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Low Valuations Make Acquisition Targets Out of Great Companies

Today I was looking at a few tech companies in the public stock market. The market capitalizations (i.e., valuation) on some have been drastically reduced. I’d imagine it’s a big distraction to the leadership and employees. I was thinking that some of these companies could benefit from being part of a larger organization where they could execute on their strategy without worrying about market gyrations or scrutiny.

Nonfinancial companies issued $1.7 trillion in bonds in 2020. That was a record. Partly it was due to the uncertainty at the time, but it was also driven by interest rates reaching record lows. It was cheap to borrow, so companies borrowed.

Many great companies are valued at a fraction of what they were, yet the fundamentals of the underlying business remain solid. I’m sure this fact hasn’t gone unnoticed by the leaders and M&A teams at companies flush with cash. If valuations keep going down, I suspect we’ll see some of these companies putting that cash to work in acquisitions.

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Valuation’s Impact on Psychology

I talked to a friend today who joked about how much her stock portfolio is down and how she’s adjusting accordingly. Another friend said something similar yesterday. Both are invested for the long term, but recent market activity has had an impact on their psychology. They’re thinking about things differently and changing their behavior.

These conversations were a reminder to me of how short-term movements in valuations can impact psychology and motivation. I can’t imagine what public companies that have seen their valuations slashed are dealing with. Morale must be—or at least it will become—a concern for these companies if pay packages have heavy stock components.

I’m curious to watch how public and private company CEOs navigate in this environment. Will we see material changes in things like compensation and publicity around new fundraising rounds?

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Thinking in Probabilities

I’ve recently been thinking about making an investment. I’ve chatted with people I respect who are credible in the space to get their perspectives. That was helpful and exposed some gaps in my thinking, but it didn’t sway me one way or the other. Today I had some downtime, so I built a quick spreadsheet.

I’ve built tons of spreadsheets for decision-making before, but I included something new in this one. For this investment to be successful, several things would have to happen. I thought through the probability of all of them happening and included it in the spreadsheet. This exercise was helpful because it forced me to carefully consider a variety of things, including what that percentage is and why it’s the right percentage. It helped clarify some things and got me closer to a decision.

Like many other things in life, this investment has a chance of being successful that can be estimated. Thinking about that probability was helpful.

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Keep in Mind Fit Matters Too

Founders looking for capital will likely talk to a lot of investors and hear no repeatedly before they hear yes. It’s a frustrating process. Today I was talking with a founder friend about finding the right investor. We discussed the importance of fit.

Founders have an objective they’re trying to achieve. They need capital, start-up knowledge, and relationships to execute and turn their vision into reality. The investors that can help them achieve this objective are the best fit. Founders are (or should be) evaluating investors for fit, but what they often don’t realize is that this is happening on the other side of the table too.

Investors, like founders, have objectives. They’re looking for opportunities that are the best fit with their objectives. Investors’ objectives vary. They probably include potential financial return, but they may also include other variables. For instance, an investor may want to fund a start-up with a specific approach to solving a problem. Or invest in certain types of solutions (e.g., software) and not others. Or give back to the community as well as make money (do good while doing well). Whatever their objectives are will play into their decision-making process. This means you could be a great founder with a great idea, but the opportunity might not be a fit with a given investor’s objectives.

Good relationships are mutually beneficial. Founders should be mindful of this when evaluating investors (or any partner for that matter). Clearly articulate what your objectives are—but understand the objectives of the other party too. The goal is to find fit: alignment of the objectives of both parties, even if they differ. When there’s a fit, the relationship will be mutually beneficial.

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Focusing on the Upside: An Investor Perspective

I had a great conversation with another investor today. One of the things he shared was his view on how important perspective is in many areas of life, especially investing. He’s a fan of focusing on the upside potential of an investment. He does his due diligence and is aware of the downside, but he doesn’t focus on it or optimize his deals for it.

Investors are partners. When founders take investments, they’re usually agreeing to partner with this person or group for many years. There will be ups and downs. Understanding the perspective of your partners is important because it will help you understand how they’ll respond and support you when things aren’t going so well.

If you’re a founder considering accepting investment, take the time to understand what everyone is focused on—the downside or the upside. Hopefully, it’s the latter.

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Thoughts about Identifying as an Investor

I’ve been thinking about identity and habits lately. I’ve come at identity from two angles: Who do I want to be? Who am I? To answer the latter, I looked at the habits I’ve had for a long time. I suspected that I believe some things about myself that I haven’t consciously acknowledged. It’s been an interesting process that’s made me more self-aware. And it’s shed light on a few things, including my investing habits.

I’ve been into finance and investing since high school. I didn’t come from a wealthy family and didn’t have money to invest, but I sought out books and online resources to learn. In college, finance was the only major I seriously considered even though I didn’t know anyone who worked in the field. As an adult, I spent free time (founding a company didn’t leave much of it) keeping up with public market investing. Now I spend my days investing in early-stage private companies at Outlander VC and still do personal investing in my free time.

Next, I asked myself why: Why have I established these habits? What is it about investing?

I took it a level deeper and reflected on what I’ve enjoyed about investing all these years to answer these questions:

  • Not the smartest person in the room – Investing attracts some of the smartest people. I love learning from bright people and having a constant feeling of not being the smartest person in the room.
  • Perpetual change – Investing is always changing. I’ve never reached a state of comfort and likely never will. This is exciting. It keeps me on my toes.
  • Complexity – Investing has a lot of moving parts. I enjoy trying to parse the complexity so I can achieve a desired outcome.
  • New problems – I love learning about problems and how companies are creating value by solving them.
  • Endless – No matter how much time I spend learning about investing, I only scratch the surface. It’s a vast industry with an endless learning curve.
  • Intellectually challenging – For the all the reasons listed above and many more, I find investing a stimulating challenge.

I’ve had an investing habit for many years. With that kind of consistency, I guess I have a core belief that I’m an investor (I don’t claim to be a good one). It feels very weird to say this publicly, and I’m not comfortable with it, but it’s hard to argue with my habits over the years, and I can’t deny that I enjoy it.

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Watch for More New Fund Managers

In the last eighteen months or so, we’ve seen asset prices increase rapidly. I’ve been having debates with friends about this. Most of them think this is a bubble and it will reverse. I think the opposite will happen: asset prices (real estate, equities, etc.) will remain elevated. Prices will go up at slower rate than we’ve seen in the last eighteen months, but they will keep increasing. I have several reasons for believing this, which I won’t get into today.

Equity (i.e., ownership) in companies is key to most investors’ strategy, and I see a change on the horizon in how they acquire it. More investors will look to invest in private companies (private equity) instead of public companies (public equity) via the stock market. The driving force will be the desire for higher returns as the stock market growth rate slows. Again, lots of reasons for this.

The private companies with the highest rate of return will likely be early-stage companies, which puts venture capital—a subset of private equity—in a position to see an influx of investor capital. Some established funds have begun taking advantage of this and have announced they’ve raised sizeable funds this year. We’ll continue to see more of these announcements, but I think we’ll see something else too: an increase in the number of investors stepping out to start their own funds for the first time. Some will come from other venture capital funds, some will be former entrepreneurs, and some will be subject matter experts in emerging fields.

Historically, experience as an investor in venture capital has been key to starting one’s own fund. Experience is hard to come by because most funds don’t have many open slots, so . . . high barrier to entry. As more investors seek equity in early-stage private companies and more capital flows into venture capital, I see this barrier being lowered. More investors will take flyers on people who have unique relationships in and understand emerging sectors well but have zero venture capital experience. Some of these new managers will fail and some—hopefully more—will succeed.

I’m not sure of the timing of all this, but I’ll be watching it closely. We could be on the cusp of a big change in venture capital!

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Paying a Premium for Greatness

I’ve been chatting with a founder friend about a deal he’s considering doing. The seller doesn’t have any other suitors, probably because they’re asking for above-market pricing. My friend knows this and has been trying to get them to a price more aligned with the current market. All the numbers support my friend’s argument.

Today we spoke again, and he told me he’s going to try to meet them in the middle. He’ll likely end up paying more than the deal is currently worth. Not expecting this, I questioned his logic. His explanation: he’s focused on future, not current, value. He has a vision for creating more value using the asset. If he executes on it, the difference between what the deal is worth now and what he paid will be negligible. He sees a great opportunity to create a large amount of value and wants to capitalize on it quickly before someone else sees it.

Recognizing greatness is important to any founder’s success. I didn’t do it early in my journey, and it hurt me. When this founder began focusing on how great this opportunity is, it changed his thought processes, actions, and sense of urgency. I’m looking forward to seeing him create something profitable and great out of this opportunity!

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Shotgun versus Sniper Solutions

I talked with an early-stage investor today about a recent investment his firm made. He listed lots of great reasons for doing the deal: strong team, great traction, big market, great customer feedback, etc. But one point stood out to me. Competitors—other well-funded large players—have platforms that solve the same problem as this new portfolio company as well as a variety of other problems. They do an okay job of solving most of them. The new portfolio company, on the other hand, solves one problem extremely well. The hyper focus on a single problem helped this investor have conviction for the deal.

I think of this new portfolio company as taking the sniper approach to solving a problem, which its new investor loves. It’s laser focused on a single problem that its leaders have taken the time to understand well. Their solution is designed to eliminate a pain point so customers don’t have to worry about it anymore.

The larger competitors are taking a shotgun approach. They’re aiming in the general vicinity of this problem and many others. They understand the problem from a high level but haven’t gone super deep. Their solution is designed to mitigate the pain of this problem, not erase it.

Both strategies have pros and cons, and large companies can be built using either. My personality leaned toward the sniper approach when I was a founder, but I’ve shotgunned too. From my experience, the decision of which to embrace depends mainly on what customers want. Who are you targeting and what do they want? A one-stop shop that does a decent job at solving many problems but doesn’t shoot for perfection? Or an expert that’s trying to eliminate a problem altogether?

Listen to what your customers want to give you a clear idea of what you need to build.

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Future versus Historical Thinking

I had a spirited chat with a friend this week about a house in Atlanta that just hit the market. We debated how long it will take to sell. I think it will sell within a week, and my friend thinks it will take a few months. Surprised, I dug into his why. He things it’s overpriced and that a price reduction will be needed to move it after it sits unsold for a few weeks. I think the price is fair. The true disconnect is what we think the house is worth.

After more back and forth, I got to the root of our disagreement. I’m bullish on Atlanta. I think the city offers qualities other major metros can’t that make it a place people see themselves settling down in and calling home for the long term. And pandemic dynamics contribute to it being a desirable destination. Home prices reflect this and are likely to continue increasing for the foreseeable future. I believe that prices are fair relative to where they’ll be in the future.

My friend has lived in Atlanta for a long time. He remembers a glut of houses on the market after the financial crisis and some now-trendy neighborhoods being seedy. He believes Atlanta is in a real estate bubble and prices will drop at some point. In other words, he believes current prices are inflated relative to historical prices.

As I reflected on our conversation, I realized that we had different perspectives: I was focused on the future, and he was focused on the past.

Looking at an opportunity, I’m a fan of future thinking. I wasn’t always like this. Flipping this mental switch transformed how I analyze opportunities. I’m able to see opportunity and capitalize on it because I can still see it as “cheap.” If things go as I predict, the asset will increase in value, and I will have gotten a deal at its current price. It’s irrelevant that I didn’t buy at the cheapest historical price, a consideration that I view as a mental trap.

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