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Choosing Ventures that Might be Valuable: Lightning

 

In the new venture world, being struck by lightning is not always a bad thing. In fact, it’s exactly what we hope for. In my last post, I talked about what distinguishes effectual startups from causal startups, and why we believe effectual heuristics help a new venture survive. But what happens after a company successfully starts, survives, and grows effectually? In order for the Willamette Angel Fund to make money, the venture needs to be struck by lightning.

Lightning and Liquidity

Angel investors rely on what we call “liquidity events” to realize a return. A liquidity event can be an acquisition, a management buyout, an  initial public offering, or even a bankruptcy — any event where current investors are cashed out. Angel investing works because a minority of successes make up for a majority of failures. Around 10% of ventures in an investor’s portfolio make up 90% of the returns. However, because angels invest so early in a company’s life cycle, it isn’t possible to accurately predict which companies will be superstars. The best we can do is determine that every investment we make has “lightning” potential. But what makes the magic happen? It often comes down to being in the right place at the right time. But there are key markers we look for to see if we’re in the sweet spot.

Scalability

An important element we look for is scalability. Does the company have the potential to explode in growth? This is easiest for companies with a low variable cost per unit sold (which can be restated as a high marginal profit per unit sold). An easy example is software — once a piece of software has been coded, the cost to duplicate it is negligible. Making ten thousand copies is as costly as making ten copies. This makes it extremely easy for the company to sell lots of product without requiring additional outside capital.

Industry Multiples

If you remember my post on the Power of Multiples from back in November, we looked at the effect of industry price-to-earnings ratios in the context of angel investing. Although we are far-removed from the public markets, these multiples offer us an indication of which industries are more likely to be struck by lightning. In highly-valued growth industries, companies don’t have to work as hard to achieve high valuations. In my November post, we saw how tech and pharma companies achieve far higher valuations per unit of earnings than companies in consumer goods industries, resulting in higher exit values for tech and pharma companies. This doesn’t mean we should never invest in lower-valued industries — it means we need to consider company valuations to ensure the price we are paying for a share of a venture matches the possibility of that venture being struck by lightning.

Comparables

In addition to looking at industries generally, we can look at specific companies that are similar to a venture we are considering. This provides us another indication of whether our particular venture has lightning potential. It is not enough to be in a high-value industry. A venture’s lightning potential increases in a segment where acquisitions are common and valuations are high. Looking at comparables lets us identify milestones required to reach a liquidity event and gauge the size and timeline of such an event. As with industry multiples, comparables provide us information regarding a venture’s valuation.

Betting on the Probability of Lightning

As angel investors, every investment we make needs to have lightning potential. With an uncertain future for our companies, our best estimate of this potential is to look at what has happened in the past to similar companies and industries. As they say, history tends to repeat itself.

 


Nathan Foos

Nathan Foos is an MBA/JD candidate at Willamette University, and is an alumnus of the WU College of Liberal Arts where he studied history, mathematics, and economics. With a strong interest in the provision of capital to growing firms, Nathan has actively engaged in the experiential course offerings at AGSM, including the O’Neill Student Investment Fund and the Willamette Angel Fund. In particular, Nathan enjoys angel investing because he can engage on a personal level with investee companies, obtain real-world insight into a plethora of industries, and learn from the mistakes and successes of hundreds of startups.

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