In The World Of Startups You Are An Asset Class

Warren Buffet famously invests in undervalued companies with management he agrees with. He holds that position until management does something he does not approve of. If this occurs, he sells his stake in the company.

A VC cannot do the same with private companies. The core difference is that changing an investment position in a private company is challenging. For example, if management is still good and the market is down, Buffet will buy more stock at a better price. VCs cannot do this.

Market price

A startup is unique as an asset class in that its valuation price is set by negotiation between management and investors. The market price is based on some distant future and must include the time value of money in the equation. In contrast, public stock is priced based on what is happening now.

Potential

At times, the public stock price aligns with the company's performance. Many times, it is not. Thus, the opportunity is presented to buy low and sell high. However, a private startup is priced more on the founding team's potential than its actual performance.

Valuation

VCs usually have a company valuation range at each stage with variables to simulate market conditions. However, this is less efficient than publicly traded stock. There is no concrete valuation in some instances, such as convertible notes and SAFEs. Instead, it is punted until a priced round in the future.

Dilution

The standard VC model is to own 1% of a billion-dollar company. However, to get there, one must own a larger percentage at the start and then continue with follow-on rounds as the company grows. This is due to what we call dilution. It means that as a company raises new rounds, the percentage of ownership goes down for everyone who participated in a previous round.

Life

Like Warren Buffet, most startup investors are betting on the management team. However, it is a long bet and should be viewed more like an actuarial table than stock trading. Founders get divorced, married, die, leave, and get sick. The longer the time frame, the higher the probability that one or more of these events will occur.

One to many

We can all list the names of the luminaries of startup founders. However, we must remember that these companies are much more than one person. A business is a team sport and, therefore, has positions that numerous talented people can fill. As the company grows, the team aspect becomes more important.

Conclusion

There is a big difference between buying public stock and taking a stake in a private company. For founders, this means making your company an attractive investment. For investors, this should include more actuarial science than market dynamics.