2009

When I managed a long-short fund and other products that traded in public securities, my conversations with analysts and other investors often revolved around market inefficiencies. Most investors believe that the stock market is highly efficient, meaning that expectations and associated public information are quickly discounted in stock prices. As such, investors tend to ignore obvious information and instead focus on insights and data that are not already widely known by others. It is joked that a trader on the New York Stock Exchange would not stop to pick up a $20 bill if he were to stumble across it on the floor of the exchange. He would reason that the $20 bill could not be real, because a real $20 bill would have been snapped up already by other traders.

The online advertising market is pretty much the opposite of the stock market when it comes to market efficiency. Matching advertisements with reader interest and pricing advertisements are highly inefficient practices. Advertisers often spend far too much money placing advertisements in front of the wrong audience. Think of how many times each day you see a banner ad that is of no interest to you. Furthermore, both advertisers and online publishers use fairly imprecise techniques tools to determine appropriate advertisement prices.

The tremendous inefficiency in the online advertising market is a big reason why we are excited about our MediaMath investment. MediaMath is a demand platform that helps advertising agencies and their brand customers place online display advertisements in front of individuals who are more likely to be interested in those advertisements. In addition, MediaMath helps ad agencies price advertisements effectively, such that an advertiser can know when to pay up because a particular a reader is more likely to purchase an advertised product and when to pay less because a different reader is very unlikely to buy that same advertised product.

In recent years much of the attention around display advertising has centered on advertising exchanges and other market infrastructure. Google has purchased DoubleClick, Yahoo has acquired Right Media, and Microsoft has scooped up AdECN. But the advertising industry has lacked an ability to use these market mechanisms effectively. That’s where MediaMath comes in. It helps ad agencies make sense of display ad markets and bid through ad exchanges intelligently.
MediaMath is led by Joe Zawadzki, who is an extremely smart serial entrepreneur with deep expertise in this space. Joe has assembled an impressive team to not only deliver leading technology solutions but also provide exceptional customer service. We have been talking with Joe for more than a year. Along the way, we have been impressed with his tendency to make smart, mature decisions to manage the company’s rapid growth and position the firm for where the industry is heading.

I think of Joe and the rest of the MediaMath team somewhat like an extremely smart (and ethical) stock market trader that makes great trades and provides outstanding customer service. And what gets me even more excited is the fact that the online display advertising market in which the group operates is the type of inefficient market that stock market traders dream of.

Alan

A lot has been written about the virtues of a capital efficient business model during the past several years.   Capital efficiency became a popular topic when exit valuations dropped significantly from levels that were achieved in the bubble.  Despite the large amount of commentary on capital efficiency, both investors and entrepreneurs tend to focus on pre-money valuation during discussion of the merits of an investment and deal terms.  A look at the math, however, shows that capital efficiency is often more important than pre-money valuation.

First, let me offer an explanation of capital efficiency for the purpose of this exercise.  A capital efficient company is one that needs a relatively small amount of equity and debt in order to achieve attractive revenue and profitability, which in turn drive a good exit for investors.

So, let’s look at two possible scenarios for investors.

Scenario #1:  An investor places $2 million in a Series A financing at a $10 million pre-money valuation.

Scenario #2:   An investor places $5 million in a Series A financing at a $5 million pre-money valuation.  The company performs well and the company raises an additional $5 million at a $20 million pre-money valuation in a Series B financing.

It would appear on the surface that scenario #2 is better than scenario #1 for a Series A investor if one focuses on pre-money valuation.  The pre-money valuation for the Series A investor is much better in scenario #2, and the company is able to raise additional capital at a big valuation step up during the Series B financing.  When one runs the math, however, the outcome actually favors the investor in scenario #1.  Assuming customary Series A terms, the Series A investment in scenario #1 would achieve a 3.3x return at a $25 million exit and a 9.5x return at a $100 million exit.  The Series A investment in scenario #2 would achieve a 2.3x return at a $25 million exit and a 7.8x return at a $100 million exit.  (The Series B investment would perform even worse.)  So, despite the much lower pre-money valuation, the Series A investment in scenario #2 is worse off because the capital needs of the company eat up returns and more than offset the lower valuation.

A capital inefficient company will also hurt founders and other common shareholders.  Let’s compare a situation in which a founder raises $10 million at a $25 million pre-money valuation in a Series A financing to a situation in which a founder raises $2 million at a $5 million valuation.  The $25 million pre-money valuation seems much better, but one would be surprised at the outcome.  In both of these cases, the founder has given away 26% of the company, but the impact of capital intensity goes beyond that.  After going through the the math using customary investment terms, one can see that the founder is left with $64 million at a $100 million exit and $16 million at a $25 million exit if the founder opts for the $2 million raise at a $5 million exit.  Alternatively, the investor is left with $61 million at a $100 million exit and only $8 million at a $25 million exit if the investor opts for the $10 million raise at a $25 million pre-money valuation.

I am not saying that venture investors should accept high pre-money valuations.  Rather, I am pointing out that capital inefficient businesses can be surprisingly unattractive to both investors and entrepreneurs.  Both would do well to discuss and think through the capital needs of a company.

Alan

Welcome to SJF Ventures’ “Web-Enhanced Services” blog. This site will focus on sectors that tap into the power of the Web to connect businesses and consumers, producing an immense set of opportunities to transform old markets and provide real value and, in many cases, to create a positive impact on individuals and the environment. We will report on industry research and trends we observe in this sector, and will sometimes profile interesting companies.

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