Chapter 80 Section 4 Investment Decision and Company Valuation

We gave an example of venture capital investment in the previous section. In this example, we ignored two key issues: how does a venture capital firm decide whether to invest in a company (or an industry), and how does a small company value.To answer these two questions clearly requires writing a special book, because the situation of each investment is different, and the case of the previous investment usually cannot be used in the next one.Therefore, here we briefly introduce some investment and valuation principles. We can see from the above examples that venture capital is often divided into stages. There can be an angel investment stage, the first round and the next round (or later rounds).The stage of angel investment is the most uncertain, and there are even no rules to follow. Many successful angel investments do not know how to succeed in retrospect, including some angel investors who started investing in Google, and they did not know what Google does.A friend of mine was one of the founders of the largest company in the world in this field, which went public on Nasdaq and sold for billions of dollars.The co-founder told me that the first money they started their business was US$500,000 from a Taiwanese angel investor.This investor was not in the IT field at all, and he didn't understand what they were going to do. Finally, he asked a physiognomist to show the three of them. The three were tall and good-looking, so the investor Just invest.When the company was acquired at a high price of several billion dollars, the angel investor should perhaps thank the Mr. Xiangmian, who brought her hundreds of times the investment income.

It is because of this uncertainty that many large VC firms skip this round.Some more conservative VC funds only participate in the last round of investment.Some clearly state not to invest in the following situations: 1. Don’t invest if it’s not profitable, 2. Do not invest in those with unstable growth, 3. If the company does not reach a certain scale, it will not invest. Even some venture capital funds only invest in companies that have plans to go public within 12 to 24 months.Of course, at this point, it is often the financing company that chooses the venture capital. The venture capital that can get the contract at this step is either a company with a wide relationship in the IT industry, or a well-known company, so that when a new company goes public, it must By their names.Usually, when shareholders see that a company to be listed is invested by KPCB or Sequoia Venture Capital, they will actively subscribe for the company's IPO shares.

More complicated is the case in the middle.Let's look at two real examples that I have come across so that the reader will have an understanding of the VC's decision-making process and stock price methodology. A student from a world-renowned university invented a very useful software on a mobile phone. He lets people download it for free on the Internet for a trial, and then charges some money from users who are willing to continue using it after the trial period expires. $100,000.He wants to set up a company to make this software bigger and better.He found a venture capital fund, and it happened that the general partner of the venture capital fund was my friend, so he asked me to have an interview with the entrepreneur.We listened carefully to his presentation and looked at his software.The investor admits that he is a capable young man and that the software is good, but he does not invest.The investor made an account for him.The software on this kind of mobile phone must be pre-installed when the mobile phone leaves the factory if it wants to be promoted. For eight cents.Usually there will be three competitors in a field during a stable competition period. It may be assumed that this entrepreneur can rank among the top three and rank second.In the software industry, the market shares of the top three companies are generally 60%, 20% and 10% (the remaining 10% is given to other competitors). 20% of the mobile phone market's pre-installation rights.We might as well assume that the world sells one billion mobile phones a year, and he can get the pre-installation rights of 200 million units, which means an annual turnover of 20 million US dollars.Readers may think that 20 million US dollars is a lot, but in fact, it is not much in the eyes of venture capitalists. In the United States, the annual cost of an engineer is 200,000 US dollars.There are nearly ten major mobile phone manufacturers in four or five countries in the world. If you want to win this 20% of the market, you need to talk with each other.The software of a mobile phone is not like that of a personal computer. If there is a bug, it will be patched automatically by posting a patch on the Internet. If there is a problem with the mobile phone software, sometimes the mobile phone must be recycled. Therefore, mobile phone manufacturers take a long time to test and take down a mobile phone. The contract usually takes 18 months, so the cost of selling this software is very high.We might as well assume that this small company has a net profit margin of 15% (not low), then its annual profit is 2.4 million US dollars. Although readers think that earning a few million dollars a year is not bad, but because This business cannot grow very fast (depending on the growth of the mobile phone market), and the average P/E ratio in the stock market is 20 times, so the market value of this company should not exceed 50 million US dollars at most.A company with a value of less than 100 million US dollars cannot be listed in the United States. Therefore, the company has not yet been established, and its fate of not being listed has already been doomed.The reason for this classmate's failure is not technical or his personal ability, but that the topic was not selected well.What venture capitalists like is the so-called billion dollar business (Billion Dollar Business).Finally, my friend who is a venture capitalist suggested that this classmate find angel investors, because such a thing is still profitable, and there may be angel investors who like to invest.

Because venture capital is high-risk, it is natural to pursue high returns.Whenever entrepreneurs tell me about their invention, the first question I ask is: "How do you guarantee that one dollar will become fifty?"Although the final return of venture capital is far from dozens of times, investors will set the rate of return at more than tens of times for each investment (the mobile phone software above obviously cannot achieve a return of dozens of times).So my first sentence usually stumps more than half of entrepreneurs.Most people’s reaction when they hear this sentence is: “Is it too greedy to want such a high return? Wouldn’t it be good to have three to five times in two years?” Generally, the traditional investment has three to five times in a few years. The return is indeed good, but because the possibility of failure of the VC is too great, it must set the rate of return very high to recover the overall investment.According to a friend of mine who is a venture capitalist, Sequoia Ventures invested more than a billion dollars in Google’s venture capital fund. Only Google’s investment was successful. Still at a loss.On the other hand, dozens of times the return on investment is completely within reach for venture capital.In the early 1950s, venture capital AR&DC invested in DEC, and the return was 5,000 times ($70,000 to $355,000,000). KPCB and Sequoia Venture Capital invested 500 times in Google (10 million to 5 billion U.S. dollars), and Google’s first Angel investor Andy Bakertosen made a return of more than 10,000 times ($100,000 to $1.5 billion today).

To achieve high returns, you must first choose the right topic.The most important thing about a good entrepreneurial topic is novelty, which is usually something that others have not thought of, rather than what others have already done successfully.Many entrepreneurs like to imitate. Although it is possible to succeed in this way, it is impossible to earn dozens or hundreds of times the return on investment for venture capital.For example, in the 1990s, there were many manufacturers of DVD players in China. The early ones made money, but the next few hundred did not.In the 1990s, the first question that venture capital firms asked entrepreneurs of software companies was "Is it possible for Microsoft to do what you want to do?" This is an unanswerable question.If the answer is "maybe", then the general partner of the venture capital fund will next say "Since Microsoft will do it, you don't have to do it." If the answer is "No", then the general partner will say "Since Microsoft will do it." If you don’t do it, it seems unnecessary, why do you do it?” After 2000, venture capital firms still ask this question to software and Internet entrepreneurs, but Microsoft has become Google.This example shows that if the entrepreneurial project and the business of companies like Microsoft and Google are likely to crash, the possibility of failure is extremely high.

In addition, a good topic must also meet the following conditions: 1. Once this project is completed, there must be a ready-made market, and it is easy to expand horizontally (Leverage). Here I want to say a few words about the importance of "ready-made market", because it is impossible for a new company to wait for several years until the market matures before starting sales.In fact, there are many failure examples where the technology and products are very good, but the market conditions are immature.For example, the network PC developed by Oracle in the past was good from idea to product, but at that time neither high-speed Internet access nor powerful data centers were popularized, so it failed.Today, ten years later, when Google proposed the concept of "cloud computing" and established a globally connected super data center, Larry Ellison's dream could become a reality.However, no small company can afford to wait ten years.

Horizontal expansion means that once a product is made, it is easy to copy and expand to related fields at low cost.Microsoft's technology is very easy to scale horizontally, and you can copy as many copies as you want after a piece of software is made.Silicon wafers for solar photoelectric conversion cannot be expanded horizontally, because it requires equipment for manufacturing semiconductor chips, which is very expensive, and it is impossible to expand the scale without limit, because the remaining capacity of semiconductor manufacturing in the world is limited. 2. Future commercial development will grow exponentially in a relatively long period of time.

The mobile phone software project we introduced earlier does not have this feature, because its growth is restricted by the growth of mobile phones. 3. It has to be revolutionary. I usually divide technological progress and new business models into two types: Evolution and Revolution. Although their English words differ by only one letter, their meanings are far different.Entrepreneurship must have a revolutionary technology or a revolutionary business model. Now, let's look at a good example - PayPal, which has the necessary conditions for the above-mentioned good topic.First of all, its market is very large.The annual business transaction volume in the world is tens of trillions of dollars, of which cash accounts for nearly half, and credit cards account for a quarter; secondly, its market conditions are mature.With the development of online transactions, cash and check transactions are obviously unrealistic, and only credit cards can be used. The transaction methods are as follows:

However, when credit cards are used online, incidents of theft often occur (for example, merchants are phishing profiteers, once they obtain the buyer’s credit card information, they will abuse their credit cards), and there is a problem with security.Therefore, a convenient online payment method is needed. PayPal's idea is very good. It will manage everyone's credit card or bank account in a unified way. Merchants cannot directly obtain the buyer's account information.During the transaction, the merchant informs PayPal of the transaction content, and asks the buyer for money through PayPal. After the buyer confirms, he authorizes PayPal to hand over the payment to the merchant. The merchant cannot know the buyer's credit card and bank account information.Moreover, PayPal requires merchants and buyers to provide and confirm their real addresses and identities to avoid fraud as much as possible.For transactions under $500, PayPal provides insurance to the payer. If the payer is cheated, PayPal will reimburse the payer for the loss and let it go after the money. PayPal's business model is as follows:

This payment method is much safer, and its benefits are obvious. When online shopping develops, the conditions for its promotion are met, and there is no need to cultivate the market.The annual transaction volume of more than ten trillion U.S. dollars is almost infinite development space for PayPal. Although PayPal is growing at a high speed of 30-40% every year, by 2007, it still only has a transaction volume of about 4 billion U.S. dollars. There is still room for development. very big.So the topic of PayPal is a business that can develop at a high speed for a long time. Although PayPal has nothing unique in technology, its business model is revolutionary.

Once a venture capital firm determines what business and company to invest in, the next question is how to value an investment object.Unlike investing in the stock market, most venture capital objects have no profits or even no turnover at all. Their valuation cannot be measured by the traditional price-to-earnings ratio (P/E value) or discounted cash flow (Discounted Cash Flow). The key is to look at the next few years The prospect of the company's development and see where the company has developed so far.Another difference from investing in the stock market is that the quality of the founders and early employees becomes critical for start-ups because there is no performance to measure.Generally speaking, some High Profile founders, such as senior employees of Cisco and professors from Stanford, can easily obtain higher stock prices in companies founded by them. Once a venture capital firm invests funds in a start-up company, its investment mission is far from being completed. In a way, it has just begun.