???????? Hi friends!

Last week was a little bit of a milestone for me.

I’ve been seeing a therapist for over a year, working through a bunch of stuff that I had been carrying with me for years – scratch that – decades.

A few weeks back, I had said to my therapist (one of the most empathetic, awesome guys I have ever met), that the work that we done had left me feeling the equivalent of several kilos lighter psychologically.

And that’s been shining through in my approach and attitude to pretty much everything these days.

So much so that when we sat down to talk last week, he suggested it might be time to wind things down.

I had been wondering what the next step was going to be as part of my therapy, and it turns out, the next step is more exploration of myself – it’s just that I have the tools to do it myself now.

In this weeks Off Balance, I’ll be chatting about:

❓ Intrinsic vs Option Value when valuing a startup
???? What framework might an investor use to evaluate your business?
???? VC Fund Portfolio Construction and why it matters for you

Also if you have any feedback or if there’s something you’re desperate to see me include, just reply to this mail or ping me online – I’m very open to conversations.

Give me a follow on LinkedIn, Twitter (do I really have to start calling it ‘X’ soon?), Instagram and drop me a note 🙂

(If you are trying to connect with me on LinkedIn, maybe read this post I wrote and make sure to start your request with “Off Balance” and, more importantly, tell me why you’d like to connect ????????)

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Now let’s get into it.

Intrinsic vs Option Value

Having written about valuation a few weeks ago, I have continued to think about this topic as we continue to see changes in the market and large swings (typically downward right now) in valuations. Just look at The Lowdown last Friday – it explores Getir’s likely down round which may mean a drop in valuation of almost 80%.

And the problem that one obviously has to answer is: How can a business in a short period of time be valued at two massively disparate valuations?

The answer, as elegantly explained in this thread by Frank Rotman (@fintechjunkie on X), comes down to the two ways that businesses are valued, intrinsic value vs option value.

Here’s the short definition of both for context:

Intrinsic value = Valuing the business based on fundamentals such as performance, cash flows, assets etc.

Option value = Valuing the business based on expectations taking into account intrinsic value, volatility, timing and interest rates.

As Frank discusses, public market investors have become great at valuing companies based on intrinsic value.

The earlier stage a business is (and the less data it has) it will have some intrinsic value, but it should be the option value you are trying to assess when investing at these stages.

Going in depth into defining option value and valuing a business using tools like Black Scholes is pretty out of scope of this post, but you can get some more detail in this article on the former, and more on the latter in this one.

For now, this thread should provide a gentle insight to understanding the issues that go into valuing early stage business, and why it’s important to hold the option value in mind.

The great debate: What is a startup worth?

It’s a contentious question that’s widely misunderstood.

What follows is a framework that cuts to the core of the issue:????????

— fintechjunkie (@fintechjunkie)
Sep 16, 2023

How can did I add value?

I have been reconnecting with some people from my past and it has been incredibly fulfilling to see where they are in their lives today.

Occasionally, that reconnection goes deeper as we realise that we have been operating in the same space; whether with startups or in the wider venture ecosystem.

Recently I’ve been speaking to one such friend who is launching something that, I think, is super interesting and he asked for my advice on it.

He wanted to know if I could pick apart his model and give him some pointers around where investors might poke holes in his deck and what he’s offering.

Now, clearly, I’m not going to go into the specific details of what he’s doing and what I suggested, but I think it is valuable to think through what investors might be looking for when they’re assessing an opportunity.

The key to much of what happens in the venture ecosystem is learning to think from the perspective of the person on the other side of the table.

And as far as getting funded is concerned, it might just make that difference between being wired the investment or not.

I don’t have all the answers, nor can I tell you precisely what every investor looks for, but what I can tell you is that most will have some kind of framework that they will work with.

I’m by no means the most prolific angel out there – and only write £1k cheques at that – but I developed a framework that works for me and won’t be miles away from how others think.

I look at:

Let’s dig into each of these one by one:

Thesis
Does the opportunity fit in to my overall thesis?

An investor’s thesis may cover such thing as sector (though some may be generalists / agnostic), stage, geography, business model, team composition, impact and any other number of things.

So the point is, make sure that if you are reaching out to an investor, you fit into their general thesis.

For example, you wouldn’t go to Notion Capital with a pre-seed e-comm business because they invest at growth in B2B SaaS.

Team
Some would argue that this is the most important thing that investors look for, but as I’ve previously discussed, market size will trump team every time.

Nonetheless, the team is always important for investors as they would like to know that they can execute on delivering the sort of outcome that an investor is looking for.

Ways of “demonstrating” this may be:

Having been founder or senior in a well known startup

Having completed a doctorate

Been part of an elite school or company

Has an obviously useful network

Things to avoid are obviously brazen attempts to build an online profile and assuming that will be sufficient – you might find yourself a mile wide but an inch deep.

Also, it’s worth noting that some of these heuristics can be quite exclusionary – i.e. not all stellar founders will come from great schools, or have access to amazing networks.

This is often argued as one of the reasons why venture remains overly exclusive to the detriment of under represented groups.

Tech
This is my short hand for whatever it is that serves as a moat for the business.

This could indeed be the technology, but it could equally be a patent, or a brand moat.

Because I prefer investing in technology first businesses, for me, it tends to be technology in its simplest sense. But even there we may see variations between software or hardware led businesses that still fit into my overall thesis.

The reason this is important though is that if the business is easily replicable, or doesn’t have any proprietary technology or moat, then it could be relatively easy for a better capitalised business or even a competitor with better marketing capability to come and take the market from under you.

Traction
Traction doesn’t have to mean revenue. It doesn’t even have to mean users (though users and paying customers are pretty good forms of traction!)

The traction should be commensurate to the stage of business you’re at.

For example, at pre-seed, traction may include having sold a non-technical solution to the product you’re building, or having conducted significant primary research. Whilst at seed expectations are more likely to include having gone beyond MVP, having customers and showing growth.

Traction is essentially a way of telling an investor whether you will use their money to meaningful progress towards your milestones.

Are you able to get to revenue in a scrappy way without burning through too much cash? Can you build a product in a lean way? Are you able to execute?

This gives investors a useful yardstick by which to measure your progress against other ventures at similar stages.

Transcendency
OK, stay with me here!

This is a bit of a grandiose word that I use to capture a couple of things that for me are really important:

Is there a massive market to capture?
Is there ‘something’ special about the business or what it’s trying to do?

The former is easier to ascertain, and ultimately one of the most, if not the most important points when investors are considering an opportunity.

The business will need to have the potential to capture a large portion or a massive market and return cash to the fund and its LPs.

The second is a bit harder.

It’s that part of investing that is way more art than science which comes from muscle memory, gut and intuition. I’m still on that journey so am still making mistakes and learning, but that’s the point – if everyone could do it, there’d be very little upside.

(and yes I know Transcendency is a bit poncy, but I couldn’t find another ‘T’ other than TAM and that just felt a bit on the nose).

Bringing it all together
Now you may have strengths in some areas but be weak in others. That doesn’t necessarily mean you won’t get investment.

The point about venture is that it should be about outliers, not businesses that conform.

But the reality is that venture is a game of numbers and you need to be able to satisfy the basic calculus of venture math to have a chance of getting funded.

For me, my main takeaway over the years is that investors are driven by two things – some index more to the first whilst others will index more to the second:

Returns

Emotion

And you have to be able to tap into both for them to bring their money to the table.

Off Balance

I’ve talked a lot about how VCs might think about any one investment in particular, from valuing it to understanding the sort of return it is likely to provide for the fund.

But the problem with this approach to understanding venture is that it misunderstands two of the fundamental concepts that apply in VC – Portfolio Construction and Power Law.

Now I have mentioned the Power Law of returns a few times, and even I’m getting a bit annoyed that I haven’t gotten round to covering it yet – but patience my young padawan, it’s coming soon!

Today, I’m going to explore the equally important question of portfolio construction because, as a founder, you need to understand how a VC is thinking about their entire portfolio of companies – not just yours.

So strap in and let’s get going.

Portfolio Construction

Why does it even matter?
Portfolio construction is all about allowing VCs to think about balancing risk and reward in their fund.

It may seem obvious that you just want to build out a portfolio of the most successful startups out there, but in reality, the stage you invest at, the amount of ownership you hold, the number of companies that sit in your portfolio will all have an impact on the success of your fund.

Essentially it is about building a diverse portfolio in a high-risk environment to give you the best chance at meeting the fund’s objectives.

If a fund doesn’t have a solid plan around how they would like their portfolio to look, they may end up overly concentrated at a certain stage and putting all their eggs into one basket, or conversely have taken so many bets that it becomes impossible to make the sort of returns expected from VC.

For startups, it’s important to understand how a VC thinks about this so that they can understand where they fit into the mental model the VC might have about their overall portfolio.

Tackling Risk

There are many different types of risks that startups face. Here’s the top 4:

Market risk – Is there a need for this product or service?

Product/ service risk – Are there technical moats, or is this easy to replicate? Does it have a strong USP so it beats the competition?

Operational risk – Do they have a strong founding team? Can the team they’ve built execute their plans?

Financial risk – Will the company have access to sufficient capital to grow?

All of this to say that it is exactly the unpredictability of startups and the risks associated with them that makes it important to build a portfolio that dampens out the adverse impact of these risks being present in one or several companies you’ve invested in.

For startups, you will want to look at the specific risks that you have in your business and try and understand whether other companies in the portfolio already face these sorts of risks. If they do, it would not be a smart move for a VC to invest in your business.

What are the key themes in Portfolio Construction?
There are several themes that a VC fund looks at when developing their portfolio construction thesis with several factors (which we’ll discuss) that play into the decision making process.

But some of the key themes that a VC will want to decide when they are structuring their fund.

Should the fund be diversified? 

This means spreading investments across across stages, sectors and even potentially being flexible on cheque size.

It is sometimes called the spray and pray approach, but oddly the high diversification can lead to some interesting outcomes.

For example, according to Moonfire, as the fund approaches 200 companies in the portfolio, the likelihood of returning less than 1x drops to close to zero.

But conversely it means that the probability of returning a massive multiple reduces significantly.

Again according to Moonfire, the likelihood of returning 10x becomes almost impossible with portfolios over 110 companies.

Or should it be concentrated?

As you might expect, a concentrated fund is one that makes larger bets on fewer, high-conviction opportunities – potentially with less diversification across sectors and stages as well.

Clearly the risk here is if, as a VC, you are not great at picking winners, there is a strong possibility there aren’t enough ventures in the portfolio with sufficiently strong outcomes to provide acceptable returns.

Should we reserve for follow-on investments?

Follow on investing is where you may take up your pro rata rights in future rounds. Typically the data would suggest that you should only do this if the subsequent investment (the follow-on) would have been the right decision on a stand alone basis.

However it is also worth noting that VCs are always looking for a target ownership stake in the businesses they invest in, and this may mean that having a good follow on strategy and reserve makes sense.

For startups, it makes sense to understand these strategies, as whichever one your target investor follows will have a direct impact on their likelihood of investing in your company.

If you are going to need a lot of capital to scale and exit, picking a firm that generally doesn’t follow on may not be sensible, for example.

So what’s the right portfolio size then?
There are a several factors that go into answering this question:

How large a fund are we targeting?
If you target a $100m fund with a 2:20 fee strategy, this means you’ll have investible capital of $80m.

Cheque size?
If you only have $80m to invest, you aren’t going to be writing $10m cheques into your portfolio. This would leave you way too under-diversified and less likely to return capital. Normally, the most sensible strategy is to write the same size cheque into each investment.

So what stage can I invest at?
Based on the above, you would either be looking to lead at pre-seed / seed or follow at seed / series A.

What’s my investment horizon?
Clearly, if you’re investing at pre-seed, you’re going to have a horizon of 7 to 10 years before you start harvesting. If you’re investing at later stage, you would expect to earn returns much earlier. This then leads to the question of whether you recycle the returns back into the fund.

Expected Returns
If you expect potential returns to have no upper limit, then it makes sense to have a larger portfolio. If you expect them to be capped, you would be better off with a more concentrated portfolio so that your losses don’t wipe out the impact of your winners.

Investment Thesis
Clearly your investment thesis will have an impact on the size of the fund. If you are investing in a very niche sector, you may simply have fewer opportunities to look at leading to a more highly concentrated portfolio.

It is clear that when you build your thesis, you may not have sufficient data to be confident in the outcomes you’re predicting.

So it’s very important for VCs to keep adjusting their assumptions as they start deploying based on what outcomes they see.

For a startup, understanding all of these factors will help them target investors for whom the opportunity is going to make the most sense.

That’s not to say they’ll always invest (or even that, if you fall outside some of their core areas that they won’t – VC is after all a game of outliers), but it’ll give you a strong basis to argue your case based on what they are looking for, rather than your own assumptions.

There is a trend for VC to become more data driven, and the team at Moonfire are at the forefront of this. I’ve leaned heavily on some of their findings in this piece – after all… I’m learning too ????????

You can access the outcomes they found simulating nearly one trillion portfolios here and build your own portfolio using their simulator here.

Every VC will have a different approach, and as I have said throughout, as a founder you want to arm yourself with knowledge and understanding to give you the bet chance of targeting those VCs who are looking to build their portfolio with a company like yours slap bang in the middle of it ???? 

I hope you found this useful, as always, I’d love to get your feedback and understand the sort of topics you’d love to hear about.

Just hit reply to this mail or drop me a line at [email protected] and let me know ????

????And that’s a wrap for this edition of Off Balance – I’d appreciate your feedback so just reply to this email if you’ve got something you’d like to say.

???? And if you think someone else might love this, please forward it on to them,

???? Finally, if you’re a fan of the Nothing Ventured podcast, please don’t forget to like, rate and subscribe wherever you get your pods – it really helps us spread the word.

That’s it from me so until next time…

Stay liquid 🙂

Aarish