My Simple Technology Investing Framework: Part I

Hey There!

If you haven’t yet, check out my conversation with Arthur Willson on his experience scaling a company. He shared some excellent tips on how to set yourself up for success in a small organization.

My good friend Anni’s recent blog post describing the difficulty of building a startup got me thinking about how to invest in the right ones post-IPO. It inspired me to write a series on my basic principles for investing in technology companies. Let’s dive into a simple framework I use that I believe benefits retail investors heavily.

Enjoy, and make sure to subscribe for Part II!

-Welty

I am not a licensed investment professional. This blog provides information for educational purposes only. It is not financial advice. Please consult a certified financial advisor before making investment decisions. Your investments carry risks, and I am not responsible for any outcomes.

The Venture and Public Investor Mindsets

How do Venture Capitalists Value Companies?

When investing in public technology companies, especially those that have just IPO’d, it is critical to understand the inherent mindset difference between the private investors who backed them, and the public investors that will soon own the company. Keep in mind that this is a simplified explanation of how the venture capital industry makes investments. There is a lot of nuances depending on the investment stage, but for the purpose of this framework, let’s keep it general.

Venture investors, fundamentally, look for companies that will provide moonshot returns due to the power law, which effectively states that the majority of returns in a venture fund will come from a small number of companies. As such, the risk profile of a venture investor is much higher than a public market investor, and their time horizon on such investments is typically 10 or more years. As part of this mindset, most venture capitalists are basing company valuations on the ability for these companies to capture their Total Addressable Market (TAM). The TAM is estimated by both the company and the investor and represents the total amount of revenue a company could earn if it holds a 100% market share.

In each investment series while private, investors are re-estimating this TAM and the ability for a given company to realistically achieve it. Because the investment exit horizon is very long, venture investors can be very optimistic in a company’s ability to hit the TAM. The TAM itself also has a changing estimation, and investors at this stage are also betting on their ability to accurately calculate this.

How do Public Investors Value Companies?

Again, this is a simplification, but is useful for this analysis. Most large, public investors have a much shorter timeframe than venture investors. Since public markets are very liquid, investors can essentially buy and sell at any point. This means that profits can be made much faster, and there is no need to wait 10+ years for liquidity to come to your investment. Given this perspective, when venture-backed technology companies IPO, often, they see a substantial drop in value within a few months (Image 1). Since the valuation is no longer pegged to the long term, venture capital perspective of the ability to capture the estimated TAM within the next 10 years, many public investors view these companies as over-valued in the short term. Especially when many of them are not profitable.

So, What can a Retail Investor do about this?

Understand Potential IPO Outcomes

Start first by understanding that there are two main potential outcomes for a venture-backed tech company that has just IPO’d:

1. The company is successfully working toward capturing its TAM, and now has a higher barrier for capital efficiency in pursuit of this goal.

2. The company has already captured its TAM. This TAM was either underestimated by VCs, or will not be efficiently achieved by the company.

In both scenarios, the company will lose valuation after it goes public. In scenario one, public investors are focused on the short-term inefficiencies and expensive cost of growth. In scenario two, public investors are also worried about efficient growth, but more importantly, the long-term growth prospects are no longer realistic. As a retail investor, you want to find Scenario 1 companies. Let’s get back to the principles that venture investors use to guide your own investing framework.

Find Scenario 1 Companies

Conviction in outcome is the most important tenent of investing in technology companies. As such, focusing on companies that you genuinely believe, from your perspective as a consumer, will be around for a long time. At the core, this is the perspective that early-stage venture investors bet on. They think about world changing products, and we can do the same. For example, were you an early Facebook user who saw your friends continue to join, even though Facebook’s IPO saw a 47% drop in price within 2 months (Source)? That is your signal. Think of products and ideas you cant imagine a world without, and take your shot.

In my portfolio, this looks like Uber and NuBank. Uber’s IPO valuation was way ahead of it’s time, with inefficient growth and cultural concerns, but as we’ve seen over the past few years, profit is arriving and the product continues to be loved. When was the last time you took a taxi? NuBank, while a South American company so the immediate consumer experience isn’t there for many of us, is almost universally beloved by it’s users, and is providing digital products to a market with strong appetite.

Leverage your Time Horizon

Once you’ve found the product and companies you have conviction in, it’s time to frame your investment time horizon. Take advantage of the ability to be a long investor in the public market, just as venture investors fund early investment rounds thinking 10 years down the road. Share prices of technology companies will swing wildly in both directions. There will be months where growth does not meet expectations in either direction, and the share price will react. Being a long term investor allows you to roll with the downturns. A long term time horizon, combined with conviction in the company reaching it’s TAM, greatly increases your chance of success.

Coming in Part II

I’ll dive deeper into how I determine which companies I believe are on the path to capture their TAM. There isn’t much science to the method, but I find it’s a digestible approach that resonates.

Have additional thoughts? Connect with me on Twitter or message me on LinkedIn and let’s chat about it! Make sure to share with your friends too if you enjoyed.