If you read Part One, you’ll remember that our investment model at Agave Lab is fairly “nontraditional” and that’s led to some confusion about how it works and how we arrived at it. In an effort to clear things up I’m writing about how we got here, the pros and cons of our model, and how our approach might be a better fit for startup creation in emerging markets.
First up, let’s talk about what’s going on in the global venture investing market.
FONZIECOIN VS PIZZACOIN
I have a close friend who is also an investor to the fund who called me a while back to encourage me to load up on a new bitcoin offering called PizzaCoin – apparently a cryptocurrency for all things Pizza. He was dumping his holdings in FonzieCoin and moving the proceeds over to the, obviously better, PizzaCoin. Hmmm. I asked him what makes PizzaCoin better than FonzieCoin and the answer I got was unsatisfying. “It just is. Look at the price gain over the past 7 days.” Hard to argue with that logic but I persisted. I wanted to know what was the fundamental difference between the two. Clearly PizzaCoin must do something better than FonzieCoin to justify the price increase. As it turns out, no. They are exactly the same thing and function in exactly the same way. What’s going on here?
The price increase was driven entirely by demand. The more people willing to buy, the higher the price would climb. This sets up a strange dynamic – a successful investment strategy is based entirely on how many people you think are willing to invest AFTER you. Imagine a long line of people, taking their turn to buy PizzaCoin. Each transaction drives the price up a bit. You only need to know two things to decide if you should invest: How many people are behind you in line, and where does the line end? Eventually, the line always ends – you run out of buyers – and that’s when we all realize that there was no intrinsic value supporting the price and PizzaCoin goes to zero. Those who correctly judged where the line ends got out and harvested the money that was invested by those who misjudged it.
I’m not claiming that this sort of thing is new. I’m sure that there are hundreds of scholarly articles about demand-based pricing by people far smarter than I. However, this example got me thinking about where we are in VC investing today.
TOO MUCH MONEY WITH NOWHERE TO GO
Big pension funds and sovereign wealth groups need to invest in early-stage technology – not exclusively because of perceived opportunity but also out of fear of missing the next Facebook or Google.1 They are driving a surplus of money into venture funds who then need to find a way to deploy it. Rather than invest in many small companies, much of this surplus gets forced into a few chosen companies. Why? Imagine that you have a $2 billion fund and you need to put it to work. You can either do 1,000 seed investments at $2 million each or plow $100 million into 20 later-stage companies. The latter strategy has many advantages:
- It’s lower risk as to the companies you invest in already have some traction.
- You have plausible deniability. Other big names are investing (or already have in an earlier round). You can piggyback on their due diligence or, more importantly, justify the investment in the off chance that things go south.
- It’s certainly more manageable (imagine going to 1,000 board meetings!)
The only problem with this that all the funds are doing the same thing. This means that the few deals that “break out” are overwhelmed with term sheets.
WHAT TO DO IF YOU’RE THE MOST POPULAR KID IN SCHOOL
How do those companies respond when they are overwhelmed by investors who want in? Simple, raise the valuation. If you’re investing $100 million and I’ve valued my company at $5 billion I’m only giving away 2% of my company – free money!2 Another factor that is driving valuations skyward is the tendency for later-stage investors to secure preferential liquidation rights. If I know that, as the last investor in, I can get 1.5x my money back BEFORE anyone else, you can name any valuation you’d like. I’ve protected my downside. This all adds up to hyperinflation when it comes to late-stage company valuations.
So back to our line metaphor. As an early investor, I’m at the front of the line. If my company is one of the very few that achieves escape velocity, I see the nominal valuation go through the roof. Awesome – the company can raise enormous sums of money while folks deeper into the line write bigger and bigger checks at higher and higher valuations.
But now we’re starting to see the end of the line. As valuations climb they also become more precarious. Eventually, things just become logically untenable – e.g. even if every human on the planet were using and paying for the product it still wouldn’t justify the valuation on a price to earnings basis. We used to have an escape hatch in the public markets but now, with private valuations going through the roof, an IPO is often a down round (see Uber and WeWork). Also, turning over your books to be scrutinized by a more objective public often exposes the real numbers as well as the magical thinking that has been used to push the valuations into the stratosphere in earlier rounds.
WHAT HAPPENS WHEN THESE MARKET DYNAMICS COME TO MEXICO
Is it possible to overlay this investment model in an emerging market? As investment power gets concentrated in fewer funds, will the deep-pocket investors who are edged out of the mega deals in the US look to LATAM as an opportunity to get closer to the front of the line? Upon entering this market we at Agave Lab saw there were tremendous greenfield opportunities – enormous markets that were ripe for disruption. The biggest challenge was that the infrastructure to capitalize on it didn’t yet exist (to be fair, the Bay Area has a 30-year head-start). Everyone was doing their first startup so we had little institutional knowledge to fall back on. Also, the legal frameworks didn’t exist, the tax code was wonky, and most investors didn’t really know what a startup was supposed to look like. Finally, exit opportunities for a company whose last private valuation was $1 Billion-plus were few and far between. Simply put, there just aren’t many companies in LATAM that have the sort of resources to buy at those prices.
With this as a backdrop, we, at Agave Lab, had to come up with an investment/support structure that could thrive. Simply importing a model that was the end product of a 30-year history was going to be a challenge. We had to assess the facts on the ground and approach the opportunity differently.
Next week I’ll talk about what we did.
Thanks for reading,
GP, Agave Lab
1) As of 3 years ago, Private Equity funds were, collectively, sitting on three-quarters of a trillion dollars in uninvested assets while Venture Funds had $121 billion in reserve.
2) Airbnb’s last round raised $1 billion and valued the company at $31 billion.