Margin of Safety in Venture Capital

A margin of safety is room for error built into the price an investor pays for an asset to lower the risk that the investor might lose money. In other words, assets are usually quite difficult to price, so you try to pay some amount well below what you think an asset is worth to minimize the impact of various issues that might impact the value of that asset. One potential issue might be in the investor’s analysis of worth (i.e. the investor is wrong), another might be an unforeseeable market event, or a temporary problem specific to the company, etc.

While I was familiar with the margin of safety concept, I hadn’t thought about how it might apply to venture investing, and Klarman’s book sparked my imagination.

Can you fundamentally build a margin of safety into an early stage venture investment? Can you fundamentally be “wrong” about your investment and still turn out alright?

The answer seems to be “sort of,” but it’s quite different than how you do it in the public markets. To figure it out, it’s worth considering price, market, and team as the potential mechanisms.

In the public markets, margin of safety is all about the price you pay for an asset. You’re looking for mispricings in the market due primarily due to irrational downward assessments of other investors — usually places where emotion takes hold and logic gives way. Irrational upward assessments happen too, but those aren’t buying opportunities and value investing is about buying, not shorting.

In the private markets, there may be the same amount of irrational upward assessment as reflected by some valuations that get ahead of themselves, but irrational downward assessment is rarer simply because such an assessment would mean the market thinks a company is not fundable and, without capital, it likely goes out of business. Therefore, it’s difficult for a private company mispriced to the downside to even exist. Even in down rounds at solid companies, there doesn’t seem to be anything near a margin of safety that Klarman or Buffett would expect. Nor do modest valuation negotiations create such a margin of safety for top venture firms that can pull off such negotiations.

We can comfortably say that price as a mechanism for margin of safety in venture doesn’t seem to work.

A bigger market is always better so if we only invest in huge markets, that’s a margin of safety, right? Unfortunately, no.

Bigger markets are usually better, but markets are extremely hard to predict, and it’s even harder to predict what market many startups even really fit into at the early stage. If you had to predict the market for people renting air beds on other people’s floors you probably would have missed the potential for the same platform to rent rooms and, ultimately, change the travel industry.

You might apply Klarman’s idea of conservatively estimating a company’s cash flows and the applicable discount rate in valuing a company as part of a margin of safety but taking a conservative view of what the market may be for a venture investment is arguably even worse than overshooting it because it will probably lead you to miss out on some great opportunities, like Airbnb above.

Market doesn’t seem to be the margin of safety in venture either.

That leaves us with team.

Fundamentally, the point of a margin of safety is to recognize that things are probably not going to go as planned. In a public investment, where value is a constant reflection of supply and demand, you can protect yourself from the unforeseen via price. In a private investment, where shares are illiquid and relationships more important, you can only protect yourself from the unforeseen via the team.

A great team is resourceful, dedicated, persistent, curious, and flexible. Those elements reduce the risk of a negative outcome when things don’t go as planned because a great team adjusts and fights through it. Fighting through a difficult time. Pivoting to something else. Pressing on with a commitment to suffering. Sometimes things go too far off the rails for even a great team to recover, but better to invest in a team that can correct setbacks than an average team that crumbles under even minor deviations.

It’s this reason that all VCs say they invest in team first. They are our margin of safety.

Disclaimer: We actively write about the themes in which we invest: virtual reality, augmented reality, artificial intelligence, and robotics. From time to time, we will write about companies that are in our portfolio. Content on this site including opinions on specific themes in technology, market estimates, and estimates and commentary regarding publicly traded or private companies is not intended for use in making investment decisions. We hold no obligation to update any of our projections. We express no warranties about any estimates or opinions we make.

Related posts:

Navegando na nostalgia, eu me recordo de ter escutado o Bill Kaulitz falando baixo no meu ouvido “I’m starring at a broken door there’s nothing left here anymore. My room is cold It’s making me…

bibit mangga gedong gincu cod Mangga Gedong Gincu, buah mangga yang satu ini banyak dikembangkan di Indramayu, walaupun harganya cukup mahal tetapi banyak dicari oleh banyak orang. Signaturnya adalah…

These kinds of freebies are usually low-cost. Their face value is $15-$50, when most cards are around $25. Since it doesn’t take much for you to enter to receive such a card, it is really worth…