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!