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The Man with the Golden Spreadsheet
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Private
Equity Is on a Roll, but Are Investors in for a Let-down?
The
Man with the Golden Spreadsheet
Prof.
Andrew Metrick's new course and book bring financial tools to VC
swashbuckling.
Asked to bet on what ended up as the most successful venture deals of all time, several Silicon Valley's leading VCs passed. As one firm jokes on its website about its failure to spot eBay, "Stamps? Coins? Comic books? You've GOT to be kidding."
That's just one of the many insights sprinkled in Prof. Andrew Metrick's new text, "Venture Capital and the Finance of Innovation." The book, published by John Wiley & Sons, is the foundation of the Wharton School's finance course with the same title. It's taught in the fall by Metrick and in the spring by Prof. Ayako Yasuda, who's also in the school's finance department.
The text and course are designed to introduce students to the "the big concepts of finance," like risk and return, valuation, option pricing and capital structure, Metrick says. "It turns out that venture capital and innovation are wonderful vehicles for teaching these concepts." Seldom are the principles of risk and reward as stark as in the world of venture capital, where nearly half of all early-stage investments give no return but where winners like eBay can shower billions of dollars on their original funders.
eBay
and Google also demonstrate how venture investing combines art and science,
Metrick says. In its infancy, eBay was proposing a new market—online
auctions—so conventional valuation tools and market tests provided
little guidance for potential investors. Curious VCs couldn't use
publicly traded companies in the same line of business as comparisons.
There weren't any.
Google,
for its part, "addressed an existing market but one without a clear path
to profitability," he writes. By the time it appeared, outfits like Yahoo,
Lycos and Altavista had established themselves as market leaders, and search
technology already had come to be seen as a commodity. "The bet on Google
was essentially a bet that its superior search technology would eventually
lead to a shift in consumer practices, allowing a pure search site to develop
its own revenue stream." And that's exactly what happened.
Unpredictable, unprecedented deals like these lead some venture capitalists to discount the usefulness of the tools and models of finance; no model could have predicted eBay's and Google's successes. They thus dismiss financial analysts as "Excel jockeys," who spend their days poring over spreadsheets, instead of prospecting for promising startups. These sorts of VCs rely instead on experience and what they jokingly call the "golden gut", an instinct for identifying deals. They then add value to the companies in their portfolios by helping them select employees and vendors, introducing them to potential partners and customers and guiding them through the toil and frustration of a typical startup's early years.
"Successful venture capitalists tend to think of themselves as company builders," not financial analysts, Metrick writes. Facility with numbers falls far below networking and technological insight on their lists of essential skills.
Even so, finance training can increase a venture investor's odds of success. Metrick compares it with free throw shooting in the National Basketball Association. "Nobody makes it to the NBA solely because of his free throw shooting, and lots of players outside the NBA are better free throw shooters than those on the inside," he writes. "Nevertheless, every single NBA player would be more valuable to his team if he could improve his free-throw shooting."
In a session of his class this fall, Metrick elaborated on the tradeoffs between art and science in venture investing and shortcomings of conventional financial tools like valuation when applied to venture deals.
When selecting public-company stocks, investors face a relatively straightforward decision, he says. "You invest when your model says your valuation is greater than the company's market capitalization." Easy availability of financial information on public companies aids in those calculations. If anything, public company investors have to sift through too much information. They confront a white noise, where their venture counterparts have to pry open a black box.
In venture capital, "the numbers aren't transparent," Metrick tells his students. Entrepreneurs courting investors make estimates of future revenues and profits in their business plans, but seasoned VCs know to apply skepticism to these. "All business plans have projections," Metrick quips, "and of course they are always grossly inflated."
Consider this tale, told to Metrick by an anonymous venture capitalist: One of his portfolio companies received an award from a national magazine for being the nation's fastest growing private firm over the prior three years. And during that time, it had failed to meet the projections that its founders had made in their plan.
In the venture world, financial tools serve more as guides in structuring deals than in picking investments, Metrick says. "We don't want to turn models into straightjackets so you miss the next Google. The models are there to be applied once you've decided to invest and are structuring the investment."
The pharmaceutical business is one of the most challenging sectors for identifying and structuring deals. Its costs are high—getting a drug approved by the U.S. Food and Drug Administration costs about $800 million. And timelines for the discovery, development and approval of drugs are long. "You can be a drug-company scientist and have only a one-in-four chance of working on an approved drug," Metrick notes.
But money continues to pour into the drug business because its serves critical needs and, when a product succeeds, returns can soar. "This is a $400 billion a year market," he points out.
It's also a vivid laboratory for studying venture investing because it lays bare the sorts of risks—technical, business and competitive—that any innovative company faces.
In the drug industry, technical risk boils down to two questions: will the drug work and what will its side effects be? Business risk entails the zigzags in sales or profits associated with the overall economy or industry; when the economy sags, and people spend less, scrimping even on drugs. And competitive risks stem from other companies' responses to your offering.
"Pharma is a fascinating industry for studying venture capital," Metrick adds. "It has everything—lots of data and probabilities and clear phases of development, and the companies spend a ton on R&D. This is an industry where you can make $100 million mistakes."
It can give even the most golden gut indigestion.
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