Why founders need to recognize the mindset of value investors

So you want an angel investor or even a family member or friend to consider investing in your business. To get an investor interested in your business, you need to think like a value investor. A value investor seeks to invest in a company that has the potential to deliver a good return but is overlooked by traditional sources of funding. A value investor is often someone who takes a company’s business model more seriously than those around them and can see value where others don’t.

The goal of any value investor is to invest in an above-average company that offers equity (percentage of stock / ownership) at below-average valuations or is willing to pay. an above-average interest rate to secure debt financing (loan). In other words, the value investor is willing to go beyond financial metrics alone and take a bit more risk because the business is willing to deliver a better return on investment and owns assets. excluding financial statements that the investor appreciates.

There are two main things that, from my perspective, can influence the mindset of the value investor when considering an investment: quantitative factors such as the overall degree of return and qualitative factors. such as the commitment of the founder (s).

Quantitative factors

At a recent Berkshire Hathaway Annual Meeting of Shareholders, a hypothetical question was asked of a VP of Insurance Operations: “Would you like to purchase a policy to cover Elon Musk’s mission to Mars?“Without thinking too much,” he said, “It’s easy. No. However, Warren Buffett, the chairman, stepped in and said: ‘It would all depend on the premium they were prepared to pay.Warren’s answer is a perfect example of a quantitative factor in a value investor’s thinking.

Investing in stock market value is investing in undervalued companies. They believe the market overreacts to good news and bad news, resulting in stock price movements that are not aligned with a company’s true long-term value. The overreaction provides an opportunity to assess investors for profit by buying stocks at discounted prices.

When it comes to publicly traded stocks, earnings per share, market capitalization, and financial ratios are quantitative factors and are used by most investors when choosing stocks.

In a letter to Berkshire Hathaway shareholders, Buffett offered an illustration of how this thinking could be applied:

If you buy a stock for a low enough price, there will usually be a setback in the company’s fortunes that will give you a chance to offload yourself with a decent profit, although the long-term performance of the company may be. terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that only has one puff left in it may not offer much smoke, but the “bargain buy” will turn that puff into a profit. “

In Elon Musk’s Mars Mission underwriting example, the question is: When would the premium paid be worth the risk of having to cover potential losses? Warren Buffett was basically saying Berkshire should see what price Musk and SpaceX would be willing to pay for the cover. Maybe they would be willing to pay too much.

Overvaluation by the founders

Founders often value their property much more than anyone else because they feel they run the most risk and therefore should receive the largest share of the rewards.

We all know the statistics that most new businesses will fail within the first five years. Yet knowing this, every year millions of people quit their jobs and risk everything to start a business even if the odds are statistically stacked against them. Many are willing to take this risk based on potential returns, monetary and otherwise.

Value investors have the same feelings about their investment and their risks. A value investor knows that the majority of funding sources simply consider the risk of investing in a business to be too high. The same more traditional sources of funding fail to define at what level of reward risk might become acceptable. A value investor recognizes that the financing options for many companies are limited. They also know that there is a good chance the business will fail before they get a return on their investment. Therefore, the value investor will demand a high enough return that the risk is worth it. Too many founders overstate their own risk and undervalue investor risk. Too many founders do not offer enough equity to an early stage value investor or are unwilling to pay a high interest rate or provide enough collateral to secure a loan.

Qualitative factors

In the private sector, quantitative factors are a bit more difficult to define and a value investor is more inclined to also rely on more subjective qualitative factors to define the overall value of a company.

Some investors may place a higher value on the management team or product space (qualitative) while others may place a higher value on financial metrics (quantitative). Ultimately, a value-driven investor will use qualitative and quantitative factors to a certain extent to determine the true overall value of a company.

In the private sector, a value-driven investor looks beyond what the ordinary financier sees and perceives the real potential of a company. Additionally, a value-driven investor recognizes that the company has few other financing options, making it appear undervalued and overlooked in the financial market.

Many investors will tell you that they are investing in the management team on a new idea for a product or service. Besides the value of the leadership team, another element of a company’s value that comes into the thinking of a value-driven investor is the commitment of the founder (s). You may have often heard the term “Skin in the Game” which refers to the level of risk (monetary or otherwise) of the founder involved in the success of the business. It’s one way to measure engagement. Too many clients I have met want an investor, be it a lender like a bank or an equity investor, to risk their capital when the founder is unwilling to invest a lot of money. money, time or collateral in their own business.

I remember when I started Horizon Interactive, my second company, I knew I had to do everything to attract investors. I got a Home Equity Line of Credit (HELOC) and pulled the entire line to invest in stocks in my new business. Then I quit my job to show my full commitment to the company. My other two investors saw my full level of engagement, and like the famous example of Cortes burning his ships to remove all retirement options, they knew I was 100% committed to the success of the business. As a result, they agreed to invest. I remember saying in my pitch that I had an old cabover motorhome that got paid for and if the business failed and I lost my house, my family and I could at least move into the camper- because as we try to rebuild our lives.

Since the risk at this point; being pre-income, was still quite high, I had to divest 20% of my business for a relatively small investment from my two partners. However, since Dale and Randy my other two partners saw how committed I was to the success of Horizon Interactive, being thoroughly, it surely helped their decision to join us and for both of them. to earn ten thousand dollars investing in the business.

Warren Buffett defined the element of qualitative factors influencing a company’s true value at Berkshire Hathaway’s annual shareholders meeting when he added:

“I would say I would probably have a somewhat different rate if Elon was on board or not on board, I mean, you know, it makes a difference called having skin in the game.”

The comment at the shareholder meeting was laughed at, perhaps because shareholders thought Elon Musk was reckless. But Bloomberg opinion columnist Matt Levine said: “Maybe SpaceX will be more careful if its CEO is on board, so it should be cheaper to insure.”

The three points to consider are:

1. A value investor will not simply reject an investment on the sole basis of financial risk, but will define at what level of reward the risk becomes acceptable. Doubling down on a risky investment may not attract the attention of a value investor, but offering a return five or ten times as high may.

2. Founders should consider the risk level of a value investor to be almost equal to their own. They should not overvalue their property or undervalue the risks and rewards necessary for a value investor to invest in their business.

3. A value investor who is considering investing in a private company will look beyond quantitative factors and also give weight to qualitative factors. Demonstrating that you have a considerable amount of skin in the game will show that you are 100% committed to the success of the business.

Have you recognized the mindset of the value investor when it comes to funding your startup?

Source link

About Robert Wright

Check Also

DOE teams up with Xcel and Berkshire Hathaway Energy on cybersecurity program to protect clean energy

Dive brief: A new public-private security partnership led by the U.S. Department of Energy aims …