Harvesting Optionality

There are a number of factors that go into determining whether or not you should invest in something.  Foremost is the probability of a positive return.  According to William Poundstone in the book Fortune’s Formula a “bet” with a negative probable return is called gambling.  The house will win in the long run.

Little Engine Ventures (LEV) is not in the business of gambling but we like being in the position to win more often and in greater magnitude than when we lose.  A mental model we challenge ourselves with often is asking the the stage of the business life cycle.  Like children who grow, test limits and find a pattern, settle into adulthood and then perform for many years before deteriorating, we believe businesses also have a finite life. There are certainly some examples of very, very old businesses that are still growing, but most businesses grow, mature and fade in a fairly predictable pattern.

Our preference is to invest with specific outcomes in mind and the risk of permanent loss disproportionately low.  In this way we are aligned as owners in the business and benefit alongside our co-owners.

The challenge with this approach is to define how much life is left in the business given what is known and who is involved.

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In the above chart, (Exhibit 1),  Credit Suisse demonstrates the relationship between reinvestment and economic return.  In the left most portion of the chart you can see how proportionately high the reinvestment of earnings are.  At this point many businesses often benefit from outside capital since spending outpaces the immediate economic returns.  This is a classic case of building a business.  Our startup companies experience this inversion on a very real and painful, daily basis. They also feel the exhilaration of a very steep upward growth in returns, often testing scary high gross margins as they begin their accent into the clouds.

Somewhere in this early stage many of our startups consider selling.  Mature businesses pay premiums to extract high growth business units from the marketplace because of how difficult and risky they are to launch internally… and how high they surmise the peak might be under their ownership.  These acquisitive companies are essentially outsourcing the R&D and early business development to truly independent startups and cost them nothing (moving cash from balance sheet to goodwill of acquired asset.)

A very, very few (<1%) of these high growth, high potential startups go on to raise additional growth capital from very large venture capital firms.  These are the Facebooks and Googles of the world.  If you are lucky enough to partner with one of these in your seed investment fund, you just hope to hold on.  At LEV, we are more likely to sell early and avoid the dilution and turnover risk.  (more will be written about why we believe there is a gap in the market that we can uniquely expose here.)

As the chart moves to the right, both reinvestment and economic return peak.  This is the exit game the big VC firms play.  They hope to IPO near the peak or find a suitor for their unicorn now that growth has begun to slow.  If they miss it they can accidentally ride the value down during lockups or changing appetites in the marketplace.

There are also many traditional businesses that achieve a sizable peak much slower.  They develop a moat over a generation or two before they reach a summit.  These businesses probably did not ride a technology wave to the top but achieved the summit through years of hard work and relentless service to their customers.  Some of these great brands are regional and dominate their small ponds.  Warren Buffett has explained how wonderful See’s Candies is to own.  This is a business that built a regional brand that had staying power and could be expanded safely for many, many more years, both through price increases and steady expansion of the regional market.  At LEV we define staying power by the length of the downhill from this peak.  Imagine a snowball at the peak.  How long can it roll, and compound moving further to the right before reversion to the mean?  Ideally, there is a very long and safe downhill decent.

At the right half of the chart, these businesses have begun to face steep competition and average to below average returns.  The profit may still perpetuate the business for many years and be acceptable for the owners who exerted so much energy early in the business… or in the worst of scenarios, the bureaucrats that now control the company for a fat salary.  At some point however, these companies may opt to sell or reinvent themselves and the cycle could potentially begin again under new leadership.  More often, when these dinosaurs exit they often overlook the hidden gems in their artifacts.

At the risk of spoiling our lop-sided game, we spend a lot of time in just two places of this chart.

LEV lifecycle focus

We invest seed capital into startups. This is just right of the far left of business life cycle.  The founder has launched but needs a lead investor to get to the first sign of scale.

We also buy businesses that are capable of steeply reducing the reinvestment rate.  These deep and wide moated castles often have founders that dream of liquidity and diversity after many, many years of blood, sweat and tears being poured into the construction of their companies.

The result of deploying our capital this way is we extract future capital from existing businesses and redeploy a portion toward completely separate innovations.  The CEOs of each business type are distinctly different. As stated earlier, the “who” is a big part of the intrinsic value in our ledger.

The reason these portions are not wider is because we are also practical regarding our role in the marketplace. We get things rolling and then exit once the pace of growth becomes repeatable.  Big companies have an appetite to take these to the next level.  On the more mature side, we must regularly prepare to exit when we begin holding too many companies for the size of our fund.   Essentially, we have to look for the highest cash flow from the fewest holdings, at the lowest acquisition price, that still maintain some diversity.   Proportionately, we deploy substantially more capital on the right, but our returns from more frequent exits on the left compose a significant portion of the overall earnings.  We also learn a lot about where traditional businesses are vulnerable to attack from disruptive innovators and become increasingly effective at timing exits.

As some have said, “it’s simple but not easy.” Therefore, we work extremely hard not to make fatal mistakes.  And when things go right, they go really, really right.

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As you can imagine, this provides us with a tremendous amount of flexibility and the ability to harvest optionality. At any point we can retain ownership and move a company between categories.  This is really hard for most CEO’s and is something we avoid because of the cost and likely personnel changes.  Simply put, it’s cheaper (if not profitable) to sell one and buy another should circumstances change.  But, again, because of our structure (which differs from many other funds), we are in fact capable of retaining ownership indefinitely.

The benefit of optionality is that the decisions do not need to be made ahead of time and the future does not need to be known.  We simply craft a steady stream of deal flow and compare deals with one another, picking the highest performing and balancing for sustainable liquidity.

In closing, it is likely that any brute would consider this an ideal plan and one worth following.  So, why don’t they?  Time.  It takes a considerable amount of time to study and prepare for these acquisitions and exits and most people do not find the stress particularly satisfying. So, why do we?  In a strange way, these different phases tend to attract one another, and seem to be attracted to LEV.  Also, our limited partners have often experienced one or the other stage, or both, and desire to help the partner companies, even if only passively through their capital.  Finally, LEV is young, small and on the left most side of the curve itself.  We are creating a situation with upside, growth and reinvestment for ourselves.  Precisely how high and how long our hill becomes is something that will ultimately be a reflection of our working harder and smarter… and potentially a few lucky situations.

If you are an accredited investor or fellow business owner, we invite you to contact us to compare notes.

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