After 17 years in M&A, Derivatives and Trading, I'm spending my time with young entrepreneurs in and around financial technology and digital media.... Read more »

April 05, 2010

Going Old School

I am frequently reminded that as much as technology has changed our world, the core principles of human communication have largely remained the same.

I was reminded of this today when a mentor, a person whom I respect a great deal who has a wealth of business and life experience, served notice that I really needed to take a "deep breath" before sending out an email that reflected my frustration with a particular negotiation. It wasn't that my email was hostile or inappropriate, but it was tonally not the message I really wanted to send. I let my emotions get the better of me. And while I truly am conscious of this issue, and constantly think that "anything I write anywhere could end up on the front page of the Wall Street Journal," his point was more subtle. Need I be ashamed of my note? Not at all. Did the note best reflect what I wanted to convey to the recipient? Probably not.

Today's email and texting culture has created artificial distance between the message and the medium. It is much easier to rip off a "poison pen" email than to speak those words to someone's face, and it is even easier than writing a letter and dropping it in the mail. Hitting send isn't much of a challenge and doesn't afford much time for reflection. At least with a letter you need to physically write it, put it in the envelope, stamp it, and walk it to the mailbox. Thought and reflection can enter at any time during this process, causing the sender to perhaps reconsider their action. The email sender has no such delayed gratification. From one's brain to one's fingers and off it goes. And sometimes the visceral reaction after sending such an ill-advised note is "whoops!" Too late...

I have also been reminded that physical relationships matter. Really, really matter. Technology is a great enabler, permitting tasks to be completed much more quickly and with much better information than in the past. But to sell, to convince people that new technologies are actually far superior than their current tool kit, requires skilled human communication. Relationship-building. Trust. Empathy. It doesn't really matter how great a product is if the buyer doesn't give it the time and attention necessary to make a decision. Why does the buyer give it the time needed? Because of the person doing the selling. If anything, relationships have become even more important in the information age, as it has become a key competitive advantage relative to those who have never developed the skill to sell effectively face-to-face. It is a different paradigm, yet one that has been around for hundreds of years. All this technology is causing certain of our skills to either atrophy or go undeveloped, to the detriment buyers and sellers alike.

Thoughtful communication and effective human interaction. Basic stuff, no? Not anymore.

April 01, 2010

IA Ventures Office Hours - getting our game on

While our little firm is still very young, we have been taking note of some of the best practices of our highly-respected brethren. One of those best practices, particularly among firms that do true seed-stage investing, is office hours. And we have finally scheduled our inaugural office hours time slot, from 9:30am-12:30pm on April 15th at TBSP, 17 West 20th Street. We have set up a Google Spreadsheet for this purpose which can be accessed here.

We intend to hold office hours every 2-4 weeks, initially with 30 minute time slots for each entrepreneur / team. If we need to recalibrate our approach, we will. Our goal is to get even closer to the start-up community, with the hope of building a reputation as the "go to" firm in NYC and elsewhere for seed stage, data-intensive and data infrastructure start-ups. This is a big goal and we've got a long way to go, but I've been pleased with the support and interest from established VCs and entrepreneurs alike who serve as sources of deal flow.

The bottom line is that you want to work with a firm and with people whom you like, trust, respect and believe can really help your company build its business and commercialize its technology. IA Ventures aspires to be this kind of firm. And by holding office hours and providing feedback and input to entrepreneurs in our areas of focus, regardless of whether or not we invest, we hope to contribute to the budding NYC venture ecosystem and to give back at least as much as we get from being a participant.

March 13, 2010

It's time to end the FASB (and shake up the SEC)

Recent "revelations" concerning the Lehman debacle highlighted a very important point: media and regulators alike have had their heads in the sand for decades. The headline of a recent New York Times article plainly makes the point: "Findings on Lehman Take Even Experts by Surprise." If this is really true, it is quite an indictment on either the lack of intelligence or truthfulness of our regulators. Sadly, either one could be the case.

Between lobbying dollars and entrenched interests, our financial regulatory regimes have become so perverted as to have little basis in reality. I recently penned an Op-Ed in the Financial Times where I made the point that all the clamor and criticism around derivatives was ill-founded, that financial transactions completely divorced from derivatives could and have caused even more damage than derivatives themselves. The Lehman example is a case in point. This is not a story about derivatives, no more than Enron was a story about derivatives. But the key take-away should be that if our rules and regulations are so porous as to allow transactions like Lehman's to gain approval from their "blue chip" legal counsel and expensive "Big Four" accountants, then there is a serious problem with the state of our regulatory framework.

The SEC is a highly politicized organization and the Financial Accounting Standards Board (FASB) is a kind of self-regulatory organization that is ultimately a stooge of industry. Consider this, taken directly from the FASB website (bolding my own):

Since 1973, the Financial Accounting Standards Board (FASB) has been the designated organization in the private sector for establishing standards of financial accounting. Those standards govern the preparation of financial statements. They are officially recognized as authoritative by the Securities and Exchange Commission (SEC) (Financial Reporting Release No. 1, Section 101, and reaffirmed in its April 2003 Policy Statement) and the American Institute of Certified Public Accountants (Rule 203, Rules of Professional Conduct, as amended May 1973 and May 1979). Such standards are important to the efficient functioning of the economy because investors, creditors, auditors, and others rely on credible, transparent, and comparable financial information.

The SEC has statutory authority to establish financial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934. Throughout its history, however, the Commission’s policy has been to rely on the private sector for this function to the extent that the private sector demonstrates ability to fulfill the responsibility in the public interest.

Do we need any more examples of the private sector's inability "to fulfill the responsibility of public interest?" I think not. The FASB has accumulated exceptional power and influence over the years, yet has merely served as an appendage of those whom it was supposed to be regulating. Consider further these points made on the FASB website:

To accomplish its mission, the FASB acts to:

  • Improve the usefulness of financial reporting by focusing on the primary characteristics of relevance and reliability and on the qualities of comparability and consistency;

  • Keep standards current to reflect changes in methods of doing business and changes in the economic environment;
     
  • Consider promptly any significant areas of deficiency in financial reporting that might be addressed through the standard-setting process;

  • Promote the international convergence of accounting standards concurrent with improving the quality of financial reporting; and
     
  • Improve the common understanding of the nature and purposes of information contained in financial reports.

Has the FASB really acted to improve usefulness, kept standards current, considered promptly any significant areas of deficiency and improved common understanding? It is pretty clear that they've broken almost every one of their stated precepts, and the SEC has been complicit in allowing this charade to continue. Someone has to call these people out and demand a change. And I am calling for nothing less than a complete de-certification of FASB and the creation of a new group of practitioners that have no linkage to industry whatsoever. Because we can't continue with a regime that is so clearly biased and ineffective, and which has been instrumental in permitting the spate of financial "revelations" to continue apace. I think this group needs to be a mix of accounting practitioners and theorists, with the practitioners coming from the ranks of those who have gamed the system for years. Because they know best how to plug the holes that they themselves marched through for the benefit of their firms and their firm's clients. It is akin to taking an accomplished hacker and putting them in charge of an NSA Tiger Team focused on preventing network intrusion. Who better than those who have beaten the system to fix the system?

I ultimately think this group should be part of the SEC, but that the SEC itself needs to be re-tooled. Lifelong politicos need not apply. It also needs to be staffed by practitioners who are pragmatic and beyond the influence of lobbyists and the like. They can have no conflicts with legacy firms through shareholdings or contractual relationships. The last thing we need is another Geithner/Paulson replay where their integrity and judgment is questioned at every turn because of ties to prior firms. We need people who really understand the markets and view such a position as an opportunity to impose ground-breaking change and to create a legacy of common sense, pragmatism and integrity. It would a refreshing change to the political morass that the SEC has become.

I have written many posts about changes to improve transparency, efficiency and fairness in both regulatory and accounting rule-making, but here are five issues (plus a bonus issue) I'd like to see changed - tomorrow.

1. End off-balance sheet transactions. If the substance of a transaction is a sale with all the risks and rewards of ownership transferred to another party, then take the asset and related liabilities off the balance sheet. But if there is some risk retention, even if it is structured to be "remote" (e.g., a sharp ratings downgrade; you see where that got firms like Citigroup, etc.), the assets and liabilities need to remain on-balance sheet. This would also end the use of securitization as a vehicle for improving balance sheet presntation. Debt is debt, regardless of where the obligation is housed. This covers the "Lehman type" transactions as well as those entered into by Enron and myriad municipalities. Substance over form must rule.

2. Impose mark-to-market accounting on bank balance sheets based upon asset funding. Financial assets should be marked-to-market. This has been a hotly contested issue for reasons that baffle me. Bottom line: if a financial firm does not have the financing in place to carry an asset to term, then it has to be marked-to-market. Mortgages and illiquid investments funded with short-term liabilities should not be able to be carried at cost. It creates an accounting charade that hits at precisely the worst time - when financing is hard to get and the assets are unable to be sold. But if stable financing is in place and the asset can (and is intended to) be carried for the long-term, then by all means reflect it at historical cost (less a haircut for permanent impairment).

3. Move over-the-counter derivatives transactions to exchanges. This is black-and-white; the fact that there are detractors to this shift amazes me. The focus should be on standardizing derivative instruments (interest rate and foreign exchange swaps and options, credit default swaps and options, etc.) and making the use of over-the-counter derivatives prohibitively expensive through capital requirements. The OTC clearing house approach would include posting of initial and variation margin, with margin thresholds that are routinely changed based upon changes in the volatility of the hedged instrument. We have the technology and the math to be able to do this. We should move towards this regime change immediately.

4. Create a cap on derivatives to be written equal to the physical underlying. A big part of dislocations in the credit derivatives market relates to the derivatives written being a multiple of the underlying asset. It theoretically and practically makes no sense that, for example, $5 billion of credit derivatives should be written on a $1 billion bond issue. This can create both increased volatility and increased risk of market failure upon settlement. This cap should be an immutable fixture of the derivatives markets.

5. Enact common sense rules regarding the capital structure of financial institutions. The suggested changes above will help better define the true liabilities of financial firms. But the one missing piece is the mismatch between the assets and liabilities of many firms, creating massive gaps in both interest rate and liquidity risks that have consistently brought down firms for generations. Whether "riding the yield curve" (lending long/borrowing short) and bleeding cash/draining capital when short rates spike (thousands of S&Ls in the 1980s), or getting into a liquidity crunch when asset values decline and short-term funding sources dry up (Bear Stearns, Lehman, etc.), this is a dangerous practice that has to be stopped. Maximum liquidity gaps need to be imposed, as well as policies around "Too Big to Fail" (TBTF - the source of a future post). These policies along will substantially enhance the stability of our financial sector, and create a more sustainable (though less profitable) industry.

Bonus issue: Eliminate the flawed financial presentation of leasing. This is related to (1) above. The hard-rules differentiating between operating (off-balance sheet) and capital (on-balance sheet) leases has created a multi-billion dollar industry more focused on accounting presentation than economic efficiency. If the substance of a lease is really a loan, then both the asset and the associated liabilities should be on the balance sheet. The threshold of what constitutes a "capital lease" (booking the asset and liability) should be sharply reduced to prevent transactions that fundamentally give rise to a debt-like obligation to be treated merely as a lease payment.

This is intended to be the start of a conversation, but one which is important and cannot be pushed aside or politicized any longer. The safety and stability of our financial system depends on it.

ADDENDUM

In the wake of my post, I just had an email exchange with the Director of Communications of the Financial Accounting Foundation/Financial Accounting Standards Board. I am posting the exact exchange below. I find his inquiry both interesting and depressing, as he is focusing on quite possibly the least important part of the issue at hand and avoiding the substantive parts (because there really aren't many good arguments against the substantive parts, I guess). He wants me to say "I made a factual error" because the rules for off-balance sheet accounting were changed last year, and I put it on my laundry list of things that need to be remedied. My intention was to raise awareness of the issue as most people don't read new FAS releases. However, if my characterization was misleading to my readers my apologies. And apologies to the FASB if I didn't give them credit for something that was done last year that should have been done more than a decade before. Anyway, here is the exchange:

FASB: Your credibility as an opinion columnist would be greatly helped if you did your homework before writing. Off balance sheet transactions were largely ended last year by the FASB under FAS 166/167. This was the number one complaint you voiced about the organization. The new rules were BIG news--they got lots of national news coverage that continues. I guess you missed it.

Roger: Your organization would have far more credibility if it was forward-looking and principles-based, not merely reactive in the face of withering public pressure. I am quite aware of FASB's changes. My article extends far beyond your single point, and is an indictment of the way the body itself functions and its self-regulatory nature. The FASB is no better than the rating agencies, Neal. I appreciate your position and motivation to defend it but as a Wall Street practitioner for almost 20 years I have a pretty good idea of FASB's past, present and (likely) future if it is not forced to change. It has not covered itself in glory.

FASB: Yes, your article does extend beyond a single point. And I defended nothing else except the fact that one of your article’s key points—is wrong and misleading. You blew it in terms of what you told your readers about off-balance sheet transactions. It would be nice if you admitted it.

Roger: It's not inaccurate. You are interpreting "keeping standards current" as being what FASB changed last year. That is like calling the fire department after the barn has burned down. Had FASB been keeping current, it would be seen these types of transactions being promulgated (and they started well more than a decade ago; I touched the structured product world from 1987-2001) and changed the rules in anticipation of abuse, before something catastrophic happened. That is not what happened. I stand by my opinion and believe it to be factually correct in all respects.

FASB: You wrote about rules that you would like to see changed tomorrow. The first one was “end off-balance sheet transactions.” They were ended last summer. Can you give me a small break here?. That’s wrong Roger. You’re making the case in your piece that they should be ended. And they already were months ago. That’s like writing a column now that George Bush should not be re-elected. It’s just my two cents, but your readers would probably appreciate it if you admitted a mea culpa on that. I’m not asking you to change your opinion about us. Just pointing out a big mistake you made.

Roger: It's not really a mea culpa - my blog is designed to raise broad awareness of issues, and that is what I did. That said, I never want to be accused of being anything less than forthright, and if my prose lacked clarity I am more than willing to make the clarification.

So readers, consider the issue clarified.

March 10, 2010

IA Venture Strategies - now on the Web

While I have written a bit about my new fund, we have not had a web presence - until now. Please check out the new website. You will learn more about our mission, investment approach and the team. We still don't have much on the portfolio page as several of our companies are still in stealth mode, but what I can say is that we've already closed deals or have signed term sheets with companies in the realms of predictive analytics, database systems, intrusion detection and advertising technology. We are currently pursuing deals in cloud-based data distribution, data normalization and an array of related domains. Our portfolio companies are based in New York, Boston, Los Angeles - and soon to include San Francisco and London. I continue to be shocked by the amount of high-quality global deal flow across the big data realm, and as long as we see strong seed-stage deals being led by super smart, experienced and passionate entrepreneurs with vision, we will continue to deploy capital at a healthy pace.

The team is still pretty frantic closing the fund, investing in and working with our companies and just generally figuring out how to best run a fund of our size and scope. The work is virtually endless, but it is the best kind of work there is. We are working towards setting up office hours, but are not quite there yet. We also have lots of job opportunities at our companies, but that utility is not yet active on the site. My colleagues Ben Siscovick and Brad Gillespie agreed that we should have a bias towards action, getting the site up and out there even though it is a work in progress. We'd love your feedback and suggestions as we are new at this and want the site to be useful and informative for entrepreneurs, venture capitalists and media alike.

Hopefully the site helps clarify some questions about the fund, and will serve as a reference point for those considering a raise from big data domain experts who roll up their sleeves and have strategic Limited Partners who do the same. Having a baked-in set of relationships with top firms with big data problems is pretty unique among venture funds, especially one as small as ours. But creating this big data ecosystem was an essential part of my strategy to help solve the generational problems arising from the onslaught of data and information. We are in the early-innings of what is likely to be an extra-innings contest, and Ben, Brad and I are laser focused on helping to be part of the solution to these seemingly intractable problems.

Please continue to check back as we make improvements to our site and grow our business. I will also keep you posted on this blog and at @infoarbitrage as well. I will likely write one more post about the fund and its LPs after I do a final closing, but for now let me say that starting a fund has been among the most satisfying things I have ever done. And it helps having two great partners like Ben and Brad helping to make our vision of improving the management and extraction of value from big data a reality.

March 05, 2010

A new model for investing in "social"

I had the pleasure of sitting on a panel last night sponsored by GoodCompany Ventures, a very interesting shop that helps entrepreneurs with a "social investing" (but not necessarily a non-profit) mission get their start with advice, mentoring, and sometimes capital. I sat on the panel with some outstanding thinkers including Jacquie Novogratz (Acumen Fund), Fred Wilson (USV), Jacob Gray (Murex Investments) and Scott Edward Anderson (The Green Skeptic). I had never spoken on the topic of "social investing" before and, quite frankly, didn't exactly know what it meant except I that generally thought of the term as pejorative from an investment perspective. Social investing? This means not really generating attractive returns, right? Well, after last night's discussion and thoughts that came to me on-the-fly during the debate I have a very different perspective on what this burgeoning asset class really means, and how it has the potential to change the world in an array of positive ways.

First of all "social investing" is a really dumb term. If you're going after conventional for-profit investors the social moniker will kill the pitch every single time. Fred Wilson raised an interesting point about the difference between short-term and long-term profit maximization. He is personally willing to take the long view on building an attractive, sustainable business even if its goal isn't maximization of short-term profits (read: Etsy). And, in fact, he cites personal examples of companies that have been short-term profit maximizers that flamed out because of unhealthy business practices. But I think the issue is more fundamental than that. Many of the companies being incubated by GoodCompany or funded by Jacquie's Acumen Fund wouldn't make the grade even on the terms Fred laid out. It's not strictly a short-term/long-term issue. It's an issue of how you define capital and return.  

My hypothesis is that we need a whole new regime for quantifying the value of businesses that have goals other than strictly financial profit. We need hard numbers - real metrics - to demonstrate the value of initiatives that create value for society beyond the payment of staff and the generation of profits for shareholders. For instance, Jacquie brought up the example of a company Acumen funded that provides treated mosquito netting for families in Africa. These nets provide people from getting malaria, saving enormous amounts of money on acute health care and work time lost, while insuring economic productivity among the youth for their lifetimes that otherwise could have been cut short by infection and disease. These benefits are able to be quantified: we have the economic data to do the crunching, and the econometric modeling techniques at our disposal to quantify the ROI of these investments. But the "R" - the return - isn't simply financial profit: it's economic utility, real benefits being enjoyed by society. These are the terms we should be used to define the benefits of this kind of investing - this asset class - which really does need to be viewed as an asset class separate and distinct from businesses principally focused on financial returns.

So if the appropriate measure is economic utility (which encompasses both financial and social profits), how should these businesses and initiatives be funded? I would argue that it should tap into capital from two key sources: Government and funds that have traditionally gone toward conventional philanthropy. Fishing around in the traditional for-profit pond is a waste of time: utility in this sphere is generally uni-dimensional - profits first and last. Let's be honest. Investing in this asset class has the potential to generate traditional financial returns, but they are tenuous. And if this is the benchmark by which capital is allocated among projects, many critical projects will go unfunded because the measure is wrong. So if we can all shed the stigma of "social investing" and acknowledge that you can still "invest" and "do philanthropy" at the same time, I think it would go a long way towards improving the messaging of this vitally important asset class. I see this approach as addressing the capital allocation problem among philanthropies. By taking a disciplined, numbers-based approach to quantifying cumulative benefits, it will become increasingly clear which businesses with a social mission should attract investment capital and which should not. It will no longer simply be a marketing issue, but one grounded in logic and reason. Will some projects go unfunded that would otherwise have attracted capital because of its PR? Yes. But will many more important projects get done that otherwise would have gone unnoticed because they might have a low Q score but massive economic utility? For sure.

These are only my initial thoughts on this topic. I will definitely be applying more mental cycles to these incredibly important issues. I'm looking forward to both stimulating and participating in this critical dialogue.

February 27, 2010

Does being a VC mean "trying to change the world?"

My friend Chris Dixon just wrote an interesting post titled It's not East Coast vs West Coast, it's about making more places like the Valley. It is very interesting and provocative, and as with all Chris's posts, it's a must-read. However, it honestly rubbed me the wrong way and prompted me to write the following comment:

Chris, I think it comes down to what being a VC really means. You seem to equate the VC mission with "making things that change the world." I believe this is a narrow and potentially dangerous definition, and actually highlights one of the biggest problems with the Silicon Valley venture scene. It also, in my experience, doesn't reflect the true dynamics of how large-scale West Coast VC works, which is a lot less sexy and entrepreneur-friendly than you indicate.

Should a good VC be working to fund ideas that change the world? Yes. Should they also be looking to back young companies working on important problems that are, say, built on top of something else and very useful but not transformational? I'd say so. There are lots of start-ups of value that will never be the next Google, Twitter, Microsoft or Apple, but that doesn't mean they shouldn't be funded and nurtured as any start-up should. If one were to apply the "change the world" mission to venture investing, the amount of capital being invested in such companies (or even that should be invested in such companies) is probably less than 20%. To me the key is making sure that those 20% or so get the requisite support and time to thrive from their venture backers, which is the much bigger issue at hand.

I'd like to think that I back worthwhile start-ups and am very entrepreneur-friendly without all that negative financial engineering you ascribe to certain East Coast VCs, but do most of my portfolio companies have a chance to change the world? Not in the way I define changing the world. And personally, I'm ok with this. I'm helping to create useful products, create jobs, and foster entrepreneurial excitement and possibilities. This is what venture investing means to me.

As it relates to large West Coast VCs, many of these firms are structurally bound to trying to change the world because they need those kinds of wins to return their funds. This doesn't make them paragons of virtue; it makes them rational. But buying this series of far out-of-the-money call options has an ugly dark side as well: if companies don't appear to have the potential to change the world (read: sell for $1 billion+, go public, etc.), they often get squashed and orphaned since they are no longer worth the VCs time. Now I'm painting with a broad brush here but you get the point. Does this dynamic help create a favorable entrepreneurial culture? Is this approach really making the world a better place? Not to me. Plenty of companies that would have made it on the East Coast will fail on the West Coast precisely because of the need to hit home runs to the exclusions of singles, doubles and triples.

Chris, I certainly agree that those investors who are heavily focused on metrics and traction are noxious and ill-placed as seed stage investors (they are really Series B, C and D investors). However, I would say that entrepreneurs who combine vision with pragmatism are more attractive to me than entrepreneurs who simply have vision. Might this pragmatism keep the starry-eyed entrepreneur from changing the world, and only building a really large, successful company? Yes. Is this necessarily an indictment on the NY VC reputation of wanting to understand plans for commercialization even in pre-revenue companies? I don't think so.

Thanks for penning this, Chris. You've raised some really important points that warrant discussion.

Roger

These were my $.02. I'd be interested in your thoughts, too.

February 23, 2010

Advice for CTO Founders: Don't Let Business Kill the Business

Founding a technology company is an amazing thing. I have met dozens of brilliant technologists with fantastic ideas, ideas requiring nurturing, mentoring and support. Too often, however, I have found CTO / Founders paired with business people who not only don't add value, but frequently detract from the value of the business. And from my perspective as an engaged seed stage venture investor, this makes them unfundable. This is not only sad but incredibly frustrating, because it is so easy to see how a great technology can be developed and commercialized if only - if only the CTO hadn't been impulsive and insecure and brought on a business partner too early in the game.

I am a business person, not a technologist. While I know I can add value, I also know when and how I can add value. It is generally a soft touch at the beginning of the development process, perhaps identifying 1-2 early alpha/beta customers to help flesh out use cases to be built upon over time. It is gently laying the foundation for a subsequent financing, helping the CTO set sensible milestones to be achieved that can demonstrate execution skill and release cycle management. It is helping with recruiting by leveraging my networks and experience in a particular domain. And it is most certainly not about me, it is about the CTO, the technology and the company. But I am doing this from the vantage point of an investor / Board member, not an operating executive. Because early in a technology company's life, a true operating executive is NOT what the company needs. In fact, they generally just get in the way.

So why do inexperienced (as entrepreneurs), ultra-skilled CTOs fall into the trap of engaging a business partner too early? Fear? Lack of confidence? Camaraderie? Perhaps all of the above. Many CTOs I know are not that comfortable with the business end of business, directly engaging with customers, speaking with investors and managing business operations. These weaknesses can be addressed in a variety of ways, ranging from engaging part-time, outsourced help to bringing on experienced advisors to help out early in the company's life. These are not revolutionary suggestions, just not necessarily those acted upon by first-time CTO / entrepreneurs. Selecting value-added angel investors and advisors can also help with the camaraderie issue, as they can provide advice and counsel during the solitary period of hard-core coding and product development. A full-time business partner is definitely not required at this point in the company's life.

But sometimes, too often, the CTO falls back on hiring a friend or someone to whom they were introduced that sells them on their value-added. They might give them too much stock, and even have that stock not subject to vesting provisions. And if this business partnership doesn't work out, the CTO / Founder, the engine of value for the company, is stuck in a bad, bad place. Fire the business partner, and the stock they've granted is off the table, stock which is needed to attract and retain talent that can actually help build value and sustainability of the business. Keep the business partner, and the business itself might be rendered unfundable, because quality investors will not put money into a venture with a weak business partner in conflict with the founder. Try to get the founder to negotiate a reasonable exit for the business partner, and this can take years off the founder's life. By the time this point has been reached, the focus has ceased to be the technology and the product, but on organization. And this is one thing that should NOT be the focus of the CTO / Founder during the company's development phase.

So my advice to CTO / Founders? JUST SAY NO TO BUSINESS PARTNERS BEFORE YOU HAVE A REAL PRODUCT THAT IS READY FOR PRIME TIME. And for gosh sakes, spend the time to find the right one. You've spent your entire career working towards this moment. Give it the justice it deserves and don't act impulsively when seeking to address business needs. Your technology brains got you this far; use some of them to make yourself stop, breathe and think. Seek advice from a mentor. Solicit trusted advisors help with interviewing. And if you do feel you've found the right person, by all means make their stock contain standard vesting provisions to guard against a bad fit that takes significant amounts of stock off the cap table.

I don't want to see any more of you with crappy business guys ruining your great ideas, ok?

February 22, 2010

Are Derivatives the Real Problem?

This piece was published in FT.com earlier today...

Regulators, Congress, and the media generally focus on the crisis at hand. The Enron scandal gave us Sarbox. The market crash has created a PR flurry against “sponsored access” and proprietary trading. AIG generated a firestorm surrounding the use of credit derivatives. The common thread is that policy-makers are reactive and missing the big picture, leading to short-termism and a host of poorly constructed rules and policies. And invariably the word “derivatives” is used as a lightening rod for why new regulations should be promulgated. The problem, however, isn’t exclusive to derivatives; it’s the underlying “business purpose” of transactions. Hedging has a legitimate business purpose. Making markets, speculation, and financing projects have solid business foundations as well. But entering into transactions that serve to hide or obfuscate economic reality work against this principle. And this lack of business purpose is not confined to the derivatives markets, but frequently takes place in the cash markets as well.

Consider leasing, a transaction that has been popular for over 50 years. As the industry has evolved, transactions such as sale/leasebacks and “asset defeasance” have been used to synthetically borrow money without the obligation being reflected as debt on the balance sheet. The form of the transaction: a lease. The substance of the transaction: a borrowing.  The multi-trillion dollar securitization industry has the same motivation: moving assets (and liabilities) off the balance sheet, while economic recourse still exists should asset values and/or debt ratings drop. This is what the market discovered when Citigroup’s multi-billion structured investment vehicles (SIVs) began to fail and the assets and liabilities came back onto its financial statements. What is the proper characterization of a contractually obligated stream of payments? Debt. How should a portfolio of assets and associated liabilities be treated if the risks and rewards of ownership haven’t been completely transferred? As never having left the balance sheet. Yet the accounting profession, with the SEC’s support, has enabled this charade to continue.

Derivatives have also been used to achieve similar ends. Structured transactions have been designed to generate upfront cash without a corresponding obligation being recorded on the financial statements. The recent discovery of Greece’s use of these instruments has shined a light on the dangers of hidden borrowings. Municipalities have mortgaged their futures by selling strips of participations in cash flow generating assets (roads, bridges, airports, etc.) in order to generate liquidity today (at a steep cost to financial solvency tomorrow). The virtually unbounded rise of the credit derivatives industry is partly due to the mismatch between the notional value of derivatives being written and the actual value of underlying instruments. This mismatch can be 5x or more of the bonds being “hedged,” leading to market failures when physical delivery is demanded from counterparties lacking actual ownership (or the ability to borrow the position). Neither of these examples embody true business purpose.

Both cash-market and derivative instruments should be put to the “business purpose” test. Accounting rule-makers, with support of the SEC, should move towards a “principles-based” system where common sense, and not black-and-white rules around which myriad loopholes can be found, should become the new paradigm. But let’s be clear. The issue isn’t derivatives; it’s all financial transactions whose objective is to deceive or to weaken financial transparency.

January 30, 2010

IA Venture Strategies - Working to Build a Better Venture Mouse-trap

As was ably covered by Dan Primack in PEHub, I am starting a new venture fund. However, as my friends and venture colleagues know, I am extremely down on what the venture industry has become. To be clear, it is less an issue of structure (management + incentive fees in a GP/LP structure) and more an issue of size. It is clear to understand how motivations get skewed when venture firms effectively become asset managers, where the management fees alone are sufficient to make the partners rich and investments must become increasingly large and non-venture like. Growth capital is not venture capital in my parlance. Venture capital means funding "ventures" - taking on early-stage risk - and actively helping companies execute their plans and achieve their potential. I have a theory that the largest a true venture fund can be, which means, having a seed-stage investment charter together with a "life cycle" approach to investing (leaning into winners, deploying larger amounts of capital in Series A and B rounds, if necessary) is around $300 million. But I digress...

I decided to start my fund after determining that many of the deals I was seeing were both strategic and thematic, strategic to my trading company and thematic in that they all had a common thread - helping to manage and extract value from massive, often real-time data sets - "big data" in jargon. Rather than prosecute them as an angel, I felt a fund structure would better enable me to "size up" in particular deals and to cast a wider net across the big data domain. I wanted the fund to be small ($25 million stated goal, but with the ability to go a little higher) and I wanted it to be different than most venture funds I know, who have raised money largely from pension funds and endowments. I really wanted the fund to be an extension of my activities as an angel, where I frequently build syndicates of value-added angels and select venture firms to help de-risk the portfolio companies and create a network effect across a particular domain. This approach has helped me win deals from conventional venture firms that couldn't (or wouldn't) bring such a syndicate to the table and generally had terms that were more oppressive than those I offered (less about valuation, more about participation and specific protective provisions). So how to create a fund that achieved my value-added investor objectives and offered the network effects I was seeking...

My answer was to raise money from "non-traditional" investors, e.g., strategic firms and individuals with knowledge of and deep interest in the big data domain, focusing on verticals with particularly acute data problems. Further, my explicit goal was to bring such strategic LPs to the table as part of a "big data ecosystem" I am creating among my Limited Partners, my venture portfolio companies, my trading company, and leading academics and thinkers in the field. Big data problems are, by their nature, big, and substantially benefit from collaboration across a wide array of domains. For instance, this is why there are several open-source database projects currently in operation, because the problems are growing at such a rapid rate and are so complex that discrete teams are often not best equipped to tackle the issues at hand.

So investor engagement, and not just money, is a ticket to play in this game. Funny thing is, they want engagement. They know that the value of the insights on the edge can impact their operating businesses to a far greater extent than any normal investment they could make. Their early involvement can also help to "de-risk" the portfolio companies, giving them early access to real customers with a strong motive to help out. My trading company also acts as a strategic partner, helping to evaluate the technologies of these big data opportunities and, on occasion, to become an early customer as well. Also, the LPs are excited about the network effects of participating in this ecosystem and sharing ideas with the other members of the community. Finally, they are interested in seeing the filtered deal flow and possibly helping with due diligence, becoming an early beta-tester and even a paying customer. It is really an institutionalized form of what I've been doing for the past five years, except with a unique array of people sitting around the table due to their operating companies and ability to test and deploy the tools, technologies and analytics being developed by the fund's portfolio companies. Neat stuff.

I am also extremely excited to be doing this fund in New York City. I have found NYC to be a great place to base my investing activities and couldn't think of a better place to start my fund. Proximity to Wall Street, big Media, the Pharma industry, several major insurers and health care providers, and a short flight to the Defense complex down in Washington D.C./Virginia. Fertile commercial ground on which to launch a big data fund. I already have three deals for the fund, one in the predictive analytics space (closed), one in database architecture (term sheet) and a NYC-based incubation of a new intrusion detection system. I couldn't be more excited to be working with my early companies and syndicate partners. I am also looking forward to working with those domain-expert angels and venture firms as partners in my portfolio companies. I've always believed in having the right people around the table, and having a venture fund won't change this one bit.

FRC's Exchange Fund: VCs are from Mars, Traders are from Venus

Both the blogosphere and the Twittersphere have been abuzz with First Round Capital's new exchange fund idea. Here are a few extract's from Josh Kopelman's post on the new program

This exchange fund was created to allow First Round Capital entrepreneurs to contribute a small piece of the stock they own in their company  -- and share in the upside of all the other companies.

When I was an entrepreneur, I remember the feeling of having all my eggs in one basket -- and it is our hope that this fund will remove some of that stress.  Now our entrepreneurs can get the same diversified portfolio that our limited partners get...

I totally get what what Josh and his partners are trying to do, and think it is both intellectually interesting and proposed with only the best of intentions. But as a practical matter, I just hate the idea.

It might be a cultural issue: I come from a very different world than Josh. He is a (very successful) serial entrepreneur and venture investor. I am a former Wall Street business head who managed groups of extremely aggressive, super high-performing originators and traders who has evolved into a venture investor. Words like "share in the upside" and "diversification" are not words with which I am familiar when it comes to the heads of my teams. In fact, they sound like communist rhetoric to the ears of someone use to the hurly-burly "Pay me for what I do" mantra of Wall Street.

Now, I'm not suggesting that "It's all about me me me" is a good thing. In fact, I think it's a bad thing - to a point. I think the root of my discomfort is with the fact that I want my entrepreneurs laser-focused and all-in, especially as they are working to establish traction and prove out the business model and value proposition. The last thing I want them to have (and I want them to want to have) is diversification. I want them to have the insane confidence my desk heads had, where they wanted to be paid for the value they created in their own businesses, and didn't want to share in the upside of (or, more importantly, have their rewards dragged down by) the performance of other units. Further, I encouraged them to cooperate with other desks and business units when it made sense, but not because I compelled them to do so but because it made long-term economic sense for them to share with others. Forced sharing isn't really sharing. It's coercion. So regardless of whether one has direct economic exposure to the group one is sharing with, the motivations are clear: if it works to benefit my business, I will share. Otherwise, I won't waste my time.

The way I've worked to relieve stress in my entrepreneurs is after they have gotten the business up and running, a scalable model is in place and the growth engine is humming along. At this point I have supported buying a small portion of the entrepreneur's stock, either as part of a financing round or where insiders with deep pockets and demand purchase the stock directly from the entrepreneur. While the amounts involved will not dis-incentivize the entrepreneur from still driving as hard as they always have, they can often be life-changing by reducing stress and really enabling them to focus their energy on the business (even after it is successful). This is my preferred way of handling the "diversification" issue. Until business stability is achieved and rapid growth has taken place, I want the entrepreneur to feel stress - positive and necessary stress, in my opinion. 

Is Josh right or am I right? Reasonable people can disagree. But I am personally fascinated with the idea because it is so completely opposite of the behavior I would want to see in my entrepreneurs.

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