INSUBCONTINENT EXCLUSIVE:
Doug Clinton
Contributor
Doug Clinton is a co-founder and managing partner at Loup Ventures, a frontier
tech-focused investment firm
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How to create the most value for the next technology wave
As a former stock analyst turned
VC, I still spend time thinking about public company investment opportunities
To that end, I recently read Seth Klarman&sMargin of Safety, a hard to find, but very insightful book about value investing
The book title, Margin of Safety, is a term borrowed from the godfather of value investing: Benjamin Graham
Warren Buffett investment philosophy is very much inspired by Graham; 85 percent as much, according to Buffett himself.
A margin of safety
is room for error built into the price an investor pays for an asset to lower the risk that the investor might lose money
In other words, assets are usually quite difficult to price, so you try to pay some amount well below what you think an asset is worth to
minimize the impact of various issues that might impact the value of that asset
One potential issue might be in the investor analysis of worth (i.e
the investor is wrong); another might be an unforeseeable market event, or a temporary problem specific to the company, etc.
While I was
familiar with the margin of safety concept, I hadn''t thought about how it might apply to venture investing, and Klarman book sparked my
imagination.
Can you fundamentally build a margin of safety into an early-stage venture investment Can you fundamentally be &wrong& about
your investment and still turn out alright
The answer seems to be &sort of,& but it quite different than how you do it in the public markets
To figure it out, it worth considering price, market and team as the potential mechanisms.
Price
In the public markets, margin of safety is
all about the price you pay for an asset
You&re looking for mispricings in the market primarily due to irrational downward assessments of other investors — usually places where
emotion takes hold and logic gives way
Irrational upward assessments happen too, but those aren''t buying opportunities, and value investing is about buying, not shorting.
In the
private markets, there may be the same amount of irrational upward assessment as reflected by some valuations that get ahead of themselves,
but irrational downward assessment is rarer simply because such an assessment would mean the market thinks a company is not fundable and,
without capital, it likely goes out of business
Therefore, it difficult for a private company mispriced to the downside to even exist
Even in down rounds at solid companies there doesn''t seem to be anything near a margin of safety that Klarman or Buffett would expect —
nor do modest valuation negotiations create such a margin of safety for top venture firms that can pull off such negotiations.
We can
comfortably say that price as a mechanism for margin of safety in venture doesn''t seem to work.
Market
A bigger market is always better, so
if we only invest in huge markets, that a margin of safety, right Unfortunately, no.
Bigger markets are usually better, but markets are
extremely hard to predict, and it even harder to predict which market many startups even really fit into at the early stage
If you had to predict the market for people renting air beds on other people floors you probably would have missed the potential for the
same platform to rent rooms and, ultimately, change the travel industry.
Can you fundamentally build a margin of safety into an
early-stage venture investment
You might apply Klarman idea of conservatively estimating a company cash flows and the applicable
discount rate in valuing a company as part of a margin of safety, but taking a conservative view of what the market may be for a venture
investment is arguably even worse than overshooting it because it will probably lead you to miss out on some great opportunities, like
Airbnb above.
Market doesn''t seem to be the margin of safety in venture either.
Team
That leaves us with team.
Fundamentally, the point of
a margin of safety is to recognize that things are probably not going to go as planned
In a public investment, where value is a constant reflection of supply and demand, you can protect yourself from the unforeseen via price
In a private investment, where shares are illiquid and relationships more important, you can only protect yourself from the unforeseen via
the team.
A great team is resourceful, dedicated, persistent, curious and flexible
Those elements reduce the risk of a negative outcome when things don''t go as planned, because a great team adjusts and fights through it
Fighting through a difficult time
Pivoting to something else
Pressing on with a commitment to suffering
Sometimes things go too far off the rails for even a great team to recover, but better to invest in a team that can correct setbacks than an
average team that crumbles under even minor deviations.
It this reason that all VCs say they invest in team first
They are our margin of safety.
Close
To bastardize Warren Buffett&sbridge analogyregarding the margin of safety: We want to invest in
founders that can lift the weight of the world, but really only need to lift the weight of one difficult startup business
We will almost certainly be fooled both positively and negatively by prices, products and markets, but we must do our best not to be fooled
by teams, because they&re the only margin of safety we have.
