One of the first lessons we learned in the MBA curriculum is the traditional discounted cash flow. DCF’s are appropriate for public investments but for high risk investments (such as startups), average cash flows are often misleading. This is because the “average” outcome is highly unlikely; startups either achieve massive growth and succeed or they fail. Searching for frameworks to think about VC investing, I turned to lessons in my entrepreneurial finance course taught by Dean Glenn Hubbard.
We covered the topic of real options, which is a project that offers a choice between different cash-flow paths. In other words, real options allow us to respond to new information. Venture has real options because of staged investments; future venture financing is dependent on milestones. There are three conditions to having real option value:
- Requires initial investment to receive new information.
- Ability to receive new information before a new decision.
- Option to make a new decision based on new information received.
For the left decision tree, when the series A investment does not depend on the milestones following a seed investment, there is no option value, because the VC invests in the A round regardless of the new information received. On the right. the milestones following the seed round presents us new information. We can choose to not invest at the A round if the milestones aren’t met. This is a real option.
Next, we want to estimate the statistical likelihood of making it to the next branch. By adding probabilities to these branches, we can build a binomial decision tree. Determining these probabilities is the challenging part. To do this, we start with a thorough due diligence of the company. Only by understanding the company and the market conditions will we be able to build a binomial decision tree.
We’ll use Veem as an example. Note that I am using publicly available information related to Veem. I have not met with Veem, have no inside information, and this analysis is not a statement on their business.
Product: Veem is a payments startup that enables small businesses to easily send and receive money cross-border. The company uses blockchain as the payment rail, where the senders’ funds is converted into bitcoin, selling the digital currency at an exchange for the receiver’s local currency. This allows Veem to charge small businesses <2% transaction fee. Veem has raised $44.3M in venture financing from notable investors KPCB, GV, and NAB Ventures. The image below shows how Veem works.
Veem offers three methods of sending money, Treasury (bank to bank’s controlled by Veem), SWIFT (existing system to send remit money), and Blockchain (digital ledger). The blockchain method is almost awards preferable to SWIFT because it happens within seconds and Veem can offer transparency in the movement of money. But there are liquidity constraints to transacting with Bitcoin. If there isn’t enough demand on the receiving end of the transaction, it becomes very expensive. In these cases, it’s better to use SWIFT.
Market: Now that we understand the product, let’s look into the market. Veem is servicing small and medium size businesses (SMB), a large and fragmented customer base. Fintech has made great strides in helping large corporations and consumers but little has been done to support SMBs. They have particular needs that can’t be satisfied with consumer tools and often can’t afford the services designed for large corporations.
To gauge the market size, we’ll look into the top MTO, Western Union. Referencing their 2017 annual report, Western Union recorded revenues of $5.4bn, 7% from their business solutions segment, which facilitates cross-border payment and FX solutions for small and medium sized enterprises. This represents $378mm. Western Union owns 13% of the global remittances market (Seeking Alpha). From these numbers, we’d estimate a $3bn target market size, an attractive market to pursue.
Competition: Western Union, MoneyGram and Ria are the incumbents that control the SMB money transfer operators market. There are many fintech startups in the larger C2C and B2C ecosystem, with some notable names moving into the B2B space. In August 2016, TransferWise launched a new platform called “TransferWise for Business,” expanding into B2B services. TransferWise has the tech capability to pose a competitive threat to Veem.
Binomial Decision Tree
The decision tree above had one decision point. In venture capital, there are multiple decision points. Say we invested in the series A round and the company did moderately well, should we invest in the B round? Or should we pass? And what about the C round after that? Each real option has a different set of factors to consider.
Now that we have a grasp on Veem’s business, we’ll build out the decision tree, and estimate the probability of raising the following round. Depending on the venture round, there are different factors to consider. For example, to raise a series B, some important factors are market penetration, product market fit, new features, and management team. I acknowledge these aren’t the only factors to consider in a series A. The list goes on but in the interest of length, we’ll keep it to four variables in each round.
For market penetration, I gave Veem a 70% chance of overcoming the challenges. They’re early movers in the SMB2B payments market and their growth is based on a viral network effects model. However, there are many risks with breaking into unfamiliar emerging markets, hence the 70% probability.
For product market fit, I gave Veem a 80% chance of overcoming the challenges. Their product has tangible and intangible value. It reduces the monetary fee SMBs have to pay by ~2% and it also creates transparency in the transaction process. However, there are some liquidity risks with using Bitcoin as a conversion rail, hence the 80% probability.
A model is only as good as the assumptions it uses so this part is critical. Below is a table summarizing probabilities for each venture rounds.
Taking real options to the next level, our entrepreneurial finance course taught us to use these probabilities to build a binomial decision tree. Binomial diagrams are useful to picture projections and serves as a framework to analyze high-risk situations. As shown below, based on our analysis of Veem and the probabilities we assigned, we’re projecting a 3.2% probability of achieving our desired outcome of an IPO or acquisition, 17% probability the startup remains a going concern, and 79.8% probability it will fail.
Taking it full circle
We should not follow these numbers blindly. 79.8% chance of failure sounds really bad but it’s part of early-stage investing. This framework isn’t intended to dictate your investing decisions. A lot of these variables are hard to quantify, especially for products that are new to the market. But this framework is valuable in following a disciplined due diligence process, making sure you consider all relevant variables and to not be driven by intuition alone. This thought process helps us stay grounded and creates a shield against heuristic biases. At the end of the day, intuition and judgment is important in venture.
In the case of Veem, the SMB cross-border payments space is ripe for disruption, the company is built upon emerging frontier technology, and they’re led by a visionary founder. Given all the hype around blockchain, Veem is one of the few startups who’ve successfully built a business on the blockchain technology. They’re growing very well, with Q4 2017 blockchain-based volume doubling from the previous year. Most importantly, they’re serving small family businesses around the world.