Seed Investing in the Stock Market
The Poker Analogy
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The past ~month has been a busy one. We made multiple additions to Coffee Can 13. It is now ~71% allocated. I also finally gave it a name “Eclectic” because this one is built different.
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Seed Investing in the Stock Market
As you know, I am a fan of taking a Venture Capital approach to the Stock Market. And the more I think about this analogy, the more ways in which I feel the venture capital mindset can be applied to the stock market.
Consider risk management as an example: Venture Capital is a risky form of investing (startup failure rates are very high), but Venture Capital is also much less risky than people realize. That’s because VCs have the opportunity to scale into their investments, only when risks have been mitigated.
Venture Capital is a lot like Poker (Texas Hold’em). A seed Investment is like “the ante.” It is like buying an option to “see the cards” and play in the next round. After investing, investors learn in greater detail how the management team operates, they learn the nuances of the market the company is operating in, they observe the strengths and weaknesses of the competition etc. Then at that point, investors can decide whether they want to see "the flop", that is, do they want to pay to see how the company performs in their next phase of growth. The price to see this is usually higher. If they don’t like their cards, they can fold. They can cut their losses. They can preserve their capital and wait for the next deal.
Put another way, VCs initially invest only a small amount of capital (relative to their capital base). In return they expect the startup to reach a particular set of milestones (like development of core infrastructure, product-market fit, a key hire, a certain amount of user growth etc). By doing so, the startup gradually proves its viability. Once a startup hits their intended milestones, this de-risks the investment and as a result, investors can choose to double down with a follow-on financing at a higher price, with new milestones in mind. And the cycle restarts.
We, as stock market investors, can do the same.
Like VCs, we can do so in two ways:
The Equity Method
The Convertible Note Method
The Equity Method
Simply put, when a VC invests in a startup, and they do so in a priced round (as opposed to a convertible note), they are using the Equity Method. They know upfront what percentage of the company they own.
For us, as stock market investors, this is no different than simply buying a stock.
However, I view a stock purchase as a seed investment when the inherent risk in a company is large, but there is some visibility into how such risks will be mitigated. Of course, in return, we are buying ourselves extremely upside potential.
As a result, the percent allocation into such a stock should be low. The goal of the investment is to get early ownership but to continue following the company to see whether it delivers on its potential (and mitigates its risks). If the company is able to reduce the risks inherent in its business model, then we can consider buying a bigger stake in the company.
An investment in Tesla, when it first came public (~$2B) would have been such an investment. As the company started to demonstrate its unmatched competitive advantages, one could have opted to buy more of the company.
Coffee Can 13’s investments in HIMS, EB, GPRO, and DIBS are examples as well.
The Convertible Note Method
A more common way to seed invest is through convertible notes. A Convertible note is debt that the investor can convert into startup equity at a future round of financing (based on a set of agreed up deal terms).
What financial instrument does that remind you of? If you said call options, you’re right!
We can think of call options as convertible debt. Why? Because one call option is a contract that gives the owner the right to buy 100 shares of a stock for a specific price by a certain date. Yes, unlike a convertible note, which may not require additional capital at the time of conversion, an option owner would need to bring new capital to the table, in order to purchase shares.
If you’re new to Options, read my Fun With Options Series:
By doing this, like seed investors, we are managing our investment risk by investing only a small amount of capital (relative to our capital base), and buying time to observe how the investment thesis plays out.
At expiry, there are 2 scenarios:
Scenario 1: At Expiry, Stock Price > Option Strike Price:
If the investment works out before expiration, we as investors then have the choice to either deploy more capital into the stock (by exercising the options) or to sell the options for profit.
If we exercise the options, think of that as buying your “full allocation” into the stock but only after the investment has already proven itself…how cool is that?! Note, this also has the benefit of deferring capital gains taxes because we’re not actually selling anything, we’re simply exercising our options contracts.
Alternatively, if we don’t want to continue to own the stock, we can simply choose to sell the options, and capture our existing profits.
Scenario 2: At Expiry, Stock Price < Option Strike Price:
In this case, at expiration, the options are worthless.
As an investor we have 2 choices:
Since the investment did not prove itself in the time allotted, we can “fold our hand.” We can take a small loss, preserve our capital, and wait for the next investment idea.
Or we can consider buying new options expiring further out into the future. Why? If we still believe the investment thesis, but believe that it just requires a little more time.
In the world of Venture Capital, this can be thought of as a “Bridge Loan”, that is, a loan to the company to give it the additional runway it needs to reach its target milestones.
Disney and Alibaba calls in Coffee Can 13 are examples of the Convertible Note Method at play.
Back To Our Poker Analogy
Ideally, as our hand improves (i.e “the cards get better”), we can increase the bet sizes, putting more money at risk in each “subsequent round of financing.” This is how smart VCs win.
That said, the poker analogy only goes so far in the public markets. For example:
Unlike in poker, if we have a bad hand, we can’t really bluff our way out of that. That said, in the stock market, even a bad investment can sometimes end up making money. Sometimes the world works in strange ways…
In Poker and Venture Capital, we can’t change our minds once we fold. However, in the stock market, we can usually reverse our decisions, if we so choose.
Due to the volatility inherent in auction based pricing in the stock market, we can sometimes acquire stocks for cheaper prices even AFTER the company has mitigated risks in its business.
VCs can impact the cards they’ve got. For example, they can leverage their network to improve the management team. Or by being on the Board, they can influence strategy to change the company trajectory or competitive positioning. In poker that’s not possible. As passive public market investors, this is not possible either. But that’s ok. VCs end up spending a disproportionate amount of time working on their “bad investments” (aka doing Damage Control) compared to their good ones. So spending time to “improve their cards” isn’t always the best ROI.
In Conclusion
Sure the ante is very risky. But if we play our hands right, the subsequent investments are much less risky, and if we can put most of our capital to work in the “later rounds of financing,” then that makes the total portfolio much less risky compared to the upfront ante.
Of course, as public market investors we don't have to “seed invest”, we can simply make much larger bets later in a company’s life, once risks have already been mitigated. That’s a tradeoff. I wrote about that dynamic here: [Link]. To each their own…
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