August 21, 2012

How to invest like a Venture Capitalist in uncertain technology companies like Facebook and Google


Google keeps developing innovations, from the driver-less car to the Project Glass. If you already have, or are currently planning to invest money in Google, how are you supposed to value these innovations. Google may lease the technology from their driver-less car to automobile manufacturers all over the world, or no-one may want the driver-less car. Will they may make billions from the project - or will they may make zero from the project? Facebook may improve their advertisement algorithms and make billions from advertisement revenues, or their users may leave for another social network. Without any users, Facebook will be worth zero. Some even argue that Facebook is the next big operating system, much like Windows and iOS are today. How are you as an investor supposed to invest in these companies when the future is so uncertain?

We can't learn how to invest in innovative technology companies from traditional investors like Warren Buffett or Peter Lynch. Both of them prefer to avoid technology companies, because technology companies are hard to value when using the tradition value metrics such as the p/e-ratio. The type of investors who often love technology companies are the Venture Capitalists - or VCs. To learn how to invest in uncertain technology companies, we should learn how VCs think when they invest in uncertainty.

One famous VC is Peter Thiel who in 2004 was among the first investors in Facebook. Here are the rules he and other VCs are using when investing in uncertainty:
  • The CEO should not be paid more than $150,000 per year. The rule says that the lower the salary, the better. If the CEO is paid less, the CEO will focus on the growth of the company so the company's shares will be worth more. If the CEO has a too high salary, the CEO will not make the correct decisions when something goes wrong since the CEO will focus on keeping his high salary. Note that most VCs invest in companies when they are small and not yet public companies, so this measure may not always be applicable when searching for larger public companies, such as Google and Facebook. Steve Jobs salary was $1 per year, but he received compensations based on the Apple stock price. Apple is now the largest public company in the world.    
  • Invest in several companies. Peter Thiel believes that you should invest in 7 to 8. Another VC, Fred Wilson, believes that 20 companies is enough. If you buy more companies, you are buying lottery tickets. It is important that the company can increase its value 10 times after your investment. If you invest in Apple with a market value of about $600 billion, and believes that Apple can increase 10 times, then how theoretically possible is it that Apple in the future will be worth $6 trillion?
    You should also invest the same amount in every investment. Don't invest more money in one of the companies because you think it will be worth more compared with the other companies in the portfolio. No-one can make that choice. The only sure thing about investing in uncertain technology companies is that there are no sure things.
    In general, the best investment will be worth as much as the rest of the portfolio combined, the second best investment will be worth as much as the the value of the third to the last company in the portfolio, and so on. The result is that the portfolio as a whole, will only make money if the best investment is worth more than the rest of the fund. In a portfolio of uncertain companies, the following will happen:
    1. The bad companies will go to zero and you will lose your investment
    2. The mediocre companies may make 1 times the investment
    3. The great companies may make 3 to 10 times the investment 

Why you need to invest in several companies. Source: AVC

  • When in doubt - stay out. You may need to wait to get more data about the company. If you don't believe in Facebook today, then wait and see what happens. You will not lose money if you wait, you will only "lose a gain" if the Facebook shares increase. 
  • Make up your own mind and don't follow everyone else. You should invest in companies you like and use.
  • Make a short analysis - 3 to 5 pages is enough.
  • Don't be afraid of investing in a company with an idea that has failed before. Ideas are no longer one-time bets. Apple tried in the 90s to create a small hand-held computer with the name Newton, but it failed. Years later, Apple created another small hand-held computer with the name iPhone. 
  • Professional VCs have no idea if their investments will become the next big thing. The VC Morten Lund invested in the startup Skype because he felt sorry for the founders who didn't have much money at the time. Morten Lund didn't really believe in the underlying business idea. Skype was later sold to eBay for at least $2.6 billion. Most VC-funds never make money. Of the around 1000 VC funds in the US, only about 50 are likely to make money. Many funds make a large gain from a couple of the companies in the fund, but they lose more on the other companies in the fund - so they end up with a loss.
  • Are people dying for a new solution? Find companies that make products in an area where people are dying for a solution to a problem they have. Must Google sell the driver-less car - or will the consumers buy the driver-less car because they really need them? 

Source: Blake Masters, YouTube, Paul Graham, AVC, AVC, The Motley Fool, Venture Capitalists at Work

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