If Warren Buffett Invested in Startups by Dani Forman
Widely considered one of the most successful investors of all time, Warren Buffett attributes much of his success to his disciplined adherence to an investment formula. Primarily a value investor, Buffett sticks to a rigid set of parameters when evaluating investment opportunities. Given his success, it’s not surprising that over the years, so many have tried to emulate his investing style when making decisions about their portfolios. Difficult as this may be when assessing stocks, trying to apply his philosophies when evaluating startup investments is even more challenging.
Startup ventures typically have little or no income, making many of Buffett’s models for evaluating the intrinsic value of a company extremely hard to calculate. Furthermore, startups don’t have track records that can be studied to understand their stability. The result is that startup investors that seek to invest using Buffett’s principles, a.k.a Buffettologists, must rely on some of Buffett’s more qualitative parameters when assessing an early-stage company.
Outlined below are three Warren Buffett-inspired investment tips to help you identify promising startup investment opportunities.
- Invest in a great team
One of Buffett’s core investment principles is investing in a great management team. While this may seem like an objective criterion, Buffett and other industry experts have come up with quantitative factors to gauge the likelihood of success in entrepreneurs. John P. Reese discusses in his book The Guru Investor that Buffett looks for companies with a 10-year average ROE (return on equity) of at least 15%. According to Buffett, this metric is a direct indicator of how capable management is of handling their company’s finances. Anything less is a sign to Buffett to stay clear of that company.
For example, Facebook Inc (NASDAQ:FB), who floated their shares on May 18th, 2014, just hit that magic number of 15% ROE. If they could manage to retain that number over the course of the next few years, they could potentially become a candidate for investment from Warren Buffett.
Investing in serial entrepreneurs is another way to help identify potentially successful startups. According to a study published in the Harvard Business Review, experienced entrepreneurs (failed entrepreneurs included), have a much higher predicted success rate then first time entrepreneurs.
When you invest in a startup, you invest in the company’s management. Finding a company with responsible, experienced leaders meets the Buffett standard for investing in a great team.
- Invest in what you know
Warren Buffett is known for investing in companies with simple businesses models. Companies like The Coca-Cola Co (NYSE:KO), Wal-Mart Stores, Inc. (NYSE:WMT) and Exxon Mobil Corporation (NYSE:XOM) are all great examples of these easy to understand companies from the Buffett portfolio.
This basic Buffett investment strategy has been applied to angel investing and has even been statistically proven to improve ROI in startup investing. The Kauffman Report, which was the largest research report on angel investing, found that investment multiples were twice as high when angels invested in industries that they were familiar with. Expertise in a specific industry helps investors differentiate between the truly remarkable companies from the simply ordinary. Peter Lynch, renowned stock investor and ex-manager of Fidelity’s Magellan Fund, coined the investment mantra “invest in what you know,” to help investors identify undervalued stocks in their industry of expertise.
Investing in companies with simple business models means that it is easy to understand how they will make money, which leads us to our next tip.
- Find companies with recurring revenue
One measurable metric that Buffett requires of all his investments is recurring annual revenue and clear earnings predictability. One sure way for a company to generate recurring revenue is by selling a product that addresses a huge market with perpetual demand. Take razor blades for example. In 1989, Berkshire Hathaway purchased $600 million of preferred stock in Gillette, a leading manufacturer of shaving razors. Gillette was acquired by Procter & Gamble Co (NYSE:PG) in 2005 for $57 billion, valuing Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B)’s stake in Gillette at a humble $4 billion.
Today’s startup/tech equivalent would be software as a service (SaaS) technologies that usually charge their customers based on a monthly subscription fee. Monthly recurring revenue (MRR) is a great way to show potential investors a consistent source of revenue as opposed to relying on large individual sales. As a startup investor, look for companies that can present solid (and simple) business plans that provide clear earnings predictability for the future.
Startup Investment Platforms
While startup investing hasn’t been a typical Buffett investment, it has managed to garner the interest of like-minded “value investors.” Jon Medved is a serial entrepreneur and professed value investor. His latest company, OurCrowd is a platform that provides accredited investors with unprecedented access to investments in innovative technology startups. The investment opportunities available on the OurCrowd platform are all pre-screened by Medved and his team of veteran startup investors and analysts. The platform also offers professionally negotiated deal terms and due diligence summaries to help educate investors and mitigate some of the risk involved in startup investing. OurCrowd is introducing a whole new asset class to value investors and revolutionizing the way people manage their investment portfolios. You can learn more about OurCrowd by visiting OurCrowd.com.