Fred Destin

What your investor does with reserves when you underperform

Let's look at how investors manage a portfolio of startup investments and what that means for you as an entrepreneur.  You may not like it.

When investors commit to your company, they will invest some money upfront (say $2M) and allocate reserves for future funding (say $6M).  Why ?  Well, we know from experience that successful businesses take real capital to get to the finish line.  Yes, even in the age of Ultra Light Startups (groupon, facebook, foursquare, you name it). 

The question that matters to you is: what happens to these reserves over time ?

I was prompted to write this post by a great contribution from Lisa Edgar (Paul Capital) on PE Hub entitled "are we going to make money on this fund ?".  A good read if you don't know how funds operate, in particular:

I would suggest that picking the winners from the losers—and more importantly, effectively managing the fund’s capital—is specifically the role of the GP (and for which the limited partners pay a management fee).

What I’m looking for is the fund manager’s view of which companies look like winners and which companies aren’t quite cutting it, so that they can manage the portfolio to support only those that deserve additional capital. I understand this is an extremely difficult exercise—especially for very early-stage companies or when the outcome is truly binary, like with many health care investments.

In practice, this means that as the portfolio of investments matures, the people investing the money will start to make decisions about where they want to drive the reserves in order to maximise the outcome, both positive ones ("I want to find a way to invest more money in company X") and negative ones ("company Y looks impaired and I will strip it of its reserves).  Because driving reserves to winners is absolutely core to fund performance.  Money invested in the past is a sunk cost; what matters is really the marginal return on the money invested.

Few firms do this well.  The major difficulty is human nature.  Being selecting about reserves means letting investments you believe in (typically) become disadvantaged, or it may mean driving dollars to another investor in your group who may get all the glory whilst you'll never know what would have happened if you had more dollars to feed your own baby.  You need intellectually honest, courageous and aligned partners to do this well.

You'll notice I use investors generically here, not "horrible venture capitalists" or "stuffy fund managers".  I think the same principles apply to "exgtremely friendly superangels" who manage larger funds and decide where to put their follow-on money.  It also applies to those building options portfolios (lots of small investments) and who invest in emerging winners only.  One of the benefits of option portfolios is that you can be extremely evidence-based in determining success and deploy very limited capital to test theses.  Fail fast / fail early.  The theory, at least, is compelling, although surely accurate selection in large option portfolios is hard too.

Before you say "here comes another non-risk taking VC", remember that some of the best returns come from supporting some companies through times of hardship, complete restarts and pivots and other contrarian investments (as usual, read the other Freddy).  You need to be contrarian, but right :-)   That's why deal picking is hard.  But the reality is also that companies that under-perform early (poor execution, damaged thesis) tend to continue to do so.  In any event, choices on where to allocate resources will and do happen.  That's the game.

So if you are an entrepreneur in a maturing company, you would be well advised to know where you stand and how your investor is thinking about the use of his or her's (naturally scarce) reserves.  Anticipating these issues gives you the time and capability to react.

Majors have no ownership in YouTube

Through Ratiatum based on this filing ,and also at PaidContent. 

It seems unclear whether the music majors received any form of ownership in YouTube / Google, contrary to stories floated at the time.  Industry insiders generally consider that the YouTube deals were too expensive, but it is getting increasingly hard to know exactly what they agreed.

Other fascinating YouTube numbers courtesy of Rafat Ali:

-- Chad Hurley received 694,087 Google shares and another 41,232 shares in a trust. Based on Google’ market price of $470.01, that values Hurley’s stake at $345.6 million.
-- Co-founder Steve Chen received 625,366 Google shares and another 68,721 in a trust, indicating his stake is valued at $326.2 million.
-- Jawed Karim, the third co-founder, received 137,443 Google shares, with an indicated value of $64.6 million.
-- Sequoia Capital’s holdings include 941,027 Google shares as part of its Sequoia Capital XI fund, with an indicated current value of more than $442.3 million.

Alarm:clock and acquisition maths

Alarm:clock takes issue with the multiple paid by Cisco on the acquisition of Ironport, citing an 8X multiple that does not compare favourably to Secure Computing's acquisition of Cyphertrust.

I always get slightly annoyed by shortcuts in reasoning, and this is a shining example, for two reasons:

• without data on the underlying growth of the respective  businesses, using static comps to compare companies is useless.  At the very least you should run comps over multiple years and rely on PEG (price-earnings growth) ratios
• value is also dependent on the acquiror; when the CFO of Cisco runs his ROI model, he takes into account the extent to which he can leverage the IronPort product across his distribution and sales channels.  In the case of Cisco, selling into entreprise, the answer is "a lot"

In fact from the very numbers disclosed on Alarm:clock it looks like the Ironport revenue scaled from $25M in 2005 to c. $100M in 2006 (although I cannot be sure the multiple is not on a forward basis).  On a standalone basis you can imagine they could double revenues, with Cisco they could do better.  Maybe not such a poor buy !

Whilst I do not know if Cisco overpaid, I am conceptually much more on the side of a Charles King (from Pund-IT Research, can't beat that) intereviewed by the Red Herring:

"The dot-com boom days are gone—large vendors are looking for startups with good technology, and profitable businesses that can operate as standalone firms,” said Mr. King. “You spend the kind of money being spent by Cisco, IBM, and EMC and you know they are looking for startups that can pay for themselves pretty quickly.”

Managing towards a downturn

The EuroVC market is hot hot hot !  Valuations are up, deal sizes are increasing fast to accomodate ownership requirements, and any respectable VC fund could probably close a deal a week given the quality of the dealflow.  There is a frenzy of dealmaking driven by the desire not to lose market share and to ride the wave.

Portfolio companies are currently in the same buoyant mood, partly because the capital markets are so supportive, and partly because we are again enjoying a period of "hyper-innovation".

Personally, having been through a couple of cycles and reading the tea leaves of the US economy, I am increasingly concerned about a market downturn sometime in 2007.

Having boarded the 05:34 Eurostar this morning (ouch) and left behind my lovely wife and kids, I was bound to be more impressionable and sensitive to gloomy projections.  But some of the insights provided by Martin Wolf in today's FT would still have made me nervous had I taken the 07:09 train:

• US real interest rates are remarkably low, yet the world seems to want ever more US assets, deepening an already imbalanced current account deficit.
• The US has financed this through a mixture of public and more importantly private borrowing, driven in large part by household indebtedness.
• The housing led consumption boom may be coming to an end, fuelled by the sharp switch in real estate market sentiment.

This matters because countries like China have not done enough to reinvest their huge surpluses in domestic demand and infrastructure.  Europe is still in a mess.  So there is no relay in global growth and no real counterweight to the anticipated "exported slowdown" of the US economy.  In other words, the unprecendented period of growth we have been enjyoing might be drawing to a close.  And if the downturn is led by a real estate readjustment, the hard landing some have been predicting might finally be materialising: the real estate market rarely adjusts through anything other than a crash.

This analysis is the basis of three thoughts I would like to put to my readers:

1. Don't assume a strong refinancing market, and manage cash accordingly

As VC's it is very important to carefully think about the timing of downturns.  We typically fund our companies through ~18 months cycles and rely on exits (ideally), credibly-led uprounds (second best) or revenue momentum to demonstrate to our LP's that we are doing a great job.  This also means we are particularly exposed to public market downturns regardless of how our companies are doing on the business front.  My personal belief is that many boards would do well to manage cash carefully and ensure they have sufficient runway to execute meaningfully on the business side, rather than rely on a strong refinancing market.

2. Take more cash now (but only as required by your business model)

Some of our portfolio companies, such as Icera, have taken advantage of strong market conditions to reinforce their balance sheet and make sure they are adequately funded to the finish line.  This makes plenty of sense.

What I do not find sensible however is that companies bump up the cash they raise for the sake of it.  Entrepreneurs may be lured by massive rounds but have to remember that these come with seniority and the attached liquidation preferences and anti-dilution provisions.  If the market downturn is bad, a heavy weight of capital almost guarantees significant dilution.  Raising too much cash is also a guarantee of lower ROE.  I, as other observers of  the market, have been struck by how much supposedly capital efficient Web2 companies have raised in the past few quarters.

3. Consider investing more slowly

It is hard to resist the momentum of the market as we all spend our time chasing the hottest deals.  But I would bet that many funds are ahead of their deployment plans at present.  Just as funds that invested heavily in 2002 are now doing great (in particular those who picked up cheap internet assets), it may be wise to consider slowing the pace of investment and consider keeping some powder dry for quieter days when valuations become more reasonable.

Having said that, we have two term-sheets out and a bunch of highly exciting irons in the fire, so I will get back to being a headless chicken and pursue these with abandon!  Happy hunting to all of you from car 12 of the Eurostar...

Private Equity: where does all the risk go ?

I was inspired to write this post by an amusing article in Friday's Financial Times (John Plender: Private Equity folks could do wonders with Microsoft) where he playfully builds the rationale for a buyout of Microsoft followed by the biggest dividend payment in history (the $288bn of available leverage assumed in the article being more than the current market cap) followed by a string of credit derivatives by the lending banks to hive off the risk, leaving everybody with no risk and cash-lined pockets and a leveraged and cash poor Microsoft.

Which begs a serious macro question: where does all the risk go?  You can simplify corporate risk to investors by thinking of two categories (performance and credit default). 

The Private Equity boys arbitrage away discrepancies between Enterpise Value as they see it and how much the banks are willing to lend to them, and very often make all their money back within months of investing by re-leveraging to the hilt and effectively creating a zero-premium equity option for upside.  Forget getting operations back in line, that's so 1990's.  The banks then use the credit markets to offload most of the principal risk to the derivatives market.

The Credit markets and in particular the CDS/CDO segment have grown fantastically in recent years.  In the olden days (as in 5 years ago) I knew where the risk went: from commercial banks to hapless insurers and re-insurers in search of high performance assets who sometimes still priced risk by looking at historical data and extrapolating that (think pricing FX risk by looking at the past performance of the dollar...).

But investment banks, having worked on securitising most of the assets of the balance sheets of commercial banks, have long been working on helping the hapless guys take risk off their balance sheet too, migrating it back into the credit markets.  So in this game of musical chairs ... who ends up with nowhere to sit ?

In Venture Land (that's where I reside) we do take principal risk, usually unlevered, and get funded by family offices or pension funds who take very long-term views.  Although I remember with a smile being approached by the Enron credit traders in London in the heydays: these guys were selling equity default protection on early stage venture investments and looking to securitise that too... wow ... but I digress.  Remember Enron ?

I think two factors are probably at work:

• to protect the profitabilty of their net trades, the commercial banks are probably keeping the most toxic portion of the credit risk on their balance sheet when they seek credit protection (which after all the investment banks are selling to them, and these guys ain't dummies). So I would bet that a lot of innocuous credit lines that sit on bank balance sheet are in fact highly leveraged pieces of nuclear credit exposure that the financial services regulators cannot adequately assess (meaning the capital reserved against these by the banks is probably inadequate)
• a number of the "long" CDO's must have been lodged with hedge funds on the one hand and people with too much cash on the other (think People's Republic of China)
  

... all this would suggest that the serpent might be biting its tail and that the leverage market supporting private equity returns has feet of clay. In the meantime investment banks make a fee on every leg of these transactions and the more agressive private equity shops keep siphoning the cash off their investee's balance sheets. Not a bad day's work if you are into making serious money. But the LTCM story proves that systemic risk (at that time starting with Danish mortages if memory serves me well) can quickly spread to an entire market. I will stick to venture and making money over 5 years, it's more sustainable.

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