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Yearly Archives: 2009
The front page of today’s WSJ business section reports on two items having to do with our industry: (1) how ‘clean-tech’ firms are responding to the failure in Copenhagen and (2) the overall outlook for the venture capital industry in 2010.
Green firms are pivoting from an international game to focus on how to exploit opportunities at the national level, and 2010 looks to be an improvement over “one of those years that the venture industry will just be glad they managed to get through.” We’re concerned that the “clean tech” sector is “over-invested”, i.e. too much capital chasing two few viable business models. There’s no question that big companies will be built in the clean-tech sector, but the risk-reward ratio continues to worry us, particularly in light of the government’s increasing, but often fickle, involvement in the industry. If the industry continues to grow, there should be a number of new opportunities for interested Southeastern investors.
As for an improving investment environment in 2010, we’d be as pleased as anyone for a 2010 stronger than 2009, but we can’t help but note the “West Coast” bias in the report. Despite tough economic conditions, the Southeast has continued to nourish rapidly growing private companies, and we were pleased to make five investments at BPV and close our second fund. If you’re not dependent on a robust IPO market for exits (as many West Coast VC funds are), there’s no reason 2009 can’t turn out to be a good year for investments, as the economy improves and investors benefit from somewhat reduced valuation expectations. Some of the best returns in the history of the private equity industry have come from investments in “difficult” years.
My op-ed about how one of the tax increases being considered by Congress will hurt business growth in Florida has just appeared in the Tampa Tribune.
The op-ed explains how the venture capital industry in Florida has played a critical role in job creation throughout the state, and how Congress’ plans will alter the balance of risk and reward involved in starting new companies – for both the entrepreneur and the VC firms who support them. If the potential reward of starting a company is reduced, fewer will get started, and since young companies create most or all of the new jobs in our economy, that will mean fewer jobs.
Here’s an excerpt from “Tax change would cloud Florida recovery“, published December 20, 2009:
Venture capital firms have invested more than half a billion dollars into private, early-stage growth companies in our state since 2005… Even more encouraging, Florida’s venture activity stretches across the state from Jacksonville to Tampa to Orlando to Palm Beach. This decentralization of growth equity capital, which is uncommon in other states, means that the venture industry’s continued growth will create more jobs statewide, rather than in only one or two regions…
HR 4213 would increase taxes up to 133 percent on venture capitalists by reclassifying their carried interest (the profits they share in if they help build successful companies) from capital gains to ordinary income… [This] will remove a major element of [the potential] reward, and these diminished incentives will particularly discourage the formation of the small venture capital funds that invest in early stage companies.
Those venture firms that do continue will likely seek shorter investment horizons and shift investments to larger, more established companies to help mitigate the risk of investment losses and rebalance the risk-reward ratio. That shift ultimately shrinks the innovation pipeline, because many promising early-stage companies simply won’t get funded. The result is fewer jobs created and fewer technological advances to spur new growth industries. This would be disastrous for Florida, which desperately needs these types of companies to broaden its economic base and be positioned for future growth.
We in the VC biz are never short of reasons why we believe our portfolio companies should exercise tight control over cash and expenses, so it’s a rare treat when we discover a new one. And since we are unselfish, we are happy to pass along the valuable nugget: it’s good for your soul.
Luxury ate my morals
IF POWER corrupts, then what does luxury do? In a new study, business school researchers find that it doesn’t take much for luxury to do its thing. Students reviewed pictures of either luxury or nonluxury shoes and watches. Later, they were asked to evaluate several business scenarios from the perspective of a CEO. Students who had been exposed to the luxury items were significantly more willing to produce a polluting car, sell buggy software, and sell a violence-inducing video game. In addition, these students were also less likely to identify prosocial words in a letter scramble. In other words, priming people with luxury makes them more selfish. The authors wonder if managers make different decisions “at a luxury resort as opposed to a modest conference room.”
As we have written elsewhere, the proposed carried interest tax increase is a drag on investment and job growth during a recession and attacks an industry that (a) doesn’t ask for bailouts and (b) is critical to the nation’s economic performance.
Today’s WSJ covers the most recent development: Zero to 35 in 24 hours
House Democrats keep stepping on President Obama’s applause lines about innovation and job creation. On Tuesday, Mr. Obama announced that “we’re proposing a complete elimination of capital gains taxes on small business investment” for one year.
Responding with rare dispatch, the House voted yesterday to change the capital gains rate for venture capitalists who invest in technology start-ups. But rather than eliminating the tax, the House more than doubled it, moving the tax rate to 35% from 15% by reclassifying such gains as ordinary income.
Knowing how popular tax increases are with unemployment at 10%, the House majority rushed the bill to the floor without a hearing or even a committee vote. Then they buried it in a package advertised as an extension of tax cuts for research and development.
Today’s WSJ has a brief, thought-provoking article about how to improve board performance. This could work very well for some companies, as best practices should, but as we’ve written elsewhere there is more to board performance than best practices.
The author is James M. Citrin a senior director and member of the worldwide board of executive search firm Spencer Stuart.
I believe that a new mandate should be established for the board compensation committee. Re-branding the committee as the compensation and leadership committee will help strike a better balance of “offense” and “defense” by giving this essential board working group permission to be more strategic and proactive. Upon being granted unambiguous responsibility for the company’s top talent, the “Compensation and Leadership Committee” will be able to be more effective in helping boards fulfill their most important responsibility, CEO succession. The broader definition will also make the committee more attractive to the strongest board members and committee chairpersons, strengthening committee performance.
The compensation and leadership committee would likely spend its time differently than the typical comp committee, moving beyond remunerating management to having systematic, consistent and continuous discussions about leadership development and succession. It will be more likely to focus on how well management has led the company’s performance relative to plan and competitors, how compensation plans can be designed to support company strategy, and how to protect valuable executive talent that might be coveted by the competition. At every one or two committee meetings, for instance, the group would be expected to have in-depth discussions about where the company needs to go and the resulting leadership implications. Then the committee would spend time determining how the current management team lines up with the leadership requirements, who the most promising talent is at various levels of the organization, how this talent compares to external benchmarks, what experience and skill gaps are present, and what the right development plans are to fill the gaps.
VC Dispatch has some fun with the old quote about The Golden Rule: he who has the gold makes the rules. But they also ask: who has the gold?
We’ll second that with our own twist on an old quote: “The fate of control is that it always seems too little or too much.” When term sheet negotiations turn to the topic of control, the cliche is that VC firms may ask for too much while entrepreneurs are inclined to offer too little.
Getting this piece right isn’t so much about control as it is about chemistry. If VC-CEO partnerships are like marriages (as is often said), then the issue of control needs to mirror that of a healthy marriage. It’s not about 100% control, or even 51% control – it’s about playing to each others’ strengths and making the concessions and adjustments that a given situation demands. One spouse may be better at particular types of decisions, the other at handling certain types of tasks. At other times an issue will just be more important to one than the other. It’s hopefully a long term relationship, and so over time you each learn when to take your shot and when to pass the ball.
From VC Dispatch’s Who Has The Gold To Make The Rule – VC Or Entrepreneur?:
Twitter Inc. as an example of a start-up that has brought in more business acumen to help it craft a business model. Indeed, Twitter co-founder founder Biz Stone said at the conference that the inclusion of more business-minded people was an essential factor in the acceptance of $135 million from investors this year. Twitter’s investors have been careful not to intervene too much, but with that big investment there is now more pressure for the executives to deliver a working business model.
For Jeff Glass, a managing director with Bain Capital Ventures, the debate over power has defined much of his career as he was a business founder and entrepreneur long before joining Bain. And, in wrestling between needing money and wanting control, he said the steps being taken at first meeting shouldn’t be taken lightly.
“A huge part on both ends is just personal chemistry between management and board; board and CEO; investor and management,” said Glass. “But being on this end now, I would advise to spend more time diligencing the VC or PE firm. Everyone’s cash is green until you have a problem.”
Jeff Glass makes a good point above. Entrepreneurs who are raising growth capital (i.e. bringing on a long term partner) as opposed to selling their businesses (i.e. get the best valuation) should invest a lot of time conducting due diligence on their prospective financial partner. A credible partner will let you (indeed, encourage you) to talk to as many of their previous entrepreneur partners as you want to get a feel for what they are like to work with. Entrepreneurs should ask for references from successful investments, unsuccessful investments and current investments. Ask for the venture firm’s entire list of previous and current investments and randomly call a number of them. Find some independent sources on your own who weren’t provided as references but know the venture firm.
Picking a financial partner is as important a decision as any an entrepreneur will make in building his or her company. Most venture firms will have a good “rap”, but it’s absolutely essential to verify that through due diligence:
Establish a solid foundation for the relationship early: Will you share the same vision? Agree on ground rules?
Once the honeymoon is over, will you collectively put forth the constant effort required to sustain the relationship? How will you resolve conflict? Are communications open and largely free of clashing egos? Does the quality of the arguments make the outcomes better? U2 credits their longevity to a “group ego” that “trumps everything else.“
Fred Wilson of Union Square Ventures, in an outstanding post at his blog, describes one key to successful long term relationships: “shtick tolerance“. You don’t have to accept everything about your partner – outside of integrity/honesty – but you must be able to more or less tune some things out over the long haul. You’re patient with their shtick because they’re patient with yours. It’s hard work.
Ballast Point Ventures had a busy November, completing two new growth equity investments: Horizon Data Center Solutions and Tower Cloud. “We are excited to partner with the Horizon and Tower Cloud teams,” said Paul Johan, BPV Partner. “Both companies are focused in rapidly growing industry segments, and we look forward to leveraging our experience and network to help fuel substantial continued growth.”
Horizon Data Center Solutions provides data center co-location services and a suite of high touch managed services primarily to small and mid-sized businesses. Tower Cloud is a leading provider of mobile backhaul services to wireless carriers nationally, with a particular emphasis on the Southeast.
Today’s WSJ reviews Start-up Nation, a book about how a small population can be very entrepreneurial and attract venture capital if it focuses on the right things. Although the book explains Israel’s high-tech success (per-capita VC invested 2.5x that of the US and 6x that of the UK), most of the lessons apply to the economic development efforts of Southeastern states as well:
[Israel has] a “classic cluster of the type Harvard professor Michael Porter has championed [and] Silicon Valley embodies”: the tight proximity of research universities, large firms and start-ups, a talent pool drawn from around the world, and an ecosystem of venture capital and military and other government R&D funding. In addition, they contend, Israel has a unique entrepreneurial culture that combines individualism, egalitarianism (a penchant for organizational flatness) and nurturing.
The authors further speculate on the origins of Israel’s unique entrepreneurial culture.
Where does this culture come from? Mainly, the Israeli military. “You have minimal guidance from the top,” Messrs. Senor and Singer write, “and are expected to improvise, even if this means breaking some rules. If you’re a junior officer, you call your higher-ups by their first names, and if you see them doing something wrong, you say so.” High-school stand-outs are recruited into elite military units and trained intensively, with an emphasis on technology. When they’re done, everything required to launch a start-up “will be a phone call away. . . . Almost everyone can find some connection to whomever he or she needs to contact to get started.” Israel is a country, it seems, where everyone knows everyone.
This description of the mandatory service requirement for every Israeli obviously won’t be duplicated in the U.S., but the principles of building an entrepreneurial culture and the importance of a broader network certainly apply. States in the Southeast that are looking to build a stronger “venture capital ecosystem” would be wise to study the factors that have made Israel a leader in venture capital investment and not focus too exclusively on simply increasing the amount of investment capital available (though that is obviously a critical piece of the puzzle).
This article by Jason Zweig from the 11/13/09 Wall Street Journal echoes one of our favorite books. Although this article focuses mostly on stock-picking, we believe the phenomenon of “the confirmation bias” affects all types of decisions and agree with the quotation from Staley Cates at Longleaf Asset Management that “a lot of psychological traps can be combated with humility, but [not this one].”
The tips below for fighting the confirmation bias are good ones and resemble some of the approaches we take when considering a venture capital investment. Assessing the probabilities for various levels of success and failure will never be an exact science, but that discipline helps focus us on the spectrum of outcomes and better understand the risk-reward tradeoff in a particular investment.
As part of that exercise, like the author suggests, we try to imagine various failure scenarios and what set of circumstances would lead to them which should make for more accurate probabilities on our spectrum of returns. The truth is, experienced investors are humble enough (and have the scars to prove it!) to know that any investment has the potential (statistically speaking) for a bad outcome and a good outcome. The key is to try to design an investment process that allows (over the course of an entire portfolio of investments) for a better probability of good outcomes than bad!
How to Ignore the Yes-Man in Your Head
A mind is a terrible thing to change.
You decide gold is a good bet to hedge against inflation, and suddenly the news seems to be teeming with signs of a falling dollar and rising prices down the road. Or you believe stocks are going to outperform other assets, and all you can hear are warnings of the bloodbath to come in the bond and commodity markets.
In short, your own mind acts like a compulsive yes-man who echoes whatever you want to believe. Psychologists call this mental gremlin the “confirmation bias.” A recent analysis of psychological studies with nearly 8,000 participants concluded that people are twice as likely to seek information that confirms what they already believe as they are to consider evidence that would challenge those beliefs.
Why is a mind-made-up so hard to penetrate?