Tuesday, March 03, 2009

Brad Feld on investment vs. speculation

One of my pet peeves is when people refer to all manner of stock and commodity trading and speculation as "investment" when it is no such thing, so I really appreciated venture capitalist Brad Feld's blog post entitled "Investment vs. Speculation." I mostly agree with him and absolutely agree the we need more attention to investment and less attention on speculation.

My main departure from Brad is that I see investment as not only long-term, but open-ended, whereas speculation can be multi-year but has a target event which will end or "exit" the speculation. Granted, no investment is necessarily "forever and ever", but would normally end only when the "investment thesis" changes or our investment goals change. But with speculation, we may have a price or P/E target in mind upfront that predetermines the decision to end or "exit" the speculation.

In short, in speculation we focus intently on the end or "exit" event, while in true investment we focus on building enterprise value over time, either to achieve dividends on an ongoing basis or to increase market value over time, but with no date or price for "exit" in mind.

In the case of venture capital investment, it is not typically open-ended and usually has a fairly clear end goal or "exit" in mind, such as an IPO or sale of the investment to another business, coupled with a distribution of stock and cash to the investors.

Venture capitalists, as the general partners of venture capital limited partnerships, have a fiduciary duty to satisfy the goals of delivering an "exit" so that the limited partners can cash out both their original investment and profit within some fairly well-defined range of years, typically 5-7 years. Granted, that timeframe is well beyond the tolerance or patience of most stock and commodity speculators, but "real" investors might use that as a minimum rather than a maximum timeframe.

Nonetheless, a venture capital investment is clearly relatively long term compared to speculative activity that we see with stocks and commodities.

Another thing about venture capital investments is that they are inherently "speculative" in nature in the sense of having a high degree of risk that the principle invested in an individual company could be completely lost. Most stock investors would never consider investing in a company that is rated in advance as being at such as high risk of a major decline or even "going to zero." I would still consider venture capital as an investment since there is a fairly high tolerance to short-term adverse events of the sort that would cause a garden-variety stock or commodity speculator to immediately hit a "stop loss" and dump their "investment." Unlike stock and commodity speculators, venture investors typically have a role on the board of directors or some other advisory role such that they can help out to significantly mitigate adverse events. The "package" of high potential return and significant technical and managerial expertise of the venture capital general partners give venture capital an acceptable level of risk for the limited partners and result in it being more of an investment than a speculation.

On the other hand, venture investors do have one quality advantage over stock investors: they have very low tolerance for allowing a company to stagnate for long periods of time and are super-motivated to aggressively push company management to "maximize shareholder value."

All of that said, I am glad to hear that someone else is beating the "investment vs. speculation" drum.

-- Jack Krupansky


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