Five Years Too Late

November 22, 2008

Fundamental vs. Technical VC Investing

Filed under: Uncategorized — Tags: — fiveyearstoolate @ 3:41 pm
Eric Wiesen

Eric Wiesen

Public market equity investors typically fall into one of two camps: Fundamental or Technical Analysis. Sure, many combine both, but most are essentially one or the other.

At a high level, fundamental investors look at the underlying business to determine how well it will perform. They look at margin expansion or contraction, performance of suppliers and customers and new market opportunities. They meet with management and assess their ability to execute the company’s strategy.

Technical investors, by contrast, are much more focused on the movement of securities within the market, and have developed a whole science around price movement, volatility, volume, etc… They look at “support levels” and patterns in time series charts. They are essentially trying to quantify the psychology of the liquid market to predict what the mass of other investors are likely to do.

Put in a simple way, fundamental investors buy the business. Technical investors buy (or sell short) the stock.

So what does this have to do with VC investing? There are no liquid markets, so everyone is a fundamental investor, right? I would argue no – that there is a type of thinking among VCs that is analogous to technical analysis, and that some measure of a VC’s decision-making process is usually contingent on this process.

The basic evaluation model here at RRE (and I suspect at most VC firms) is often described on this blog: Market/People/Technology. It’s relatively straightforward – is a given company led by great entrepreneurs, targeting a big opportunity in a defensible way? This is the fundamental analysis we perform, and it generally drives our yay or nay decision on companies we see. Is this (or is it likely to be) a good business? But once we’ve gotten comfort on these first-order questions, we then ask another set of questions:

  • Who are the company’s comparables, be they startups or public companies?
  • How do the markets value those companies?
  • What success stories can we find of companies taking a similar approach to the one we’re looking at?
  • Who are the likely buyers for this company? What multiple of revenues or EBITDA do those companies enjoy in the market? How acquisitive have they historically been?

These aren’t questions about the business itself. They don’t speak to whether the company has good leadership, whether its customers will want its product or whether its business model makes sense. These are market attitude and structure questions. They poll, to the extent that we can, the psychology and appetite in the market for this type of company.

Ultimately, this is the technical analysis piece of VC investing, and often is a part of the pitch process that entrepreneurs don’t expect. While there aren’t head-and-shoulders or cup-and-handle charts, it’s the part of the evaluation that gets done more on the position of the company as a tradable asset rather than as an underlying business. How will it be valued, and when, and by whom?

The approach to this piece of the analysis varies from investor to investor. Some will ask the entrepreneur straight out, “Who buys this business?” to see how the she thinks about the exit opportunities. Others don’t consider this a part of the process, but will think about it internally. Personally, I like to have this dialog with founders, to see if they are thinking early on about the exit trajectory the business could take, even though we usually agree we’ll have very limited visibility at an early stage. It’s more process and attitude than anything else.

Ultimately, you can see evidence of firms who prioritize the technical piece more than others. When you see VC “momentum investing” in a sector – consistent funding of a dozen or more ad networks, for example, it is at least partially the result of investors looking at the market, seeing the big exits and robust valuations and wanting to make a bet in a market that’s clearly in favor. This is the VC flavor of technical analysis.

Generally speaking, this element is something we do at RRE, but it’s second-order for us. To put it another way, we will not make a bet purely on momentum and analogous big outcomes, but it will help inform a decision about a business we like. If the fundamental analysis comes back strong, but the technical piece looks very bad (public comps are valued very low, previous exits in the space have been at 1X revenues) it will admittedly give us pause. Because ultimately we need to see an opportunity to return a multiple of capital to our limited partners, and if the market isn’t interested in a deal we do, that is going to matter.

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  1. Great post!

    Still it feels a bit like magic when you decide. The mix of Fundamental + Technical, but a lot of it sounds like gut feeling, is it?

    Also, given the economy, do you think the future of VC is in fundamental investments?

    Comment by Alex Iskold — November 22, 2008 @ 6:52 pm

  2. Alex – I guess I’d put it this way: early-stage investing exists in a relative lack of observable data. There aren’t a lot of metrics around the company or its products (for seed stage investing, there often isn’t a product). So the determination of the fundamental side of the equation is often going to be somewhat opaque to the outside. Part of what we’re trying to do with this blog is offer as much insight as we can into our process, in hopes that it sheds some light on how this works.

    In addition, it really depends on the style of the individual VC. Some VCs are extremely thematic. The VC develops a thesis that (for example) casual gaming on mobile devices is going to be a large, profitable sector. That VC is then likely to go to conferences and have conversations with all the companies in that space, and then make a bet on the one s/he determines to be the best bet going forward. That bet is some combination of belief in the management team, the product they have developed and other value-added one-offs that may be present (e.g. the founder used to work at the most likely acquirer for the company). Other investors are more opportunistic, seeing deals through their network and making bets on teams and markets that they may only be evaluating in connection with a particular investment. I’ve seen both styles executed successfully.

    But in the end, it’s always going to seem like magic in some sense. Because early-stage investing has a lot of shared vision in it between founders and investors. You generally have to believe in a market niche that is small now but is going to be huge in 3 years, or a technology that may be nascent today but is going to be very important once the pieces fall into place. Generally the obvious opportunities are already being exploited by incumbents, so there are bets being made in early-stage companies. We can only do so many, so the difference between one that gets done and one that doesn’t may not always be obvious and yes, there is a lot of gut feeling involved when you are betting on these kinds of companies.

    Comment by fiveyearstoolate — November 22, 2008 @ 7:21 pm

  3. Keep up the good work! Great post!

    Comment by Dmoney — November 23, 2008 @ 3:29 pm

  4. While the stock market can literally make you rich overnight it usually requires much more time and attention to detail to make a profit on your investment. When trading stocks don’t expect to immediately make millions of dollars. While this is possible that rarely happens and the stock market is never 100% predictable. So if you think you are going to quit your job and get rich daytrading you might want to reconsider.

    Comment by Stockmarketbasics — November 24, 2008 @ 1:18 am

  5. I guess this is almost the same as the classical distinction between ressource- or market based view. I do think it makes a lot of sense to combine both, as you do.

    Comment by Philipp — November 24, 2008 @ 8:50 am

  6. Great post Eric. While VC investing is best done based on deliberation from both angles, fundamentals should take center stage. The reason being that technical investing is dubious. Looking at public comps and recent exits inherently means that the space is already maturing, and the potential investment in question may be too late to the party. Markets, pricing and returns are governed by supply and demand. Furthermore, a future acquirer can come from an unexpected industry. Comcast bought DailyCandy for $125 million! Comcast? Really?

    Comment by Andres Moran — November 24, 2008 @ 12:48 pm

  7. Another thought I had on the topic:

    Fundamental analysis helps answer the question “Are we willing to invest in this business?”

    Technical analysis helps answer the question “What valuation are we willing to give this business?”

    Comment by Andres Moran — November 24, 2008 @ 1:22 pm

  8. I like this post a lot.

    Given the long time window between when you make an investment and an acquisition, do you think there is a place for the contrarian technical VC investor? The kind of guys who intentionally stay away from the sectors that are in vogue, even if they like the company, because they’ll end up paying too much and instead focus on opportunities that have good fundamentals in sectors that aren’t so hot? The other reason to stay away from the hot sectors being that when those opportunities mature, there will be lots of startups competing against your portfolio company since the sector was so hot when you were funding it.

    Kind of like one hedge fund manager who told me he liked to stay away from the sector graduating MBA’s most wanted to get into because they went to school to get into that industry and by now it’s ready for a down cycle…

    Comment by Dave — November 24, 2008 @ 5:54 pm

  9. Great article. However, I have a question from an entrepreneur’s perspective –

    I have a vision that drives both my motivation and my partners’ motivation for creating our product/service. Furthermore, the authenticity and integrity of our vision drives our consumers/users to participate with us.

    From this standpoint, talk of “where is your exit strategy?” and other technical evaluations may not be a compatible approach to investing in companies that value financial intangibles such as ‘vision’ and ‘authenticity’ so highly. Won’t a commodity-centric/technically minded VC push a company in directions incompatible with its vision? Now, obviously a VC has an obligation to its investors to maximize profit, and there is nothing wrong with this. But it does beg the question: Is there a fundamental incompatibility between visionaries and VC’s whose investors see them as an asset class?

    This idea was recently proposed to me by an angel investor who wants to raise a mezzanine amount of money for my company all through an angel network where everyone, as he puts it, “personally understands that they are making an investment in both a profitable venture, and a piece of history.” I’m curious to hear a VC’s/other entrepreneurs’ thoughts. Thanks!

    Comment by Carter — November 29, 2008 @ 7:50 pm

  10. You mention using comps to help value a company…but in this kind of macro environment, what are the comps?

    I don’t have the answer but I think its an interesting question given that many of the comps (revenue exit multiples, etc) I hear during pitches are based on fundings or exits that occurred in 2006 and 2007…comps which are quite clearly not accurate in this market.

    Makes it tough to define a reasonable exit value, although ultimately the VC needs to do some sensitivity analysis to figure out (in the absence of comps) what they think a company will be worth.

    Comment by jgannonwp — December 2, 2008 @ 2:37 pm

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