All in + Finance

Another problem would be: should the underwriters, led by Goldman Sachs and Morgan Stanley, be responsible for this? If they had seen a sharp divide between private equity investors ($15) and public traders ($10) during book-building, they should have advised the founders to lower the subscription price to below $10 even though the PE people have put in enough subscription at $15 to complete IPO. 

I believe that this is not the case in FCFF & EV valuations, as there's no effect on how the FCFF is distributed if we exclude tax impacts. I would say that if the Terminal Values in your FCFF models account for huge part of your EVs, the models are still unreliable. This is the case of many LBO modelings where revenue growths are modeled only up to 5 years and also to be low single-digits. 

In the case of high-growth startup modeling, it's important to project FCFFs up to 10 years or 20 years until the company hits maturity. If after doing all this a significant portion of the EV still comes from Terminal Values, then this model is just as unreliable as a 5-year LBO one, if not more.

Like many hot startup subjects, crowdfunding is an oft-misunderstood one. At the Hardware Club we have more than 20 startups that broke $1M on Kickstarter or Indiegogo. In our portfolio companies along we have 3. We consider ourselves knowing the art of crowdfunding better than most average investors.

However, I constantly run into hardware founders that have very distorted views on crowdfunding. This article is to share my opinions on this subject as an investor. 

While most outsiders think a VC's job is the same as a stock picker, which is to make better decision in buying stocks than others. It could not be further away from the truth.

90% of our job is sell-side, if not more. Making the buy-side investment decisions is key to our eventual financial performances. However, without the 90% of sell-side effort, we may never get to choose, to exit and even to have the money to invest!

This article was first published on RudeBaguette.

When I joined my partners at the Hardware Club to re-focus myself on investments in hardware startups, my former boss at my previous VC firm warned me, out of concerns about my career, that hardware startups were capital inefficient and would not be able to generate the investment returns as well as lean startups.

At the time I did not try to refute him, party due to that there were not enough data back then. Since then various hardware startups such as NestGoProOculus VR and now Fitbit made their way to great exits either through IPO or M&A, making generous returns for their investors. In addition, various young hardware startups have nudged their way into the realm of unicorns, led by the ridiculously fast rising Xiaomi. I feel that it’s time to do an official analysis and refute this popular myth of capital inefficiency in hardware startups compared to their lean brothers.

Let me jump to the conclusion first: successful lean startups are as capital efficient, if not more, as their lean counter parts. They will generate as good, if not better, returns for their VC investors.

There is, both historically and theoretically, a correlation between public market values and private market valuations. This is not just because most successful startups will eventually hit IPO and hence become public companies, but also because in the valuation models of private companies, public comparables are often included despite the obvious differences in growth potential and therefore valuation multiples.

When public market rose in the past couple of years, so did the valuation of private startups. If the market takes a hit in the months to come, it's reasonable to expect a correction on the valuation of startups that are raising new rounds. In the worst case scenario, a startup might be forced to take a down round, which might trigger some embedded rights in the contracts with previous investors, which leads to further dilution or a complete impasse in fundraising.

In the later case, the startup might run out of cash and roll over.

Modern hardware startups are hitting IPO, starting with the brilliant Fitbit

As a startup of 7+ years old, backed by $66m of VC money over four rounds by prominent firms such as True Ventures, Foundry Group and Qualcomm Ventures, Fitbit has many of the characteristics that symbolize the modern hardware startups. The only major piece missing is the fact that it never went through the crowdfunding phase.

But then again, Kickstarter was launched in April 2009 and didn’t become a hardware hotbed until several years later. Fitbit on the other hand was already shipping its first Fitbit tracker in 2009. I believe if James Park and Eric N. Friedman had started Fitbit or any sort of hardware startup a couple of years later, they would definitely have enjoyed having Kickstarter/Indiegogo as a perfect launching pad.

Whatever the story, Fitbit’s IPO is bound to become that reference point for us to return to years later when this hardware revolution becomes widely recognized and accepted as a fact. It is therefore worth digging into its S-1 form at this moment.

But I have always loved economics and financial theories, studying them causally by myself over the years of my engineering career. That should have been a clear sign to me were it not for my engineer pride. Then as I progressed through formal finance curriculum (both at HEC Paris MBA program and in parallel the CFA training), I quickly realized that: yes, these two sectors actually require similar personalities (and intellects): objective, analytical, inquisitive, systematic, theory-driven, etc. 

Even more, I've come to realized that in their trainings and practices the engineers and the financiers even share some common theories and disciplines, among which the dealing with signal and noise is the most revealing discovery I've had.

... if the VC investment is 100% a game of outliers, then trying to find such outliers using a structure, however flexible and loose it is, seems to go against such nature. I hope I'm wrong and I wish the best outcome for the VCs that use more structural approaches for deal sourcing and their startups. On my side, as a super structural person I've been working very hard to "destructure myself" when it comes to deal sourcing.

Especially given the nature of hardware investments — we have to see the working prototype with our own eyes in addition to meeting the team. My partners and I travel efficiently to every potential city to seek out the outliers and evaluate the potentials, instead of sitting in the office and waiting for pitches. We spend time with the team to learn more about them. We try to pick up signals whether the founders might be too stubborn for their own good or too compliant for our own good. We make friends with those that we come to respect and like even if they don't need our investments. At the Hardware Club everything starts with our COMMUNITY and the fantastic entrepreneurs that we invite to join us.

This is obviously very tiresome and another VC might prefer the traditional funnel way so that he or she could enjoy full access to the air conditioning office and the same delivered food company everyday. However, my partners and I see no other way in our hunt for the next hardware Unicorn.

If everything goes well and in 1 year the startup successfully IPOs at $11B market cap (assuming no debt on the book), this group of investors will receive $1.1B for their investment and therefore a 10% return, annualized. Not bad for a growth-fund type of investment. The other previous investors will have 90% of the value which is $9.9B and fully 

However, if things do not go as expected and the firm IPOs at a valuation of $9B, which is lower than its Series E valuation of $10B, the liquidation preference will kick in and guarantee that the Series E investors get their full $1B of original investment back. Previous investors will be left with $8B.

Note that sans liquidation preference, Series E investors will have 10% * $9B = $0.9B while the other investors have $8.1B. With liquidation preference, Series E investors have their downside protected at the expense of previous investors.

One can also apply Heisenberg's Uncertainty Principle to the stock market (and any asset market) in the spirit that the observation changes the behaviors of the observed. For example, even the most rigorous and painstaking DCF valuation model needs to decide on a discount rate (or multiple rates for different periods of the firm's life). Such a discount rate is related to the risk (volatility) of the free cash flows in each year of projection. If the risk is low, the discount rate is low and vice versa.

But risk is very difficult to measure even for the least sexy financial products such as bonds, as the recent financial crisis proved to us. It's even more difficult to assess for a disruptive startup trying to change the world — even the great Peter Thiel would be lying to say that he had known the proper discount rates for the years to come when he became the first external investor to Facebook in the summer of 2004, when he put in $500k on Mark in return for $10.2% of the shares, essentially valuing Facebook at $4.9M.

You now see the fallacy of valuing a real game-changer such as Uber using market sizes estimated with public information. And this is essentially the problem of employing classical equity analyses and strategic analyses – be it Porter Five Forces or SWOT – on startups. There will always be new markets coming up if the changes introduced by new business entities are fundamental enough. To value a game-changing startup using the visible market size goes essentially against the notion of disruptive startups.