Article adapted from Seraf: Portfolio Management for Early-Stage Investors
The first approach we recommend for selecting investable companies is to screen each company by examining the Team, Market Opportunity and Product. That’s a great way to sift through hundreds of companies to find the few diamonds in the rough. But for serious angels with more solid prospects than they can possibly invest in, a second filter is needed. Whether they realize it or not, most investors apply a second level of filter in their screening process. Investors might use different words but they are all doing the same basic analysis. We call this secondary filter the 3 P’s. They are easy to remember and understand:
- Potential — How big is the potential theoretical exit?
- Probability — How likely is the company to achieve break-out success?
- Period — How long are you likely going to have to wait?
The 3 P’s are a favorite of Christopher’s. He likes to discuss this filtering method when he is speaking with entrepreneurs in classes that he teaches all over the Boston entrepreneurial ecosystem. Since he challenges the entrepreneurs with answering these questions for their companies and investors, let’s see how he does answering them for this article.
We all hope for huge exits where we get more than 10x our initial investment. How do you determine the potential exit for a company?
Fantasizing about the potential is easy – after all, you can never really be proven wrong because you can just say a company didn’t live up to its true potential. Predicting the objectively likely outcome is much harder. It is important to accept that you are not going to be right in many cases – that is the nature of this business.
You also need to understand the difference between strategic buyers and financial buyers. Strategic buyers purchase companies for competitive or strategic reasons, and financial buyers buy companies strictly on a “business case” basis. As a result, strategic buyers are often willing to pay more because their model for an acquisition can encompass more qualitative factors and can assume more aggressive projections due to operational synergies, investments in growth and strategic factors. Financial buyers tend to look exclusively through the lens of the net present value of future cash flows while assuming conservative growth projections and maybe a little cost-cutting.
To the extent you have a prayer of being right when determining a company’s potential exit, you are going to need to start with an awareness of the strategic buyers. This requires a good sense of the ever-changing competitive landscape and the overall market of buyers of comparable companies. Questions to ask include:
- What is hot right now?
- What is cooling down?
- Where are big competitors likely to clash and feel the need to bolster their positions, or become threatened and decide to make a defensive acquisition?
- Is this company indicative of a growing trend, if it scales and succeeds?
- Who will it be stealing sales from?
In short you are asking “if my company wins, who loses or is inconvenienced or annoyed?”
Hopefully these strategic buyers are motivated by the concept of buying the entire company; perhaps for its strategic position, the threat it represents, the great brand it has built, or the number of customers or eyeballs. Sometimes strategic buyers will justify buying a company just for a single product, technology or feature. They will even sometimes buy a company for its engineers. Needless to say, the valuation goes down as you move down that list.
If your exit assumptions rely on financial buyers, you’d better go back and really look at the financial model and the operational plan. If the company’s only path to market share is by burning tons of equity and there is no reliance on customer revenue to fund operations and net income to fund growth, you may be heading for a disconnect. Financial buyers are really just looking to buy the company’s business and will generally value the company on a multiple of revenue, or a multiple of EBITDA. These are pretty straight-forward financial modeling exercises with pretty conservative growth, renewal and profitability assumptions. You are not often going to see financial buyers overpay using the kind of magic justifications the strategics will use.
Now perhaps the hardest question: the likelihood of success. I know you don’t have a crystal ball, so how do you go about measuring the probability that a company will succeed?
This one is indeed very difficult. In fact, in some ways it is easier to start by evaluating likelihood of failure. You can recognize certain problematic patterns and evaluate what they mean. If that meltdown risk feels pretty low, or there are some “soft failure” modes where you could recoup your money and maybe a small return, that can be some comfort. Turning to the success side, of course you are never going to get anywhere near certainty because so many of the companies, even in a solid angel investor portfolio, are going to fail. That is the nature of the game. But you can look at the diligence, gauge the buying priorities and resulting market size, and try to construct a mental map of a couple pathways to success. In doing so it is essential to evaluate the assumptions you are making. If the only maps you can build describe really winding routes and assume many things that just are not likely to occur, you are probably rationalizing the investment and need to be honest with yourself about the low probability. You might still choose to invest if the potential is high enough and the amount of time (and rounds) you will have to slog through before you will know is low enough, but you need to be eyes open about the lower probability of success.
Predicting how long you will hold an investment in a startup is also not easy to do. What factors do you use to figure out approximate holding periods for your investments?
The analysis starts with who the likely buyers might be a few years out. To figure that out, you need to understand who the players might be and also understand what they are likely to buy the company for. As I mentioned above, strategic and financial buyers value companies for different reasons, so you are going to have to make some assumptions. Based on those assumptions, the next question becomes what are the milestones the company is going to need to hit before those buyers are even interested? That can be ascertained by looking at comparable deals and trying to ask around to get a sense of buying patterns in the industry. Once you have done that, the question is how long is it going to take this company to execute its plan to achieve those milestones? Here there is no substitute for experience. It always takes longer and costs more, so you should also circle back and look at the assumptions of what it is going to take and what resources are assumed in reaching those milestones. Make sure those resources will not only be available but the ultimate buyer will pay enough to deliver a good multiple on the consumed resources.