Risks, uncertainties, smart money & pre-money valuations

It was extremely hot in Paris last week. Most Parisian apartments do not have air conditioning even though it does get very hot for a short period of time in the summer, much in the same rationale as most Taiwanese apartments do not come equipped with heating systems even though it could get freaking cold in the winter when a cold front from the mainland hits.

Transient

Surprisingly, reading in such hot days with but a small retro fan struggling to keep one's body temparture down has its merits. Specifically I was referring to the 460-page « The Signal and The Noise » by the famed statistician and writer Nate Silver. While I've always enjoyed individual brainstorming with a good book — for sure much more than with some big-egoed MBAs — the heat really added some twists as my brain raced through distinct subjects that interwined with the texts in front of my eyes, and therefore this post on 4 illusively interconnected subjects:

  • Risks
  • Uncertainties
  • Smart money
  • Pre-money valuations

 

Risks can be priced

I really appreciate that Mr. Silver took a little bit a time to distinguish risks from uncertainties for the readers. Even for people with financial training, the two slightly different concepts sometimes get mixed up nonetheless.

The simpliest way to distinguish one from the other is risks can be priced while uncertainties cannot.

By the priceability of risks, we're talking about the relatively stable required rates of return established in different asset classes. For example, the US treasury is often considered risk-free. The point isn't whether it's truly absolutely risk-free but more that compared to the other 99.9999% of available investment vehicles, US treasury is as good as risk-free. The rate of return a buyer is compensated for shall then reflect the fact that no risk has been taken, and therefore shall be very low. (The 10-year treasury note is currently priced at a yield of 2.5%)

As one moves to riskier vehicles: corporate bonds, non-USA sovereign bonds, municipal bonds and different kinds of equities, the expected rate of return gets higher and higher to compensate for the risks taken, specifically those risks that could not be diversified away.

Take investing in the equities for example. While we will not know whether for a particular company the CEO will be caught sleeping with the secretary and forced to resign or whether there's a hiccup in the manufacturing process waiting to wreck havoc on the operations in 17 days, we do know that different companies don't join hands and exhibit these types of risks at the same time and in the same way. These are therefore idiosyncratic risks which could be diversified away when you hold them in one portfolio.

And since they can be diversified away by the investors at little cost — an index ETF like SPDR S&P 500 has an expense ratio of 0.1102% — investors should not be compensated for exposing themselves to these idiosyncratic risks.

After we properly diversify away the idiosyncratic risks, researches found that different asset classes and different industries actually exhibit relatively stable return profiles, based on historical return figures. Of course industries continue to evolve and new industries continue to emerge, but in general when taken as a whole the risks can now be priced — utility industry is apparently less risky than semiconductor industry and therefore should expect a lower rate of return, for example.

 

Uncertainties cannot be priced

What are uncertainties then? Well, think 911 terrorist attack, Hurricane Katrina, the bankrupcty of Lehmann Brothers and the Fukushima earthquake.

These are all significant events of which the timings and magnitudes could not have been predicted by examining the historical events. One will struggle to find in the archives a similar terrorist attack like 911, a catastrophic hurricane like Katrina that was compounded by the failure of a government, an insolvency of a major investment bank while its peers had been bailed out a couple of months ago and an earthquake that happened to exceed the sustainable limit that a nuclear plant was built with. And even if you do find one, that's still only a sample of one, not enough for variance anlaysis.

Since these events are sporadic and distinct from even their closest relatives, they cannot be priced. In other words, it's very difficult to pursuade someone to be your counterparty to complete a transaction where the underlying is a future event in this category.

 

What does this have to do with startups?

Well, from the eyes of investors, startups face both substantial amount of priceable risks and non-priceable uncertainties.

For the priceable risks, I am referring to startups whose business models could be compared to some established transactions or even public companies. For example, the hundreds of Uber-like startups around the world could probably take inspiration from the jaw-dropping Uber valuation. Even if none of them is close to the scale and brand name of Travis' baby, it remains true that there doesn't seem to be much fixed-cost and entry barrier to this particular business. While Uber is probably overvalued, at least the similar startups are now priceable, give or take some discounts.

Uber co-founder and CEO, Travis C. Kalanick

Uber co-founder and CEO, Travis C. Kalanick

For these priceable Uberish starups, however, they and their investors still face daunting uncertainties: Will the market in Jakarta be big enough to sustain the growth? How is the regulator in Bangkok going to react? For how long do the Parisian chauffeurs have to worry about their windshields being smashed by another G7 taxi driver? Are the entrepreneurs really dreaming big or are they just a fleeting copy cat?

And occasionally VCs will run into a really brand new idea like running into Uber when they first started in 2009. There everything is uncertain and pricing of the investment will solely rely on the vision of the entrepreneurs and the VCs, as well as on the negotiation power.

 

Smart money over high pre-money valuations

This brings us to my point: if you are an entrepreneur, especially an early-stage one, you shall always prefer smart money over high pre-money valuations when given the luxury to choose investors.

In the world of VC investments, smart money refers to venture investors who not only bring the desired capital but also have the right networks and resources to help a specific startup grow even faster than what it could do on its own with the same amount of fresh money.

A simple example for smart money would be VCs that are experienced in helping a company expand internationally. Instead of having the entrepreneurs sitting on the pile of new cash confused about where to start in Russia, a smart-money VC might already has such experiences with prior investments and could accelerate the process with you.

Yet another example of smart money would be VCs so well connected that they could persuade an industry veteran to leave his or her comfortable corner office overlooking the Hudson River to join the startup as a board director, thereby enabling the company to quickly penetrate into the industrial giants' backyards with the brand new toys that they had invented.

And whenever you have the chance to go with smart money, you should not quibble over whether the pre-money valuation should be $15m or $16.5m.

Why?

Again, think about the non-priceable uncertainties. Both you and the VCs who invest in your startup face a lot of uncertainties that makes it extremely difficult to price your startup. This means that when a VC invests in you it's very different from the case when Procter & Gamble takes a 30% stake in a small life-science company that's already selling their products in 20 countries. The VC does not have much incentive to low-ball you in any event because even with a late-stage startup there's still a 50% for you to go bankrupt, wiping out all equity values. If a VC really does low-ball you and acquire a high percentage of stocks with limited cash injection, he now faces the risk that you're no longer closely aligned in interest with this highly vulnerable startup. A another problem would be that both you and the VC will face a tough time when in one year you need to raise another round — the high valuation at the previous round will scare away many potential investors, which is bad not just for you but also for the VC, usually required to have 3rd party investments in the next round for auditing and risk-diversification purposes.

In short, VCs are far from your enemy in negotiating the valuation. Getting yourself a better valuation is not always a good thing, if in return you get dumb money — or worse, a thorny board director from a dumb-money VC firm.

And trust me, you'd rather deal with a difficult B2B client such as Samsung than a dumb-money board director, any time of your life.

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