Friday, October 26, 2012

The Moderate's Manifesto

A moderate believes in limited government.

A moderate believes (really believes) that economic growth comes from private enterprise.

A moderate believes that individuals must be responsible for themselves, that communities should take care of their own and that local solutions are usually better than national solutions.

A moderate believes that government's primary functions are to protect it’s citizens, to create an environment where an appropriately regulated free enterprise economy can flourish, and to make the critical investments in infrastructure, education and primary research that would not be made by private enterprises pursuing their own limited goals.

A moderate believes that the government has an obligation to regulate business to ensure the health of its citizens and to curb the power of monopolies and economically powerful special interests.  However regulation should be as limited as possible because each regulation puts a tax on the economy and further limits growth and prosperity.

A moderate would do whatever is possible to reduce the power of special interests in shaping policy, taxes and regulations.

A moderate believes in progressive taxation where the wealthy pay a greater share of their income in taxes.  However a moderate believes that the tax system should not be used to confiscate the assets of the wealthy.  The incentive to be productive and retain the fruits of your efforts is critical to the economic success of a free enterprise economy.

A moderate believes in a balanced budget where spending is limited to be no greater than income.  In times of great crisis, economic or military, government may have to spend more but should return to balanced budgets when the threat has mitigated. 

A moderate believes that the path from the present to a balanced budget will require a significant reduction in subsidies for special interests, increases in taxes for the wealthy and the middle class and reductions in defense and entitlement spending.

A moderate believes in a strong national defense but does not believe in an activist foreign policy.

A moderate believes in free trade but not in unfair trade where government intervention (foreign or domestic) results in market distortions.

A moderate believes in a government-assured safety net providing basic necessities for those who fall out of the general economic system.  However such a system needs to strike a balance between caring for the unfortunate and becoming an incentive for people to drop out and live on the fruits of someone else’s labor.  It needs to provide a strong incentive for those who are able to return to the workforce.

A moderate believes in complete separation of church and state.

A moderate believes in personal liberties including the right to marry whom so ever one chooses.

A moderate may struggle with the issue of abortion but eventually determines that a woman must have the right to choose.

Friday, January 21, 2011

Mob Rule By Proxy

The New York Times today published another article in a seemingly endless series.  How do we balance the budget when people don't want to cut entitlements and don't want to raise taxes.  Duh!!!

"While Americans are near-unanimous in calling deficits a problem — a “very serious” problem, say 7 out of 10 — a majority believes it should not be necessary for them to pay higher taxes to bridge the shortfall between what the government spends and what it takes in."

"Americans overwhelmingly say that in general they prefer cutting government spending to paying higher taxes, according to the latest New York Times/CBS News poll.  Yet their preference for spending cuts, even in programs that benefit them, dissolves when they are presented with specific options related to Medicare and Social Security, the programs that directly touch the most people and also are the biggest drivers of the government’s projected long-term debt."

Let's look back.

"A republic is different from a democracy as its government is placed in the hands of delegates" - James Madison from the 10th Federalist Paper.

The founding fathers were (correctly) certain that direct democracy was a path to failure. "A pure democracy can admit no cure for the mischiefs of faction. A common passion or interest will be felt by a majority, and there is nothing to check the inducements to sacrifice the weaker party. Hence it is, that democracies have ever been found incompatible with personal security or the rights of property; and have, in general, been as short in their lives as they have been violent in their deaths."

Madison was living in an era of true statesmen. He expected elected representatives to govern with wisdom, judgement and restraint. To do what was right and not just what was popular.  Unfortunately, the current crop of representatives are more concerned with being reelected than with providing sound governance. They legislate by taking polls rather than by leading public opinion.  What the country gets is mob rule by proxy.

Alexander Fraiser Tytler, a contemporary of Madison, had a more cynical (realistic?) perspective.   "A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largess from the public treasury. From that time on the majority always votes for the candidates promising the most benefits from the public treasury, with the results that a democracy always collapses over loose fiscal policy."

Are there any statesmen left?  Is is possible to raise taxes and reduce entitlements and balance the budget?  Probably not but we can always hope.  Send a message to congress.  Tell them to do the right thing!

Sunday, December 12, 2010

It IS broke!

I was referred to an article written by 2 professors and published recently in The Journal of Applied Corporate Finance.  Made me wonder how anyone can make a living as an economist?  You get 3 of them in a room and you can get 3 different opinions about virtually anything.  Most of the time all 3 of them are wrong.  It is titled "If it ain't broke:  The Past, Present and Future of Venture Capital".  Check this out if you have the stomache to get through it.

In the spirit of their econometric black box analysis I offer the following rebuttal:
  • In 1960 business capital spending in the US was $30B and ITC represented 9% of that or $2.7B.
  • In 2001 business capital spending in the US was $877B and ITC represented 39% of that or $342B.
  • In that period business capital spending increased at a CAGR of 8.8%, ITC spending increased at a CAGR of 14%.
  • Over 100% of venture capital returns came from ITC between 1960 and 2001 (other sectors showed overall negative returns).
  • After significant declines ITC capital spending in 2008 recovered to the level of $300B, a decline of 14% since 2001.
  • Total capital spending during that period remained nearly flat at $810B.
  • ITC declined as a percentage of total capital spending to 37%.
  • After 40 years of outperforming the economy by nearly 50% per year, ITC spending, the engine of Venture Capital has significantly underperformed since 2001. (Who can't make money investing in a sector that is outperforming the economy by 50%?)
  • Do you wonder why the venture fund returns since 2000 have been negative?
  • With ITC running at 37% of the total capital spend, future ITC spending will approximately track the economy and will not outperform it.
  • Venture capital thrives in immature markets with lots of white space. Mature business sectors present significantly smaller venture capital opportunities because the scale and coverage of the incumbents is overwhelming and they control the paths to market.
  • The "historical results" of the Venture Capital industry occurred during a completely anomalous period when the investment sector was hugely outperforming the economy as a whole.
  • That period is definitively OVER.
  • The Venture Capital Industry in 2001 was (over)sized to reflect a bubble.  that bubble has popped.
  • There is, at the moment, no replacement investment area which can be leveraged to provide similar "rising tide" returns for the industry.
  • The past only predicts the future until something changes and then it doens't any more.
"If it ain't broke.."???

It IS broke!


Monday, September 20, 2010

William Wang and the 21st Century Business Model

“Thus, what is of supreme importance in war is to attack the enemy's strategy.
Sun Tzu

It is hard to imagine how someone could start an HDTV company in 2002 to compete with Sony, Samsung and Sharp.  And start it with less than $1M in total capital ($600,000 to be exact)!!  Can’t be done!

William Wang did it.  In just 7 years Vizio became the second largest supplier of televisions in North America.  He didn’t just compete with the giants, he won!  I am not going to spend time recounting the journey.  A couple good links to the William Wang story are below:

What I will observe is that William understood the disruptive business environment in the 21st century and the opportunity it created.  Old business models are increasing vulnerable.  This is spectacularly evident in industries like music, media, newspapers, travel etc. where old businesses are collapsing.  The common thread is that contemporary cost structures are radically lower than they were in the past.  William recognized that this opportunity also existed in consumer manufacturing and he created the most successful and visible model (so far) for this sector.

The keys to his success:

He understood his strategic opportunity.
He knew what he HAD to do himself and outsourced everything else.
He recruited partners (not just suppliers) and distributed the risk and reward.
He built a culture that conserves cash and delights customers.


Deliver a lower cost product by building a lower cost company.  Focus on quality and customer service. Control and promote the brand.


Build a lower cost company by outsourcing everything to partners who have scale.  Scale yields low unit cost. Ride on the partners scale while the business is small.  Outsourcing to large partners helps create a fundamentally lower cost structure.  Further, outsourcing supports easier scaling and provides better flexibility to respond to changing market circumstances.  Keep direct control of customer service and the brand.  William Wang built a $2 billion business with fewer than 100 employees.


Recruit partners who have a critical interest in participating in your opportunity and are willing to take some of the risk in return for some of the reward.  This reduces the capital requirements and is key to getting the benefit of the partners scale when you are small.  The partners make an investment in the business either directly or through advantageous business relationships that conserve capital and reduce costs.  We will address the difference between a partner and a supplier/distributor in later posts.


To create a low cost company, you must create a low cost culture.  EVERYONE must embrace the  premise - in words attributed to Tom Perkins - that “Cash is more important than your F#$%^@& mother”.  There are no deep pockets around to put in more money.  The company has to pay its bills with the money it receives from its customers.  Culture can focus on the company stock price or on the company cash flow.  The employees can be "Traders" or "Owners".  Ask yourself - do the employees of your company care more about the share price or the weekly cash flow?  Venture Capital has created a pervasive Trader culture among management and employees in the technology sector.  Owner and Trader cultures result in huge differences in the attitudes, behaviors and actions of the people who make up the company.  We will focus further on Owner and Trader cultures in future posts.

By innovating and executing in these key areas, William Wang not only created a company which beat the incumbents, he created a cultural, operational and financial competitive advantage that his competition cannot overcome.  He defeated the enemy's strategy!

Thursday, September 9, 2010

Back to the Future? - How about Forward to the Past!

I just finished watching the first 4 episodes the so-called smackdown on TechCrunch featuring Dave McClure and Dave Hornik pissing at each other about the validity of the Super Angel vs. mainstream VC investment models.  Frankly there isn't much difference and my conclusion is that it was "much ado about nothing."  I think both models can work if they are scaled appropriately for the opportunity space and are well run by thoughtful and skilled professionals.

The mainstream venture model evolved over 40+ years to the point where huge firms investing huge funds became the norm.  The industry is massively overbuilt.  Returns have been negative for 10 years.  There is, and will continue to be, major downsizing.  Most (greater than 50%) of the mainstream firms will go away.  Many of the remaining firms will look to invest overseas.  There will never again be the kind of returns generated in the 90s because the technology industry is more mature, there is less white-space to conquer and paths to market are dominated by large and successful firms who extract a lot of the value.  Mainstream venture capital is a significantly tougher business than it was in the 1990s.  It will probably be 2015 or later before the industry is right-sized and modest positive returns start to reappear across the category.  Conclusion - nothing wrong with the model if it is sized to the opportunity space.

Super-angel funds are, in-fact, nothing of the sort.  Angels are investors invest their own money and, overwhelmingly, they made that money by being successsful entrepreneurs themselves.  Super-angels are really just micro VC funds.  They raise money just like mainstream VCs.  They just raise less money, invest in deals at lower valuations and look for exits in the sub - $100M range.  They also make the claims that they are "seasoned entrepreneurs" and provide special help to their portfolio companies (Hmmm - maybe).  Oddly this model looks EXACTLY like a the mainstream VC funds of the early 1980s.  Duh!!

There is a current opportunity for these funds because the mainstream firms have too much money under management to support small scale investment and small scale exits.  This space is nowhere near as overbuilt as mainstream venture capital so there is less of a supply/demand disequilibrium.   It is also supported by the ecology because the larger technology firms are having trouble innovating and are looking to buy early-stage innovation at early-stage prices.  Early-stage exits are a defeat for mainstream venture firms.  They are a victory for super-angel firms.  Conclusion - probably a better space in the short term for companies, limiteds and investors who are happy playing on a smaller chessboard and not committed to changing the world. 

What both firms have in common is that they exist to buy and sell equities.  They both buy from entrepreneurs and they both sell to acquirers or (very infrequently these days) to public shareholders.  They are, at their very core, traders.  Their job is to buy low and sell high.  This fundamental truth about the venture business informs every action they take whether mainstream or super-angel.  It also informs the culture of the businesses they create.  Everyone is looking for a pot of gold at the end of the rainbow - the life changing - all consuming - EXIT!!  The nature of their business model demands it.  These are close-end funds.  They have to return money - cash - to their investors and they have to do it in a fixed period of time.

In this blog over the next several months I am going to explore another - even more ancient - model for company creation.  This is art and practice of building and running a business for POSITIVE CASH FLOW.  Before there was venture capital and before there were EXITS, people built businesses to make money so they could pay their bills.  I will argue that re-discovering this model drives a corporate culture which is much healthier, more robust and more survivable than the EXIT-focused culture created by the venture capital model.  I will also argue that the cash flow model can engage the employees, the critical human capital asset of every business, to significantly greater efficacy than equity models.  Lastly, I will argue that we can modestly scale this model to the point that it can become a significant factor in new business creation.

We will follow the early success this model has had in a couple of businesses and, with luck, the later success it will have as the effort proceeds.   The first part of this adventure will start next week.

Monday, May 3, 2010

It’s The Compensation Stupid!

(Rather than regulate the banks, get them to regulate themselves)

The recent debate on financial regulation is missing the point. The focus has been exclusively on regulating the financial institutions. This is akin to preventing drunk driving by giving a breath test to the car.

The key problem in the financial industry is not the institutions, it is the people. The people in the financial industry are mercenaries. They owe no allegiance to their employer, to their shareholders, to their clients or to their peers. They are in it for themselves. The problem they work on, every hour of every day, is how to maximize their personal financial reward.

I learned very early in my business career that the most important factor in managing a sales force is defining the comp plan. Salesmen are smart. They will quickly understand what the comp plan tells them to do and they will do it. You had better make sure that the comp plan tells them to do exactly what you want them to do! Bankers are super salesmen. Bankers are smart. Bankers do exactly what their comp plan tells them to do.

What does a Bankers comp plan tell him to do?

First, understand that bankers are playing with Other People’s Money (OPM). What if they lose it all? Well, it’s not their money. What if they invest it conservatively and make a modest return? They probably get to buy a midsize American car and a 2 bedroom house in a distant suburb. What if they gamble it on really high risk bets and they win? They buy a Bentley and a penthouse condo with a 360 degree view. Understand that, when bankers are playing with the OPM, the comp plan tells them to take huge risks. Heads I win, tails you lose! If I lose all your money I will just play again with someone else’s. There seems to be no end to the people who will line up for the privilege. If I soil one corporate platform I will just jump to another.

Many years ago, when the investment banks were partnerships - they played with their own money. The risk management responsibility was understood by everyone in the firm. It was THEIR money!! Then a really smart generation of managers figured out that they could sell the shares of the bank to investors. This was a blinding insight!!

Step 1: get an ENORMOUS windfall by taking the proceeds of the IPO and putting it in your pocket.

Step 2: pay yourself the same amount of money you did when you were the owner. Most of that money should now go to the shareholder but you can always tell them that if they don’t pay it to you, you will quit and go next door and their shares will be worthless.

Step 3: take the shareholders (and the clients) money and gamble it with the objective of maximizing return with no concern for risk. Keep doing this until you are obscenely wealthy.

Step 4: keep inventing new ways to gamble the money so that the game is too complex and moving too fast for the outsiders to keep up.

Step 5: pocket the proceeds along the way. It is very important that you don’t drink your own cool-aid (some bankers forgot this?!)

Step 6: when everything crashes lie low for a while (with your pile of cash) and then emerge with a new hedge fund or another bank and go back to Step 2 (unfortunately Step 1 was a one- time deal - those guys were really smart!).

The amount of money that leaked out of the system into the pockets of the bankers during the run-up to the recent financial crisis was absolutely staggering. The small team that invented the Credit Default Swap at AIG paid themselves over $3B in bonuses before the roof fell in. The AIG shareholders were wiped out. The US government had to put in $100B to keep the company from collapsing. The perpetrators are sailing the Mediterranean in their yachts waiting for the storm to blow over so they can start somewhere else and do it again.

So now our congress is going to create new financial regulations to keep this from happening again. How are they going to do this? They are going to let the big banks fail!!!! WHO CARES!! Maybe the shareholders but certainly not the bankers! If you want to prevent another financial crisis you have to eliminate the reward that the bankers get for creating that crisis! You have to create the right comp plan!

In concept, the right comp plan is simple. You have to keep the bankers from making money if they are doing something that doesn’t serve the interests of the shareholders and the clients. In practice it may be trickier. The key however lies with two principles: fiduciary duty and clawbacks!

Fiduciary Duty – Make it a key legal obligation for EVERYONE involved in a transaction to have a fiduciary duty to their client. Make it incumbent on them to represent to the client that they have done their homework, they have disclosed everything and that they believe this to be a good transaction for the client.

Clawbacks – Create a system where if the banker (the person not the institution) does not responsibly discharge his fiduciary duty then any and all compensation earned on that and all related transactions will be forfeited. You might even want to put some or all of the compensation into escrow for a while (a few years) to make enforcement easier and the message clearer.

Such a system may be difficult to design and administer but the principles should not be hard to embed in legislation. Leave it up to the legal system to administer. Or perhaps there should be a civil agency which uses this structure, sort of like the RICO act, to go after some of the worst actors and make an example out of them. Or maybe a new breed of bounty hunters (ambulance-chasing lawyers no doubt) could emerge to assure the enforcement of these principles.

If every banker had to worry, every day, that there is someone out there who will hunt him down and take the money back if he doesn’t do the right thing, the need for complicated regulation would fade into the woodwork.

It’s the compensation stupid!

Monday, January 5, 2009

The Primacy of the New Tool

Steven Chu, Nobel Prize winner and Energy Secretary designate, gave a fascinating interview at UC Berkeley recently. There is a particular section that I found to be deeply insightful and relevant to the Venture Capital business. I quote from this section beginning at about minute 48:

“The lesson I learned is that you don’t even have to be brilliant if you are the first to look at something with a new tool… What are the new tools…? Let’s figure out something to do with it…

If you use an old tool to tackle a problem you’ve got to be really smarter than the rest of the folks because everybody has this tool. If you are the first to look with something new it’s like starting a new world. You just look around and everything you see is going to be new.”

He goes on to explain how he applied some new science to develop some very powerful solutions to important problems. He explains that it does little good to start with the problem. Without a new tool you only have conventional and well travelled paths to address it. It may not be obvious what problem exists and can be solved but starting with a new tool gives you a chance to create something truly disruptive.

The history of innovation is replete with examples of the primacy of the new tool. It probably begins with fire. The printing press, the water wheel, the steam engine, the internal combustion engine, the assembly line, electricity, the electric motor etc. etc. Each of these fundamental inventions gave rise to an era of new inventions addressing applications which could not have been conceived before the technology. Who would have ever considered the automobile before the existence of the engine? Wiring of the world to power light bulbs provided the foundation for thousands of electrical appliances that surround us every day of our lives.

Institutional Venture Capital

Venture capital with a small c has been a part of the world for hundreds of years. Queen Isabella provided the seed capital that got Columbus onto the water.

Venture Capital as an industry began in the 1960s. This was a magical time. The post war economic recovery was in full swing. The transistor was the first seed of this reality and integrated circuits were just emerging. The earliest computers were providing a clumsy but very useful model for applying electronic computation and “software” to solve difficult problems. The transistor, the integrated circuit, the minicomputer, the PC, the hard disk, Ethernet, wireless telephony and networking, the internet emerged in a continuous stream. Each of these fundamental new tools created a “new world” of opportunities to create disruptive solutions. As the tools matured and grew more powerful the solutions they enabled became more and more pervasive. As Steven Chu observed, “You don’t have to be brilliant if you are the first to look at something with a new tool”. The breadth and depth of the new field of opportunities opened up by these tools was probably unique in history. Tens of thousands of entrepreneurs started tens of thousands of startups, fueled by a rapidly growing Venture Capital industry. These startups turned into Microsoft, Google, Cisco, Amazon, Apple etc. etc. Countless smaller companies also participated and became part of the wave of technology that has inundated our daily lives. Technology grew from essentially zero to represent nearly 35% of the US GDP. Billions of dollars were invested and billions were returned to smart and lucky investors. The golden years!

Hitting the wall

The San Jose Mercury published a graph of venture backed IPO recently:

The decade from 1991 to 2000 produced nearly 500 IPOs. The decade from 2001 to present has produced 88. 2008 produced 1 IPO and 2009 doesn’t look much better. What has happened? I do not have data on hand for venture capital returns but I would bet that overall returns since 2000 have been very strongly negative.

Some folks blame the economy or other transitory exogenous factors. I believe that there is a much more fundamental and intrinsic factor at work.

The Sudden Absence of New Tools

The waterfall of new tools that started with the transistor in the 1960s has slowed to a trickle. The technology industry is, as a result, consolidating with a handful of monster players controlling the path to market for almost all technologies. Refining the old tools has become a business requiring massive injections of capital and long incubation periods. A new startup “has to be really smarter than the rest of the folks because everyone has this tool”. There are a few of these but nowhere near enough to support the massive scale that the Venture Capital industry has achieved. As a result there are billions of dollars chasing a small and declining base of quality deals.

Why has the emergence of new technologies declined so significantly? My guess is that it is a macro level systems phenomenon. Stephen Jay Gould developed the now standard evolutionary theory of “Punctuated Equilibrium”.

In essence he observed that evolution was not a smooth and continuous series of gradual changes. Instead it was marked by long periods of near complete stability, punctuated by brief periods of rapid and fundamental change. I suspect that many systems follow this same model, including innovation. The burst of invention and commercial success which was initiated by the invention of the transistor has run its course. The changes are not over but the rate of change has slowed dramatically and the difficulty faced by a “new species” in the resulting ecology is dramatically greater (survival rate is far lower). The rapid evolution of new tools is over and will not resume until and unless there is another fundamental technology innovation comparable to the transistor.

An Industry in Denial

I know of no example of an industry which conducted an orderly and systematic downsizing when the opportunity it addressed disappeared or radically changed. We can look around at the auto and recording industries for recent tragedies. The Venture Capital industry is no exception. Instead of recognizing the hand writing on the wall, VCs are inventing new places to put money and trumpeting the “opportunity” they represent.

The Clean-Tech Mirage

One of the most outrageous of these is “Clean-tech”. Is there a market for Clean-tech? Probably. Will there be a few companies created which succeed. Probably. Is there a fundamentally new tool that creates the dynamic required for a large scale venture capital industry to thrive and provide good returns? NO!!

Without a new tool you struggle with Steven Chu’s dilemma. You have to be “smarter than the rest of the folks”. A few may leap over that hurdle but the folks running Exxon, Shell, General Electric and other majors have the same tools, by and large and they are just as smart, they are far more nimble than they were 30 years ago, they have access to far greater resources and they have far broader market reach. According to the Mercury News the Venture Capital industry invested $6 Billion in 2007 and $8 billion in 2008 in Clean-tech. My guess is that the returns will be a very small fraction of that amount.


There is still a market for venture capital with a small c. Innovation is not dead. Smaller new tools emerge around the fringe of the market every day. A few of the big C investments will work but the Venture Capital industry as a whole will destroy billions and billions of dollars of investor’s capital in the post 2000 meltdown. I guess the good news is that, however big the capital destruction is, it will be a drop in the bucket compared to that recently achieved by the real masters of the universe, the Wall Street bankers.

If and when venture capital returns to its roots it will recover its business value. The new "micro-venture" model is: to start a very small fund (perhaps a separate fund for each separate investment); to include a significant amount of the general partner's own money; to make small investments in capital efficient businesses which can become profitable early and with no more than a couple of million dollars; and to pay the general partner exclusively with carried interest after the principal have been returned to the investors. Small startup opportunities exist and are ignored by the big-fund coupon clippers. If you can find (or start) a micro-venture fund, with good solid partners, you can still make an (admitedly smaller) investment in the venture capital sector with a reasonable expectation of an appropriate return.