Blog

Viewing posts for the category finance

Upside Protection

Unlike many other types of investors venture capitalists are not as worried about downside protection. There is inherent downside protection in equity investing, namely you can only lose as much as you invest. Yet the equity can grow infinitely in value. Also unlike most equity investors, VCs expect to make the vast majority of their returns with only a small handful of investments. With the rest of the investments either being losses or a "push". Because of the fixed limit on the downside and a focus on the few investments with great upside potential. Therefore, it is more important as a VC to focus on upside protection. That is to capture as much return as possible on investments in companies whose valuations are growing very quickly. This can be done through a variety of mechanisms. I want to talk a bit about two of such mechanisms here.

Follow-on investing. Many VCs retain large portions of their funds to make subsequent investments in companies that are doing really well.[1] This helps to alleviate dilution in further financing rounds and exposes the firm to more of the positive upside potential. This is why small funds with a limited ability to follow on, can be disadvantaged. This can also be a huge disadvantage for angel investors who do not have reserves of capital to invest in their winners. Tucker Max has a good post that cites the limited ability to follow-on in winners as a reason for small angel investors to never start investing at all.

Convertible note with a valuation cap VS a note with just a discount. This is more subtle, but an important mechanism for investors who use convertible notes. For example, let's say you are the first investor in a very early stage company. The company is just a founder with an idea. You and the founder decide to use a convertible note for simplicity as well as to not have to come up with an exact valuation for the very early stage company. You give the note a 20% discount as it converts in the next round. This sounds reasonable, as you are taking more risk so your reward is a 20% discount.

Consider if the company is doing really well and they do an equity round with a valuation of $20 million dollars. Your investment converts at a 20% discount, $16 million dollars. A valuation much higher surely then you would have agreed to when the company was just an idea. However, if you had negotiated a $3 million valuation cap. Your investment would convert at the $3 million cap and you would effectively own 5x more of the company than just based on the discount note. That is upside protection. In the first case, you would effectively be punished for taking a chance investing earlier in the company because of how well it was performing so quickly.

This is important because at a $3m cap and a $20 million valuation this investment might be the one that returns your whole fund. It would not have done so simply with a 20% discount and certainly wouldn't cover the other losses and "pushes" in the fund.

Notes:

[1] Some companies also encourage this behavior with a pay to play clause.

Expand or Cut the Cake (Creating Value)

I've been trying to write a post on value creation and rent capture for a couple weeks now. My words weren't coming together the way I wanted and while researching I stumbled upon Yishan Wong's Quora answer to the question "What does it mean to create value?" He captures exactly the point I wanted to make, so I scrapped my writing and here is Yishan's full response:

What does it mean to create value?

It means making something out of nothing using human effort and ingenuity.

"Creating value" is a very important concept that for years I thought was just a business buzzword, but it captures a very important distinction from doing other things that make money, as making money is a big thing in our world, and for better or worse it's often the source of a lot of grief, joy, and politics. 

Creating value is something that people inherently understand from a young age, but then later forget.  For instance, a five-year-old will make a birthday card for you out of construction paper.  This is creation of value.  When we get older, many people forget this and start to think that such shoddy handmade things are worthless, that the only value is in things we pay money for, e.g. a store-bought card or gift.  But the five-year-old has no money, and no choice but to create something of value out of nothing but the application of her effort and ingenuity upon raw materials.  Money simply represents this value creation - the five-year-old could sell the card for money.  Likewise, money you use to buy a store-bought card came from real value you created by doing your job, which likely required your own effort and/or ingenuity.

There's another way to generate money, which is rent capture (see:http://en.wikipedia.org/wiki/Ren...).  This is a money-making method that does not create new value, but rather exploits a property of the environment (physical, social, or economic) in order to incur favorable transactions.  The easiest example of this is forcibly taking over a piece of unowned land or open road and charging others a toll to use it.  No new value is created, but the ability to charge "rent" is captured.  Keep in mind thatcharging rent is not necessarily rent capture - if you build an apartment complex and rent out its units, you have created an item of value and are merely charging for it, i.e. making money exchanging something of value you created.  Rent capture refers to charging money for usage (or relief from) a facet of the pre-existing environment you have exploited.  There are complicated philosophical issues around whether the unilateral acquisition of unowned-but-finite environmental resources and their place in value-creation, but I still skip those.

Either way, the phrase "creating value" is typically used to designate activities which make money but which are not rent-capturing, i.e. new value is created through either mutually beneficial exchange transactions or producing something valuable out of raw materials through human effort and/or ingenuity.  "Enlightened" capitalists or businessmen often use this term to designate "positive" business activities that make money because they apply the effort of human beings towards creating new value, versus other activities that generate money but not value.  This distinction is significant because many metrics of business success are measured by numbers on financial statements, which are nominally blind as to whether increases in money flow are value-creating or not.

Basically, there are two ways to make money:

1) Create new value and capture x percent of the new value created. (creating value)
2) Capture rent on an already existing asset. (rent capture)

The first form is the one that moves everybody forward. I think it is altogether too easy to forget that new value can be created. While accumulating wealth, you are not necessarily taking money from others. If you create new value for society that did not exist before, you have created new wealth and are entitled to capture a sustainable portion of that newly created value.

Source: 

https://www.quora.com/What-does-it-mean-to-create-value