Why You Need to Stack the Odds When Investing Early
While investing with entrepreneurs in early-stage companies is both intellectually stimulating and potentially very lucrative, it can also be fun. That said, the fun disappears very quickly when a company hits the ropes and the value of one’s investment materially declines. Having lost money on too many promising early-stage companies, I have become convinced that this form of investing ultimately requires one to — in baseball parlance — swing for the fences with each individual investment. Each early-stage investment must have significant potential.
Continuing with the baseball analogy, when investing in early stage companies — unlike other assets like real estate or public equities — I don’t believe the goal of consistently hitting singles and doubles makes sense because of the preponderance of strike-outs.
The odds of real success in early stage investments are so low that one typically needs the perennial grand slam to offset the cumulative losses in the portfolio. Recognizing this reality encourages an investor to stack the odds in their favor by investing only in those companies with the potential to be true home runs. I believe these types of investment opportunities have certain characteristics that are fairly easy to identify. While having these qualities doesn’t remotely ensure success, adhering to these criteria may disqualify a number of investments which offer even a lower likelihood of success and negatively impact the overall portfolio.
The first criteria, and easiest to ascertain, is the size of the possible target addressable market (TAM). Businesses may have TAMs that have massive global reach, or may just focus on a local niche market. It goes without saying, however, that the possible size of the market will directly influence how big a business can grow down the road. For example, a business such as AeroFarms that is trying to disrupt the farming market with high tech aeroponics has far larger market to scale into than a local chain of farm to table restaurants in a mid-size market. While both businesses may theoretically have single digit probabilities for success, the fact that one even has a remote possibility of growing into a multi-billion dollar business has implications for their individual investment potential as well as the potential impact on the overall portfolio.
Assessing the size of a TAM is an easy and obvious first step, however, an investor should carefully examine the state of the market as well. Is the market ripe for disruption using technology or new methodologies? Is it an easy market to enter or are there substantial barriers to entry? It should come as no surprise that the larger and more lucrative a TAM is, the more likely it is that there will be many competitors pursuing the opportunity. Are supply and demand forces positively or negatively influencing the underlying business? Investors should be searching for businesses that perform well against examinations like these.
To illustrate an ideal market one can look to healthcare, specifically primary care, because it literally applies to everyone. This massive market is even more compelling because it’s widely accepted that it is broken and in a state of crisis. There is a growing shortage of primary care doctors available to support the increasing demand. The demand side of the equation is the exact opposite as people are living longer with more chronic conditions than ever before. Geographically, many Americans do not live in easy proximity to quality and accessible care. Given the reality of this market, it is not surprising that many companies are rushing to develop innovative solutions for the delivery of care.
Assuming a market is ripe, investors must next evaluate a company’s proposed value proposition, as this will drive the likelihood of gaining traction with potential users. Promises to the user regarding factors like quality, cost, access, and efficiency all represent viable aspects of value propositions. Delivering on just one of these value propositions is acceptable; of course, fulfilling two of them is better, and three or more is ideal.
In fact, some of the biggest success stories in recent years are of companies that have delivered a multi-pronged value proposition to the marketplace. Uber is a great example of a company delivering a value proposition on multiple fronts and to multiple constituencies. They offer consumers on-demand access — in non-surge times — to cost-efficient transportation. For drivers, they offer convenient and optimized access to a market that is growing by virtue of their changing consumer behavior. Today, it’s often easier and smarter — especially when alcohol or fatigue is involved — to simply hail a ride sharing service. On this point, Uber’s value proposition applied to a massive market represents the ideal characteristics of a potential grand slam investment.
Unfortunately, just having a favorable market to pursue and a compelling value proposition are not enough. Companies must also have a compelling business model and, more specifically, a clear and reasonable path to profitability. The marketplace is rightfully becoming less enamored or accepting of fuzzy non-traditional metrics like “eyeballs” as an indicator of future paying customers. One of the most egregious metrics I have seen was a company promoting the number of customer proposals they were submitting. Comically, this company didn’t supply a corresponding success or closing rate.
It’s rarely simple and straightforward to pry payment from would-be or existing users. Even in cases when one is successful at this and therefore able to generate revenues, it says nothing about the existence of the key requirements for an enduring business — positive cash flow and profitability. As investors finally realized with WeWork, revenues matter little in the long term without corresponding profits and cash flows. It’s truly mind-boggling that investors ever accepted the promise that “we will figure profitability out later.” Clearly understanding upfront how a company will generate profits on an overall and per unit basis should be essential before investing in any early stage company.
A final and extremely advantageous factor is whether the company has or can build a formidable moat, a term that refers to the ability to maintain or protect a competitive advantage. Depending on the product or service, a moat can be established by virtue of superior or proprietary technology, scale, regulatory approvals or capital resources. The harder and longer it takes for a would-be competitor to penetrate a moat, the better.
Take healthcare, for example. Companies looking to reinvent the industry must contend with the prevailing regulatory environment in each state, which makes assembling nationwide approval a daunting task. A moat in this regard would be formidable — even the most well-capitalized and sophisticated competitor would need to go through the time-consuming task of working with state licensing authorities. This moat isn’t permanent, but would likely translate to a 12–18 month head start, which can be an eternity for any others attempting to rapidly scale a new business or product in the same market.
Of course, success is not guaranteed even for a company that targets a massive dysfunctional market with an appealing value proposition and a distinct competitive advantage. A powerful and effective leadership team with the ability to execute and iterate is critical. My view is that if an investor is going to invest in early-stage companies, directly or indirectly through a fund, they can improve their odds by carefully analyzing these categories and applying the discipline to ensure that all of these criteria are present. This approach, combined with the often-needed healthy dose of luck, may create a grand slam investment that can offset the other inevitable early stage investments that will fizzle out.
Originally published on Data Driven Investor.