Startups – How to Value Stuff

The Value of Luck

Few people are as good at framing ideas as Rory Sutherland. In a talk he gave at the SprintAd-dagen in March of 2019, Rory opened up with the following thoughts on the role of luck and experimentation under capitalism:

“You’ve got to leave enough money free and you got to enough eccentric things to give yourself the change to be lucky…

One of the reasons that a lot of people don’t like capitalism is that some of the people who do very well under capitalism are actually total idiots. They happen to stumble into a business at exactly the right industry at the right time. They got lucky.

And even spectacularly intelligent people, I think we can argue…I don’t think there is any argument that Gates and Jobs are hugely intelligent….they were both spectacularly lucky as well as being hugely intelligent…partly by accident of their birth.

If you notice, a lot of those people, Ellison, Gates, Jobs – the giants of the tech industry – were all born within about 18 months of each other. And there was a tiny moment where you had to be young to make it in tech. Five years earlier and they would have ended up working for IBM. Five years later and it would have been to late.

One of the important things about capitalism, interestingly, is that it is a mechanism for rewarding people simply for being lucky. And the strangest thing about that is that it is precisely that, that makes people so angry about capitalism.

But if you don’t have a mechanism that rewards luck, the majority of great discovery don’t get banked.

If you look at the history of science, there is probably as much you can attribute to lucky accidents… Penicillin, Viagra, for example…the two wonder drugs. Those were both a product of completely lucky accidents.

The discovery of vaccination was just one man that happened notice that milk maids didn’t get smallpox. It’s just those tiny things that can have huge effects and we need to leave enough space to actually be lucky.

And the very strength of capitalism is precisely that it rewards ideas that at first make no sense.“

Rory’s full talk at SprintAd-dagen

The Value of Making Up Brand Names

In a recent episode of the Invest Like the Best podcast, Patrick O’Shaughnessy asked Rich Barton about his thoughts about coming up with brand names. His reply is a great guide on the value of brand names.

Here is the gist of what Rich Barton said (this is paraphrased as I didn’t have much time to transcribe, but you can find the section on minute 56 in the podcast):

Rich Barton: “I love to make up words for companies. I love to make up brand names. It’s just a classic example of thinking long-term versus short-term.

If you are thinking short-term, you think of the easiest most recognizable words. Put a dot com after it and that’s the name of your company. Blood.com. I don’t want to insult anybody by giving you the name of a real company. But a lot of companies have done that. And that’s great. The SEO is really great in the short term. Everybody knows what you do. It’s easy.

What’s harder is to make up a word. But if you can do it and fill that empty vessel of a word with meaning and emotion, then long-term you will have invented something that actually enters the language. And it is yours. It’s much better in the long-term.

So, my rules of making up words – and I don’t think that every company should do it, but most I think) – but when I’m thinking about consumer brands, which is kind of my space.

I have a few rules.

The first one is High-Point Scrabble Letters. For the Scrabble players out there […] you know that the highest point Scrabble letters are z and q. Those are 10. Why is z worth 10? Z is worth ten because Z is the least used letter in English. Which means that when you see it on a page, it stands out and is memorable.
Two syllables is good. I think fewer syllables is better. I think the sweet spot is two. Expedia was too long. It had the X which was great. It kind of invoked speed and expedition. But it was four syllables and was just too long.
Does it make a good dog name? That is rule number three.
Something interesting about the letters. Palindromes are really interesting. Double letters are interesting. Zoom is a really terrific one. They actually repurposed an existing word and then refilled it with a new definition. Zillow filled all of these goals so maybe I’m doing a kind retrofit.

When people call me and ask me about making up words, then this is the checklist I go through.

Are you looking for a brand name? Make sure you have the .com domain ending. Check out available .com domains for memorable and readable names at Dragon Value.

The Entrepreneur vs The Investor

In this speech by Peter Thiel, he says the following when talking about how to detect patterns when trying to recognizing entrepreneurs as a venture capitalist:

“You always want to invest in the ones where they speak in definite future tense. You sometimes have to be careful they’re not totally crazy people, but that’s the sort of person you want to invest in. You do not want to invest in people who are talking too much about probabilities or risks or things like that because my experience has been that the people who think they’re involved in some sort of lottery ticket-like dynamic are already setting themselves up to already somehow get the probabilities wrong and invariably lose.”

“There is a similar version of this that I experience as an investor in these ventures. There’s always this very tricky question of the role of luck and chance in these things working. There certainly is this external truth perspective that there is a certain amount of luck that is built into the nature of the universe and you try to model it. You try to account for it. You try to get the probabilities right, as you assess these things. So, when people say that luck is involved, this is a statement about the deep nature of our universe.”

“And then there is this sort of internal truth version. Whenever we have thought that it is a matter of work. Psychologically I can say that this has often been a very bad sign. Where you say, “well, we don’t know if this is going to work. Maybe it works. Maybe it doesn’t. So, let’s just invest a slightly smaller amount for our lack of knowledge.” And as a pattern, I would say, those are investments that have generally gone very badly wrong.”

“If I had to sort of explain why. When you think you are multiplying a small probability by a big payoff, you sort of psycho yourself into playing the lottery and you psych yourself into losing. Because you somehow are being sloppy and not doing that much work.”

I think these thoughts do a great job of highlighting the inherent differences between entrepreneurs and investors. The entrepreneurs Peter looks for speak of the future through a deterministic mindset. They have a clear sense of the future and how they are going to shape it. Peter himself, on the other hand, as a venture capitalist does not invest his all his funds in one company. In his role he needs to have a more probabilistic mindset, even though he bets big once he has a high conviction on particular investments.

The World According to…

The Entrepreneur	The Investor
Deterministic mindset	Probabilistic mindset
Risk is endogenic	Risk is exogenic
Analytical	Statistical
Concentration	Diversification
High Conviction	Risk Management

Entrepreneurs vs Investors: Different Characteristics

Longevity as an Investment Criteria

In the world of startups and new ventures, the central theme seems to gravitate towards growth and scaling.

When it comes to growth and scaling, learning how to manage an organization that is constantly getting bigger becomes the biggest challenge.

However, when you look at the oldest companies in the world, these are all small operations in industries that have hardly changed much throughout the lifetime of those companies.

Build to Last

Two of the oldest companies in the world are a:

Japanese Ryokan
German Brewery

When founders start new companies, most of the time their vision is to disrupt an industry.

But what if the objective would be to create something that was built to last? If you want to build an impenetrable fortress, you don’t want it to be ever-expanding, would you?

So, here’s a question: What if you were asked to build a company and there would only be one constraint: The total size of the organization would not be allowed to exceed 8 people.

What would you build?

The Value of Mezzanine Debt for Growth Companies

For a high growth company, selling equity can be very expensive. Why?

If a company is growing its profits by 100% annually, it will have grown its profit by a multiple of x32 by the end of year 5 (a 3,200% increase).

Accordingly, if the management of that company decided to raise equity at the beginning of year 1, they would need to sell at an earnings multiple of 320x the current year’s profit to sell at a 10x multiple of profits in year 5.

Not many venture companies manage to do that and are forced to raise capital at lower multiples. If their growth projections then become reality, the equity raise will turn out to have been very expensive for the sellers.

Enter Mezzanine Financing

Mezzanine capital is hybrid financing that consists of both debt and equity exposure, which gives the lender the right to convert to an equity interest in the company at a predetermined exchange rate. Because the investor is entering with debt, his downside is better protected. As such, the investor is also willing to sacrifice his exposure to the upside.

Mezzanine financing can be a useful tool for many high growth companies in order to fuel growth at a relatively low cost of capital. Mezzanine finance specialists work with owners to design custom funding packages that aim to lower the cost of capital and mitigate excessive dilution for founders.

Tag: Startups