Portfolio Math

There has been a great deal of discussion about the viability of the venture capital industry.


What types of returns are required to justify the asset class' risk? Are such returns available in today's market? How much risk does an early stage venture capitalist need to take to justify the premise of the business?

To find out, I constructed a simple model of a portfolio with the following characteristics:

1. # of companies in portfolio
1. 10


2. $ per company ($m)
1. $10


3. management fee
1. $0 (to keep this simple:))
   
4. Probability of Success
1. 40%


5. Probability of Failure
1. 60%


6. Definition of Success
1. 5x money


7. Definition of Failure
1. 0x money

The table below illustrates the probability of N successes, the value of the Nth success, and the expected value of the Nth success:









For example, in a portfolio of 10 companies:

• the probability of 4 successful outcomes is 25%
• or, 10!/4!6!*(.4)^4*(.6)^6
• the value of 4 successes is $200m, or 4x5x10
• the expected value (prob * value) of the fund, the sum of the total distribution of expected values, is also $200m
  

To 3x a fund, one would need:

• $300m,
• given a 40% success rate, and 7.5x your money/success

To 5x a fund, one would need:

• $500m, or
• given a 40% hit rate, 12.5x your money/success

To 8x a fund, one would need:

• $800m, or
• given a 40% hit rate, 20x your money/success

Now, if the hit rate falls to 20%, to 3x a fund, one would need:

• $300m, and
• 15x your money/success

If you hold 5x money/success, each 1% improvement in the hit rate is worth $5m.

If you hold the hit rate constant at 40%, each .5x money/success is worth $20m.

In summary, given that early stage venture capital often experiences binary outcomes, individual firms should look to ensure that deals support the possibility, if not the probability, of a 10x or better outcome.

Furthermore, LPs should diversify across multiple partnerships and look for firms that look to create large winners, not incremental winners. Conventional wisdom holds that 10x returns are required for Series A investors, however, the math exercise helps illustrate why that is the case.

Back to the original question...The early stage very capitalist appears to only be able to justify the risk involved in the asset class if they can either

• materially increase the hit rate, ie reduce probability of failure per deal
• create deals with 10x+ returns on invested capital
  

Are there 10x or greater deals in the market? Of course, however, great funds will need to find quite a few in order to justify their existence.

Hitting doubles or triples, in the face of a high mortality rate, will not cut it.

Note: thank you to Hunter Hancock for his valuable feedback and help on this post.

Six Filters for Business Evaluation

I am currently reading, Seeking Wisdom: From Darwin to Munger. The book seeks to provide guidelines for better thinking, explain what influences our thinking, and delves into the psychology of misjudgments. All topics of real interest to investors.

The book leans heavily on the writing and speeches of Warren Buffet and Charlie Munger. It reads like a reference book - with each chapter full of terrific nuggets of wisdom and quotes to remember.

The book includes a useful checklist for business evaluation. All investors, like pilots, need to have a checklist to ensure consistent best practices in decision making. At Hummer Winblad, we put together a checklist for every deal.

The book's checklist follows. While perhaps the book's list is not perfectly suited for early stage investing....like many frameworks, the real value lies not in the specific framework itself, but in the consistent application of a mental model that ensures diligent analysis and carefully weighed decision making.

Filter 1: Can I understand the business - predictability?
Reasons for demand - how certain am I that people are likely to buy this type of product or service? why will they buy? what are the benefits?
Return characteristics - Industry and company return characteristics and change over the last five years? Is there a business model comparable that has made real money for its investors and management team and proven the operating model's economic value?
Industry structure - (a la Michael Porter), no of competitors and size? Who dictates terms in this industry? Do I know who is going to make the money in this market and why?
Real customer - who decides what to buy and what are his decision criteria?

Filter 2: Does it look the business has some kind of sustainable competitive advantage?
Competitive advantage - can I explain why the customer is likely to buy from this company as opposed to others in the market? what is the basis of the advantage - market knowledge, execution strength, or technology?
Value - how strong is this advantage, does the advantage benefit from network effects or scale that will make it stronger and more durable over the years?
Profitability - can the advantage be translated into profitability and why?

Filter 3: Able and honest management?
Is the team competent and honest? Do they understand the market and are they focused on value creation for the owners of the business?

Filter 4: Is the price right?
Can I buy at a price that provides a good rate of return with an adequate margin of safety?

Filter 5: Disprove
How can the business get killed?
Who could kill it?
If it failed, what are the likely internal and external causes?

Filter 6: What are the consequences if I am wrong?

At Hummer Winblad, we add:
Filter 7 - what disruption will aid the company is driving growth?
What wave will the company ride that rewrites the operating dynamics of the industry and drives the reallocation of capital away from old models and technologies to new players in the market?

The book is a fun read and one to have on your desk.

Rich Price - Playing on Sept 25th in SF

My brother, Rich, is a wonderfully talented recording artist.

His new band, RGB, will be playing in SF on Sept 25th.

Below is a note from Rich and I hope some of you can make it!

Hi Bay Area friends, I hope all's well. I'm excited to announce I'll be bringing my new trio, RGB (Rich Price/Greg Naughton/Brian Chartrand) to San Francisco a week from this coming Tuesday.

I'm thrilled to be performing with two of my favorite songwriters, and the trio has been great fun. It's like Crosby, Stills and Nash had a one night stand with Paul Simon, The Police, David Gray, Martin Sexton and that short guy from Fantasy Island and somehow managed to produce a three-headed singing beast...that's RGB.

If you're free on Sept 25th, we'd love to see you! Thanks for all the support and for helping to spread the word!! All the best, Rich

RGB (feat. Rich Price)
Tues, Sept 25th at 8pm (sharp)
Red Devil Lounge
1695 Polk St (at Clay)
San Francisco, CA

link to purchase $10 ticket





p.s. I'll be performing in SF in late Oct with my old band. More details to follow.

What is a Brand?

I recently heard a very succinct and compelling answer to the question, "how do you define the concept of a brand?"

The answer, from the CEO of E&J Gallo Winery,...

"A brand is a promise to a customer of quality, image, and differentiation."

The definition elegantly boils down a complex concept to five key elements:

1. a promise...a commitment from the company.
   
1. Employees across the organization need to internalize that promise and live up to the commitment that is at the heart of the company/customer relationship
2. a customer
   
1. the company needs to understand the interests, demographic profile, characteristics, motivations of the customer. What makes them tick? Who are they?
   
2. A clear picture of the target customer helps align the product, sales and marketing strategy, and positioning with the customer's interests and needs
   
3. quality
   
1. a value...be it an experience, physical good, or relationship
   
4. an image
   
1. a set of mental associations that complement the interests and self-image of the customer
   
5. a differentiation
   
1. a clearly unique proposition that is effectively communicated to and understood by the customer

I think all five elements are worthy of thought and reflection.

• what is your brand's promise?
• who is your brand's customer?
• what is your brand's quality?
• what is your brand's image, mental associations, characteristics?
• what is your brand's differentiation?

Simple questions with surprisingly hard answers.