Wise words from Reid Hoffman

Towards the end of 2008, we wrote: "We continually try to draw people's attention back to the fact that investing is about providing capital to businesses, whether you are investing in common stock or whether you are searching for yield through ownership of bonds, preferreds, or other income securities."

In light of the tremendous importance of seeing yourself as an investor in the role of one who is providing capital to businesses, the above video conversation between three venture capitalists and an "angel investor" contains some useful insights from individuals whose entire work and livelihood centers around the concept of providing capital to businesses.

A venture capitalist provides capital to entrepreneurs or "start-up" companies, typically in exchange for a share in the business. If they provide a million dollars to a start-up, at an agreed-upon valuation for that company of ten million, then they would expect to receive a share of 10% of that company. If that company becomes more and more successful and is later acquired by another company for a hundred million dollars, or sold to the public through an IPO for five hundred million dollars, for example, then the ten percent ownership of the capitalist investor would be worth ten million dollars or fifty million dollars, a tenfold or a fiftyfold increase in this scenario.

An angel investor does the same thing, although usually acting alone using his own personal money, as opposed to the venture capitalist who typically works at a venture capital firm and uses capital pooled together from wealthy investors looking for exponential returns.

An environment in which there are structures and institutions for channeling capital towards entrepreneurial activity is critical for long-term economic success in any country. As McGill University economics professor Reuven Brenner points out in his insightful work The Force of Finance, "countries prosper when better matches are made between capital and talent. And the corollary is also true: they become poorer and fall behind when the two are mismatched, and the mismatches persist" (10).

In America, one of the most dynamic intersections between talent and capital takes place in California's Silicon Valley. There, institutions such as the start-up culture, the venture capital culture, the angel investing culture, the entrepreneurially-focused Stanford Business School, and discussion forums such as the Churchill Club where venture capitalists and entrepreneurs and other members of the community can discuss entrepreneurial topics have created an environment that has made it one of the most fertile entrepreneurial regions in the world's history.

In the above Churchill Club dinner event from March 16 of this year, venture capitalist Jeff Yang of Redpoint Ventures, venture capitalist Matt Murphy of Kleiner Perkins Caufield & Byers, angel investor Reid Hoffman (founding CEO of Linked-In), and venture capitalist Jay Hoag of Technology Crossover Ventures discuss "Trends and Strategies 2009."

The entire clip is over an hour and a half long, but Reid Hoffman makes a very important point for all investors at about fifteen minutes and twelve seconds into the video (slide the progress bar to 0:15:12).

He says: "I think one of the things that's always interesting in these conversations is: We're actually all in the business of -- and differentially -- but all in the business of longer time-frames. So, you know, one of the things that I was mulling about with a few early-stage venture guys about a year ago was that my average number of years to liquidity as an angel investor is about seven, right? That's seven years out in the future from where you are now. And so, overly predicting based on what the market is this year for what's going to be going on in seven years strikes me as something of a fool's game. [. . .] I actually think that the current market has very little to do with what you're planning on other than intermediate rounds of capital, and questions of appropriate valuation."

This strikes us as a very important point at this juncture in time, when investors are still reeling from a bear market plunge unlike any in the past sixty years, and at a time when brokerage firms and other members of the financial industry are cranking up their advertising with offers of investment strategies calculated to sound soothing and attractive to people in a state of maximum fear and confusion.

Instead of rushing into guaranteed products, or "diversifying" into commodities (which, incredibly, some advertisements are offering as a wise "non-correlated asset," less than a year after the commodities index plunged 47% in nine months), investors would be wise to consider themselves as being in the business of making "better matches between capital and talent," in the words of Professor Brenner.

They would also be wise to consider, in the words of Reid Hoffman, their "number of years to liquidity" -- how long they are allocating capital to those businesses -- and if the number is less than seven, they may want to reconsider their time horizons (for more on that topic, see the Taylor Frigon commentary, "What Hasty Investors Could Learn from an Ent").

We would strongly agree with Mr. Hoffman that "overly predicting based on what the market is this year for what's going to be going on in seven years" is something of a fool's game. Instead, investors should adopt more of the mindset of a benevolent capitalist, searching for innovation and maintaining a flint-like business focus. Doing so is the best prescription for investors going forward.

For later posts dealing with this same subject, see also:

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