July 31, 2019
What if I were to tell you that there’s an early-stage fund that’s charging investors a 25% management fee, is that something you might be interested in?
While there’s no track record for this particular strategy and it’s hard enough for early-stage funds to earn a reasonable return (it is a real fund), have a look at a recent article I wrote about the subject, people are falling over themselves to get involved. This is largely premised on how the offering is packaged and how investors are framing the fees. Framing, or more specifically being able to change the frame of reference for an investment proposition, is in my opinion one of the most important skills in investing.
When I talk about framing, I’m talking about how you view the proposition in light of other comparative propositions. An investor might talk about companies in terms of the earnings multiple, which is good if you want to look at things from a relative perspective, but the really interesting insights come when you begin to reframe concepts in an absolute manner. I’m talking about applying the kind of back-of-the-envelope tests that Ben Graham applied, they can be applied to a business at any level.
This is particularly a problem in early-stage investing because people can take traction to mean product-market fit and then extrapolate those metrics to assume financial success. This is all well and good if the company can be acquired before it’s judged based on bottom-line results. However, the fundamentals typically come home to roost and, if an investment is made on sound principles, then it’s going to significantly increase the chances of overall success. Let’s look at a couple of examples:
I recently heard GGV outline their thesis on why they invested in the bike sharing startup HelloBike (Hello ChuXing). The reasoning went as follows (the numbers are made up for illustration purposes): As soon as they reach a penetration of 20 bikes/square kilometre in a major city (people need to be confident they’ll get service so they can comfortably change their habits), then each bike will be servicing ~15 rides/day, each ride will generate 10 cents on average, each bike costs $150, then it will take 100 days (150/(15 x 0.10)) for the rides to pay off the value of the bike, after that point it will be pure profit. Now this doesn’t consider maintenance or overhead that would be associated with the corporate structure to administer the service. However, it gives some comfort in knowing that the idea will be able to produce replicable cash flows over time as it is effectively acquiring lots of small assets with relatively small payback periods.
Another example that I heard of a while back (and I can’t find the source) but one of the VCs that was later to the party to invest in Facebook before it listed had a reasonable justification for their investment. The valuation at the time (again, I’m making up numbers because I can’t find the exact example, let me know if you have the reference and I’ll update the information) was around $1bn. The platform had acquired ~300m users so the investor reasoned that they were paying ~$3/user. The platform was pre-revenue so he had no idea how it was going to monetise the platform but could have made a reasonable assumption that those eyeballs could be translated into advertising revenue. That appears to be a rather prescient insight because now the company generates >$25/user each year.
ETH vs AWS
Another recent and more tangible example that I’ve seen which used framing to glean an insight on where crypto valuations are was Pfeffer’stake on Ethereum vs AWS. While this is a relative comparison and it fails to take into consideration store of value arguments and a number of other factors, it does give a range for where the value of the token could sit based on utility. I won’t go into the details, as there are many and they’re outlined on pages 9–10 of the document, but suffice it to say that ETH’s price would have needed some pretty hefty assumptions to be able to justify the compute power that it was providing as compared to AWS. I’m not making a statement about my belief in what the value is as compared to the price, all I’m saying is that this is an interesting way to break down different investment ideas.
These insights don’t come easily and are generally the results of having a broad world view and the ability to step outside of the financial models and spreadsheets that investors tend to rely on. An investor wanting to frame things differently should read broadly, speak to people with differing views (with an open mind), and spend time in thought (not confusing constant activity with thoughtful action). Failing that, you could always just follow everyone else and do what they’re doing, while paying away a 25% management fee in the hopes that there’s a greater fool to bail you out if that’s something you might be interested in.