’s tempting to think that we can opt out and not invest at all.
But, whether we like it or not, everything we have is invested in something. Investing in nothing is not as easy as it looks. We can't choose not to choose.
Perhaps we prefer to keep our cash under the mattress. In that case we are investing in the specific currency we've selected and we are betting against inflation.
Perhaps we put our money in the bank or on term deposit. In that case we are investing in the institution that holds that cash for us. Of course, they almost certainly don’t actually “hold” it as cash – so, it's worth considering what they are doing with our money in order to be able to pay us interest and still have a profit left over for themselves. Those folks who invested in finance companies prior to the GFC learned the hard way these sort of investments are not zero risk.
Perhaps we invest in the stock market. In that case the choice is a bit more obvious. Hopefully the particular company we picked does well, so the share price goes up. Or, maybe the company will do well, but not as well as others were expecting, so the share price goes down (remember, on the public markets, a share price is just a measurement of current market expectations).
Perhaps we prefer to hedge our bets a little by investing in an index fund. However, an index is just a collection of individual companies and this same logic applies to each of them and therefore to all of them together. The reason why investing in an index is considered lower risk is because the returns will be average - i.e. gains at one company will offset losses at another.1 But the average can still be negative.
Perhaps we like to own real estate. In that case we're investing in a local property market. If we have a mortgage we are borrowing (and paying interest on that loan) in order to be able to invest more than we would otherwise be able to afford. It’s interesting how much people are willing to borrow to invest in property when they would be very unlikely to do that for any of the other investment options listed above. Presumably they believe the risk is lower and that the gains will still be positive even after all of those expenses are included2, and so choose to leverage that investment.
Perhaps we have invested in our own small business. Actually, those who do this usually invest in multiple different ways - firstly by putting in the capital to get the business off the ground, and then by paying themselves less than they could earn elsewhere. These are just slightly longer term investments, in the hope that the business will grow and generate a return. When we look at it this way, I wonder how many small businesses perform better than the equivalent amount of cash in the bank, when all things are considered?
Perhaps we prefer to spend than to save. At least by investing in expensive toys today we will have less of a problem deciding what to invest in down the track!
Even if we choose to give our money away, we're effectively making an investment in a specific charity or non-profit to do something useful with that money. Or not, as the case may be.
Perhaps we just spread our bets, and do some of all of these things?
Still, every dollar we have is invested in something.
2. There are no shortcuts
There is no such thing as "free".
To say that something is free is just another way of saying that it's paid for by somebody else, paid for at some other time, or paid for in some other way.
This is true of free education, free healthcare and free shipping.
Rather than constantly looking for ways to make something cheaper by offloading or deferring costs, it's more useful to understand that the things we value the most are expensive, and be willing to pay for them (sometimes directly, but often indirectly).
I recall this wise observation, from a conversation I had with an NGO worker in Africa many years ago, where he was describing the pressure he was under to provide goods and services for free, both from the poor people he was trying to help and the rich donors who enabled him to be there:
When you ask me to give something to you for free, you are giving me all the power – to choose who gets what and when. And, to be honest, I don’t believe you really want to give me that power.
When you pay me you create an expectation that I will deliver value for money. I may or may not, and that is the risk you take, but the expectation exists nonetheless.
It’s worth thinking about what we're giving up next time we appear to get something for nothing.
The secret to sustainable investment returns isn't finding the previously undiscovered shortcut or the bigger fool, it's just being willing to do the work.
3. It's okay if other people win
It's tempting to think that the goal of investing is to "get ahead".
In New Zealand the most popular way that we're advised to get ahead is to be on the "property ladder". Even that metaphor is interesting to me. The implication is there are well defined levels, and the goal is to climb up through those over time.
Research would suggest we are quite motivated by relative results. For example, when we control for other variables, how our income compares to our peers influences our overall happiness more than the absolute amount of income we receive.
But investing is not a zero-sum game. We don't "win" at somebody else's expense. Indeed, the most successful investments generally produce a great return for lots of people. The more the better!
It's okay if somebody else makes an investment that goes well. That doesn't mean there is somehow less left in the pot for us. We don't need to worry about what other people are investing in or what returns they are getting. We just need to worry about the things we are investing in, and whether the returns we’re getting are good enough.
It's dangerous to predict that somebody else is making a bad investment. If we are correct then we look mean. If we are wrong then we look silly. We lose either way.
Anyway, in the best case, we can only tell how good their outcome is from the outside.
This is especially true for startups. It's amazing how often what is presented as a great exit was actually a lot of drama for those investors who were directly involved. And, depressingly, the true stories are often not what get shared and amplified (more on this in coming weeks, perhaps).
We need to stop comparing how we feel on the inside with how other people look on the outside.
We need make sure that the fear-of-missing-out doesn’t cloud our judgement.
The challenge isn't to invest in everything that might be good.
I've seen some of the most successful early-stage investors pile into an investment without giving it the necessary attention, when they felt like the might be missing out on something.3 I've done that myself.
In those situations it's easy for everybody to assume that somebody else has done the work to validate the opportunity. But, far more often, it means that nobody has done the work.
And that's a terrible way to make investment decisions.
4. Everything is just a row in a database
It's easy to get a bit myopic about a particular asset class.
We are all biased towards the particular things that we like to invest in.
This is true for those who invest in startups and those who invest in real estate. It's especially true for those who invest in crypto.4 It's even true of those who advise a balanced investment approach.
It's useful to step back and realise that everything is just a row in a database.
Our bank account balances, share registers, property titles, and bitcoin wallets.
None of these things are, by themselves, intrinsically or inherently valuable.
Once we have that mindset, then we can try and think a bit more clearly about what makes these things valuable to us now, and what will mean they might still be valuable (or hopefully more valuable) to us in the future.
Seinfeld: “What have I been doing? Nothing!”
🧮 Value
Let’s say we own shares in a startup.
What are they worth?
The most likely honest answer to this question is $0.
But that's fine. Don’t panic. Put your head down. Let me explain...
We often see headlines, when a fast growing startup attracts investment, that says the company is valued at $20 million, or $100 million, or $1 billion.
But that value very rarely corresponds to the price that shareholders could get if they sold all their shares.
It usually just means some new investors have paid a small fraction of that amount in return for a corresponding percentage of the future value of the company, typically on favourable terms.5
One of the defining characteristics of a startup is that it’s an illiquid investment for a long time. It’s typically only after many years, if at all, that shareholders (including founders) get any returns.
It's tempting to think that the value of a startup increases in a straight line over that time. Or, as these media reports would suggest, in well defined steps, up and to the right, with each round of investment.
But, that’s not my experience.
I recommend that founders calculate the valuation in each round based on other variables: the amount of cash they need to fund the next unit of progress over the next 18-24 months, in return for 20-30% of the company (while ensuring that the founders and existing investors retain a motivating stake).
See: Show Me The Money
Those are just rules-of-thumb, but if you’re going outside of that range in discussions with potential investors it's good to understand “how you win”.
Are you screwing the new investors? Is that how you'd like to start that relationship?
Are you ratcheting up the pressure on yourself in terms of the terminal / exit valuation required? Do you really need to make it harder?
Are you not really raising enough to fund the plan, because you’re trying to avoid diluting too much? Isn't that just kicking the can down the road?
None of those alternatives seem very smart, when you think about them.
Don’t Kick It, Pass It!
Here are three different perspectives on the valuation of a startup:
The price that gets documents in a term sheet from investors
This is usually stated as a “Pre-money Valuation” - meaning the value of the existing shares of the company before the new investment is received.
But, as we’ve seen, this is often calculated using percentage of ownership and estimated costs.
This number is also heavily influenced by the supply of capital. Currently this is very high, which means investors are competing for deals, which increases valuations (in practice: investors are willing to give founders a larger share of any future gains). The opposite is true when capital is scarce.
So, this valuation is best taken with a pinch of salt, as soon as the money hits the company bank account.
The price that is used by accountants
One of the quirks of venture capital funds is they need to report on the value of their investments frequently (at least once per year, usually more often) but that doesn’t line up nicely with funding rounds. So, they need some other way to calculate the "holding value" of their investments.
In the simple case this is the cost price. But, more commonly it is calculated using a complex formula that attempts to approximate the "fair value" (i.e. the price that would be received if the assets were sold “in an Orderly Transaction between Market Participants”.
Perhaps this value is useful for auditors, but it's important that we don't confuse complexity with accuracy when looking at these numbers. Most of the time those doing the calculations don't really know, so are basically guessing.6 They are just a number on a balance sheet, not an offer price.
The price that somebody else has offered to buy them for
This is the only useful answer, in my opinion.
In practical terms shares in a startup are worth nothing, until somebody offers to buy them. Then they are worth what has been offered. But only if we accept the offer at that point. Otherwise they go back to being worth nothing again.
Sometimes there are opportunities for individual shareholders to sell to new investors in later funding rounds, if the demand from new investors exceeds the funding that the company itself needs (this is called "secondary"). But, that is opportunistic, rather than something you can plan for.
Finding A Buyer
Great companies are bought not sold7
This is the advice I've always given to founders of the startups I've invested in:
Our shares are worth nothing until we sell them.
If we want to maximise the price we get then we need to build a company that somebody wants to buy, rather than one we want to sell.
In the meantime, we shouldn't optimise on current valuation. It's much smarter to choose investors based on who we want to work with and who can help us grow the business, rather than based on who will pay the most today.
🚀 Launch
Readers who were paying attention last week may have noticed it was a Top Three with only two things (in my defence, they were long things!) And, those subscribers who got the first edition via email were teased with a missing [NEEDS LINK] (thanks to everybody who replied to tell me about that - the chocolate fish for being first goes to Ben Pujji from Atomic: 🍫🐠).
Now the payback…
I started this newsletter in January to try and create an artificial deadline for myself each week. It’s worked even better than I expected. It’s forced me to complete and publish many of the drafts that have languished in my notebook and filesystem for too long, even if I massively underestimated the effort required to get to this point when I started.
But, as I’ve noted in the footnotes each week, it was always intended as a place for “half-formed work-in-progress”.
This week I’ve started to migrate some of this writing to a new permanent home:
That site was first set up in 2006. I started a blog to highlight the things I was working on at the time, as part of the Trade Me Product and Development teams. Later it evolved to cover many other topics: Business, Technology, Startups, New Zealand, Sport, Health & Fitness and many others. I finally called time on that in 2015.
Now I’m reviving it to be home to essays, which can be updated as required, but which capture all of this writing I’ve done this year in one place.
Starting with this trilogy, which captures the ideas I’ve shared here this year about the technology ecosystem, looking back at the spark that was lit by Paul Callaghan and forward to some of the myths that still persist around this today:
I’ll be adding much more to this list over the coming weeks, and I’ll share more links here as they are published.
All of my old writing is now also available there, including these three favourites you may or may not have read before:
For those who have followed this newsletter from the beginning, thanks for the support and encouragement. Even if it was just your clicks it’s given me an insight to what is interesting to people outside of my head. And, it’s often surprised me. Especially thanks to those who have subscribed. That growing counter has created the extrinsic motivation I’ve needed to get to this point. It’s much appreciated! 🙏
Top Three is a weekly collection of things I notice in 2021. I’m writing it for myself, and will include a lot of half-formed work-in-progress, but please feel free to follow along and share it if it’s interesting to you.
See Diworsification, for some previous thoughts on diversification as it applies to angel investments, for example.
When we calculate the returns on property investments it's important we include interest costs, but also insurance, rates, maintenance and the opportunity cost of capital. Many property investors are also landlords, so should also factor in the cost of their time. On a purely mathematical basis perhaps investing in property isn't a rational choice, once all expenses are considered, but this was still the first thing I did when I had the opportunity.
One of the things that complicates this is that a house can be an investment, but is also a place to live. When we treat property as a retirement savings scheme, as many people in New Zealand do, it’s useful to remember that you can’t eat your house).
For example, I think this partly explains the increasing popularity of convertible notes - these offer a "discount" on a future valuation, which makes investors feel like they are "getting ahead" of those imaginary others who might invest later.
Likewise, it's also true for those people who hang out at the TAB all day or keep going back to the casino.
One of the many reasons why the headline values are so often misleading is they don’t capture all of the other terms that shareholder have agreed to. For example, it is common for new investors to get “preference shares” which means in the event of a less than ideal outcome they rank ahead of founders and other earlier investors and get their cash out first. So, putting the same value on all of the shares on that basis is a mistake.
If we wanted to be especially cynical we could also consider the various incentives that those doing the calculations have to under- or over-estimate the value that is reported.
Many people believe the opposite. Most of them work in M&A.