I’m often asked how I developed a “nose” for a good deal and the things that venture capitalists are mindful of when choosing to invest in a startup. I’ve been a venture capitalist since I was in my 20s. I was taking companies public and very often investing my own money in these companies before they went public. And by seeing so many companies start and fail, start and succeed, you begin to see certain commonalities in deals that succeed and other commonalities in deals that fail.
At this point I can pretty much look at any business, and although it’s not a guarantee, I can get an idea, a sense that a particular business has what it takes to succeed at a reasonable level.
It very often starts with the company’s management—with the actual entrepreneur themselves. It’s said that a great entrepreneur can take a lousy idea and make it work and an awful entrepreneur can take a great idea and destroy it. But here’s a better way of looking at it …
Great entrepreneurs will very quickly recognize a lousy idea and change course. Only an idiot bangs his head against the wall again and again and again expecting different results. Albert Einstein said that’s the definition of insanity, right? An entrepreneur who doesn’t look at his results and say—hey it’s not working, let me change my approach—isn’t really an entrepreneur at all. He’s just this sort of low-level worker bee that should be working for someone else, not someone who owns their own business.
The next thing I want to know is if the management team has the skillset necessary to achieve the vision they’ve laid out. A lot of times I’ll find that people come up with great ideas, but they have no way of building on those ideas because they lack a certain skillset. So now they have to go out and get it, either by learning it themselves or by bringing someone else into the company that already has the skillset
I begin with the actual size of the industry. Like healthcare—it’s a $500 billion market. Now I ask myself, “How much money is the most successful player in the industry making?” In other words, if you go into a business that’s hitting them out of the ballpark and the top guy in the company is making $7 million a year, to me that’s not a very lucrative business to go into. Relatively speaking, it’s really not that much money.
Conversely, if I look at a business like Wall Street, what are the big players making? The top guys are pulling in $10-$12 billion a year and average players are making $10-$15 million a year. That’s a business where the fundamentals of the industry yield massive profits.
Then I look at the competitors for this new venture. Again, who are the biggest players and if they aren’t making that much money it’s probably a business I wouldn’t want to get into.
Next thing I look at is cash flow, which is a crucial element for any business, but especially startups and growing companies. I’ll dissect the company and make the principals tell me in painstaking detail how they actually run their business.
If the business pays suppliers before they get paid by their customers, they’re operating on negative cash flow. If they have enough money in the bank to cover these shortages, that’s one thing, but negative cash flow limits growth. The faster they grow their company the less cash they’ll have in the bank.
On the other hand if you can hold off on paying your suppliers for 60 days and you get paid by your customers right away, the faster you grow the more money you’ll have in the bank. Now you have positive cash flow and my interest as well.
And finally, I future pace the business. I actually project out in my own mind and think it through, imagining this company growing, the kind of challenges and obstacles they’ll face, the kind of companies they’ll need to align themselves with. I want to imagine this company operating fluidly, elegantly and profitably three years down the road. If I can’t think a very clear picture in my mind of this company blowing up and being wildly successful, I tend to shy away from it.
On the other hand, if I can convince myself, based on the experience I have, based on the deals I’ve seen, based on the failures and successes and I can actually see the venture making big money in the future, then I tend to say that deal has a shot at being good.
Of course there’s a need to perform due diligence, going through the numbers, visiting the company and kicking the tires if you will, scouring everything from A to Z, you’ve got a pretty good shot of picking a gem versus a zircon.
The tangible and intangible
In terms of venture capital, sometimes the best deals are the ones where you can’t put a specific value in the project. Biotechnology is an example of an industry where the first 3 to 5 years, even 7 years, there will be no profits at all and yet the company’s stock will trade based on the size of the market and the ability of the company to pass FDA trials and get approved. Then they can capture this market or sell to one of the major pharmaceutical houses. So in the case of biotech you can have a company that’s valued at $5 million, be valued at $300 million and it’s never sold anything. The high valuation is based on the hype or expectation of future FDA approval.
But there are grave pitfalls as well, as in the case of Tetraphase Pharmaceuticals, already a publicly traded company. Their new antibiotic recently failed FDA trials. This past Tuesday the stock was trading at $44.78 a share at the closing bell. Four hours later when the news broke, the stock tanked to $9.53 a share, down a whopping 78.72%. Like I said earlier, there are no guarantees.
Other examples are hi-tech where a research project is trying to perfect a way to create an alternative energy source. An example is wave technology—harnessing the power of waves to create electricity or perform desalinization. These are potentially massive markets if they can get the bugs out. But while they’re getting there and even though they’re not making any money, Wall Street and venture capital will actually give them some of that future value based on the expectation that one day they might capture the market.
Conversely, when dealing with plain-vanilla businesses where they’re buying something at X and selling it at Y, you can project the growth out to three years on paper and they never get that huge market cap—the ability of the stock to go from $5 to $500. They’re pretty much defined by what’s tangible. In biotech or hi-tech or alternative energy or mining deals you get defined and valued on the intangible.
All the best,
PS: Last call for the folks in Dublin, Ireland. I’ll be returning this Saturday, September 12, speaking at the Royal Dublin Society, Main Hall. Believe me, you DO NOT want to miss this event. Get your tickets at http://www.wolfofwallstreetdublin.com/