The Crowd Loves An Idea, But They Hate Playing The Odds
By Rupert Taylor on 2nd March 2016
Investment wisdom tells us that valuation is the single most important consideration when choosing an equity investment. The world is an uncertain place - even more so in the world of business. As such only a fool would believe that they can predict the future with any certainty. Seasoned investors tend to have learned this lesson. Experience has taught them that even the best ideas come up against pitfalls as the un-predictable nature of the world conspires to obstruct, or even prevent, progress towards a plan. Even Warren Buffett, master investor of Berkshire Hathaway fame, has the humility to acknowledge this.
“At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it.”
As a result the wisest investors will always explain that they play the odds. Or as Buffett expresses it - ‘the margin of safety’. They know they cannot be sure that a great idea will come to fruition, and so they ensure that probability is on their side. More specifically they ensure that the implied probability of success is considerably lower than the actual likelihood of success. They understand that success can never be guaranteed. But if they back enough ideas with an 80% chance of succeeding, at an implied probability of 40%, then over time they will make money. Even if some of the 80% shots do not in fact succeed. Note that these percentages are not fixed. According to this logic, backing an investment with a 30% chance of success at 10% implied is a better bet than backing an investment with a 90% chance of success at 95% implied.
So where do I find the implied probability of success of my crowdfunding campaign? Easy – it’s the valuation.
Valuation is a measure of implied probability. It’s crude, but it’s the best we’ve got. To figure it out you need to familiarize yourself with the concept of pay-off. Pay-off is what success looks like - it is what the company could be worth if everything turns out as planned. Let’s take an example:
- A red hot fast growth brewery has revenues growing at 100% i.e. doubling every year.
- Revenues are £30m. The valuation is £300m.
- Year 2 revenues will be £60m, year 3 £120m.
- Then inevitably growth will moderate to a less incredible 50%.
- Year 4 revenues are £180m.
- Followed by 3 years of 20% revenue growth.
- As a result, in year 7, revenues are £310m.
- The brewery now has significant penetration of its segments and growth is now 2x GDP – still incredibly impressive. This would command a valuation of around 1x sales, i.e. 1 x £310m = approximately £300m.
The problem is I am being asked to pay £300m today. £300m for something which if everything goes to plan will be worth approximately £300m! i.e. if the company delivers perfectly then it will justify today’s valuation but no more. In effect there is no payoff even in a perfect scenario. And to make matters worst there is also considerable risk. As an equity investment, start-up equity at that, if the company delivers anything less than perfection then I can expect to lose money – possibly all of my money. Effectively the company is already priced for perfect execution.
So let’s take this back to the idea of implied probability. This company is priced for guaranteed success. Anything less and I will lose money. It might be such a strong brand, with such mystical management, that it’s a guaranteed success. But it still will not allow investors to make any money. Even if EVERYTHING goes to plan. And in anything less than that golden scenario I would lose money.
So what implied probability should I look for? This is impossible to answer. Except to say ‘less than 100%’! Would I buy this priced at 50% of the implied best case payoff? No.
Here at AltFi we have long expressed concern over equity crowdfunding valuations. Our sense is that ‘the crowd’ gets lured by a great story without being sufficiently discerning about valuation. Effectively they are prepared to accept far too low a potential pay off given how un-certain they should be of success. New research published today seems to confirm our fear.
CROWDRATING is a service that offers ratings for crowdfunding campaigns. They provide a score across three criteria: management; product; and investment. Of these, ‘investment’ encompasses the company’s financials and valuation.
Having rated 155 campaigns between April and December 2015 they can identify which factors determine whether or not a campaign is successful, i.e. if they score a campaign well or badly on those factors does it appear to have any effect on the crowds inclination to invest? The results are startling.
The crowd pays attention to management and product. Campaigns that scored highly in these categories had a better success rate of getting funded than those that scored poorly. However, when it comes to financials, the pattern fails. In fact, campaigns that scored badly for financials got funded. Those that scored well struggled.
Like all analysis done in this nascent sector, patience is required to support any findings. It is early days and only time will allow us to see if valuations are being set at a level that allows the crowd to achieve an adequate pay off if a company succeeds. However, unless the crowd is disciplined about the implied probability that they are prepared to accept, they should not expect to make impressive investment returns. If, however, the crowd can indeed predict the future with absolute certainty then Mr Buffett, and indeed investors everywhere, will be most keen to borrow the crowd’s crystal ball!