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Category Archives: Venture Capital Industry
On this day in 1906, the Wright Brothers were granted a patent for their “flying machine.” In honor of the anniversary, we reprint this – one of our most popular, most-read pieces.
(Original publish date: April 17, 2013)
The process of productive capital allocation is a critical ingredient of innovation and job growth. Entrepreneurs spending their own (and their partners’) money will create more jobs, more innovation, and a more vibrant economy than politicians picking winners and losers based on cronyism, campaign contributions, and constituent pork.
When government strays out from funding basic research into either applied research or the means of production, the results range from poor to scandalous. Ideas are infinite, and in the absence of competent execution, they are worth nothing. Even if the idea has merit, the true expertise is crowded out. There are better ways policymakers can help encourage innovation.
The invention of the airplane provides an excellent example. While we’re all aware it was the Wright Brothers, many interesting details about funding the innovation don’t make it into school textbooks. In A Tale of ‘Government Investment’ Lee Habeeb & Mike Leven recount the race between the bicycle shop owner/operators and the government-backed head of the Smithsonian.
Who better to win the race [to powered flight] for us, thought our leaders, than the best and brightest minds the government could buy? They chose Samuel Langley. [The War Department gave Langley $50,000, an enormous sum at the time, which The Smithsonian augmented with taxpayer funds of its own.] You don’t know him, but in his day, Langley was a big deal. He had a big brain and lots of credentials. A renowned scientist and a professor of astronomy, he wrote books about aviation and was the head of the Smithsonian. It was the kind of decision that well-intentioned bureaucrats would make throughout the century — and still make today. Give taxpayer money to the smartest guys in the room, the ones with lots of degrees. They’ll innovate and do good for us.
For that Solyndra-type investment the country got the “Great Aerodrome,” which “fell like a ton of mortar’ into the Potomac River – twice. Representative Gilbert Hitchcock of Nebraska remarked, “You tell Langley for me that the only thing he ever made fly was government money.”
Nine days after that second failed test flight, a “sturdy, well-designed craft, costing about $1000, struggled into the air in Kitty Hawk.”
How did two Ohio brothers accomplish what the combined efforts of the War Department, The Smithsonian, and other people’s money could not? The authors cite James Tobin’s To Conquer the Air: The Wright Brothers and The Great Race for Flight (2004) to provide a few answers:
- Langley saw the problem as one of power: how to go from zero to 60 in 70 feet, the stress of which was too great for the materials used. The Wright Brothers, inspired by the practical skills and insights gained from tinkering in their bike shop, understood the problem was one of balance (on a bike, balance+practice = control). They invented the three-axis control (pitch, yaw, roll) still standard on fixed-wing aircraft today. Their entrepreneurial technical expertise was an advantage neither the government nor other private competitors (Alexander Graham Bell) could match.
- Since they couldn’t afford repeated test flights the Wright Brothers were forced to develop a wind tunnel to test their aerodynamics. This saved money and time, since they weren’t bogged down repairing the wrecks of a flawed design.
- No government money also meant no government strings. They were freer to experiment and innovate without worrying about non-essential requests and hidden agendas. They also managed to do more with less since they couldn’t afford subsidy-induced waste.
Habeeb & Levin also offer this fascinating, if not unexpected, coda:
Though the Wrights beat Langley and the Smithsonian, the race didn’t end there. Powerful interests vied for the patent to this revolutionary invention and, more important, for the credit for it. With Smithsonian approval, a well-known aviation expert modified Langley’s Aerodrome and in 1914 made some short flights designed to bypass the Wright brothers’ patent application and to vindicate the Smithsonian and its fearless leader, Samuel Langley.
That’s right. The Smithsonian’s brain trust couldn’t beat the bicycle-shop owners fair and square, so they used their power to steal the credit. And then they used their bully pulpit to rewrite history. In 1914, America’s most esteemed historical museum cooked the books and displayed the Smithsonian-funded Langley Aerodrome in its museum as the first manned aircraft heavier than air and capable of flight.
Orville Wright, who outlived his brother Wilbur, accused the Smithsonian of falsifying the historical record. So upset was he that he sent the 1903 Kitty Hawk Flyer, the plane that made aviation history, to a science museum in . . . London.
But truth is a stubborn thing. And in 1942, after much embarrassment, the Smithsonian recanted its false claims about the Aerodrome. The British museum returned the Wright brothers’ historic Flyer to America, and the Smithsonian put it on display in their Arts and Industries Building on December 17, 1948, 45 years to the day after the aircraft’s only flights. A grand government deception was at last foiled by facts and fate.
As for Samuel Langley, he died in obscurity a broken and disappointed man. Friends often noted that he could have beaten the Wright brothers if only he’d had more time — and more government funding.
Some things never change.
The Wright brothers’ airplane business never took off (groan) due to a combination of poor business decisions and sloppy patent work. Wilbur sadly died young (in 1912 at age 45, of illness that some suspect was contracted due to exhaustion from the patent battles) and Orville sold the company in 1915. So the industry grew under the leadership of other companies and other men. (Although the Curtiss-Wright Corporation remains in business today producing high-tech components for the aerospace industry.) One can’t help but wonder what the original inventors might have done had they been the beneficiary of a strong partnership with a VC fund…
We have written from time to time on the question of which legal structure is best suited to private growth companies looking to raise outside growth capital. Not surprisingly, there is no one right answer to the question, but recent tax legislation should compel entrepreneurs to give serious consideration to the C-corporation structure.
This article in last week’s Business Observer contains important news about the potential tax benefits of a C-corporation for entrepreneurs and their investors.
However… just as people shouldn’t decide to have children for the tax benefits, we advise founders to not view tax considerations in a vacuum when choosing the legal structure for their businesses. They need to think hard about the long term goals for the business and seek expert advice on the optimal legal structure.
The author of the article (Pamela Schuneman, C.P.A.) first argues that the prospects of federal tax reform may tip the scales towards choosing a C-corp:
Now, with tax reform on the horizon and a push to lower the corporate tax rate, current tax savings on C Corporation earnings could be substantial if the corporate rate drops to 15% and the top individual rate only drops to 33%. That’s an 18% difference — $18,000 more on $100,000 of income.
It’s a little more accurate to say the corporate rate drops “closer” to 15%, which compares favorably to an LLC structure where investors are taxed at their individual income tax rates on income that is “passed through” to investors.
Next she explains that a 1993-era tax provision governing a type of capital gains, originally scheduled to expire at the end of 2010, has been made permanent. And this change, in our view, is a potential game changer.
The gain exclusion for Sec. 1202 was originally set [now made permanent – ed] at 50% for stock acquired [in private C corps – ed] on or after Aug. 11, 1993, increased to 75% for acquisitions after Feb. 17, 2009, and expanded to a full 100% exclusion for acquisitions after Sept. 27, 2010.
The 2010 law also removed of one of the main drawbacks of this tax provision – the alternative minimum tax preference.
In a nutshell, Sec. 1202 allows taxpayers (other than corporations) to exclude from federal income tax 100% of the gain from the sale of qualified small business stock (“QSBS”). The amount of gain excluded is limited to the greater of $10 million or 10 times the adjusted basis of the investment.
There are requirements to qualify for the tax break, which we outline below. But first we’d like to share one more excerpt from the article to emphasize the importance of this legislation to founders and their investors:
For example, Tom and Jane decide to start a software development business. They purchase stock for $10,000 each and have a 50-50 ownership interest in the C Corporation. The stock is eligible for Sec. 1202 treatment if held for five years. In six years, they sell the stock of the company to Google for $10 million. They each have a $4,990,000 gain on the sale of the stock and their tax on the transaction is zero.
Of course we see this as a positive development for the high-growth companies responsible for all net job growth in our economy. Reasonable people will disagree on what tax rates should be. But can we at least agree that there are some forms of investment activity which promote economic growth, and that those forms ought to be encouraged, perhaps with favorable tax treatment?
RELATED STORY: Warren Buffett and after tax returns
If a company’s stock is qualified small business stock (QSBS) then the Internal Revenue Code (§1202) provides a tax break on the equity investments. To qualify as QSBS and for the 0% federal tax rate on gains from the sale of QSBS, the following requirements must be met:
1.) Original issue. The taxpayer recognizing the gain must be an individual, partnership, S corporation or estate and must have acquired the stock at original issue from a US domestic C corporation.
2.) Five-year holding period. The taxpayer must have held the stock for more than five years prior to selling the stock.
3.) After September 27, 2010. The taxpayer must have acquired the stock at original issue after September 27, 2010, in exchange for cash, property other than cash or stock, or services.
4.) $50 million Gross Assets Test. The aggregate gross assets of the corporation that issued the stock cannot have exceeded $50 million at the time of (including immediately before and after) the issuance of the stock to the investor.
5.) Active Business Test. During substantially all of the taxpayer’s holding period of the stock, at least 80% of the issuing corporation’s assets must be used by the corporation in the active conduct of one or more qualified trades or businesses. (Certain types of businesses, including some pure service businesses like consulting firms or doctor practices, don’t qualify, but many businesses do.)
6.) No significant redemptions. The issuer of the stock must not have engaged in specific levels of buybacks (redemptions) of its own stock during specified periods (typically one year) before or after the date of issuance of the stock to the taxpayer.
The amount of gain eligible for this 0% rate is subject to a cap, however. Section 1202(b)(1) states that the aggregate amount of gain for any taxpayer regarding an investment in any single issuer that may qualify for these benefits is generally limited to the greater of (a) $10 million, or (b) 10 times the taxpayer’s adjusted tax basis in the stock. For a taxpayer who invests cash in the QSBS, basis would generally be equal to the cash purchase price.
Like all issues tax-related, entrepreneurs need to consult with their tax counsel and accounting firm to determine if their businesses qualify for QSBS status. If a business does qualify, an entrepreneur must decide whether these potentially significant tax savings outweigh other considerations. In our view, Congress has now put its thumb on the scale firmly on the side of choosing the C-corporation structure.
PowerDMS, an Orlando-based portfolio company of ours, has received widespread local and national news coverage for its efforts to help the Baltimore Police Department ensure officers see, know, and implement critical policies in critical moments.
Here is the story in the Orlando Sentinel, which includes an interview with PowerDMS CEO Josh Brown.
National print coverage included stories in The Washington Post and The Baltimore Sun; national television coverage included ABC News (“…the department will use web and smartphone applications to help make sure officers read and understand new rules.”) and Fox News (“Baltimore police to use apps for new policies.”)
Baltimore PD’s press conference included a 15-minute live demonstration of PowerDMS, run by the customer. The local CBS Affiliate has footage of that press conference here. (Scroll to the bottom of the story.)
This story is also an example of one of the best things about our business: one of our companies doing well by doing good. While this happens often, it rarely is highlighted so clearly (and broadly!).
In Paradox of the Power Law in Venture Capital, Ho Nam urges entrepreneurs to do their homework on their potential financial partners:
The track record of VCs is overwhelmingly skewed by a tiny handful of winners. However, as an entrepreneur, if you try to assess the reputation of VCs by only looking at home runs, you may get a skewed view.
In good times, investors will be supportive. However, how will they behave during bad times? Even great companies go through ups and downs. If your startup is not one of the big winners (which is likely, based on probabilities), how will your VCs behave? Will they abandon ship, or worse, will they turn negative or downright hostile?
VCs check references before making investments. Entrepreneurs should do the same and check references before taking VC funding. It is critical to talk not only to winners but also to the long tail companies—you will have plenty to choose from… There will be skeletons in every VC closet (disgruntled entrepreneurs) so be realistic in how you assess VCs and what they can do for you… some VCs will work with companies to the end, treating people fairly and with respect. Some VCs will not. You’ll get a much better sense for this when you talk to the long tail.
We gave the very same advice to entrepreneurs a few years ago in Due diligence – mine, yours, and ours.
(M)ost firms will have a good ‘rap’ so it is absolutely essential to verify through your own independent efforts that the partner you choose will be a good fit.
The entrepreneur-VC partnership is a long term one, with shared skin in the game, and so the incentive is to communicate good news and bad to communicate good news and bad forthrightly and in real-time, with both partners promoting transparency and honesty promoting transparency and honesty. That begins during due diligence, when it’s critical to resist the implicit pressure to sugarcoat the negative, and carries through to what legendary venture capitalist Bill Draper calls the “Oh sh- meeting.” calls the “Oh sh- meeting.”
We encourage all our prospective entrepreneur partners to speak with as many of our current and former entrepreneurs as possible – some successful, some less so – in order to get a feel for what we are like to work with in good times and when challenges arise.
Innovation was once a dirty word because it upset the established order; now the word is a form of high praise. It’s also, as we’ve often argued, the source of virtually all of the improvements that make our lives happier, healthier, and more convenient.
In The Great Enrichment, Deirdre Nansen McCloskey writes that “contrary to the conviction of the ‘clerisy’ of artists and intellectuals,” entrepreneurs are “pretty good” and responsible for the “gigantic improvement” in life since roughly 1848, when society as a whole underwent “a startling revaluation of the trading and betterment in which the bourgeoisie specialized.”
(T)he modern world was made not by material causes, such as coal or thrift or capital or exports or exploitation or imperialism or good property rights or even good science, all of which have been widespread in other cultures and other times… [and it] cannot be explained in any deep way by the accumulation of capital, despite what economists from the blessed Adam Smith through Karl Marx to Thomas Piketty have believed, and as the very word “capitalism” seems to imply.
The word embodies a scientific mistake. Our riches did not come from piling brick on brick, or bachelor’s degree on bachelor’s degree, or bank balance on bank balance, but from piling idea on idea. The bricks, B.A.s, and bank balances — the “capital” accumulations — were of course necessary. But so were a labor force and liquid water and the arrow of time. Oxygen is necessary for a fire, but it does not provide an illuminating explanation of the Chicago Fire. Better: a long dry spell, the city’s wooden buildings, a strong wind from the southwest, and, if you disdain Irish immigrants, Mrs. O’Leary’s cow.
The modern world similarly cannot be explained by routine brick-piling, such as the Indian Ocean trade, English banking, canals, the British savings rate, the Atlantic slave trade, coal, natural resources, the enclosure movement, the exploitation of workers in Satanic mills, or the accumulation in European cities of capital, whether physical or human. Such materialist ways and means are too common in world history and, as explanation, too feeble in quantitative oomph…
The magnitude of the improvement stuns. Economists and historians have no satisfactory explanation for it. Time to rethink our materialist explanations of economies and histories…
(W)hat mattered were two levels of ideas: the ideas for the betterments themselves (the electric motor, the airplane, the stock market), dreamed up in the heads of the new entrepreneurs drawn from the ranks of ordinary people; and the ideas in the society at large about such people and their betterments — in a word, liberalism, in all but the modern American sense. The market-tested betterment, the Great Enrichment, was itself caused by a Scottish Enlightenment version of equality, a new equality of legal rights and social dignity that made every Tom, Dick, and Harriet a potential innovator.
Precisely two years ago we blogged about a VC Dispatch article on tips for pitching a venture capitalist. The hook was that it would take not 1 but 7 cocktail napkins – Pitch, People, Pain, Product, Players, Projections, Proposition.
In December’s Inc.com Josh Linkner reminds that (in Silicon Valley) “only one in 300 pitches to a venture capitalist gets funded” before offering 11 insider tips. It’s a good, if somewhat cheeky, list with a decidedly early-stage feel: “Don’t take yourself so seriously. We sure don’t! In fact, we’ll probably make fun of you the minute you leave.” (Ouch!) Even so, it does include good advice, like #9:
Tell us the “hard part.” Picking out cool colors for your new digs will be fun, but easy. All businesses have a “hard part”. Getting customers to pay a premium or attracting top talent. We’ll have fun together with the easy stuff, but we want to understand from you what the biggest challenges will be. We can plan the holiday party later.
Yesterday at the Florida Venture Forum Boot camp event at the Citrus Club in Orlando, Josh Brown (PowerDMS CEO), Cathy McKenna (PowerDMS’s auditor for Vestal and Wiler), Jeremy Sloane (PowerDMS’s counsel from law firm Sloane and Johnson), and I had a chance to do a panel discussion moderated by Steve Castino of Vestal and Wiler on the topic of Ballast Point’s investment in PowerDMS in April of 2014 and lessons learned thereafter.
To no one’s surprise, Josh did a great job in laying out the reasons for his company’s success to date and his rationale for choosing Ballast Point as an investment partner. Josh focused on issues of team-building and empowering employees, even mentioning the famous line from the Founders’ Dilemma as he said that he had to make the decision “Do I want to be rich or king?” He made the point that he could have tried to build a lifestyle business where he could have been “king,” but he saw the market opportunity and the company’s positioning and made the conscious decision to build an exciting, high-growth company.
To do that, he needed to invest in his team in a big way and bring on a trusted investment partner who could really help him on the team-building and network side. He had to relinquish some control in order to accomplish these goals of building an exciting, venture-backed company, but he was able to get comfortable with this decision by making a conscious effort on the relationship side to hire people with the highest ethical standards and choose an investment partner that he knew would support the company in good times and in bad.
Josh has let his talented employees flourish in a way that has driven PowerDMS’s growth beyond what he could have accomplished on his own, and that growth has once again landed PowerDMS on the Inc. 5000 list of fastest-growing private companies. We at Ballast Point are thankful that Josh and the team at PowerDMS chose us as his investment partner, as we have joined them on this exciting journey to build a high-growth, SAAS company in central Florida.
For the 2nd year in a row our portfolio company PowerDMS has been named one of Florida’s best mid-sized companies by Florida Trend magazine. (They’re up to #3 this year.)
The news comes on the heels of May’s news that the company had been named one of Central Florida’s 2015 Best Places to Work by Nebraska-based Quantum Workplace, and June’s big event: the company’s relocation to the Church Street Exchange Building as an anchor tenant in the newly repurposed technology hub. The iconic building, built in 1988, was a shopping, dining, and entertainment destination for theme park tourists until the parks caught onto the idea and built their own. The rebirth of “The Exchange” took partial inspiration from how downtown Chicago’s “1871” building became a hub for start-ups.
We’re very proud of what Josh (Josh Brown, CEO) and his team have built, which is, in addition to being a great place to work, a visionary technology platform and the leader in the ECM/GRC (Enterprise Content Management/Governance Risk Compliance) space.
From Florida Trend:
To identify Florida’s best employers, Florida Trend partners with the Best Companies Group, which surveyed firms that chose to participate. Any firm with at least 15 employees in Florida, including firms based outside the state, could participate at no cost.
The first part of the survey involved a questionnaire about company policies, practices and demographics. The second part went to a randomly selected group of each firm’s employees, who responded — anonymously — to 72 statements on a five-point agreement scale.
The survey also included two open-ended questions and seven demographic questions. The questions focused on eight themes: Leadership and planning; corporate culture and communications; role satisfaction; work environment; relationship with supervisor; training and development; pay and benefits; and overall engagement.
The 2015 baseball season is demonstrating that when it comes to untangling the roles skill and luck play in sports and business, luck may play a greater role than we’d like to think.
With technology and best practices so widely and easily articulated and disseminated, the difference between the best competitors and the worst is less than in the past. So a hot stretch of cluster luck can make the difference.
Case in point: so many teams currently hover close to .500, in contention for the 10 playoff births, that the trade market has been slow to develop. Teams can think in terms of limping into the playoffs and then getting hot, and so take longer to choose whether they’re buying or selling assets.
The pre-season projected standings predicted such parity, with only 23 projected wins separating the leaders from the laggards entering this season and only 2 teams projected to finish with 90+ wins. Welcome to MLB’s 2015 Projected Standings, Where Everyone (and No One) Is a Winner:
Projection systems tend to forecast more conservative winning percentages than we’re used to seeing in the final standings. That’s because projected win totals reflect the most common outcomes of thousands or even millions of simulations, whereas a single season, with its wild fluctuations in luck, offers ample opportunity for teams to significantly exceed or fall far short of their true talent levels… As Phil Birnbaum and Neil Paine have noted, there’s an absolute limit to the accuracy of baseball projections. Even if we were omniscient when it came to team talent levels, we wouldn’t be able to predict luck. And luck has large effects: As Birnbaum wrote, “On average, nine teams per season will be lucky by six wins or more.”
It’s not only harder to separate yourself from the pack, there’s also less incentive to do so:
Last August, Birnbaum wrote that in a rational market, an expanded playoff field should make bad teams more willing than before to spend on free agents, and good teams more willing to tighten their belts. “With more teams qualifying for the post-season, there’s less point making yourself into a 98-win team when a 93-win team will probably be good enough,” Birnbaum wrote. “And, even an average team has a shot at a wild card, if they get lucky, so why not spend a few bucks to raise your talent from 79 games to (say) 83 games, like maybe the Blue Jays did last year?” That’s exactly what we’ve seen. … (However) as soon as it sinks in that not all “postseason” spots have equal value, teams might start prioritizing division titles over coin-flip wild-card games and aiming, once again, for greatness instead of good-enough-ness.
Somewhat ironically, the team suffering the most from bad luck so far this season is the very same team who invented “Moneyball.”
Billy Beane actually built a competitive team, but one that’s had an absolutely brutal run of luck. By BaseRuns, the A’s have played .596 baseball, good for a 51-34 record that would make them the second-best team in baseball. In reality, though, the A’s are a wildly frustrating 38-47 (.447), leaving them a whopping 13 games behind their expected record. No other team in baseball is more than five games below its BaseRuns-expected record. Oakland is 6-21 in one-run games; that .222 winning percentage would be the worst figure over a full season in 80 years.
The A’s will have more luck in one-run games. And they’ll play more like the .596 team than the .447 team over the rest of the season. If anybody in baseball has faith in trusting that longer view of performance, it’s Beane. The problem, of course, is that they may be buried too far in the standings to catch up.