The secrets of investing in early-stage companies

It wasn’t that long ago that if you heard about someone being disruptive, it was viewed as a negative trait. These days, however, disrupters are considered entrepreneurs and idealists who are shaking up established industries. While generally linked to the tech sector, disrupters can be found in most industries. But how do you value them?

This is one topic that was discussed at the November 2019 Future Generation Investment Forum. The Australian Financial Review Chanticleer columnist, James Thomson, sat down with co-founder and partner of Square Peg Capital, Paul Bassat, and chairman and chief investment officer of Cooper Investors, Peter Cooper, to find out their views on the new guard.

Watch the discussion or read the editorialised summary below to find out their thoughts on today’s disrupters, their views on what we can learn from the Westpac fiasco, and which private company has caught Bassat’s interest.

What to look for in a disrupter

Today’s low interest rates are making it trickier to value companies. The rates are unique for the times and a key driver in pushing equity prices higher. Bassat says this situation is not as relevant for the companies he invests in as their growth is not correlated to how the economy is performing.

“The reason why our companies are growing is because they are disrupting large, existing markets and their growth is related to disruption rather than macroeconomic factors per se.”

Cooper agrees asset prices are high but the companies in which he invests have strong latent balance sheets that can take advantage of any price downturns. “Sources of funding structures are also important, so we want to be exposed to those companies with well-diversified sources.”

He adds stock markets around the world have generally been delivering 6% to 8% over the last 15 years; not the 20% experienced over the past 12 months, which is the key number to focus in on. “We are lucky to live in a region where there are lots of opportunities and emerging segments of the market. Even in a stand-still economy there are new growth areas everywhere.”

Lessons for entrepreneurs

While the year started off strongly for technology IPOs, the market’s appetite now appears to be sated. Uber and Lyft, for example, were high-profile listings that are now trading below their issue price. Then in October, WeWork pulled its IPO after failing to find investor support. Is there a lesson in here for entrepreneurs?

Bassat says there is really only one rule for a start-up and that is don’t run out of money. “Over the past 10 years, one thing that has been forgotten is that it has been easy to raise early stage capital. But you want to raise as little as you possibly you can, as late as you possibly can and minimise your dilution, which is hard as entrepreneurs are pathologically optimistic.”

He adds this process works well when everything is going well. But if there’s a macro problem or a challenge with your business, then it can be catastrophic as evidenced in the dot-com crash.

First and foremost, according to Bassat, is ensuring an organisation has substantial cash to continue to grow the business and execute on its plan. “It also needs plenty of time to raise the next round lot of capital in case things get a bit hairy.”

Short-term profitability remains an issue

Discussions around when a company is going to be profitable dominate many investing conversations. But it is one thing that frustrates Bassat. “In every period over the past 20 years, people have said Google and Amazon are overvalued and don’t make money,” he says. “But if you can invest a dollar and it delivers $10 over the next five years, are you really not going to invest that dollar because it’s going to make you unprofitable in the short term?”

The focus on short-term profitability in Australia is a major issue, Bassat says. He believes as a result we are going to see many of our businesses disrupted by global companies who want to come here and build a 50 or a 100-year business.

“Ultimately the metrics of what matters are building strong competitive positions, investing in product, building a competitive moat, and acquiring customers. It also may require some time before that happens.”

Cooper agrees there is an overemphasis on profitability. “One thing that concerns me is the number of US investment banks that are picking up tech stocks and bringing them here. It implies an overvaluation in this market. I like to separate those that are making promises of the future versus those that have real products that can hollow out new future markets.”

He adds, he doesn’t see any point in talking about value versus growth. “The future is about new economies and new services. This doesn’t mean incumbents can’t also reinvent themselves. You don’t need to be a tech company to avail yourself of the new growth area.”

Learning from the Westpac fiasco

A key topic of conversation is the latest happenings around Westpac. The bank is accused of breaching anti-money laundering and counterterrorism finance laws 23 million times. Many companies make mistakes but this is in a different league and perhaps a timely reminder for emerging fintech companies to stay on top of such issues.

On Westpac, Bassat says while there are exceptions, big established Australian companies have never been more threatened by disruption than they are now, especially from global-driven software companies, which are solving issues on a global basis. His grievance is that instead of dealing with this threat, Australia’s big companies are responding by paying out large dividends and seemingly underinvesting in systems and processes.

“The fintech companies have to be worried about risk just as much as the big companies are,” Bassat says. “They have a big advantage in they don’t have legacy systems and architecture but they have the disadvantage in they don’t have the level of resources to invest in these areas in some cases.”

Cooper adds it’s a question of culture and risk. “No matter what type of company you are running, if you don’t have the cultural ethos no amount of regulation and process will solve the risk problem. I think the big issue is that the culture is not correct in these types of companies.”

What companies do they like?

Paul Bassat

Athena: Square Peg Capital invested in this private company for first time 20 months ago and has since invested three more times. It provides home loans at 2.84%, has no fees, and guarantees no front or back-book differentiation where new customers pay less than existing customers. It has also streamlined the application process to around 20 minutes, thus eliminating what has been a high-friction point. While it is early days for the company, it easily beat its first-year target for new loans. It’s not listed at this stage, but Bassat calls its story “extraordinary”.

Peter Cooper

Infratil (IFT): This is best described as private equity in the infrastructure space. It is exposed to great thematics. It has data centres, including a semi-monopoly position with data centres in Canberra, it is invested in Wellington Airport, retirement villages, and its cornerstone area of investment, which continues to grow, is in the renewable energy space in hydro and wind.

Watch the full video here for more detail on these companies.