In this 2-year ongoing pandemic, apart from boom in the stock markets, there has been a big boom in Fintwit (financial market experts – ‘wizards’ they call themselves – on twitter – fondly called fintwit) where everybody and nobody have claimed massive gains given their ‘unique thought process’, ‘clear vision’, ‘in-depth insight into business dynamics’, ‘amazing chart reading ability’. First thing you need to do, as a ‘small investor’, is to stop reading / taking Fintwit seriously (unless you know the person personally of course)
As a ‘small investor’, the only objective is multiplying your capital. The only way to multiply your capital significantly is to laser-focus on only 2 things and 2 things only – “growth in earnings” and “theme” as a fundamental investor:
Growth in earnings: Different ways to do it in terms of understanding business dynamics, management ability to read the market, changing product profile, changing product dynamics, changing competitive dynamics, growth in the overall market etc. Any aspect which is not helping you figure the above is not worth your time.
Theme is critical for a quicker PE re-rating: There are obviously various kind of themes in terms of market caps, sectors, fraud-themes like ESG etc., but the best kind of theme to latch on is where earnings are growing/will potentially grow because that’s when the wealth generated will be more sustainable.
That’s the summary really – earnings and themes where earnings will grow/are growing – don’t listen to anything else, don’t read anything else, don’t waste time on anything else. Everything else is probably important, but not at the stage of capital you are in. All of that – ‘protection of capital’, ‘playing offense + defense’, ‘understanding every stock that moves’, ‘behavioral sciences’, ‘this bias and that bias’, ‘management culture’, ‘re-investment risk’, ‘FII flows’, ‘DII exits’, ‘only 20-30 stocks expected to have FII flows and hence XXX P/E’, ‘fancy investors buying certain stocks’, ‘float mop’, ‘why 100 PE like coffee-can and not 20PE like tea-can’.
Good twitter accounts to follow: Nooreshtech, Prashant Krish, Prabhakar Kudva, Gordon Max
Today’s VC ecosystem is such a well-oiled machine that we sometimes forget what problem it fundamentally solves. One recurring theme is the idea that startups aren’t economically sensible. This isn’t a criticism of your startup; it’s just the reality of building the future without a road map.
First, you do not know how much money you will make if you succeed. You can guess – a lot, hopefully – but you cannot know. Second, you do not know how much capital you will have to raise before you reach positive cash flow.
The combination of these two unknowns means that even the best founders cannot know the true value of their own equity – even if you could somehow correctly discount for execution risk. This is a problem! When you’re starting out, your equity is the main thing you have to trade. If you can’t know what it’s worth, and investors can’t either, you can’t fund yourself across the gap and get to positive cash flow.
But When you write the first check, do you know that the next check will not only be there, but will be willing to pay a higher price? And will that second check have that same confidence in the third check? And the fourth?
The early investors and late investors are in a bit of a standoff here. The early investor asks, why should I commit to writing the check, since I have the farthest amount of distance, dilution, and coordination risk between my check and a default-alive business? And the late investor asks, why should I commit to writing the check, when I have the least amount of information here?
When a VC issues a term sheet, they’re doing two things. First, it’s a literal commitment: if that term sheet is accepted, they have to put up money, and then help the founder realize that valuation over the coming 12-18 months.
Second, it’s also a signal. The number on a term sheet, if we’re being honest, isn’t actually a “valuation” of the company. You can’t signal anything like “we believe this number represents a discount to book value” because book value is still imaginary at this point. But if you think like a bridge player, you’ll see an opportunity here. You can still communicate a lot of information with your bid; just different information, that’s more useful to the task at hand.
Market price changes continuously, but at any given moment you’ll have rules of thumb like, “500k in ARR gets you X valuation”, “Having two repeat cofounders gets you Y”, or “going through YC gets you Z.”
These are not real valuations: they’re more useful than that! In bridge terms, you’d call this convention bidding. It’s a real bid, and you commit to pay a real price. But your signal communicates something different, that’s understood by convention among the other players- “By signing this term sheet, we anticipate this company will grow into a 1.5M ARR business by next term sheet” or the like. It’s not a valuation; it’s a convention.
With their term sheet bid, early investors telegraph to both present and future investors: we believe that this $6M price reflects a discount to the price next round. Nowhere are they signalling, “this company is ‘worth’ 6 million dollars”; because the equity is still impossible to value. The signal is: “Now is your chance to get in at 6, because the next round will be higher.”
If you carry this forward across multiple rounds of funding, this remarkable emergent coordination takes place: the early investors signal forward to the later investors, “you’re covered”, and then implicitly, the late investors signal back to the early investors, “you’re covered too” – even though those rounds haven’t actually happened yet. It’s highly recursive, like the blue eyes problem you learn in undergrad CS.
This is how Silicon Valley has created a kind of “controlled bubble” sort of environment, where inflated valuations can defy gravity for a lot longer than they normally should. The intricate system of back-and-forth signalling between present and future investors, and even the ability to place bids at permissible valuations at all, is only possible because VCs have learned convention bidding.
In the founder-VC dynamic thus far, one assumption that’s been more or less taken for granted is that if founders want cash, raising equity is how you do it. But now, founders (especially ones with recurring revenue type businesses) are learning they have other options – Like raising debt.
As debt arrives to the startup world (on whatever schedule it may), we’ll perhaps see tech converge with the rest of the world, where selling equity is viewed as a weaker signal whereas selling debt is viewed as a stronger one. If you’re a company who raises money by selling equity, you’re basically telling the market: “Hey, we have the most information here, and we think our stock is overvalued. We’d rather have the cash.” This is true everywhere else but in Silicon Valley.
Why not here, though? Well, for one, founders typically don’t have any other option. But the other reason why is because investors on the other side of that deal are signalling, “I believe I’m getting a good deal buying this equity. And unlike the founder, who has one company, out of the last 100 deals I’ve seen, I pick this one. This price represents a discount to the next round, which there definitely will be.”