Valuation discipline can make venture firms miss power-law winners

Transcript

From the transcript How I Invest publishes with the episode.

1. 2:10

   Why do you believe this has happened at BAND Capital? I think certainly going back in time, there were elements of risk management that were quite unconscious. I mean, gets into venture capital. Anyone who ends up being successful in venture capital with a risk seeking frame really is about actually looking for audacity, seeking out improbable founders and improbable outcomes and non consensus companies and markets and even the shape of the humans you're funding.

2. 2:46

   And that certainly characterizes our partnership. But we were born out of Bain Capital, which of course in its other asset classes does have aspects of risk management which are good and proper. If you're running a private equity strategy, avoiding losses is prudent. If you're running a credit strategy, avoiding losses is critical. You can't really make up for a cluster of losses with vast returns elsewhere when you're in a fixed income world.

3. 3:16

   So our question, I think, and I and I have to assume that there was some element in the early days and even the middle days of being capital ventures that sort of through osmosis carried some of that flavor of risk management unconsciously into which deals we brought forward and which deals passed investment committee. To be specific, though, I think it was really about valuation sensitivity. So it was actually kind of less about, you know, avoiding outlandish projects that ended up working because we did Crusoe and, you know, ten years ago, and that was when it started as an example of a company.

4. 3:52

   You know, they were mining Bitcoin at the oil heads in, you know, Arctic Canada. So it was an outlandish proposition, to be sure. And those are actually the sort of thing we like. But where we struggled historically is sort of paying market price when market price got really high. And I think that that's a fundamental problem actually in a power law industry because price is a signal of a sort. It can obviously be wrong.

5. 4:22

   But the fact is, like Databricks and Stripe and Ramp, I mean, the companies that end up being massively valuable are overvalued, quote unquote, at every round. And so if you take a view that you're gonna turn down things that are overvalued at the very moment in time they're being valued, you will systematically miss the power law companies on average. How would you describe that so many of the winners are, quote, unquote, overvalued?

6. 4:53

   I mean, we're talking about semantics here. I mean, in retrospect, they were undervalued. Right? But But on on a multiple basis. Because they have extraordinary founders. They have extraordinary ambition. Those elements that led to them being these hyperscaled winners were present at the time. And thoughtful investors saw those. And multiple thoughtful investors saw those characteristics, the extraordinary nature of the Collison Brother leadership or Eric at Ramp and said, You know what?

7. 5:25

   I will definitely pay 50% more on a multiple basis to back these individuals because of the scope of their ambition and the quality of their leadership. So it has to do with some subset of the market actually being perceptive. It leads to another problem in our asset class, though, which is that if you say to a venture capitalist and I'd be curious your perspective on this, if you say to venture capitalists, all the best deals are 50% too high on a multiple basis.

8. 5:56

   Well, that's going to lead to some perverse behavior. Right? Because you brought a deal to committee. So your partner brought a deal to you and said this, you know, we we've looked at application layer AI companies and averagely 20 times revenue is sort of where the average, you know, application layer AI company is going. We've got a really interesting one. It's 20 times revenue so you know perfectly appropriately priced.

9. 6:19

   Like by rights you should say look unless it's 30 times we shouldn't do it. Because my all my pattern recognition tells me that it unless it's 50 above market it's not a power law company so we should pass on anything that's not 50% too expensive. That wouldn't ever be like written down in an investment committee charter of course but the fact is like that mindset is what leads to bubbles in our asset class because people have a price quality relationship in their mind and therefore almost the higher the better.

10. 6:51

    This episode is presented by Juniper Square, the operations partner for private markets.