Value Investing in Venture:
A Fresh Approach to Leading VC Returns
By Kent Lucas and Susan Park of non sibi ventures
Value investing in the public markets is a longstanding investment strategy: find companies that are undervalued relative to their peers and take advantage of the disparity between their intrinsic value versus the current stock price. And overtime value investing as an investment strategy has outperformed growth investing. Considering historical U.S. stock market data from 1927 to 2021, value stocks have outperformed growth stocks by 4.1% per year but for private markets such as venture capital, value investing hasn’t been applied.
Classic Value investing principles are based on assessing a company’s intrinsic value which takes into account various metrics including revenue, balance sheet ratios, earnings power, dividends and cash flow. So, is it possible to use that same successful investment strategy in private markets if a company is in a growth stage or later stage of development? For early-stage companies, classic value strategies fall short, conventional analysis and approach are problematic and generally don’t fit. A fresh approach is needed to find value and improve returns.
Reviewing the Challenges of Value Investing in Venture Capital
Successful venture investing in early stage companies requires finding fast growing companies targeting new or even undefined markets. Venture capitalists also like to ride the momentum of a company that is already gaining ground, those with expected phenomenal growth rates. During the 13-year bull market that has now ended, venture capitalists had been bidding up private companies and startups with diminishing concern for valuation (and now we’re seeing down rounds). Since the 2009 bottom, venture capital investors, with access to record amounts of capital to deploy and a favorable macro cycle, have effectively been engaging in growth and momentum investing, pushing up valuations and prices paid. The pace of deals picked up, while rigorous analysis and due diligence lessened.
In that type of market, valuation metrics matter less. Value investing principles don’t transfer well to venture capital investing, especially during an extended bull market where discipline and valuation took a back seat to momentum and FOMO (fear of missing out).
The second challenge is that startup companies typically do not have common or reliable valuation metrics such as cash flow, debt/equity ratios or tangible assets to easily estimate their intrinsic value. These young companies have just begun their journey of revenue growth while positive margins and profits rarely exist at this point. And while a company could be the next Apple or Amazon, it is pretty difficult to predict that future outcome from value investing valuation tools when there is so little past history to go on. Given these realities, where does value investing fit?
Readers with knowledge of public market investing will pause here and frame the conversation as value investing versus growth — and say that value investing means lower growth, less risky, more cyclical — and that that’s not going to fly in venture investing! Sure, but the missing element is that successful value investors are very disciplined, require company strong fundamentals and invest at lower valuations, in less popular and less obvious companies — that produce better returns — sounds like that would work. Let’s explore it.
Uncovering Value in Sourcing and Selection
At non sibi ventures, we shift value investing principles from focusing on investment metrics and growth parameters to focus on finding value in our sourcing and selection approach. We have identified what we call the Value Gap of overlooked and underrepresented founders. Additionally, through this Value Gap lens, we look for technology-driven solutions that focus on less-popular or less-obvious markets and customers. We wrote about the Value Gap in a prior Medium piece but here we’re double clicking into value investing in venture.
“The non sibi ventures team applies over 25 years of fundamental, research-driven institutional public equities investing expertise and outperformance to our venture selection process.”
We’re not applying value investing principles to other areas of our investment process such as weighing a company’s quantitative metrics such as growth rates. But by focusing on sourcing and selection we are able to look, find and fund these founders and technologies that are less sought after and undercapitalized. It’s a little bit of contrarian investing, a close sibling of value investing. We end up paying lower prices, investing at lower valuations to improve returns multiples and fund performance. The chart below shocks us every time we reference it — comparing the median seed round for Black women and Latina founders vs. the national median.
This is the Value Gap: Differences in Median Seed Round Sizes
Econ 101 — Supply & Demand Imbalances Result In Investments at Lower Prices
Source: Project Diane Data as of 2020
Doing More with Less Leads to Better Outcomes
While it is tough to quantify how much resourcefulness and determination matter, enough evidence suggests that these type characteristics also contribute to better portfolio returns. We know these diverse founders do more with less and are used to grinding it out and being resourceful. Despite not having the same access to capital or networks — they outperform their peers. The “value” in that is overlooked. Julia Collins, CEO of Planet FWD was interviewed by Forbes earlier this year on the topic of Raising Money in a Tough Market. Her quote alludes to resiliency, grit and determination of diverse founders:
”…As a Black woman, I am always working from the mindset that I have to solve my own problems…I’m always conscious about burn. And so I think for founders who are very conscious of the fundamentals are at a bit of an advantage right now. We’ve already engineered ourselves to be able to survive tough times.”
According to 500 Startups, in 2020, 30% of female-founded startups had just 4–6 months of runway. 25% had 1–3 months and just 8% had more than 1 year of runway — and they still outperform as a group! A study by First Round Capital looking at over 300 of their investments over 10 years showed that their investments in companies with at least one female founder outperformed those with all-male founding teams by 63%. And from Forbes:
“Teams of diverse founders (more than one gender and/or more than one race or ethnicity represented) produce 30% higher multiples on invested capital (MOIC) upon exit vs. homogenous teams”
It is safe to say that a reasonable part of the explanation for these better returns, beyond resourcefulness and hustle, is because of the lower valuations that funds get to invest in these companies as they garner less attention and are not in the line of sight of most Silicon Valley venture capital firms. One day this Value gap will close, we hope.
Value Investing based on Geography
Now let’s double click into where our team looks to find Value: in less prominent regions and cities. The prime geographic areas — namely the Bay Area and New York City (NYC) — have been “over-farmed.” In 2021, startups in California, New York and Massachusetts received 73% of venture capital funding. These coastal areas represent the majority of funding dollars and have tremendous investor networks in place. But as a consequence, the same people meet the same people in the same network again and again. Valuations are bid up. This is much less the case outside these regions.
Source: Pitchbook
In our search for Value, we look beyond Silicon Valley to these other U.S. cities and regions with lower profiles. Geographies such as the Midwest, South and Southeast attract far fewer venture dollars and have consequently been under-indexed, yet they are fast growing tech hubs percolating with innovation. Overall, according to Kauffman Fellows valuations and prices are measurably lower in the Central and Southeast U.S. compared to the Pacific and Northeast U.S. Our strong, growing network ensures access to top startups fits into value investing in these geographic areas.
Value Investing Principles Can be Applied in Venture Capital
We hope we have illustrated how long standing, proven aspects of value Investing principles have a place in venture investing. Classic value investing tactics can be specifically redirected to the sourcing and selection methodology to increase returns in early stage investing. At non sibi ventures we are committed to the fact that this Value exists in the founders, geographies, markets or customers that are not in the pattern recognition path of typical venture capital firms. And that shortcoming allows firms like ours to have an early edge on price and valuation to help our portfolio’s long-term returns.
To be clear, non sibi seeks to invest in any startup that we believe has the potential to return a multiple of the fund and where we know we can add value to its success — but we are intentional about investing in diverse founders because these founders improve our odds of finding such unicorns. With our intention, we expect that two-thirds of our investments will be in diverse founders and 50% will be in women. Our modified approach to value investing where we source diverse founders, is financially driven, first and foremost; while being impact driven as well — allowing us to achieve best-in-class double bottom line results.
About non sibi ventures
non sibi ventures is a differentiated black and female led investment firm targeting leading venture returns by applying value investing principles to our sourcing and selection process to invest in category defining early stage U.S. based technology companies. The fund is targeting seed and series A investments in underrepresented minority (67%) and women (50%) founders and undervalued solutions that address underserved consumers, enterprises or markets — in industry 4.0 related sectors where we have domain expertise: sustainability, industrial tech and people optimization. Our team and strategy are further differentiated by our experience, network and access along with specialized leadership development programming for all of our invested founders.
