It’s all about identifying outliers

What startup investors can learn from sports betting

Early stage investing is a complex and relatively new practice, which makes it fertile ground for analogies which can help explain the more abstract concepts to both newcomers and veterans alike. 

In this particular case, grappling with the intrinsic value of pre-revenue startups, there’s an interesting parallel to sports betting. Fundamentally, both involve looking at the strength of a team and the competitive landscape and making a judgement on future potential.

What we’re considering here is the idea that a startup – even a pre-revenue startup – has a determinable value even before that value has been tested in the form of a market transaction. This is also what you might call a ‘fair market’ valuation, which is what we aim for at Equidam

MOIC vs. betting odds

In early stage investing, investors will look to benchmark potential returns using a metric called the multiple of invested capital (MOIC). MOIC is calculated by taking the total potential return on an investment and dividing it by the amount of money invested. For example, with an investment of $100,000 in a company with an expected MOIC of 10, the company should have the potential to return $1M.

In sports betting, participants measure their potential returns using the odds of winning, which represents the probability of success. For example, if the odds of a team winning a basketball game are 9:1, it means the team is assumed to have a 10% chance of winning and the return would be a multiple of 10. 

Rewarding the earliest participants

In both examples, the earliest (successful) participants receive the most lucrative returns. In investing, this is because early investors are able to get a lower share price than later investors. In sports betting, this is because early participants are able to secure better odds.

In both cases, this is for the same reason: At the very beginning there is the least available evidence to indicate an assumed outcome, thus a greater level of perceived risk associated with the choice. This is true both in terms of signals from other participants (other bets or investments made) as well as actual progress in terms of milestones achieved, such as games won or revenue secured. 

Qualitative and quantitative measures

In early stage investing, investors use a variety of qualitative and quantitative measures to judge the potential of a company. Qualitative measures might include the management team, strategic relationships, and the competitive environment. Quantitative measures include things like the company’s projected financial performance, market growth and associated risk. This is reflected in the form of the valuation, which ultimately informs the potential return on investment.

In sports betting, participants use similar measures to judge the potential of a team. That might include the team’s roster, their experience together, track record of the coach, and the threat posed by other teams. This is reflected in the form of a perspective on what the betting odds should be to provide appropriate upside for that level of risk.  

What this means for early stage investors

According to some, a startup does not have a valuation until it has been priced in an equity transaction. To an extent (in a strict and formal sense) that is correct. It does not itself have a valuation, because value is not an objective concept. Like beauty, it lies in the eye of the beholder. However, we shouldn’t pretend that an equity transaction represents an ‘objective’ read on value either; it’s also just the opinion of an investor.

What this analogy illustrates is that you, as an early stage investor, should have your own personal read on valuation as a reflection of future potential. You need to understand the qualitative and quantitative factors involved, and determine a practical framework to run your own analysis. It’s the best way to sharpen your judgement on future potential, take an informed perspective on risk vs return, and put your money to better use.

If you are investing your own money, it’s not crucial that your valuation framework be seen as objective or fair. Many investors look at valuation primarily in terms of market context and what other investors are doing. Others use simple heuristics like national averages adjusted with a few qualitative measures, even if that screens out some deals. Whatever approach you use, if it allows you to reach your desired level of returns then it is clearly working. 

When being objective is important 

Imagine it’s January 2023, and a friend is looking to place a bet on the upcoming NBA championship, and you – being wise and well informed – recommend putting money on the Denver Nuggets. This is a team which hasn’t won a championship in its 47 year history, and a year ago they lost in the first round, so the odds are great (in terms of MOIC) but your friend will take some convincing. 

It’s in explaining this opportunity to another person that objectivity becomes important; your rationale must survive without the support of your own biases and perceptions. What are the data points which conclude that the Denver Nuggets have been overlooked or undervalued by the market? What is it about their 2023 roster and the wider competitive environment which indicates for success? How do you piece that into a compelling story for your friend? 

This is, again, mirrored in the world of early stage investment. If you are looking for input on the potential of a startup – which has not yet been rubber-stamped in a market transaction – you will want to see it in a transparent, objective format which covers all of the key indicators. This is applicable in a range of cases, whether that is determining a valuation for the first round of a company, proposing a valuation to a group of angel investors, or reporting updated valuations to your LPs.

This is where we finally arrive closer to assigning a ‘fair valuation’ to a startup, rather than the individual perspectives on valuation. Not a number determined by the combination of gut-feel and Excel-gymnastics designed to pattern-match past success, but something scrutable, explainable and repeatable. 

Crucially, valuation can be incredibly useful even when it’s not associated with a market transaction. In fact, the single perspective of a lead investor on the value of a company is potentially less valid, and less reliable, than a more objective framework.1

Backing outliers is the whole ballgame

Early stage investment pivots around uncertainty and valuation is always a tricky exercise in assessing the tangible and the intangible. Reaching 100% efficiency in the risk/reward is never going to happen. 

Similarly, your friend doesn’t have to buy every data point in your recommendation, they just have to understand what you are looking at, the conclusions drawn, and appreciate that it was a rational process with an outcome they can challenge or disregard as they wish. 

Had they made their bet based on the odds at the start of the season, following the favourite as indicated by the market, they’d have lost their money. Had they waited a few months to see how each team performed in order to inform their judgement, they would have increased their chance to pick the right team, but with much lower potential returns.

And that’s the argument in a nutshell. In order to understand an opportunity while the terms are most favourable, or to explain that opportunity to others, you need to think about practical and objective measures of future potential. Early stage investing is all about identifying outliers, like the Nuggets, which is precisely why we approach valuation from this perspective. 

  1. Especially given the extreme proclivity of investors to pass the buck, and base their pricing on other market transactions. []

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