Diversified Venture Investments Still Beat Public Markets

Welcome to the new world where business plans suffer higher scrutiny, are probed for possible infusion of government capital, are examined for whether they would displace any US jobs and excruciatingly bracketed under one of the three areas the government wants to promote - energy, health care and education. The first thing to note is why someone would be interested in investing in a venture-financed business at all. One could argue that, given the current credit conditions, it is harder for small businesses to survive, as is. But, that is the beauty of venture-financed businesses. They dont depend on credit for growth and expansion - they depend on equity investments (which sometimes is so fortified that they might look like debt instruments) from investors and high net worth individual, who are adept at measuring and rewarding relatively higher risks. According to Thomson Reuters and the National Venture Capital Association (NVCA), the one year all venture Private Equity Performance Index (PEPI) declined significantly to -20.9%. Venture returns declined, in fact, across all horizons (3,5 and 10 years) and only the 20 year horizon remained in the black. While, this may look like a sad tale for the venture capital market, it is worth noting that the venture returns across all horizons outperformed public market indices, the NASDAQ and the S&P 500, through December 31,2008. The 20-year all-venture returns are around 17%, whereas the 20-year early seed VC returns are around 21% - the well-entrenched high risk, high reward position. It is pertinent to note that the 20-year return for the balanced and the later-stage VCs were the same at 14.5% each. It is clear from this analysis that investors who can gauge early stage companies successfully tend to reap better returns. It is in this context that diversification becomes important.

In a recent online presentation of opportunities available for VC investment, I was delighted to find an array of opportunities available out there for investment. The opportunities ranged from an agro-bio company in the US to a financial services data provider in vietnam to a cell phone provider who wants to enhance value-added services in Africa. As with stock picking, it is important for early stage investors to diversify their portfolios. Today's business environment is global - the opportunities to spawn small companies at standardized risk is available in several countries across the world. More so than ever, several countries and new markets have understood the importance of leveraging private equity capital to seed and grow companies.

New portals such as vator.tv and thefunded.com allow investors to get to know about opportunities in early stage markets. More such exchanges are in the making. While the value of being an insider on Sand Hill Road in Menlo Park, California cannot be underestimated, it is also worthwhile to understand that diversified investment opportunities are being made available to more of us. An early-stage/diversely invested asset class is perhaps a good addition to your investment to your portfolio, given the prevailing risk-reward situation in the economy.

What Gets You Better Valuations?

In a recent examination of publicly traded stocks using MorningStar screens, we noticed that even in these depressed market conditions there are at least three dozen healthy domestic stocks with market capitalizations greater than $500 million trading at a greater than 6 price to sales (P/S). Google had a much better P/S multiple than Yahoo; Visa topped out MasterCard; Alnylam topped out all other siRNA therapeutics companies; Dolby Technologies topped out its peers like DTS Inc., First Solar topped out other semiconductor companies; RedHat topped out its open source counterparts; QualComm topped out other wireless equipment manufacturers. What makes these companies tick? Our first observation was the market shares. Companies with the largest market share and with proven barriers to entry tended to be rewarded more. Holding unsurpassable intellectual property was also greatly rewarded.

Google has a 62% market share in the paid-search market compared to Yahoo, which has just 13% - a distant second. Visa's logos are carried on about 63% of the worldwide credit and debit cards, while MasterCard's share is only 31%. Alnylam holds the rights to nobel-prize winning technology and licenses that to several siRNA therapeutics companies. Alnylam's IP allows the firm to create an entirely new class of therapeutics for tough-to-treat diseases.Similarly, Dolby's technologies continue to be included as new digital broadcasting standards are rolled out internationally.First Solar is the undisputed leader in cost-per-watt solar cell production with its competitors a distant second.Red Hat has more experience distributing and supporting Linux than any other company does. Again, in the IP leadership area, Qualcomm's patents are central to the CDMA technology for 3G mobile communications.

It is important to note that strong market leadership and unsurpassable barriers to entry - be it branding or holding central intellectual property that is sessential for the growth and development of a whole market - is what attracts P/S multiples in excess of 6.0. Unless your business model is designed to make your company the overhwelming leader in market share or IP rights, there is very little chance that the market will value your firm at 6.0+ P/S multiple.

When we come across small companies that request us to classify them under this 6.0+ leadership category, we calmly tell them what it takes to get there. When starting out, it is important for entrepreneurs to understand their return on investment 8 to 10 years down the line, so they can structure their external financing requirements in a way that optimizes their RoI. Entrepreneurs need to have a good understanding of what their exit multiples are likely to be to align the financial risk/reward system better within the company.