Lessons for early-stage investment

Summary of the Lance Wiggs Investor Master Class

For the last Snowball Effect investor master class of 2017 we invited Lance Wiggs of Punakaiki Fund to repeat his popular early-stage portfolio investing workshop from 2016. The evening was an interactive session where attendees were split into small groups and given a budget and a series of hypothetical companies to invest into. Over the course of the evening investments were made, rounds filled up, and deals were negotiated. In the end, the performance of each company was tallied up so that the teams could see how their hypothetical portfolios had performed.

Based on the events of the evening, Lance shared his lessons on early-stage investing in general, on choosing specific companies to invest in, and on things to watch out for when finalising deal terms.

Things to watch out for in the early-stage investing process:

There were several investment lessons that Lance drew from the evening, which can help anyone who is investing in early-stage companies as an asset class:

1. Fear of missing out

We kept a running tally of investments on the whiteboard and there was a noticeable rush to get into some rounds before they filled up. Lance's advice was to be wary of scarcity and fear of missing out as a driver of investment. Observing the level of demand from other investors is a natural data-point to add into your own investment decisions. But in the end, you need to make up your own mind on the business fundamentals.

2. Golden rule (whoever has the gold, makes the rules)

Several of the rounds filled up and seemed to have closed, but then a late-arriving investor offered a better valuation and the company cancelled their previous investors to take up the better offer. In real life, such behaviour could be considered unethical and possibly even unlawful, but the lesson was very important. Never assume that the stated terms of an offer are fixed in stone. It's always possible to negotiate for a better deal, especially if you are the one making the investment.

3. Death by committee

Some of the larger groups struggled to make their investment decisions as fast as the smaller groups. This led to them missing out on some of the most sought after investment rounds. Lance warned of the dangers of large committees and consensus-based investment groups. Lance explained that the investment committees for a venture capital fund can still move quickly because of specialisation of focus, but for most investors, trying to get a committee to consensus slows things down too much.

4. Career lock step income (can afford to speculate)

For the hypothetical investments, every group had a fixed amount at the start of the evening. Real investors will also need to choose how much of their overall portfolio to allocate to high-risk investments. Lance give the usual disclaimers that diversified index funds, repaying debt, and education are usually the most sensible personal investments. But he made an interesting comment on asset allocation that I hadn't heard before: When you are in a profession where your annual income will rise predictably over time, then you can afford to take higher than usual risks earlier on, because you can make up the early losses with increased income later. Lance didn't specify an exact recommended allocation for early-stage investments on this basis, but we've heard anecdotal evidence from Snowball Effect investors who are professional people using their early-stage investments as a way to learn and educate themselves about entrepreneurship and business growth.

5. Clear mandate

The groups that decided on a way to focus their investment strategy and made quick decisions seemed to perform better than groups who struggled to decide on which investments to make. Lance mentioned that having a clear mandate or intention helps with real world investing because it makes it faster to filter your prospective investments and easier to keep emotion out of your decision-making process. Lance also reminded us that an event where you are being served alcohol is not the place to make a binding investment decision.

6. You can say no

Several groups did not invest their entire funds and those groups avoided making heavy losses, but they also missed out on making major gains. The lesson that Lance drew from this is that it's ok to say no and that you shouldn't let an allocation of funds burn a hole in your pocket while looking for investments. There are a lot of bad investments out there and a large part of early-stage investing is saying no a lot.

Things to look for when assessing an early-stage investment:

Having told us the things to watch out for in the asset class overall, Lance shared some of the things that he and Punakaiki look for in specific investments that they make:

1. End-user

Take the time to understand the product and the end consumer or user of the product. This is equally important for consumer products and for B2B companies, every company has an end user of some form and their experience with the product has to be good.

2. Customer

Look for a paying customer that allows for a solid business model and good scalability over time. The company has to solve a real pain that people are willing to pay for.

3. People and execution

The team's experience and discipline when executing on the business plan are vital. Look for people with a deep knowledge of their subject matter. Also do personal background checks and look into the integrity of the founders and CEO.

4. Numbers

The numbers have to add up and Lance looks for well prepared financials that show the company has put thought and care into their preparation. However, he cautioned against labouring over the exact numbers for projections that everyone knows have too much uncertainty when an early-stage company is looking 3-5 years out.

Red flags when assessing early-stage deal terms:

Finally, Lance shared some quick gotchas that he sees in the market at large when negotiating deal terms:

1. Big assumptions

Making assumptions about large and stable markets seems tempting because they appear to be very slow moving, but even seemingly stable markets can change over time. For example, the Yellow pages assumed that everyone would continue to pay for listing in a paper directory forever. Look out for companies that say things like "If we could only get 5% of this market..." without giving any thought to the underlying market and it's stability (or lack thereof).

2. Unnecessary complexity

Trying to manage control of the company through tricky shareholders agreements, company constitutions and overly complex share classes. Complexity in control suggests that the management team aren't comfortable with outside investment or that the major investors aren't used to this type of investing, or that their lawyers just got too excited. Shareholder protections are important, but watch out for too much weirdness around voting, appointment or directors or other control clauses as they are often a symptom of deeper issues.

3. Discounted Cash Flow

Discounted Cash Flow is a popular method for valuing later stage companies and potential projects inside a large corporate. Lance shared a story about how the DCF model breaks if the growth rate is faster than the discount rate (which it should be for almost all high growth investments). Therefore, he warned us off relying too heavily on any one valuation methodology for early-stage investing and, rather, looking at the investment as a sum of all the considerations, risks and assumptions involved.

Overall, the evening was highly educational and entertaining. We'll look to run more interactive investment sessions with a similar format in the new year. Lance's personal website is https://lancewiggs.com and the Punakaiki Fund website is https://punakaikifund.co.nz