My neighbor is a vet. Bright fellow. Follows the market.
He wants to grow his savings. But he’s more scared about losing what he has already saved up. He says it’s a substantial amount.
He’s not that far away from retirement. He’s conservative with his investments. Understandably so.
The other day, he asked me what’s considered good growth for a company.
He told me his version.
“If I were a CEO and growing profits by 10% a year, I’d be overjoyed.”
Such a simple assertion…
I completely understood where he was coming from. There’s something magical-sounding about double-digit growth, even if it is at the very bottom of the range.
If you managed to expand 10% annually, in roughly seven years you would have doubled your bottom line.
Who wouldn’t like that?
The answer is…
Anyone who invests in the earliest stages of a startup company’s journey.
Paying for Growth
Early-stage investing is different. And one of the most unique things about it is this…
It’s the only equity investment where you pay low for high growth expectations.
Think about it…
The high growth expectations of companies like Google come at a high price. Google’s price-to-earnings (P/E) ratio is 26.4. Facebook’s is 69.7. And Amazon’s for this year is 162.8.
But how about the even newer publicly traded companies? Under Armour’s P/E is 78.5. Alibaba’s P/E is 47.1. And Shake Shack’s (for 2015) is 915.6. Gosh!
Investors pay for those ambitious growth expectations.
And that is what I told my neighbor. “It depends on what kind of growth investors expect of you.”
Now, I like to target startups just getting started, within the first year or two of their existence.
Usually, that’s around when a company raises its first serious amount of money that isn’t from friends or family.
What are my growth expectations?
I want these early-stage companies to grow by at least 50% to 100% a year once they figure out their products, pricing and market fit (discussed in this earlier article). Hopefully, they’ll grow by more than that.
And, no, I’m not being overly demanding. It’s a very reasonable expectation.
So, what do I expect to pay?
Let me put it this way: about one-tenth to one-twentieth of what investors are paying right now for Shake Shack, a fast-growing hamburger/beer/wine franchise still figuring out how to become profitable.
Its shares go for around $46.
High growth expectations alongside a fractional price? What gives?
The best way to explain it is through the “J-Curve.” Venture-capital companies are very familiar with it. But you may not be. Here is what it looks like…
As you see, valuations start low and often dip before beginning to rise. The dip is often called the “valley of tears” because startups are spending money while developing their product ideas and products. But making no money.
It takes time and cash, even in this day and age when the cost to develop “lean” products has gone from years to months. Investors put down their money, hoping that the company will reach the high growth typical of Stage 2. But between 30% and 50% (I’ve seen estimates of up to 70%) of them don’t make it to Stage 2.
Their products don’t capture the imagination of customers.
Or they’ve run out of money and/or stamina.
Or they’re much better at thinking up big ideas than executing them.
Stage 2 Offers a Different Mix of Risk and Upside
For these reasons, some investors prefer Stage 2 companies. You don’t make the enormous money on companies that take off like you can with Stage 1 startups. But the risk of failure goes way down. These companies are growing between 50% and 100%. They’re generating revenues of between $50 million and $100 million. And they have proof of concept, market fit and dependable cash flow.
You can also make a lot of money investing during this stage, and you’re only about three to four years away from cashing in. But there is still risk: risk of down rounds, poor execution and failure to scale sufficiently.
The last stage – doing an IPO or getting bought out – greatly rewards all the existing investors, but the earlier ones get the bigger payoff.
Even this stage is not completely without risk. The public market could turn bearish. Your company’s sales growth could be slowing. A competitor’s product might be trumping yours. (Jawbone is a good example of this. At 16 years old, this maker of fitness-tracker bracelets is no closer to making a profit than it was a decade ago. Read more about it in this excellent article from Fortune.)
The J-Curve embodies classic investment principles. As the price or valuation of the company goes up, the risk goes down. And as the risk goes down, so do your returns.
Is Stage 1 Getting Better?
But recent angel and VC investor trends could be working in favor of individuals who like Stage 1 investing.
Startups are now expected to be much further along in Stage 1…
Proof of concept should be confirmed. Take that risk off the table.
Identifying their most enthusiastic and receptive customers should be well on its way. That takes market fit mostly off the table.
There should be a plan for managing how fast costs rise, and timing fundraising and revenue-generating initiatives accordingly.
To the extent that a startup has performed well in these areas, you have an early indication of execution. But executing at this stage and executing at Stages 2 and 3 are different matters. And they require different skill sets.
So execution and scalability, which come further down the road, remain on the table. Strength of the team is not entirely known, but even at this early stage, it’s one of the most important calculations you make.
But just enough risks are taken off the table to make Stage 1 investing attractive to investors who can stomach failures, knowing that one big winner can more than offset several losses.
Founder, Early Investing