VC Entry, Exit, Fungibility, and Public Market Mutability

Total venture investing looks like its rebounded from the early 2009 trough, but the amount devoted to start-up rounds has decreased dramatically.

This fits what I’ve been seeing  in the market, and it is what you’d expect (as Om Malik theorizes above) when you have a general belief that time to liquidity (via IPO, M&A, or other means) is lengthening.  It’s a variation on the Prisoner’s Dilemma, where you hoard capital because you think the next guy is going to hoard his, and is similar to the capital flows you see in public markets into highly liquid, large capitalization stocks at times of heightened volatility.

This implicit view  that exit times are still lengthening (but based on observed action) contrasts with the pretty constant barrage of verbal predictions (from bankers, VC participants, and some company executives) of an IPO flood coming imminently.

You’re starting to see a couple of deals that we’re working on – I’m talking about $40 million, $50 million revenue companies with $200 million, $250 million market caps,” Becker said. “Those will come out in the next couple of months and they’ll be a good test case. We believe there’s a real appetite from investors” in these smaller companies.

I don’t happen to be seeing many on the institutional investment side hopping up and down begging for IPOs at that size point, so I’m very uncertain about where this is coming from.  As the man says, we’ll see, and Wall Street’s a big place, so maybe it’s just less visible where I am.  However,  Quinn Street, an excellent company with run rate revenues well above $250 million and an implied market capitalization of around $800 million (still a touch on the small side, I think, for relevance in the public markets, but a heck of a lot north of $200 million) is cutting the size of its proposed offering, not a sign of enthusiasm.

There’s lot of commentary on VC entry and structural problems in venture and that this is depressing returns; the prevailing wisdom is  only partially correct in explaining exit problems as directly attributable too much venture money being raised.

TechCrunch (which drives me nuts with its sometimes flaky link system, so just google ” Why VCs Should Take Their Own Advice”) has a good summary of the party line on venture investing:

There’s too much money in the industry and it’s killing the kind of early stage investing the asset class was founded on. And that’s killing returns.

Too much money depresses returns in any investment arena where the fungibility or  “commodity-ness” of the underlying investment is high; it can happen in Venture (remember the 150 disk drive companies in the 1980s?), but it’s not a necessary outcome.  While there are lots of copycats in certain sectors (like ad networks), I’m not convinced that gluing them all together (for a super network, in this case) would necessarily make a company that could go public.  And in most other cases, I’m seeing a divergence of business models, which would make mergers more than just crazy-gluing companies together.   This means that issues other than just a sheer oversupply of VCs are to  blame for the dearth of exits.

Structural change in public equity markets is the elephant in the room ( not Sarbanes-Oxley which is a red herring), and that the analysis needs to shift there for a more complete picture.   Before you get into something, you have to figure out the exit for you and why that exit is going to be an attractive entrance point for someone else.    There’s more going on that just a weeding out of too many VCs: global de-leveraging coupled with internet and Spitzer fueled changes on Wall Street have radically altered the public investing landscape.

Here’s where to look for a possible solution.  Instead of two phases of external equity financing, you get three: VC, PE, Public.  Time horizons match up better.  A Trend: First Facebook, Then Zynga, Now Yelp – Venture Capital Dispatch – WSJ.

Stiglitz on 2009

We’re two weeks into the New Year, and on reflection, I’d still have to point to Joseph Stiglitz’s op-ed piece in The China Daily on New Year’s eve as the best summary of 2009 around.  The shortpeice is worth reading more than once, and is a model of elegant communication.  I was struck most by this:

The first lesson is that markets are not self-correcting. Indeed, without adequate regulation, they are prone to excess. In 2009, we again saw why Adam Smith’s invisible hand often appeared invisible: it is not there.

I am sick of the neo-con refrain that the free market will fix anything, with the mechanics of the instantiation of any market taken as inevitable and immutable as the force of gravity.  I’m not for government setting a market, either, but as a society we have to get back to looking at the fundamental mechanics of individual markets.  There’s got to be middle ground between Ayn Rand’s adolescent fantasy (on the Republican side) and command and control pseudo-socialism (on the Democratic).

IPO Markets, VC Exits and Startup Funding

Robert Mancuso’s article in The Deal about the advisability of going the IPO route is a refreshingly different perspective.  He summarizes the many pitfalls of being public, the most important of which (from my experience in being a lead banker on 40+ of them) is that if your company or the stock market slips early on, you lose relevance with the investment community and then you’re just, well, screwed.  As he puts it:

The reality is that size matters in the public equity markets.  [....]But once the company stops growing, people lose interest. If that growth is muted, or worse, interrupted by a down quarter, the consequences are severe. As a company’s stock price falls, its value as a traded currency, one of the principal reasons to go public, is questioned. If the stock price continues to fall, management stock options lose their ability to motivate existing management and to encourage new hires. As Wall Street analyst coverage drops, underwriters stop covering the company, and so the stock languishes.

Liquidity for early investors has to come from somewhere, but the NVCA’s wishful thinking that a new form of public market is going to solve things just ignores micro-economic reality.  The internet, the rise of Electronic Clearing Networks, and the “Spitzer Reforms” have eliminated the essential economic relationships that allowed the old IPO eco-system to work (which Paul Kedrosky touches on).

Having started on the buy-side, I can tell you size does matter, especially when IPOs are being done in a rational pricing environment.  To build a successful IPO, you need a base holding of institutional investors. As the mutual fund industry has consolidated over the last 20 years, the average size has gone up.  A $500 million market capitalization just isn’t going to move the needle with these people, and their active participation is what makes the market actually liquid, as opposed to theoretically liquid.  For me (and I assume Mr. Mancuso), that points to M&A exits or even secondary sales from VCs to Private Equity firms and a much deferred IPO.  The latter pathway, however, implies a rational buyer process with no “strategic” premium for the VC exit, which as Howard Anderson made quite clear (albeit in 2005), depresses the expected returns from venture investments.  Which in turn explains some-but not all- of the turmoil we’re seeing in startup financing.

I don’t say this with any joy, as I really enjoyed my decade working with small technology companies as they went public (with the exception of 1998-99 when way too many entrepreneurs, VCs, analysts and bankers were drinking their own bathwater and calling it Champagne).  Economic dislocation is difficult, as I can personally attest.  I am sure the liquidity problem is being addressed in ways that I don’t fully see developing now, but I’m equally sure that yesterday’s IPO markets are today’s chimera.

Mofo The Psychic Gorilla’s Rules of Investing

When Penn & Teller were first making the rounds somewhere between the invention of PCs and the introduction of laptops, part of their act was the amazing “Mofo, The Psychic Gorilla,” which involved a plastic ape head hooked up to a microphone.  I loved the act, and a friend gave me a small stuffed ape (no, not a real one), promptly named Mofo, to keep on my desk when I was working as a stock analyst for an exceedingly large, Boston-based mutual fund complex.  His psychic powers were to be used as an aid in picking stocks, and he was at least useful in giving me an excuse to scream, “Mofo!”, when anything went wrong.  Given I was covering technology stocks, that meant I got to scream it about 5 times a day, at least in earnings season.  At the same time as Mofo made his appearance, the following rules for investing were circulating around the investment community (via cutting edge, high speed fax), and they somehow got merged with Mofo.  Many applications outside of Wall Street.  Feel free to cut and clip on your cube wall as motivation.

I wish I were The Oatmeal, my hero, so I could do this 100x better.

Application Rules

Two short posts came up next to each other in my reader.

Eric Weisen at Five Years Too Late has a nice summary of his perspective on mobile app investing.  I always thought that trying to get ahead of the adoption curve in a new space was the better strategy, but Eric makes an excellent case for delaying the hunt in a resource constrained environment. Deferring (or actually skipping) on Windows Mobile and BB seems prudent, despite the size of the installed base for each: the application environment is a horror show on both platforms.  I might aim for the middle ground and add Android to the mix, but given the almost-fragmentation of the software platform, I can understand keeping options open.

To the same point, Gigaom has a great graphic on the size of iPhone application market, which blew my mind: $500 million a month in iPhone application revenue.  So much for my instinct on getting ahead of the curve and adopting for multiple mobile platforms in every case.

Tim Oren’s Perspective on the Nexus One as a Strategic Success

In addition to my own piece of verbosity on the Nexus One from a media strategy perspective, Tim Oren’s succinct case for Google’s “cunning plan” is highlighted below.  Distribution models are radically different in the PC and Cell Phone world, so all of this nonsense about Google “competing with its customers” is, well, so much nonsense.  So what if your techno-box looks and functions like someone else’s?  You can’t have channel conflict where the selling path to a customer goes through the provider of a complementary asset!

via Tim Oren’s Due Diligence: Is Nexus A Platform War Mistake?.

I think Google’s move is no mistake, and the analogy to the PC market is false in this case. Both for the same reason: Wireless carriers.

PC vendors have never been forced to deal with a distribution channel with such divergent interests in product sales, up to and including desires to cripple functionality in the interests of maintaining customer control (the so-called ‘walled garden’). Handset vendors, in contrast, are near-captives of the existing carrier distribution system, and may not dare to work around it, in fear of retribution in the next buying cycle.

Great point, and rather than lining up to throw bricks at Google’s front door, cell manufactueres may actually be sending boxes of chocolates and bundles of flowers.  Or something like that.

I’ll stand by my media comments about the Google Phone having nothing to do with Google’s interest in owning the consumer electronics market per se, but those avoid the whole gadget argument.  Tim Oren’s comments are a great perspective on the Nexus One even if my media conjectures are wrong.  Either way, buy one or don’t, but don’t lt it keep you awake.  Those rumblings are just slippage on the San Andreas fault rather than a tectonic shift in Silicon Valley.

The Way We Live Now – Walk Away From Your Mortgage! – NYTimes.com

Roger Lowenstein had a great piece in the Sunday NYT about mortgage defaults: The Way We Live Now – Walk Away From Your Mortgage!

Mortgage holders do sign a promissory note, which is a promise to pay. But the contract explicitly details the penalty for nonpayment — surrender of the property. The borrower isn’t escaping the consequences; he is suffering them.

Anybody who’s been to an English-speaking business school in the last 30 years has read Brealey & Myers Principles of Corporate Finance.  It’s notable for (among many other accomplishments) providing completeness of principle for the entire field of finance, yet doing so in a concise, readable fashion.  I can’t link to the specific chapter, but there’s an eye-opening (when you first encounter it) description of modeling a corporate loan as essentially providing a put option to the borrower, and one that the borrower pays for in his interest rate; it’s not a gift or a loophole. And when I say modeling, I don’t mean  some hypothetical exercise involving arm waving, but as a plug-the-numbers-into-a-spreadsheet example.  The price of default is in fact embedded in the cost charged borrowers, whether they be corporations or individuals.  Companies default all the time, sometimes with great reluctance, and sometimes with enthusiasm, as it lets them dig out from debt in the least destructive manner.  The debtor’s put option is, in fact, an essential component of market-based capitalism, and the farthest thing from market (or moral) failure imaginable.  So as banks default with each other and suffer default at the hands of large corporate clients, why the constant hectoring of hundreds of thousands of home purchasers that they risk eternal damnation if they exercise their put option?  There are broader social costs, as Lowenstein makes  clear, but it’s not as if everyone is chomping at the bit to dump the old homestead, regardless of simple economic efficiency.

But at the end of the day, this is a variation on the old adage: owe a banker a thousand dollars, and you have a problem; owe a banker a million dollars, and the banker has a problem.  Adjust for inflation, and then ask yourself what the difference between being a serf and being told in the USA that you can’t use contractual market mechanisms to solve a problem.

No one says defaulting on a contract is pretty or that, in a perfectly functioning society, defaults would be the rule. But to put the onus for restraint on ordinary homeowners seems rather strange. If the Mortgage Bankers Association is against defaults, its members, presumably the experts in such matters, might take better care not to lend people more than their homes are worth.

And banks might want to get prepared to suffer the consequences.  The USA is far from cleaning out the real estate mess, and I predict that in addition to the commercial real estate debt tsunami bearing down over the next 24 months, broader American society is going to make peace with mailing in the keys on residential real estate, as opposed to seeing millions of Americans locked hypocritically in serfdom.  Which begs the final question: why the hell are commercial banks trading at these kind of multiples?

Well Worth Reading: Om Malik’s Summary of Geolocation

Om Malik, in typically  high signal-to-noise ratio, has a great summary of Geo-location trends.  In particular (but read the original in its entirety):

Today we “check in” to places, but soon it will become part of the platform, and when that happens we’ll shift focus to applications and services that build upon the concept of checking in.

Absolutely!  Hence Apple and Google both pushing into mobile ad-platforms from completely different starting points.  Talk about convergence.  Although as the man points out, this questions most of the logic behind independent location-based platforms.

As Morgan explained [do see the whole article] — we’re going through a phase in the mobile ecosystem where folks are getting excited about location-specific applications. Eventually, all apps will have location-based functionality built in. [And that's my emphasis, not Om's.]

Morgan, who in the past has been pretty prescient about location-based services, believes 2010 will see the emergence of two major trends that are going to gain traction in years to come:

* Location-based ads will become mainstream as advertising and the mobile web become location-aware.

* Brands will start to use location-based apps to drive sales and marketing efforts.

Tying together the virtual and real world is absolutely the enabler to make brand dialogue constructive for both sides: interaction with the consumer at the point of potential purchase will be as meaningful as it can get…assuming it’s done well.

See also Placecast (and follow @placecast) and Sense Networks for examples of proper “semantic” mapping of the real world (among many other things) and generating action-based data (which is always higher quality since it takes effort to generate).

The Google Phone: It’s about Accelerating the Mobile Web, not Selling You a Phone

I can’t take it anymore about the Google Phone: a month of fevered speculation, 3 weeks of snooping on Google’s “dog-fooding” of the device, and a full week of post-introduction moaning about:

• The triumph/failure relative to the iPhone as a device.  The relative merits of the Google Phone as a consumer purchase are summarized (and meta-summarized)  everywhere.  Looks good to me, but so does the iPhone.  Take your pick and run with it.

• Google’s failure in “competing” with its customers, whether they’re device manufacturers or wireless carriers.  They’ve jumped the shark on this one!  Were this criticism on target, it would a surprising change for one of the few web-based companies to take micro-economics so seriously.  I mean, they have their own Chief Economist, Hal Varian,who literally wrote the book on the subject.

Competing with your own customers, entering new markets you don’t understand, turning the rest of Silicon Valley and the Taiwanese manufacturing base against you are unlikely mistakes.  The Google Phone strikes me as a Rorschach test more than anything else.  Apparently we all have a big daddy complex for Google, since a lot of commentary centered on the idea that Google was here to solve our problems with everything:

• Google’s all about disruption, and their intent is to disrupt the mobile wireless space and provide us all with salvation not just from AT&T, but from the whole industry…

• Google’s all about disruption, and their intent is to disrupt the mobile wireless device world and conquer Apple….

I’d say that

• Google’s all about disruption….where they can make money

• And they’re smart enough to distinguish between moving a market and entering a market

At the end of the day, their mission in life is not to disrupt markets that are unattractive or where they can’t make money, no matter how great the suffering of the poor, downtrodden consumer.  (So much for the daddy complex…)

Google make’s money (mostly) from selling ads on the web accessed from a desktop computer.   I can’t find anyone who disagrees that the mobile media and ad market is going to be enormous (although I’d love to see their analysis if it exists), so let’s take it for granted and assume Google does, too.  I’m also assuming that they don’t take their dominance of this mobile space for granted (hence the Admob acquisition, for instance).

But the mobile media and ad market takes a lot of complementary assets to make it happen, more even than Google can pull together:

• A nationwide data network (forget voice, since SIP clients like Gizmo5 will make voice another IP stream real soon) is expensive, and more to the point, provides low return on invested capital by Google standards, unless something has magically changed in telecomm in the last few days. (And the whole “white-space” spectrum issue is a red herring for now.)

• Ubiquitous device distribution, since no device equals no media, which means no ads.  (And why on Earth would Google be entranced by entering the device market, where gross margins routinely hover around 25%?!)

The point of introducing Android (which Google doesn’t charge for) and now the Nexus One: the smartphone market (ex-Apple) was moving too slowly, and that’s limiting Google’s mobile media and ad revenues.  And in the case of Apple, they can’t be sure that Apple won’t effectively serve as a blocking mechanism (as in Google Voice) and leave them isolated from direct contact with mobile media customers.

Henry Blodget sums up the case for dismissing all of this nonsense about Google entering the device market beautifully: “So, forgive us if we’re missing something, but isn’t it fair to say that what Google actually did yesterday was open a mobile phone store?”

A touch more than that, of course, and I’m sure Mr. Blodget is aware of that.  I thought Google’s contemporaneous announcements this week were far more illuminating about what’s really going on.

Click-to-call is being re-released.  What a great way to tie a call-to-action to the web, especially with mobile search.

And automatic location based search.  Which is how I’d love to be able to use my phone, and undoubtedly will (and yes, we all know about the alternatives).

Action-inviting advertising and actionable local information are keys to tying the web and the real world together for the bulk of the time you’re not siting on your butt in front of your computer.  (You know, doing something actually social as opposed to virtually social.)  Its a big market, and it’ll be an extremely lucrative market, particularly in the hyper-local space, if you can pull the web along.

• Move the development and adoption curve in the mobile handset space, or in other words, move a market for complementary goods without entering it;

• Set out a reference design that shows wireless handset makers what to do;

• Provide a user device that gets the non-Apple market (where you may be blocked) excited, and does so without cutting out wireless carriers completely, since you link in to their service offerings, presumably with a light or zero commission;

• And promise to sell handsets from all manufacturers, broadening distribution.

Rather than a fail, the introduction of the Neus One this strikes me as a brilliant maneuver to accelerate development where Google needs it.  After all, it’s a media company, not a consumer electronics company.  Economic rents don’t necessarily depend on ownership, but economic rents can be increased by accelerating the development and adoption of complementary assets.

Now if only T-Mobile offered a decent plan for this phone! Total fail.  Alas, can’t control everything.