Companies That I Like
STORY INLINE POST
As an investor, I am often asked to speak to the types of businesses I like to invest in. It’s a tough question. Overall, the companies we choose have common themes, some of which we feel are necessary to produce the big outcomes that are required for us early-stage venture investors.
Everything begins with people. Great companies require leaders who are great, not merely good. You cannot achieve exceptional results investing in unexceptional people. Founders must possess the ability to scale into many different skill-sets as their company grows. This is something most people cannot do, unfortunately. As an investor, a big part of my job is evaluating whether a founder or founders have the horsepower required to build a large enterprise that wins its market over the long term. Succeeding requires intelligence, passion and integrity, and as they say, without the latter, the first two don’t matter. As the controversial yet legendary builder Robert Moses once said: “It is an ancient truth that it is not knowledge, but action which is the great end and objective in life, and that for every dozen men with bright ideas there is at most one who can execute them.”
Then there’s the business itself. A lasting enterprise must feature a powerful, profitable business model that uses capital efficiently. In the words of Warren Buffet, a “truly great business must have an enduring moat that protects excellent returns on invested capital.” A great business model often even outlives a company’s founders as well – as some say, an amazing business should be possible to run with an idiot in charge, because very often, it eventually will be. At Gilgamesh, our investment philosophy believes there are three types of opportunities in our investment universe. We seek to invest in the first category, although we will from time to time invest in the second when the likelihood of success feels particularly high. The third type is inappropriate for us and must be avoided in all circumstances.
Some businesses are what we call “Fission-Powered.” As most know, nuclear energy is special in that a tiny amount of fuel can produce huge amounts of energy. That’s what we’re looking for when investing in companies. Fission-Powered companies require modest capital investment and feature large, accelerating financial returns. In fintech, Visa and Adyen come to mind as achieving this status. Of course, almost all scaled businesses require meaningful up-front investments. But once established, businesses of this type throw-off magnificent returns to shareholders, both today and tomorrow. They simultaneously produce fantastic growth rates and profit margins and feature very rapid payback periods. Businesses like this tend to benefit from network effects, and their growth often feels “pulled” by the market. And once scale is reached, they are often cash cows, which can be reinvested for growth or sometimes distributed to shareholders via dividends or buybacks in the long run. Unfortunately, these types of companies are extremely rare. But when you find them, they have the ability to produce magnificent returns.
Other businesses are “Internal Combustion.” Gas engines are needier than nuclear reactors. You’ve got to fill the tank frequently, but they can still crank out lots of power. Companies in this category can deliver large financial returns, but they require meaningful equity investment to keep growing. In fintech, big winners like NuBank come to mind. Internal Combustion businesses are also great investments, but their return on invested capital may be tempered by dilution from required equity funding as they grow. Sometimes, these are “capital intensive” businesses. That said, if well managed, these companies can produce excellent returns, although usually marginally lower returns relative to the astronomical potential from the first category.
And then there are “Wood Burning” businesses. If you’ve ever burned wood to heat a home, you probably understand the analogy – sometimes the benefits from the fire are outweighed by the effort put into fueling it. Investments in this category require huge investments of capital, but deliver little in the way of financial returns, and often those returns occur at a decelerating rate. These businesses can chew up tons of capital, yet still disappoint in the end. They’re sometimes called a “money pit.” We really try to avoid companies in this category. Sometimes these problems stem from balance sheet intensity gone wrong, sometimes due to operational inefficiencies, other times due to excessive working capital requirements, and sometimes simply due to managerial incompetence. But just as often, it comes down to an overly competitive market in which the firm lacks a clear competitive advantage. Commodified fields like on-demand-groceries or even ride-hailing companies like Uber or Lyft come to mind when thinking of this archetype – certain cash outlays today, yet uncertain returns tomorrow. Investors beware.
Warren Buffett captured these categories eloquently in the past: “To sum up, think of three types of savings accounts. The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.”
It’s probably no surprise that as venture investors, we seek very fast growth. Of course, we want fast growth and big exits! But beyond the simple statement that growth is good, this remains a meaningful hurdle and leads us to pass on many companies we like. Distilling it to its constituent parts is helpful. The need for fast growth means we cannot invest in companies with structural restraints on growth. Examples of such growth restraints include onerous capital requirements (such as with banks), slow learning feedback loops, or challenging regulatory constraints (like difficult, multi-jurisdictional licensure requirements). Sadly, this criteria excludes investments in many exceptional businesses, even though they are run by great people and have great strategies. But venture capital investment requires that we pick companies that can meet exceedingly high return expectations – it’s an extremely high bar.
And last, there’s valuation. Everyone knows it’s important to buy low and sell high. But how do we think about valuation at the point of deciding whether to invest or not? The issue is simple in concept, but complex in practice. As venture investors, an entry valuation (and ownership percentage) needs to be such that each individual investment has the potential to return the value of the entire fund (or more) in an upside scenario. If your fund is $100 million, you’d need each investment out of the fund to likely exceed $100 million in returned capital if things go well. Of course this depends on each fund’s investment strategy, but it’s reasonably consistent across the venture capital industry. The math depends on the type of company, business model, margin profile, the expected dilution in later rounds, size of foreseeable upside events (based on public companies and transactions), and the level of confidence in getting to a liquidity event. All of this is highly subjective, and the assumptions are many. But generally higher entry valuations make it harder to invest. Sometimes the math simply doesn’t work. And as we all know, sometimes investors hold their nose and invest even when they shouldn’t due to valuation reasons – investors are not immune from emotional decision-making, as the last few years have illustrated.
The things that make a company great are constantly shifting as trends, technologies, and markets evolve. There’s no constant rubric to making good decisions. Indeed, sometimes the difference between a good and a great investor is knowing when to bend the rules. But the rules still matter, and investors' ability to adhere to them – even when it’s tough – often makes all the difference in success versus failure.