Connecting the Dots

Seeds, Unicorns, and the Value of Venture Capital

May 23, 2017

Silicon Valley is a mystery to most people. So is technology in general, for that matter.

We like our gadgets, but we don’t really understand where they originate. We like tech stocks as long as they go up.

It doesn’t occur to us that when a tech stock goes public and millions of starry-eyed mainstream investors scramble to buy shares in the IPO, the “smart money,” aka the early investors, are already cashing out and moving on.

Learn how hedge fund extraordinaire Mark Hart is positioning his portfolio on the winning side of the Paradigm Shifts.

This week, I’m at our Strategic Investment Conference, so instead of current news, I have a movie review for you. As you’ll see below, it’s a good peek into early-stage venture investing and has some lessons we can all apply.

First, a reminder: You can follow the conference action on our SIC Live Blog. We’ll be updating it frequently with session recaps, photos, and videos. Check out the agenda for speakers and times.

Now, on with the show.

Red Carpet

Back in March, I went to the South by Southwest Conference in Austin, part of which is a film festival. Many aspiring filmmakers premiere their creations at SXSW. I’ve never paid much attention, but this year, I noticed one that looked economically interesting.

Seed is a documentary by producer Andrew Wonder. The subject is AngelHack, a competition where teams of would-be tech entrepreneurs compete for venture capital funding. Here’s the official synopsis.

Seed follows three start-ups from around the world as they descend on San Francisco for AngelHack’s Silicon Valley Week. For three intense days they’ll hone their pitches, tell their story, and face humiliation at the hands of mentors just to get the chance to present their start-up to a panel of judges who could change their lives… or destroy their dreams.

Ethan, Devin, and Pulkit are high school kids from Palo Alto who think they’ve got the tech to breakthrough, and Shaher drives an Uber in New York to fund his company back home in Palestine, where his partner Ahmed keeps the coding going while supporting his family. Bettirose and team Taka travelled all the way from Nairobi, Kenya with an app they hope can save lives back home. Dreams will be crushed and partnerships will crumble.

The film was directed by Andrew Wonder and produced in partnership with AngelHack, the world’s largest and most diverse hacker community, and funded by our client Hewlett Packard Enterprise (HPE).

You can also watch a two-minute trailer here.

Seed is relatively short (79 minutes), but by the end I was pretty attached to the characters. The film does a good job showing their dreams as well as their flaws.

If you think the younger generation has no drive to succeed, you’ll see otherwise in this film. You’ll also see why, for all our flaws, people around the world still believe the US is a place where dreams can come true.

Seed isn’t yet available on video, but Amazon Prime members can watch free here.

Venture World

Watching this film, along with other startup pitches at SXSW, got me thinking about the way venture capital works in the tech world.

In a nutshell, it goes like this: Somebody has an innovative new technology idea. They do enough work to see if it’s viable. Maybe they build a prototype. Then they look for investors to pay for developing the product and eventually selling it. Often it’s by pitching the idea at events like AngelHack.

That process can go on for years, with the founders giving up more and more ownership in repeated funding rounds. Some startups raise billions and hire thousands of people before they ever book a cent of revenue. They get away with it as long as the VCs believe profits will come someday.

In the best case, the early investors “exit” by selling their shares either in an IPO or when a larger company buys the startup. In those cases, the returns can be astronomical. But you also have to consider the much larger number whose ideas turn out not to work and whose investors lose 100% of their money. Ouch.

Coincidental Talent

All this would be much easier if you could identify winning ideas earlier. That’s tough, and I have a theory why.

To succeed under the VC model, you need three components:

  • A unique and practical business idea
  • The ability to stand on a stage and convince investors to give you money
  • Management skill to bring the idea to market

Those are three very different kinds of talent, which rarely coexist in the same person. You need a team to make it work.

Training people on their individual jobs is the easy part. Getting them to interact with each other and build a company is harder. It’s exponentially harder when you try to scale up from a couple of people to hundreds in a year or two. But that’s what many try to do.

It’s no wonder, then, that even the best VC investors take many losses.

Contrast this with the old-fashioned way: launch your business with your own capital and maybe help from family and friends. Get at least some revenue coming in pronto. Use your free cash flow to expand slowly or qualify for a bank loan. Work hard, grow slow.

Is that method better? My guess, without any scientific evidence, is that the old way has a higher success rate over time. However, it usually doesn’t lead to billion-dollar valuations and IPOs.

It takes longer, too—time you may not have if you’re competing against others for a specific market.

Rainbows & Unicorns

Does VC investing pay off? Hard to say. It isn’t like buying stocks or mutual funds, and there’s no central market to tell you where you stand. Valuations are pretty subjective until the exit, either through an IPO or acquisition.

If VC returns are significantly higher than publicly traded stocks, I suspect it’s because the risk is higher and the liquidity lower.

That doesn’t make VC investing worthless, of course. There’s still diversification value, since your VC returns have low correlation with other asset classes. That’s a big plus for institutional investors.

Whether you invest or not, I think it’s useful to watch the startup world. It is an early-warning system that helps you see what’s coming next.

As you’ll see when you watch Seed, sometimes even great ideas go nowhere. But they’ll always teach you something useful. If you’re lucky, it will pay off later on.

See you at the top,

Patrick Watson

P.S. If you’re reading this because someone shared it with you, click here to get your own free Connecting the Dots subscription. You can also follow me on Twitter: @PatrickW.

 

Subscribe to Connecting the Dots—and
Get a Glimpse of the Future

Discuss This

We welcome your comments. Please comply with our Community Rules.

Comments

There are no comments at this time.


Use of this content, the Mauldin Economics website, and related sites and applications is provided under the Mauldin Economics Terms & Conditions of Use.

Unauthorized Disclosure Prohibited

The information provided in this publication is private, privileged, and confidential information, licensed for your sole individual use as a subscriber. Mauldin Economics reserves all rights to the content of this publication and related materials. Forwarding, copying, disseminating, or distributing this report in whole or in part, including substantial quotation of any portion the publication or any release of specific investment recommendations, is strictly prohibited.
Participation in such activity is grounds for immediate termination of all subscriptions of registered subscribers deemed to be involved at Mauldin Economics’ sole discretion, may violate the copyright laws of the United States, and may subject the violator to legal prosecution. Mauldin Economics reserves the right to monitor the use of this publication without disclosure by any electronic means it deems necessary and may change those means without notice at any time. If you have received this publication and are not the intended subscriber, please contact service@mauldineconomics.com.

Disclaimers

The Mauldin Economics website, Yield Shark, Thoughts from the Frontline, Patrick Cox’s Tech Digest, Outside the Box, Over My Shoulder, World Money Analyst, Street Freak, Just One Trade, Transformational Technology Alert, Rational Bear, The 10th Man, Connecting the Dots, This Week in Geopolitics, Stray Reflections, and Conversations are published by Mauldin Economics, LLC. Information contained in such publications is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. The information contained in such publications is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in such publications are those of the publisher and are subject to change without notice. The information in such publications may become outdated and there is no obligation to update any such information. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.
John Mauldin, Mauldin Economics, LLC and other entities in which he has an interest, employees, officers, family, and associates may from time to time have positions in the securities or commodities covered in these publications or web site. Corporate policies are in effect that attempt to avoid potential conflicts of interest and resolve conflicts of interest that do arise in a timely fashion.
Mauldin Economics, LLC reserves the right to cancel any subscription at any time, and if it does so it will promptly refund to the subscriber the amount of the subscription payment previously received relating to the remaining subscription period. Cancellation of a subscription may result from any unauthorized use or reproduction or rebroadcast of any Mauldin Economics publication or website, any infringement or misappropriation of Mauldin Economics, LLC’s proprietary rights, or any other reason determined in the sole discretion of Mauldin Economics, LLC.

Affiliate Notice

Mauldin Economics has affiliate agreements in place that may include fee sharing. If you have a website or newsletter and would like to be considered for inclusion in the Mauldin Economics affiliate program, please go to http://affiliates.pubrm.net/signup/me. Likewise, from time to time Mauldin Economics may engage in affiliate programs offered by other companies, though corporate policy firmly dictates that such agreements will have no influence on any product or service recommendations, nor alter the pricing that would otherwise be available in absence of such an agreement. As always, it is important that you do your own due diligence before transacting any business with any firm, for any product or service.

© Copyright 2017 Mauldin Economics