Venture Capital Investment Theory – The Four Horsemen

Venture Capital investing in high risk businesses has long been considered an alternative asset class and is invested in by major institutional investors, accredited individual investors, and most recently by non-accredited smaller investors under the provisions of the JOBS Act.

Venture Capital is invested in seed, start-up, early and later stage companies and new business concepts. The risks are high, with only fifteen percent of all investments making anything at all, but if an investment hits, it can generate a return exceeding ten times or better on capital invested.

Investment in venture capital has several unique features, other than a high potential return on investment, that makes it a compelling asset class for many investors: it can be a value investment; a high growth investment; non-correlated to other types of investments; and a contrarian investment. Each of these unique investment features provides a venture capital investment with compelling economics which can differentiate it from other investment vehicles. Depending on market timing, when all features are brought to bear simultaneously, the returns can be extraordinary.

Warren Buffet is known as the essential value investor, particularly earlier in his investment career. Following his mentor Ben Graham, his approach was to invest in stocks of companies he viewed as undervalued compared to other investment opportunities in a similar space. “Price is what you pay, value is what you get.” Buffett evaluated various factors and data in his analysis of value but he really liked investments that had an intrinsic value (what you could sell it for) that were either higher than the investment’s net asset value, or better yet, the cash it held or could quickly assemble. Buffett was looking for value needles in the haystack, and the approach worked both because he had an instinct for finding the needles and the haystack of opportunities was sufficiently large with initially not too many others looking in the same haystack.

As more investors piled into Buffet’s value approach to investing, he added a second approach his value approach: growth investing. Growth investing is all about identifying those sectors of the economy whether in the form of stocks of fast growing public companies or the companies themselves if still privately held. The growth investor accepts a higher risk for the potential greater return that a growth investment is likely to provide, and assumes that the market will pay more for higher growth. Like a value investor, a growth investor must also buy low for fair value or on exit from the investment may not provide an adequate reward for the risk taken.

Venture Capital investing almost always combines both the value and growth approach in a successful investment. Most venture capital investments, particularly at the early stage, whether seed, start-up or the next stage of growth possess few to no assets, are spending all the cash they can raise, and their growth rate is a “hockey stick” projection of dubious certainty held in the mind of an entrepreneur. A venture capitalist, however, must be able to judge both the “value,” to know what price to pay for the investment, and the likely growth rate to know what the return and/or pay back multiple the investment is likely to produce. This necessary insight is often the product of having evaluated and made many successful and unsuccessful investments. If the value judgment is correct or near correct and the growth call is spot on, then the investment will likely return ten times or better on the capital invested, or what the industry calls a “home run.”

If an investor is making or has made a number of other asset class investments such as stocks, bonds, real estate, or art, a venture capital investment can often add additional value as it will be non-correlated to those other assets. When those assets move up or down in value the venture capital investment will often move in the opposite or near opposite direction. One of the major reasons a venture capital investment is non-correlated is that it generally has little or no value until it is either sold or taken pubic in an initial public offering. Until this final exit, many venture capital firms do not write up or down the book value of the investment unless it is viewed as worthless. Since the exit may occur at any time, the exit value is often not related to how stocks, bonds, or other assets are performing.

If the venture capital investment is viewed as worthless it is almost certain it is non-correlated to a more liquid asset that is inclined to hold at least some value. Being non-correlated can be of real value to an investor as the cash from the exit can be deployed advantageously at a time when other investments are non-performing or would need to be sold at an unfavorable price for liquidity.

Venture Capital investors also look for opportunity where others are not looking. They are contrarian investors going against the grain and the herd. Peter Thiel, in his book “Zero to One,” puts it best: “what important truth do very few people agree with you on” or in business terms: “what important company is nobody building.” According to Thiel, if an entrepreneur can answer this question and execute on the answer it will often lead to a monopoly position and real success. The failure to adequately answer leads to me-too companies, many competitors, and often disaster-a successful company should avoid gathering a competitive crowd. Most venture capital investments fail and with them most venture capital investment funds. Often they fail because too many people agree on the truth the entrepreneur sees. The entrepreneur and the venture capitalist lack the contrarian view. However, once the contrarian view is firmly in view then all roads lead to Rome.

The combination of value, growth, non-correlated, and contrarian investment approaches in the venture capital asset class provides four powerful investment processes which has and will continue to provide outsized high performing returns to venture capital investors.